Global Macro Commentary

…this time for gold.

Gold JUN09: 1-month

Here are a couple charts that show some sign of hope for gold (and silver). The first chart is the dollar index, which looks like it is forming a potential double top. With increasing talk about deflation, a dollar devaluation would be a relief to asset prices denominated in dollars. The second chart is the silver:gold ratio, which looks like it is coming off a stable bottoming pattern. Silver tends to take the lead during precious metals rallies, so it will be interesting to see how silver performs in the coming weeks.

Dollar Index (potential double top with strong divergence)

Silver:Gold (nice bottoming pattern with strong divergence)

It looks like the FT is getting comfortable with pointing the finger at deflation. The last time this country had to fight deflation, FDR devalued the dollar by 40% (and confiscated gold).

It’s been a while since I decided to take a break from trading (why? stop losses, market sucks, busy at work etc.). But I’m still on the lookout for interesting trades. For example, long gold/short crude has been a consistent winner during the past three months of financial armageddon. The trade also looks like it has a bit more to go.

Gold:Crude (I will post a more short term chart soon)

…quite refreshing after so many deflationary days.

Let’s try to understand what may have aggravated the volatility and depth of this week’s “crash”. There is no doubt that we just witnessed panic selling of historic proportion. So what triggered it? Although many institutional investors (Japanese, mutual funds etc.) are cashing out, not all investors are selling assets in fear that the market is going to wipe everyone out. Of course, some are temporarily reducing exposure to hide from volatility and wait for even cheaper valuations. But most importantly, there has been a fire sale of assets in order to meet margin calls and increased collateral demand.

There is a big difference between “selling” (deflation) and “fire sale” (de-leveraging). We are seeing hints of a deflationary phase, but nothing is for certain until the de-leveraging cools off. Many hedge funds are angry about last week’s 100+% margin increases by dealers and prime brokers, and they argue that the inevitable forced liquidations will only create more panic and trigger more margin calls. This shows how extreme the fear of counterparty risk has become in a $52 trillion market where virtually every entity is a counterparty to another entity. So unless capital markets start functioning again, there will be more margin calls, more forced liquidations, and eventually, a cascade of defaults (i.e. credit events). Here’s a scenario to illustrate this point:

1. Big bank X needs to raise cash pronto. X’s share price has come down 26% in the past three days (down 72% ytd) and some of its loan portfolios may have to be written down significantly on a marked to market basis. X has hedged its loan portfolios via CDS’s, but X is worried that the counterparties may not be able to pay up, let alone exist the next day.
2. Big hedge fund Y has had a good relationship with X ever since the “artificial” boom began post-9/11. Y has synthetic exposure to some of X’s investment-grade loan portfolios through a swap agreement with X. Although Y could have invested directly in the underlying assets, the swap with X provided 33:1 leverage. This means Y only had to put down $33 million as collateral for exposure to underlying assets worth $1 billion.
3. X’s valuation model is showing a significant drop in some of X’s loan portfolios, which Y also has exposure to through the swap. This valuation gave X a right under the swap to demand more collateral from Y. X then gives Y a notice demanding more collateral which would reduce the leverage under the swap to 10:1. This means Y has to put up $67 million as extra collateral (usually cash) within a short grace-period (usually three business days) or otherwise default on the swap and potentially damage its reputation among other swap dealers.
4. There is no way Y can post $67 million in cash overnight. Y thinks X is coercing its counterparties to meet its own capital needs. So Y gets quotes on its exposure from other dealers and tells X that its valuation and collateral demand are unreasonable. X does not trust the quotes from other dealers’ models and rejects Y’s demand. X reminds Y that the grace-period expires in two business days.
5. It’s 6pm and Y decides to post the extra collateral. Y also expects there to be more margin calls, so Y instructs its London and Hong Kong offices to force liquidate half of its portfolios. Y also happens to hold a large equity position in big US company Z, and Y’s NY office is preparing to pull the plug on Z. Most other banks and hedge funds face the same problem.

…I hate politicians.

…that I expect/hope to see in the very near future:

Crude rally
NDX rally

Update on 10-3-08: this deflation is kinda getting scary…

Good to be back in the USSRA comrades. I could not have timed my vacation any better.

Like most people, I thought the bailout plan would pass. I checked tradesports.com yesterday morning to see what the forecasting market thought about the bailout plan, and the contract for the bill to pass was trading at a mere 20%. It turned out to be correct…amazing.

I think there’s a good chance that stocks have bottomed for the short to medium term: there’s is too much panic right now.

Gold has held up quite well recently during extreme deflationary pressure. With potential massive reflation underway, it will be interesting to see how gold transitions from a safe haven to inflation hedge…this transition will probably take some time.

The day started off with the stagflation trades taking off pretty hard, but everything reversed on its head during the afternoon. The government is trying to implement a “permanent” solution to this financial crisis with the revival of the RTC created during the S&L crisis. Stocks rallied like crazy in response, and the consensus seems to be that stocks have put in a medium term bottom. Gold is already down $80 from today’s highs, and we may see continued strength from USD. Although the government’s “permanent” solution is bullish for gold, it seems that the panic-driven parabolic movement during the past few days may have been overdone (China loading up?). One thing is pretty clear: the government proposal and the stock market reaction are both INSANE.

From Michael Pettis’ China Financial Markets blog:

The most interesting news this week has been the slew of numbers released earlier today by China’s National Bureau of Statistics. Of these the most eagerly anticipated, CPI inflation for August, was surprisingly good, coming in at 4.9% year on year, which is well below July’s 6.3% and also well below market expectations of around 5.5%. The decline in CPI inflation was driven mostly by declining prices in pork and vegetable oil.

Quite honestly I am puzzled by this unexpectedly low CPI inflation number. Part of me would like to conclude that I have been overly alarmed about the threat of inflation all year, and that inflation is no longer the risk that I always assumed it was. That would certainly be good news, and would give the government greater room for maneuver on the money and credit side, although Mark Williams at Capital Economics says in his research piece today that he actually thinks there is a risk of deflation next year.

But I am still puzzled. Money growth has been so rapid in the past couple of years, and probably credit growth too if you count all loans in the formal and informal banking sector, that it seems very strange that inflation could come down so quickly. Is it possible that the huge decline in stock market prices and the smaller decline in real estate prices have had a correspondingly large impact in reducing money in the system? Or did food prices shoot up so quickly early this year for what were extraordinary reasons, and now as they revert to some more reasonable level of implied inflation they are causing a sharp but temporary decline in inflation. Or could it even be that price controls and other administrative measures (e.g. selling of food stocks) have seriously tainted the CPI numbers? I am not really sure.

Not surprisingly, Bloomberg survey forecasts a drop in US PPI and CPI for August.

In wake of the FNM/FRE bailout, the Congressional Budget Office (CBO) issued a report today that caught the government by surprise:

Given the steps announced by the Treasury Department and the Federal Housing Finance Agency on September 7, it is CBO’s view that the operations of Fannie Mae and Freddie Mac should be directly incorporated into the federal budget. The GSEs’ revenue would be treated as federal revenue and their expenditures as federal outlays, with appropriate adjustments for the manner in which credit transactions (like a mortgage guarantee) are reflected in the federal budget.

The CBO’s suggestion that the government budget should account for FNM/FRE’s $5.4 trillion mortgage portfolio is not surprising (high five Bill Gross!), but I found the CBO’s forecast of the budget deficit and GDP to be quite aggressive (for a semi-government entity).

CBO’s Baseline Budget Outlook

Buzz and banter about the possibility of an Israeli/US attack on Iran has escalated during the past few weeks. There is also an Iran War Resolution that is most likely to be approved in Congress before the fourth of July. I’m not a fear-mongerer (though fear is good for gold and silver), but I do believe that the manner in which this possible war with Iran unfolds will have a significant impact on US markets, and especially politics. With markets puking and a historical presidential election in several months, it will be interesting to see how everything ties in together with the Iran situation (maybe nothing will happen). I decided to maintain an “Iran Watch” update to keep track of anything significant that comes up.

Update on 7/1/08: OK…maybe I got a little carried away here heh~ PEACE

Are we near the bottom of the wheat correction?

Jim has pointed me to a nice chart of VIX. The chart shows how much volatility has come down during the past few weeks. Perhaps this is a sign to buy a little protection.

Good morning. Today’s data indicates that consumer prices in the U.S. were UNCHANGED during the month of February. If I’m not mistaken, energy and commodities prices were surging to historical levels throughout February. Bloomberg news is citing dropping fuel costs as the cause of last month’s CPI, but whatever the cause may be, inflation rate is most certainly NOT unchanged.

Looking at initial market reaction to the CPI data right now, the dollar seems to be slightly bid, as cooling inflation should support the greenback. The yield curve is also flattening. But considering that Fed day is just around the corner, I think the market will interpret today’s CPI data as giving Bernanke more room to cut rates. This should be bullish for both stocks and commodities (extra bullish for mining stocks).

With prices across all assets breaking below key technical levels, we may see some deep sell offs in stocks, commodities, and forex. The notion of a recession seems to have settled within the mainstream, so there is more room to short various markets. The key will be on timing, of course, and a trader who is short the market should not be faked out by sharp intra-day rallies. The biggest challenge, however, is choosing the right moment to cover and go long. A market reversal to the upside will be hard to time, and highly dependent on action by the Fed (forget about fiscal stimulus). Good luck everyone.

1. Fed funds rate: 3%
2. Crude: $125
3. Gold: $1,100
4. Silver: $22
5. Nikkei: 22,000
6. My weight: 155 lbs
7. Google: $900
8. China (FXI): $400
9. Beer 6-pack: $20

HAPPY NEW YEAR!!!

After news of Bhutto’s assassination sparked a rally in gold, crude, and bonds, we saw lower than expected durable goods orders and higher than expected consumer confidence numbers, providing a mixed view of the U.S. economy. Considering the seasonally low volume across all markets (happy holidays!), I must assume that any market movement right now is just noise. I don’t know why I’m looking at markets when I should be getting wasted instead!

For those following the gold market, the ultimate question has been whether the current triangular formation will result in a breakout to the upside or the downside. Indeed, the two-month consolidation in gold is very near its end, and we will probably see a breakout by the end of the year (or early January). Considering the recent dollar rally, along with seasonal factors supporting the dollar during the months of December and January, I have been anticipating a breakout to the downside for gold: a drop to $760-$775 would be a great buying opportunity for gold’s ultimate ride to $1,000 and beyond. During the past week, however, gold has seen a strong rally from $790 to $830.

Although the triangular formation for Feb. Gold futures (shown above) seems to be intact despite the current rally, other gold charts such as GLD and Gold EOD (shown below) are showing signs of a breakout to the upside. Such breakout to the upside, however, should be dealt with caution. This is mainly because the current rally has not been supported by volume. I would expect a breakout from a two-month consolidation to be confirmed by well-above-normal volume, but this is not the case.

So…with the consolidation near its end, is gold going up or down? I think gold will cool off from its current rally (perhaps we will see positive durable goods and consumer confidence numbers today), and eventually break to the downside during the first week of January when we get an onslaught of economic numbers: manufacturing, FOMC minutes, employment, ECB rate decision. If not, we should see gold shoot above $850…hopefully with some strong volume!

The chart below (March EUR) really sums it up. Once again, the Economist cover contrarian trade prevails. With models and rappers talking up the euro, a dollar counter-rally makes sense. Euro has sold off to my initial estimate around $1.43 (post below), and it may continue to sell off, pending future data. But I’m expecting not much action until year-end, at least not until we get US payroll data and ECB rate decision during the first half of Jan. 2008.

Yesterday we got big retail numbers and the dollar rallied hard, causing euro, gold, and silver to sell off. Today’s inflation numbers diminished rate cut expectations, and intensified the dollar rally. Although the Fed has dropped its previous language of balance between growth risk and inflation risk, the Fed has not given the market a clear signal that it will give priority to growth risk. Instead, the Fed has unveiled a new plan to soothe global liquidity problems. The response from the stock market was temporarily bullish, but short lived as doubts were raised as to the plans novelty and its ability help resolve the real underlying issues of inter-bank liquidity: housing and credit crisis. What we really need is for the Fed to break out of its “gradualism” and be more aggressive. Of course, the Fed will eventually have to resort to aggressive measures…it’s just a matter of time before we see more pain in the US economy.

In the meantime, looking at the euro, the big question is how far will it drop. My guess is around $1.43, and then I think it will range until early next year, or at least until we see more pain in the US.

Weakness in the European economy, especially the money market, seems to be intensifying. Yesterday’s global central bank coordination announcement revealed more serious liquidity problems (or as some say, insolvency) among banks in Europe. So I think this announcement may have created more fear, at least in Europe, rather than soothe the markets. Consequently, the euro is currently under a lot of pressure (shown below), which is also having an impact on gold and silver. Despite yesterday’s rally, sparked by the Fed’s new plans for capital injection, it is important to remember that the Fed still disappointed market expectations concerning the fed funds rate. A euro sell-off may very well bring gold and silver down to $760 and $13.5. Retail sales are expected to come out strong, while inflation numbers are expected to come out high. So watch out for a sell-off in euro, gold, and silver!

With inventory numbers coming out today, I need not explain how important they will be for crude: just look at the chart below. I think crude has bottomed, and a clear break above 90.625 would be very bullish. We may very well see $100 traded by the end of the month.

First, a comment on yesterday’s Fed decision: what were they thinking? Ohhh…so this is what they had in mind: a new money pumping machine! Indeed, markets have reversed sharply overnight.

An important debate in recent weeks has been whether gold would correct to $780 or break below $780 to pre-October levels of $740-$760. Similarly, traders debated whether silver would correct to $14 or break below $14 to pre-October levels of $13.25-$13.50. Indeed, the recent volatility in the gold market (silver has been less volatile, surprise) has made it impossible to find a clear direction. Two weeks ago, gold went from $780 to $845, and then back down to $780 in just matter of ten trading days!

Despite all the noise during the past month, gold and silver seem to have slowly consolidated above $780 and $14. I think we will see a rally to re-test November highs.

One caveat would be the the impact of the euro on precious metals, as investors see gold as a hedge against weakening dollar. Both the dollar and the euro are depreciating due to excessive money supply, and the euro/dollar exchange rate has become a function of which central banks inflates the most. So precious metals should eventually decouple from its relationship with euro/dollar, because gold has been, and will continue to, appreciate against all major currencies. For now though, it seems like the recent dollar rally has come to an end (shown below).

Stocks sold off yesterday on diminished rate cut hopes, and precious metals also experienced selling pressures. While silver futures sold off all the way to 14, gold futures held steady at 790. I have been silver-biased for a while (perhaps because I was long silver during its parabolic rise in early 2006), but after experiencing a blow to my pnl yesterday, I acknowledge that gold is better. Silver may tend to outperform gold during strong rallies, but silver is more volatile and vulnerable during times of risk aversion in the markets (like right now: look at bonds). Gold has shifted gears to acceleration mode (chart below), and interestingly, the start of the new uptrend line coincides with the 10/19 stock market sell off. Don’t forget that the Fed has cut 75 bp in the past six weeks, and there is still a lot more reflation to go. Everybody is talking about $100 crude, but it won’t be long before we hear $1000 gold in the media.

Good morning. Today is Fed day, and the markets have taken some risk off the table during the past two days. Crude, gold and silver saw a sharp sell off as traders took profit ahead of Fed day. My positions were also stopped out, but I did notice that euro/yen and nzd/yen were not budging. Let’s also not forget that reflation is still in tact. A positive market reaction to the Fed today will probably send bond prices to 111-112, while gold will break above 800. There is a lot of talk about how the Fed must meet market expectations (futures predict 95% of 25bp cut), and we will most likely see a 25bp cut. If the Fed doesn’t meet market expectations, things could get really nasty.

The key issue right now is whether the housing virus is spilling into the broader economy. Weak earnings in manufacturing (domestic) and financials are indicating a possible spillover. Although the employment situation seemed pretty positive last month, it may be only a matter of time before employment numbers break lower. Despite this ongoing debate about a possible recession, tech stocks have outperformed the dow/s&p since the subprime crisis came to light. Also, look at the bottom graph to see how the nasdaq is still very undervalued relative to the dow. Compared to the late 90’s, technology in many sectors (consumer, internet, alternative energy, healthcare etc.) has advanced dramatically (also increasing global market share), and it will be interesting to see how tech stocks weather through increasing U.S. recession pressures. Last week’s Google earnings and today’s Apple earnings are bullish for tech stocks.

[NDX/INDU: 2-year chart]

[NDX/INDU: 10-year chart]

On the 20th anniversary of Black Monday (10/19/87), stocks sold off sharply, fueled by renewed recession fears. Consequently, the yen traded to pre-fed rate cut (9/18) resistance of 113 as carry trades were unwound. Although a more dovish BOJ may help sustain the carry trade against the dollar, possible spillover of the housing correction into the broader economy will force the Fed to keep cutting borrowing costs and put more pressure on the dollar. Fukui was hawkish at the G7 meeting this week, but his comments seem to conflict with the IMF’s view (slowing growth and deflation) of the Japanese economy. Fukui was probably bluffing as usual.

[Dollar/Yen spot: 5-month chart]