We decided that it was worth sharing our views of the inflation/deflation debate with all of our readers.  In our weekly newsletter we are already positioned to take advantage of some of the current as well as potential trends that will benefit from our scenario.

The following are our views on different parts of the puzzle that show that we are currently in, and will likely be experiencing deflation for longer then most people seem to think.

Savings-

Here are some interesting, and unfortunately not surprising, savings rate numbers.  The current savings rate is 5.7%, the all time high in 5/1/75 was 14.6%, the all time low was in 8/1/05 with a savings rate of -2.7%, the historical average is 6.8%, and the 10-Year average is 1.7%.  As you can see in the chart the past year has seen a huge uptick in the savings rate as consumers are trying to pay off debt and save some money.

Personal Saving Rate

Of course as savings go up spending goes down.  While this is good for the individual household it is a negative for the overall economy as it means less money is being spent on items from housing to cars to clothes.  While this could just be an abnormal blip in the scheme of things there are several reasons to think that this time the trend will hold for a while.

Baby boomers as a group don’t have anywhere near the funds to retire.  After 2008 wiped out 42% of the worlds wealth they should be scared and saving for their rapidly approaching retirements.  Once the economy starts to pick up they may very well start spending like it was 1999 again but we don’t think that they will because while most people are ok with the idea of working a bit past the age of 65, they do not plan on working into their 80′s and 90′s.

If the savings rate gets back up to the historical average of 6.8% or higher and then stays there for a while, it will be a huge drag on the economy. As consumers buy less and less, pricing will likely come down.  We are already seeing this in the form of huge sales in stores across the nation.  Many retailers have already had several markdown sales and it is safe to assume that this trend will continue for at least the next year or so.  If our projections are right and the savings rate gets back to “normal” we will likely see a re-pricing as most businesses just accept that fact that their profit margins will be smaller going forward.

Housing-

The monthly proclamations of a bottom by the NAR notwithstanding we have yet to see anything resembling a bottom in real estate. The Case Shiller 10-City index is down 33% from its peak and the 20-City index is down 32%.  Both charts look the same, which is to say each month is lower then the last month.  So far there has been no bottom.

Case Shiller 10-City Index

Not surprisingly housing sales numbers don’t look much better.  In spite of the monthly bottom calling we continue to see more new lows every few months.  As you can see in the chart below we are just off of new all time lows since the data series started in 1963.

SA Housing Sales

Zooming in a bit you can see that while we have had several blips over the last few years none of them have lasted for more then a few months and all have led to new lows. Our best guess is that we are headed lower in the next few months.

SA Housing Sales-A Closer Look

As if residential housing was not enough, the commercial real estate market is playing catch up.  Residential peaked in June 2006 and commercial held up until October of 2007.  Since October of last year however commercial has made a valiant effort to catch up and is now down -29.48% since then.  In fact from March to April alone it dropped -8.62%.  If real estate has found at bottom it is keeping its location secret because none of the data that we have seen points to it.

Moody’s REAL Commercial Property Price Index Composite(CPPI)

Of course you may be thinking that there has to be some commercial real estate that has found a bottom.  This may be the case on a geographic basis but it is definitely not the case when it comes to segments of the commercial market.  As you can see in the chart below industrial is the strongest part of the market and yet it is still down -14.26% from its highs.  Apartments are next being down -19.01%, followed by retail which is down -23.11%, and finally office space which is down a whopping -30.22%.  Judging by the massive drop this last quarter it is safe to assume that we have a ways to go before we really hit the bottom.

Moody’s REAL Commercial Property Price Indices

Employment-

In case you haven’t noticed employment has been horrible and getting worse.  One of the newest “in indicators” is the exhaustion rate.  While this indicator is not new it has luckily not garnered much attention over the years because it only gives a real signal once or twice a decade.  The exhaustion rate is the rate at which people come off, or exhaust, their unemployment benefits without having securing a job.  Why is this the “it indicator” right now?  Well if you look at the chart below you can see that we are not only at all time highs but are actually at 49.23%.  Yes, that means that almost half of the unemployed are done receiving unemployment money.  That of course leads to even less money to spend on anything.

Exhaustion Rate

After looking at the exhaustion rate chart it should come as now surprise that unemployment is high.  In fact it is at its second highest level ever at 9.4%.  As bad as unemployment is right now, it is going to get worse before it gets better.  We will likely hit at least 11% ,and we would not be surprised to see 12-14% unemployment before jobs data bottoms out.

Unemployment Rate

At this point it should not be much of a surprise but as you can see in the chart below, average weekly hours and non farm payrolls data are also both declining on a year over year basis.

Average Weekly Hours and Non Farm Payrolls

So how does all of this effect deflation?  If people are not working then they are not able to spend as much on consumer goods and services.  That includes clothing, food, entertainment, transportation, etc.  If they stay unemployed long enough and fall off of their unemployment benefits then they are able to spend even less.  Along with the lack of, or at least severely impaired, spending power there is a host of other side effects, which includes everything from defaulting on credit cards to defaulting on their mortgages.  As consumers spend less, businesses have to lay off more employees as sales drop off and margins are squeezed with exacerbates the situation.  One consistent relationship is that of the unemployment rate and capacity utilization.  As unemployment rises, capacity utilization drops as demand falls out.

Unemployment and Capacity Utilization (inverted)

If there is no demand then there is no spending.  If no one is spending then there can be no inflation.  If things are contracting then we are in deflation.  One more indicator that shows this is that of the output gap. The output gap is the difference between the amount that we can produce and the amount that we are currently producing.  In the chart below a positive number indicates under-utilization, and negative numbers reflect over-utilization.  If the line is rising things are getting worse and if it is declining things are improving.  As you can see the line has risen quite a bit and at least for now is showing no signs of turning around.  The output gap is a good indication of available demand.  As you can see. the output gap is bad and getting worse as demand continues to decline.

5-Year Output Gap

Banking-

While we could go on and on about banking we will try and keep it short.  Most people are pointing to the charts from the Fed on bank reserves and saying that they will cause hyper inflation.  Yes, the monetary base is at historic highs but guess what?  Until that money is actually in circulation it does not cause inflation.  You can print ten quadrillion dollars but if you bury it in a hole then it does not cause inflation.

Look at the chart below of the Adjusted Reserves.  As you can see it is at record high levels.  While it is extremely high it is not in circulation yet and likely will not make it to consumers for some time.

Adjusted Reserves

This number is extremely high due to all of the money that has been printed over the past year in response to the financial crisis.  But the inflationistas are missing one important point, namely that until banks have rebuilt their reserves they will not be lending.  As long as residential and commercial mortgage defaults continue banks will continue to rebuild their balance sheets.  Once they have a stable asset base they will start lending and we will likely see some really high inflation but until then we will be in a deflationary environment as the money is not being put into circulation.

Commodities-

Commodities are another reason that many use to justify their inflation arguments.  After having a good bull market from the end of 2002 until fall of 2007, they took off and got a bit parabolic for the first half of 2008 before crashing and coming back to levels not seen since 2002. Of course as anyone who has filled up their gas tank knows, commodities have started to climb once again moving from 200 up to 250 from the March lows.

Commodity Research Bureau Index

The rise has been widespread with energy, base metals, agriculturals, and even precious metals rising considerably.  Aside from precious metals it appears as though the primary reason that we had such a strong rebound was due to buying out of China.  In the first two quarters of the year the Chinese government decided to use some of their surplus to buy raw materials.  They bought a lot of copper, secured oil contracts, and stocked up on everything else.  Now it appears as though their buying is slowing to a trickle of what it was and with the run up in prices they are taking a break as they will likely get to buy more at lower levels.

While the buying out of China may help commodities put in a bottom, it does not appear as though it will drive them much higher.  With the possible exceptions of precious metals and energy we see most commodities turning in flat to slightly negative results for the rest of the year.  With the demand destruction that we have seen over the past year commodities have a tough road ahead of them before they will be able to climb higher.

Deflation-

So where does all this leave us?  Demand has been absolutely crushed on several fronts:  People are finally saving and paying down debt instead of spending.  Real estate is still falling, and with inventories as high as they are, will likely not fully recover for years.  Employment is as bad as at any time in the Post WW2 era.  Banks are still impaired and unable/scared to lend.  And with all this demand destruction commodities are unlikely to continue upwards for a while.

Finally there is the matter that while we can speculate on inflation we are currently in deflation as can be seen in the chart below of the CPI.  We have officially been in deflation for the last three months and while it might slowdown a bit we will likely stay in a deflationary environment for longer then most people think.

CPI-YoY % Change 1922-Now

What are we doing?

So if we believe that we are in deflation what do we do about it?  The best deflation trade that we have found is to be long bonds.  As we stated in our last blog post as well as the last few newsletter we are long TLT-20+ Year Treasury Bond ETF.  Not only are we in deflation but the trade was decent on its own merits.

Real yields on Treasury bonds at the end of May were at their highest levels since February 1995 and right now they are at 4.76% for the 10-Year and 5.58% for the 30-Year.  In an environment where we expect most assets to fall or go nowhere, we think that Treasury Bonds offer good value.

10-Year Treasury Bond Real Yield

Treasury bonds got almost as oversold recently as they were overbought back at the end of 2008.  By normalizing the trend using a 200-day moving average we build reversion to the mean charts that show how far above or below securities are from their mean.  In the case of the long bond our charts showed that it was extremely oversold and that it was a good time to start building a position.

TYX-30-Year Treasury Bond Yield Reversion to the Mean Chart

Looking at the chart of the TLT we could see it running up into the 100-105 range over the next month or two as investors take advantage of deflation, the oversold conditions, and the favorable real yield.

TLT 20+ Year Treasury ETF

While the long bond is definitely our favorite deflation trade, it also makes some sense to go long the US Dollar and/or the Japanese Yen as investors flock towards safety.  Other trades would be to short stocks and short commodities in anticipation of them falling as demand continues to decline and margins shrink.

And what about inflation?  We actually do believe that eventually all of this printed money will lead to some hefty inflation but right now we are in deflation.   Additionally the inflation trade is  the most overcrowded and one sided trade in the financial markets right now.  If we are right we will do well, and with the aid of risk management if we are wrong we will be stopped out for a small loss.

Happy Trading,

The Macro Trader

Dave@TheMacroTrader.com

Disclaimer-We currently hold positions in TLT

If you’re getting value out of our posts, you can do us a favor by linking to us and mentioning The Macro Trader to friends and co-workers. Here’s the link information for this article:
Title: Deflation And What We Are Doing About It
URL: http://www.themacrotrader.com/2009/06/27/deflation-and-what-we-are-doing-about-it/

Bookmarks

Long term Treasury yields have been in a 30 year downtrend. As you can see in the chart below we are testing this downtrend line right now.

30-Year Treasury Yield

Why are yields rising?  There are a variety of reasons, each at least partially true.  One of the primary reasons that investors have been dumping bonds as of late is due to the fact that the government has been printing money as fast as ever, and spending it even faster.  This can, and likley will, lead to some strong inflation down the road.  That being said we think that the inflation trade is a bit overdone for now as it appears as though we will be in a deflationary state for at least the rest of the year.

Another major reason that bonds have been selling off is due to the fact that the United States has far more unfunded libailitis then it can hope to pay off without some major dollar devaluation.  While we have years to go before an eventual and inevitable credit downgrade, we think that it is a near certaintly that it will happen.

The last major reason for investors to be selling off Treasury bonds is due to the fact that they yields were simply too low.  Who wants to lend money for 30 years at 2.6%?  In anything less then an all out depression a yield of 2.6% is terrible.  Consequently bond investors started to leave Treasuries,  and have continued to leave as they go into investment grade corporate bonds, junk bonds, and municipal bonds.  This selloff in bonds has of course caused yields to climb higher and higher, finally hitting one year highs.

Due to the violent selling in long term Treasuries we see some potential on the long side.  Yes, long term we are bearish and feel that they have only begun a multi year fall from grace.  But for now they are extremely oversold and we see a solid risk to reward opportunity.

The chart below shows the 30-Year yield, the distance from the 200-day moving average, and both the 1 and 2 standard deviations from the historic mean.  Essentially this chart shows how oversold or overbought yields are in relation to its historic relationships with its 200-day moving average.  As you can see in this chart we have gone from a drastically oversold condition into a drastically overbought condition.  Remember that this chart shows the yield of the 30-Year bonds so it is charted inversely to the actual bonds.

TYX 30-Year Reversion to the Mean

As seen in the long term chart of the 30-Year yield we are right at a 30 year resistance line.  While we will eventually break above that line, for now we are looking for a strong rebound.  Looking at the chart below of the TLT 20+ Year Treasury ETF we have drawn two different lines.  The first line is a short term downtrend line that is right at $96.  The second line is just short of $100 and is a major area of resistance.  Essentially we are looking for a pullback into one if not both of these areas.  In our model portfolio we are already long and are looking to sell if we can hit either of our targets.

TLT 20+ Year Treasury ETF

Happy Trading,

The Macro Trader

Dave@TheMacroTrader.com

Disclaimer-We currently have a position in TLT

If you’re getting value out of our posts, you can do us a favor by linking to us and mentioning The Macro Trader to friends and co-workers. Here’s the link information for this article:
Title: Our Macro View On Treasury Bonds
URL: http://www.themacrotrader.com/2009/06/16/our-macro-view-on-treasury-bonds/

Bookmarks

In our ETF based newsletter, the carry trade is one of the strategies that we employ.  For those unfamiliar with the carry trade, you are essentially trading the interest rate differentials of different countries.  You short a low-yielding currency and go  long a higher-yielding currency.

You can make money in two ways.  You earn the “carry” if the currencies remain very stable, and neither move.  You can also make money in this trade by being correct in the direction.  For instance if you are short the Japanese Yen and long the Australian dollar, then you can also make money if the Australian dollar goes up, and the Yen goes down.

As an example of how to earn the carry, lets look at the Japanese Yen versus the Australian Dollar.  The Yen has been the carry trade vehicle of choice for much of the past decade because Japan has consistently had extremely low interest rates.  Australia, on the other hand, has had relatively high rates over the last decade.

To construct the differential for this trade, take one rate and subtract the other rate. In the chart below, we plot the difference between the AUD and the Yen since the beginning of 2007.  As you can see, at one point the carry was as high as 7.34, but it has since declined to 2.69.  If you had been long the AUD and short the Yen, you would have earned this interest rate differential the whole time.

AUD-JPY Interest Rate Differential

Of course as we already mentioned, in order to make money on the carry trade, your long must outperform or stay flat relative to your short position in order to make money since a big directional move against you will wipe away any gains that you would be making solely off the carry.

There have been several academic studies as well as real world trading results that show that volatility is the biggest risk that the carry trade faces.  Over the years, most studies were stuck using the SP500 VIX as a proxy for global financial market volatility.  While it correlates quite well, there are now some far better options to help track and manage risk in the currency markets.  We at The Macro Trader use the JP Morgan G-7 VIX index for our carry trading model as it correlates extremely well to the volatility in the DBV-Currency Harvest Trust ETF.

What we first found in the academic literature, later confirmed by our own testing and used successfully in our trading, was that when volatility in the currency markets is flat or declining, the carry trade works very well.  On the other hand, when currency volatility is high, the carry trade typically is a money loser because the directional aspect of the trade overwhelms the carry, giving you a loss.

We look at the JP Morgan G-7 VIX using two different charts.  The first one is a reversion to the mean chart where plot the VIX data, the historic mean, then one and two standard deviations above and below the mean.  When volatility is high and then falls below one standard deviation, we start looking to enter the carry trade and when it get above the one standard deviation line we would sell if not already stopped out.  On the downside, we look to sell when volatility declines too much since it represents excessive complacency and usually is a sign of higher volatility ahead.

JP Morgan G-7 VIX

The other way that we like to look at the currency VIX is to invert it on a chart alongside the DBV. As you can see in the below chart, not only was equity volatility declining, but DBV managed to base for a few months before climbing higher and then consolidating at its 200-day moving average.  Finally today it was able to break out to the upside.

DBV and JPM G-7 VIX

Finally we have the DBV itself.  As you can see in the chart below, not only was equity volatility declining, but DBV managed to base for a few months before climbing higher and then consolidating at its 200-day moving average.  Finally today it broke out to the upside.

DBV-Carry Trade ETF

Hopefully you see how volatility is bad for a lazy trade like the carry trade where you trying to get paid for sitting.  If volatility climbs above 1 standard deviation above its mean we will look to tighten our stops as the odds of a downside move increase significantly.

DBV-G-10 Currency Harvest Fund is an ETF that goes long the three highest yielding currencies of the G-10 and shorts the three lowest yielding currencies on a 2x levered basis.  While investors can go into the spot and futures FX markets and put on the same trade the DBV is a very simple way to gain exposure to positive carry in the currency markets.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-We currently hold positions in the DBV-G10 Currency Harvest Fund and FXA-Australian Dollar ETF.

If you’re getting value out of our posts, you can do us a favor by linking to us and mentioning The Macro Trader to friends and co-workers. Here’s the link information for this article:
Title: The Carry Trade And Volatility
URL: http://www.themacrotrader.com/2009/06/01/the-carry-trade-and-volatility/

Bookmarks