We track volatility across asset classes and throughout this year, especially the second half, have been amazed and the consistent volatility compression across assets.  Here is our Average VIX where we take a simple average of several different volatility indices.  Right now we are sitting at levels last seen in mid-2007 and we are struck with the complacency in the marketplace.(Click on chart to enlarge)

Are the potential risks really so small that no one finds it worthwhile to buy protection?  A short list of potential risks would be the sovereign debt issues, fiscal cliff, Europe, Japan, China, Italy, Middle East, etc.,we can almost literally go on forever.  Our current list of risks is as high as it has ever been and yet volatility is getting lower and lower from already low levels.   While the Bernanke put has some power we question whether it is really the holy grail of safety nets.  Just something to think about as we watch European stocks breaking out and US equities moving higher while at the same time Treasuries continue to catch a bid.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

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While not quite as cool sounding as “the most interesting man in the world” the most overvalued currency could actually help you make money.  Interesting doesn’t pay like over/under valuation.  So what is the most overvalued currency in the G-10?  If you guessed the Australian Dollar you win.  Across pairs the AUD is consistently the most expensive currency and has been for a while.

Why is the AUD so overvalued?  They never had a housing crash like in the US and southern Europe, they have strong natural resources, up until this year investors kept believing that China can save all, and last but not least they had the highest short term interest rates in the G-10.  With high relative interest rates the AUD has been the carry trade of choice and consequently has been one of the go to “Risk On” trades since the 2008 crash.  How high have rates been relative to the rest of the G-10?  Below is a chart of G-10 90-day rates. (Click on chart to enlarge)

G-10 90-Day Interest Rates

Combined with the ZIRP or near ZIRP policies in most of the world the AUD has attracted a lot of money looking for yield.  Of course you then have to ask is this yield safe?  Judging from the slowdown in China and the drop in Australian interest rates we question the safety of this trade, of course we question anything that is considered safe.

So how overvalued is the AUD?  Well using PPP-purchasing price parity as our valuation gauge here are a few charts showing how extended it really is. Our first chart is of the EUR/AUD.  Here the AUD is “only” 20% overvalued.(Click on chart to enlarge)

 EUR/AUD PPP

Next up is the AUD/CAD.  Here you would think the relationship would be closer since the makeup of their economies is similar with commodities making up such a large part.  Of course Canada is tied to the US and Australia is tied to China.  Either way the AUD/CAD is overvalued to the tune of 27%.(Click on chart to enlarge)

 AUD/CAD PPP

 Looking at the AUD/JPY things continue to get worse as the Australian Dollar is overvalued against the Yen by 40%.(Click on chart to enlarge)

AUD/JPY PPP

Up last we have the worst case of overvaluation of the group.  The AUD/USD is ridiculous for several reasons but the one we are looking at today is that it is overvalued by over 50%.(Click on chart to enlarge)

AUD/USD PPP

 As you can see by the charts currencies have their share of value fluctuations but like most of finance things are rarely different and it is hard to fight reality forever.  Trading currencies based on valuations is not for the impatient as it can take months and even years for things to come back in line but as evidenced by the above charts once the pendulum starts to swing the other direction it tends to carry it for some time.  With China slowing down and the RBA in a rate easing cycle we think that the pendulum is ready to swing the other way.

*-We deal primarily in G-10 currencies. AUD is not the most overvalued currency on the planet, but is the most overvalued currency in the industrialized world.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-In our model portfolio we are short the AUD

Take a $1 trial of The Macro Trader to receive unbiased actionable research

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Right now we think it highly likely that going forward we see an increase in the rate of economic deterioration.  Europe is already in a mess but the economy in the United States is now showing signs of its last gasp of growth.  One indicator that we track is the Citi Economic Surprise Index.  In the chart below you can see that economic numbers have been coming in very strong for the past few months.  Based upon previous history it is safe to say that we have peaked or are very near peaking and that economic numbers going forward should start to turn lower.

Citi Economic Surprise Index USD and G-10

Not only are economic numbers expected to turn lower but we are also seeing several signs that inflation is dropping.  One relationship that we follow closely is that of the CRB Raw Industrials Index against the SP500.  As you can see in the chart below the two are usually very correlated.  When the industrials are moving higher stocks usually follow and when they turn down stocks tend to do the same.  Right now there is a disconnect, one that we expect to be resolved with the SP500 moving lower.

CRB Raw Industrials Index and SP500

This relationship matters because if inflation moves lower the stock market will as well.  We can see this very clearly in the next chart where we have overlaid the weekly SP500 with the 10-Yr TIPS breakeven rate.  As you can see these have a very tight relationship.  What you can’t see is that this relationship goes back long before the crisis.  When inflation expectations rise the stock market rises and when they fall the market falls.

SP500 and 10-Yr Breakeven Rate

Other signs that inflation is not upon are that government bond yields are hovering around historic lows.  As you can see in the next chart the 2-Year Treasury yield has been low and headed lower.  Despite all the hype regarding hyperinflation we have not seen any of it, and based upon the messages from the bond market we are not seeing it anytime soon.  In case you are wondering we are seeing the same thing farther out on the curve with 10 and 30 year yields also near their lows.

2-Yr US Treasury Yield

Another sign that we have been following is this chart of the Shanghai composite and the CRB index.  As you can see the two indexes peaked within two weeks of each other and have been steadily working their way lower for the past eight months.  As the nation of commodity stockpiling has slowed down so have their stockpiles.  As this huge underlying commodity bid has vanished it has allowed industrial commodities to drop.

Shanghai Composite and CRB Index

Whether it becomes an all out crash, ala 2008, or not is not known but we are confident that the global slowdown will continue.  So what have we done with this view?  In our model portfolio we are short the AUD/USD as we expect the Australian Dollar to move lower as commodity prices and Asian demand continues to falter.  We are short the EUR/USD via options in a trade we placed back in August.  Recently we bought the USD/CHF as we expect the Swiss Franc to weaken considerably from here.  We are also short the SP500 via options and long the Lehman/Barclays Aggregate index which is highly weighted with US Treasuries and investment grade credits.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research.

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One group of indicators that we follow quite closely are yield spreads.  They work as great risk indicators as well as  economic indicators. In the case of junk spreads they tend to lead rather than coincide or lag the overall economy.  One area where they really shine is at the darker end of the economy.  As you can see in the chart below junk spreads tend to lead the initial unemployment claims by anywhere from two-five months.  For the past four months junk spreads have been inching higher and higher as the economy has noticeably weakened.  What does this mean?  Well if the correlation holds up then we would expect initial claims to move higher.  This would go along well with most of the indicators that we are seeing such as the various manufacturing indexes pointing lower, with the exception of the Chicago PMI, as most indicators whether economic or market are pointing to a weaker economy. (Click on chart to enlarge)

Junk Spreads and Initial Unemployment Claims

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-We are long US Treasuries and Gold.

Take a $1 trial of The Macro Trader to receive unbiased actionable research.

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Yesterday in our post Myths Surrounding The US Dollar we discussed how contrary to the medias perception the US Dollar is not tanking.  Today we will look at another common misconception regarding the US Dollar.  That is that if the monetary base goes up the US Dollar goes down.  While this has definitely worked several times in the past it has also not worked several times in the past.  Right now the idea of researching before you speak is even more important than normal because the numbers are far larger than normal.  if you thought that an increase in the money supply drove the USD lower then you would think that an almost tripling of the monetary base inside of three years would force the USD to drop like rock.  In fact most people with whose experience with trading and economics is via their television set would say that the US Dollar would be worth less than their toilet paper.

If you are one of these people who only listen to pundits, politicians, and other putzes and you believe this then please stop reading, scroll down to the bottom of the page, find my e-mail, and let me know how many squares of toilet paper you need.  I am running a special of two triple ply Charmin squares for each dollar you send me.  Seriously I will trade toilet paper for US Dollars all day long.  Why you may ask?  Well if you look at the evidence you will see that while the monetary base has exploded to almost triple the size of three years ago and yet the US Dollar is essentially in the same place that is was three years ago.  Look at the chart below and you will see that while some rises in the monetary base led to a fall in the USD others led to a rise in the USD.  Over the past three years it has obviously let to nothing at all in the USD as the price is virtually unchanged.  With the runaway inflation, runaway deficit, and collossal rise in the monetary base the USD by conventional wisdom should be trading at 0, instead it is holding up quite well. (Click on chart to enlarge)

US Dollar Spot Index and US Monetary Base

Please don’t listen blindly to so called experts on TV.  Everyone is always talking their book and in the case of people that aren’t running money their “book” is called hype and they want as much as possible.  Instead of watching the TV, and that includes CNBC, or reading Newsweek to help guide your investment decisions try doing your own research.  If you want to save time, or just supplement your research then consider services such as The Macro Trader (I just talked my book) or others who market their goods not by ridiculous hype but by sharing their research backed by something other then an ill-informed sound bytes.   No one will ever be perfect but we can all at least live in reality and not in lala land where the USD is toilet paper, all bonds have defaulted, and Armageddon reigns on earth.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-In our model portfolio we are currently short the EUR/USD which means we are long the USD and at home we are long several bundles of toilet paper from Costco.

Take a $1 trial of The Macro Trader to receive unbiased actionable research.

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In our last post “Democrats and Republicans Don’t Care About You And The Bond Market Doesn’t Care About Them” we discussed how many pundits show their stupidity by sticking to their opinions without making sure that their view is grounded in reality.  In that post we showed how politicians and media hype be damned the bond market doesn’t care much about the potential “technical default”, instead it seems to think that US debts will continue to be paid.  So despite all the hullabaloo about how interest rates will skyrocket pushing up the cost of our debt the truth is that bonds are higher/yields are lower over the past five months or so which is coincidentally the same amount of time that the debt ceiling debate has been raging on.

Now it is time to look at the US Dollar.  If you ask the average 24 hour news watcher, and it doesn’t matter if it is MSNBC, FOX, or CNN, what the US Dollar has done over the past three years they will usually say it is down.  If you ask how much they all guess 10-30%.  Luckily for us there is a place called reality and reality doesn’t care what people think, it just is.  In this land called reality the US Dollar despite some large gyrations is actually up over the last three years.  Don’t believe us?  Well take a look at the following chart. (Click on chart to enlarge)

US Dollar Index

As you can see over the past few years it has effectively gone nowhere.  Why has this happened?  If the US has huge debt and the Fed is mismanaging the monetary base shouldn’t the USD be lower?  In a vacuum yes but since currencies do not trade in a vacuum the USD is holding its own.  As opposed to equities, fixed income, or commodities the currency market always trades against other currencies.  For instance while you could have every stock in the SP500 climb higher the same is not possible in currencies.  If the USD goes up then what did it go up against?  If the Swiss Franc is down then what did it go down against?  This is why currency quotes are always quoted EUR/USD or JPY/USD.  For one currency to go up at least one other currency has to go down.  So anytime you hear someone on the news say that the (name your currency) is going higher you need to ask against what.

When all currencies trade against each other the resilience of the US Dollar makes more sense.  After all the US may have a ton of debt but how are its competitors doing?  The Euro Zone is crumbling before our eyes, Japan has an even higher Debt to GDP ratio then the US, and the UK economy is in horrible shape.  So while the United States has a lot of issues our largest free floating trading partners do too and this goes a long ways towards leveling the playing field. So until the United States is the only major economy with a debt crisis we will not go into a free fall.  Remember to look at reality before you make trading and investment decisions.  Do not trade based upon what you want to happen but instead trade off what is actually happening.  Distancing yourself from empty opinions will improve your bottom line year in and year out.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-In our model portfolio we are currently short the USD/CHF and short the EUR/USD.

Take a $1 trial of The Macro Trader to receive unbiased actionable research.

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So hopefully it is fairly obvious that we are in deflation or at least disinflation.  If that isn’t obvious enough then read our previous posts.  If nothing else you will see that it has been our view since at least June of 2009 is that we are in deflation.  That being said we are currently long gold.  Some of you might be thinking that we must be smoking crack, after all how can we be long gold if we dont see inflation anytime soon.  Because of the general perception that gold is an inflation trade we thought it would be useful to look at the current situation.

Currently the situation in Europe is pretty bad.  The EU is essentially in complete disarray as new problems seem to surface every couple of weeks.  Everyone but the EU knew that the PIIGS had problems but now Hungary, Belgium, and even France are coming up in the news as problem areas.   We are seeing currency issues, debt issues, liquidity issues, structural issues, etc.  The EU right now is like the Lindsay Lohan of regimes with all of its issues.  All of this adds up to what is the largest fear, a sovereign default.  If this were to happen, or when it happens we will see some major turmoil across all markets.

So what are investors doing right now?  The have been fleeing the Euro and Euro denominated assets.  No one wants EU based stocks, bonds, or the Euro.  As they leave the Euro they have been going into the US Dollar, US Treasuries, and into gold.  Yes, they are leaving the Euro to buy gold.  While investors across the world have been buying gold the trend has been especially obvious in the EU and its neighbors.  We can see this in the following charts.

Here is GLD the gold ETF.  As you can see it has been steadily moving higher but only recently started hitting new highs as it sold off back in December and took a long time to consolidate.

GLD-Gold

For real evidence that gold is going up on worries of a sovereign default we need to look at gold priced in Euros.  As you can see in the chart below gold in Euros consolidated but has barely even pulled back during the past year and has really accelerated to the upside over the last few months.

Gold in Euros

Being very tied to the mainland Europe, and having a weak economy as well many UK investors have also been buying gold to get out of Pounds.  While not quite the move of the Gold/EUR this has been a strong and steady move.

Gold in Pounds

Finally lets look at gold in Swiss Francs.  As you an see the trend has been pretty much the same with a steady move higher and very tight consolidation.  One thing worth noting with the Swiss Franc is that in a normal crisis investors would be taking their money out of their regular bank and putting it in Swiss banks.  This time around Switzerland gave up their role as the ultimate bank by giving away their client list to the I.R.S.  We think that Swiss Banks will be looking back and shaking their heads at that move.  This is not the only reason (the Swiss want a weak currency for example) for the relatively poor performance of the Swissy but it does not help, especially in the long term.

Gold in Swiss Francs

Comparing gold in US Dollars to gold in European currencies it is obvious that people want out of the Euro and see gold as a reasonable substitute.  Hopefully this helps answer why gold can be a good investment even if we are in a deflationary environment.

Happy Trading,

Dave@TheMacroTrader.com

Disclaimer-We are long GLD

Take a $1 trial of The Macro Trader to receive unbiased actionable research.

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A few weeks ago in our newsletter we discussed our view on the EUR/GBP.  Essentially we were leaning towards the downside as it appeared that the pair was about to break lower.  While initially we were drawn to this trade due to the great triangle pattern, the more we look at the fundamental situation the more we like it.  Basically both of these currencies are loaded with issues.  But with the UK having taken a lot of pain early via QE and the EU just now opening up to the idea that all is not well let alone QE,  we think that this pair has a ways to go.  Heck we think that the EU might lose the U here in the next few years as the PIIGS saga plays itself out.

FXE-EUR/FXB-GBP

Yellow Area=First target

Next Line Down=Measured Move

Happy Trading,

Dave@TheMacroTrader.com

Disclaimer-We are short the EUR/GBP

Take a $1 trial of The Macro Trader to receive unbiased actionable research.

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10-Yr Swap Spreads hit their lowest level since 1988 on 3/9/10 hitting 3.25.  How many more days until they go negative? (Click on chart to enlarge)

10-Yr Swap Spread

Go short Treasuries, its the most obvious trade ever right?  While they might go up or down the MOVE Index continues to forecast less and less volatility, which at least to us indicates that the market is not expecting yields to change a whole lot anytime soon. (Click on chart to enlarge)

MOVE Index

Not sure if Chanos is right on China being in a huge bubble, but looking at the chart it appears as though at least a few investors are less than bullish. (Click on chart to enlarge)

FXI China ETF

We just crossed the one year anniversary of the current rally/bull market the other day.  Over that time on a weekly closing basis the SP500 is up over 66%.  This has been the largest one year rally in over 60 years.  We are starting to hedge our long exposure as we are currently cautiously bullish. (Click on chart to enlarge)

SP500 1-Yr Rolling Returns

Back in December we shorted the Euro on the basis of the EU being weak, overvalued, and sentiment becoming far too one sided.  In these pages we also looked at buying the USD on a technical basis. Looking at the USD and T-Bills however shows another reason for the USD rally. (Click on chart to enlarge)

US Dollar and T-Bill Yield

Happy Trading,

Dave@TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research.

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Back in December when we wrote our post “Is It Finally Time To Sort The Euro” we got a lot of flack for saying that the US Dollar was bottoming out and that the Euro was going to drop.  We received e-mails telling us about all of the problems with the US and why the Dollar is going down forever.  Our basic answer has been that while the US has tons, and by tons we mean trillions upon trillions, of problems the US Dollar is not going the way of toilet paper anytime soon.

While we knew of many of the problems in the EU when we wrote our post we had no idea how bad and how fast they would manifest themselves.  As you can see in the chart below since our post the Euro has broken down, consolidated at the 200-day moving average, and then broke down some more. (Click on cart to enlarge)

EUR/USD Daily Chart

So what do we see going forward?  In our earlier post we showed a chart of the EUR/USD purchasing power parity that showed the Euro as being 35% overvalued relative to the US Dollar.  As you can see in the chart below the Euro has narrowed the valuation gap considerably but is still 22% overvalued to the USD.  We would not be surprised to see the EUR/USD hit the 2008 lows around 1.25 before finding strong support.  (Click on chart to enlarge)

EUR/USD PPP Chart

Happy Trading,

Dave@TheMacroTrader.com

Disclaimer-In The Macro Trader newsletter we are short the EUR/USD

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