So far this year I think my most hated new term is “The Great Rotation”.  Supposedly stocks are moving higher as money is flowing from the overpriced bond market and into equities.  Since the term has gone ballistic, also known as annoying, we decided to look into it.

Here is a chart from Google Trends showing how search volume has gone crazy. Until the past few months it barely existed although it was moving higher into year end but more on that in a minute. (Click on chart to enlarge)

Looking at the performance of stocks versus bonds we can see part of the reason why the term was becoming popular.  Without reading too much into it stocks were moving higher while bonds were moving lower…..most of the time. (Click on chart to enlarge)

While stocks have indeed been outperforming bonds over the past few months the other side of the case for “the great rotation” was that money was coming out of bonds and going into stocks.  Well thanks to the ICI we have data that allows us to look at this idea.  Stocks funds saw a large increase in assets of 5.2% from December to January but Bonds also saw in increase in assets. (Click on table to enlarge)

We are not sure exactly where the rotation is here so we then broke down the weekly data to see if we could discern this rotation pattern in the data.  Well what we found was that year end and beginning of the year investment trends have a strong seasonal pattern.  Want to guess what the pattern is?  If you said mixed into year end and positive at the beginning of the new year then you win.  Here is the weekly data for equities from the beginning of 2007 to now.  We decided to show data from the beginning of October through the end of February in order to give the rotation argument as much rope as it might need. While 2013 has definitely seen the largest January flows  since 2007, the reality is that every single January sees positive flows.  (Click on chart to enlarge)

What about bonds?  Well we already spoiled that surprise earlier with the ICI table so you know that bonds saw inflows but guess what we found?  If you said seasonality you win…again.  Not surprisngly the past seven years have seen net inflows to bonds the majority of the time but the flows are a lot smoother at the beginning of the year as investors obviously put a lot of money to work each and every January. (Click on chart to enlarge)

Here is a chart of the cumulative in and outflows for both equity and fixed income funds.  As you can see bond funds have been the asset gathering champions of the past 6+ years as they have seen huge net inflows almost the entire time. At the same time equity funds have been net asset losers.  What of course sticks out to us is that over the past little while equities have indeed made some inroads but that there is zero rotation going on. Let me repeat that-there is zero rotation going on.  (Click on chart to enlarge)

We know that we have not accounted for ETF’s, Closed End Funds, Hedge Funds, etc.  but from the data we have seen, with one exception, we are seeing the same thing.  Namely that equities are getting more more money but that fixed income is still getting net new money.  What is the one exception?  We have come to the conclusion that the vast majority of the new money has come from two places: money market funds and all the special one time dividends that got paid out at the end of last year in anticipation of higher dividend taxes this year.

If you want to call a slight drop in assets in money market funds a great rotation go ahead but just know that you are full of it.  Which gets us to our last point, this is all marketing.  I don’t know where this meme originated but we would put money on it being from an equity shop that was sick of losing assets both in absolute as well as relative terms while the fixed income guys were killing it over the past six years.  We have not seen a slew of advertisements for the rotation yet but here is a classic ad that you can refer to anytime your broker, advisor, etc. calls you up with a pitch so that you maintain a healthy degree of skepticism. (Click on ad to enlarge) 

Stocks can go up or down while bonds go up or down and there can be great reasons to buy or sell either but “The Great Rotation” is not one of them.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

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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

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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

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We have all seen a chart similar to the one below of the effects of QE on the stock market.  When the Fed is buying the market moves higher and when it sells it helps the market move lower.  Of course what we have all noticed, well everyone except for Buzz Lightyear at the Fed, is that each successive buy program has led to a smaller and smaller rise in the market.  So the question is with a zero interest rate policy and with an additional and infinite buy program in place, at what point do we decide that maybe it is alright to fight the Fed?  The more we look at it the more we think that their stance is sufficiently weakened that shorting may soon be, and indeed may already be, a viable option.

Looking at the situation from a smaller time frame the results are basically the same.  Here is a table showing how Fed buy days compare against sell days as well as all days for the SP500.  As you can see the out performance was fairly consistent since the end of August 2005.  If you bought the market at the open on the day of a POMO buy and sold at the close you outperformed by a wide margin.  If you held for 10 days you still were winning.

When we go to the latest finished action of operation twist however we can see that, like the large chart above shows, the effects of Fed buying have been drastically diminished.  Buy days still outperform the SP500 by a small margin but does not fare so well against the sell days.  Wen you take it out to 10 days the out performance is almost non-existent showing that Fed buying is not what it used to be.

All of this combined with out slowdown/recession forecast gives us more and more reason to look for shorting opportunities.  If we are entering an earnings led recession and the Fed’s efforts are falling on investors with less and less force than it is getting closer and closer to being safe to fight Buzz Lightyear Bernanke and the Fed.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-In our model portfolio we are long TLT.

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The majority of investors seem to hate them and the rest are shorting them.  While at some point shorting bonds will be a huge trade we think that the timing is still a ways off for the end of the 31-Year bond bull.  So what do bonds have going for them?  Well the most obvious and yet what seems to be the most overlooked is the simple trend.  Looking at the chart below you should ask yourself how many times have investors been convinced that rates were too low? (click on chart below to enlarge)

30-Year Treasury Yield

Aside from the trend we have the current situation with GDP growth of only 1.7% which is very slow for a so-called recovery, especially one that is five years along.  In addition we have very slow growth globally as Europe continues to blow up and we keep seeing estimates for China drop every month or two.  We have very slow global growth and this is showing in very low inflation data.  Yes, the central banks led by Helicopter Ben are juicing the system, hell I hear Ben is dressing up as Buzz Lightyear for Halloween so he can say “QE to infinity and beyond” but the fact is that despite their best efforts inflation remains muted.

In a world of extremely slow growth and chronically low inflation we would expect Treasuries to do well and lo and behold they have.  Since QE1 was announced November 25th 2008 we have seen 30-Yr yields drop from 3.632% to 2.988% and the 10-Yr dropped from 3.092% all the way to 1.811%.  If this does not make it obvious that QE alone does not cause the bond market to crash then nothing will.  No, until we see stronger growth and a large pick up with inflation we expect fundamental picture to remain decent to strong for Treasuries.

Now of course we are going to get some people saying “but bonds are up too much”  our natural response would be something like WTF? but our more reasoned response would be compared to what?  Bonds have been up “too much” for the last 20 years.  Who would have ever thought that 5% 30-Yr interest rates would sound high?  Rates are low but they are a long ways from 0% which would indicate that they have room to go lower.  That said what does the technical picture look for bonds?  In the chart below we have our intermediate term 30-Yr Reversion to the Mean (RTM) chart.  While the RTM chart isn’t saying load the boat it is also not saying run for the hills as it is instead giving us an almost perfectly neutral reading which indicates that bonds have plenty of room to go up or down before reaching anything near an oversold/overbought point. (click on chart to enlarge)

30-Yr Treasury RTM

Finally, at least for now, is the sentiment picture.  We all know that volatility is one of the most mean reverting series in all of finance.  In the chart below we have the Treasury MOVE index vs the 30-Yr yield and then we have overlaid the 30-Yr yield with an inverse scale.  We inverted it so it is a better visual as to what happens to bond prices when the MOVE index is so low.  As you can see when Treasury volatility is really low it is usually a time to be buying bonds and when it is high is when you should be selling.  Well right now we are hovering close to the lows of the past five years indicating that bonds could take off at any time.  (click on chart to enlarge)

So is going long bonds the new trade of the century?  Nope not by a long shot.  Still that doesn’t meant that there isn’t a case to be made for being long.  The economic fundamentals are in place, unless you think we are the cusp of a huge growth spree.  The technical picture is saying that while its not a perfect buy there is plenty of room to run.  Finally sentiment/volatility are saying that the time in at hand for a renewed move higher in Treasury bonds.  Obviously we could be wrong but the risk reward is there.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-In our model portfolio we are long TLT, AGG, and FLAT.

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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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We follow several different types of indicators to include economic, valuation, sentiment, technical, etc. but one of the most important and powerful family of indicators would be monetary indicators.  Monetary indicators allow us to measure liquidity which of course affects all markets.  Historically some of the best gauges of liquidity have been interest rate trends, interest rates, margin debt, public offerings, money supply, etc.  One of the most powerful indicators is Fed policy and the tools it uses to put their policy into effect.  We have all heard the saying “dont fight the Fed” and while many market sayings are cliche this one carries weight.

During this cycle the Fed, in addition to its zero interest rate policy ZIRP, has been using quantitative easing to inject money into the economy in an effort to “prime the pump” and get people spending.  Unfortunately there is little if any evidence that any of this money has been finding its way to main street. Instead it has been going into financial markets and in the process has helped fuel some bubbles.  While the term bubble has been overused as of late we are using it in the sense that without QE1 and QE2 most financial markets would be a lot lower then they are today or a few weeks ago.

All of this brings us to the current situation.  As you can see in the chart below whenever the Fed is actively buying or selling securities the market goes up or down.  From mid 2005-2007 the Fed was buying small quantities and the market, already in an uptrend, continued higher with muted volatility.  Later during the early stages of the crisis, and after the Bear Stearns breakdown, the Fed decided in all its wisdom to sell some of its securities taking liquidity out of the market at the exact time that they should have been adding it.  While not the cause of the crash it did further enable it.  In early 2009 the Fed began QE1 at the same time that the government passed TARP.  Between these two massive stimuli the market was able to shoot higher.  While the argument can be made that the pump was primed and brought investors back into the market it is hard not to notice what happened once the Fed stopped buying.  As you can see the correction in mid 2010 coincided with the end of QE1.  As this correction got going and with the backdrop of high unemployment and a still sluggish economy the Fed embarked on QE2.  As you can see the market once again started to move higher.  Well guess what?  Since the Fed stopped buying the market has consolidated and as you have likely noticed over the past few weeks has started to crash moving down 18% in just two weeks.  (Click on chart to enlarge)

POMO and SP500

While it is true that there are other factors at work it is obvious to everyone except maybe the Fed that they have been the buyer and until the economy really does improve the risk markets will fall anytime that they back away.  With the statement earlier this week that the Fed is going to maintain a ZIRP until at least 2013 we are also led to expect an eventual announcement of QE3.  While we don’t think that it will help the economy and might actually hurt it, we do think that in the framework of Helicopter Ben’s mind this is the only course of action.  If we break lower by 5-10% expect the Fed to come out and announce another round of purchasing.  Oh and one more thing, don’t fight the Fed.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-We are long US Treasuries via TLT  and gold via GLD.

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

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Hopefully the title made you laugh a bit but sadly enough it is the truth.  Right now all we see on the news is talk of the debt ceiling and the oncoming crisis if we don’t raise it or the eventual destruction if we do.  Both sides of the aisle just want to make the other side look bad but in the process they end up all looking like idiots.  To better explain what I mean let me pose a question: Which of the following two scenarios is sustainable?  1-Never limit spending, add more entitlement programs, let the government run everything.  2-Cut spending while the economy is slowing down from the weakest recovery in the past century.  My answer is neither, and yet that is essentially what both sides are trying to do.  Congress and the President are doing a great job of showing how little they care about you and instead how much they like fighting with each other. (Click on image to enlarge)

We need some type of sensible long term plan that actually does something and holds people accountable.   The basic outline would go something like this.  We go over current spending and see what actually contributes to the economy and what does not.  If it does not, or if we can not prove it either way, we can start to cut or at least put plans in place to cut over the next X amount of years.  In many cases you could put in a timeline of 10-20 years and till see great long term benefits.  However if the spending can be shown to create worthwhile and not just bureaucratic  jobs then we keep them and possibly even spend more on them if they scale.  If anyone in Washington was able to be objective on this we could really clean up a lot of the budget without sinking the economy.

The next thing that we could do is to make a smart stimulus bill.  This will never happen because politicians want votes and not progress but the idea has a lot of merit.  Basically instead of just throwing money at pork as in the famous unread and totally inefficient stimulus bill when Obama first came into office we would instead spend X amount on infrastructure.  The countries electricity grid, bridges, and roads are in really bad shape.  If we spent money here we could quantify the amount that we spend as well as improve and stimulate the current economy.  This creates jobs and yet as opposed to entitlement programs like welfare or healthcare rebuilding a bridge or road has an end point.  Its not a spend forever idea but instead a spend now on things we need idea. (Click on image to enlarge)

Is This What The United States Will Look Like August 2?

But enough with the useful policy.  What happens if we raise the debt ceiling?  Does the world grind to a halt?  Is it Armageddon 2011?  And what about the budget, don’t interest rates skyrocket further worsening our debt problem?  And isn’t the US Dollar going to 0?  No, the world doesn’t grind to a halt, Armageddon 2011 does not happen, and borrowing costs do not skyrocket.   The only people that say borrowing costs will skyrocket are people trying to get on TV.  Here’s a hint people CNN, MSNBC, FOX, CNBC, etc don’t know what they are talking about.  Why do you think they are on TV and not running an investment management company?

First lets look at borrowing costs.  Markets are usually forward looking and with all the attention that the debt ceiling is getting they, meaning investors,  definitely know that there is a high probability of a technical default.  In this scenario you might expect interest rates to skyrocket, at least that is what the media seems to think will happen.  Lets go look at some charts.  First is the yield on 90-Day Treasury Bills.  You might think that if the government might default on August second that investors would be especially worried about the short term.  As you can see not only are rates rediculously low but they HAVE BEEN GOING DOWN for a few months.  Yes, instead of going up from historically low levels they are in fact headed lower. (Click on chart to enlarge)

90-Day Treasury and 90-Day LIBOR yields

Maybe investors aren’t worried about the next 90 days but they have to be worrying about the next two years don’t they?  Maybe the default won’t hurt us too much in the very near term but over the next two years or so it might kill confidence in the US and its ability to  pay its debts.  Well if you look at the chart below of the yield on the 2-Year you will see that again not only are rates at/near historic lows but have in fact been trending lower since this sideshow we call Washington does what it does best, which is nothing useful.  (Click on chart to enlarge)

2-Year Treasury Yield

OK so maybe the next few years are going to be fine.  After all the US economy can’t die inside of two years can it?  Well even the message of the 30-Year bond is saying that this is all much ado about nothing.  The 30-Year yield is low and has not been able to break above 4.9% and has actually been headed lower since all the talk started to pick up a few months ago .  (Click on chart to enlarge)

30-Year Treasury Yield

If you take a step back and take all of this in you will see that the bond market considers the US Government money good.  No, they don’t love a huge deficit, a lack of a long term plan, or anything of the sort.  But the bond market does understand that we are a long ways from Armageddon and that in the meantime we can make debt payments.  One thing a lot of people forget is that we not only create our own currency but in fact are THE reserve currency of the world.  While long term it might not be the best plan we can always pay off debts by just creating more money.  Taken to its extreme this is of course bad but in the meantime it goes a long way to allay the fears of investors.

So the next time that you hear about how this or that is going to shock the markets do some research instead of repeating the false hype.  If the market is scared you will see it like we did during the 2007-08 crisis or back in the dot com crash or even more appropriate would be the epic move higher of yields back in 1994.  Right now it is obvious to us that the markets are not so worried about what is going on in the United States and instead are extremely concerned about what is happening in Europe.  Instead of technical defaults where we have to prioritize payments like in the United States, Europe is facing the very real possibility of actual defaults where the money is never paid and investors have to settle for 0% of their money back.  Now that is a debt crisis.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-In our model portfolio we are long TLT the 20+ Year Treasury ETF.

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

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During the crisis you may remember that everyone started following the TED spread.  Where one year earlier only investment professionals even knew what it was during 2008 it seemed as though everyone and their dog were experts on all types of credit market indicators.  Well now that we haven’t seen anything in the news talking about the TED or other money market spreads for months, in a contrarion way it is probably a good time to pay attention to them.

In the chart below we have the TED, LIBOR-OIS, and Commercial Paper-T-Bills spreads overlaid.  As you can see they started to trend up a while back and that trend is still in force.  So is it the end?  Is the United States defaulting tomorrow?  No, nothing like that.  Instead it is a sign that investors are starting to acknowledge that all is not rainbows and butterflies and that there are some risks out there.  At current levels none of these spreads are saying anything other then that liquidity has tightened up a bit, but only a bit.

Money Market Spreads

So what to make of this?  Only that we need to start getting more cautious.  The Fed liquidity bull is slowing down ever so slightly as QE2 nears its end and that may bring with it rising volatility in the markets.  For now however the trend is up and new liquidity is being injected every few days, consequently we are long and medium term bullish on the risk trade.

Happy Trading,

Dave@TheMacroTrader.com

P.S.-We have obviously not posted to the site in some time and aim to correct this.

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