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.

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

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With the steepest global yield curve in history it appeared in mid 2009 as though we were going to go on the credit binge to end all credit binges.  We were going to see inflation of eight gazillion percent and gold was headed to $50,000 as we went back to the gold standard.  As we now know that is not what happened. Instead banks bought Treasuries and there has been a massive contraction in lending as borrowing.  Instead of massive amounts of real growth the record steep yield curve instead brought with it a credit contraction that appears to be slowly but steadily sapping the energy from this so-called recovery.

Looking at the global GDP weighted yield curve right now you can see that since April of 2010 long term government rates have been steadily coming down as the short term rates are close to zero percent in many developed nations, which of course make up the bulk of a GDP weighted yield curve.

Global GDP Weighted Yield Curve

What is obvious to us when looking at this chart is that we are in a slow to negative growth environment for the foreseeable future.  We see this in both the economic data as well as in the markets themselves with stocks showing increased volatility and bond yields of all maturities hitting new lows or close to near lows. Until we start to see signs of real growth we expect the curve to continue to flatten, primarily on the long end.   One potential trade to take advantage of declining long bond yields is to either buy the long bond or buy TLT the 20+ year Treasury ETF. While we expect pullbacks and corrections, we expect long term Treasuries to continue to do well as an investment over the coming several months and maybe even the next few years.  Yes, yields are low but they can go lower.

Happy Trading,

Dave@TheMacroTrader.com

Disclaimer-In our model portfolio we are long TLT

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

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Some of the more useful liquidity indicators are the different money market spreads.  Typically when the financial system is feeling stress  we will see spreads rise as banks become hesitant to even lend to each other due to counter party risk and general uncertainty.  We saw this in the 1987 crash, in the 90-92 recession, in the bond market route of 94, in the .com crash, and then in the crash of 2008.  A rise in spreads does not guarantee a crisis or crash but we have seen higher spreads during each crisis.

Right now we are seeing what could be the beginnings of a new liquidity crisis or maybe just the second leg of the last crisis.  If spreads were rising just due to a weakening economy then we would not be overly concerned as these events take some time to really move lower.  Right now however we have a huge mess that goes by the name of the EU.  We are not necessarily saying that 2008 part 2 is upon us but we are saying that this is a real cause for concern, basically the rise in spreads is anything but bullish and as it reinforces our view that this is not just a normal correction but instead could be the start of something a lot worse.

Money Market Spreads

Happy Trading,

Dave@TheMacroTrader.com

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

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One of the strongest inflation/deflation indicators is the bond market.  When inflation is expected to be high yields tend to go up and when the market expects deflation/disinflation yields tend to be low.  So what are the markets telling us right now?

First lets look at the two year yield.  After all if hyper inflation is right around the corner it would make sense that we might see some of that in the short end of the curve.  As you can see in the chart below the 2-Year is not signaling higher inflation anytime soon.

2-Year Treasury Yield

Maybe looking at the long end of the yield curve would give a signal.  After all if gold is climbing inflation must be almost here, right?  Looking at the chart it would appear as though the market is not expecting much.

30-Year Treasury Yield

Lets give this all one more chance.  What are TIPS showing us?  Surely if hyper inflation is upon us inflation protected bonds would give us a sign.  Looking at the 10-Year breakeven rate it appears as though inflation expectations are in fact dropping instead of rising.

10-Year Breakeven Rate

Apparently many investors are reading things a bit wrong.  Gold is not going higher due to fears of imminent inflation.  Right now gold is almost purely a currency trade right now.  With the problems in Europe investors are scared of government and instead have been going to the shiny stuff as a perceived safe asset.

Inflation will come at some point down the road but it is not right around the corner.  Whether you are looking at bond yields, commodity prices, the CPI, housing, or Fed statements we are seeing the same signals, and they are almost all pointing towards deflation/disinflation and not inflation.

Happy Trading,

Dave@TheMacroTrader.com

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

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In the investment world it should be no surprise to anyone anymore that outlying events actually happen with a decent amount of regularity. Looking at the past 12 years we have had the Asian Contagion, Russian Default, LTCM, .Com crash, housing crash, and the subsequent crash of everything else. Most of these are one in a gazillion year type events and yet they all happened inside of 12 years. Statistics while useful, are not able to perfectly model the real world.

So mixing stats with history let us look at the MOVE Index. The MOVE Index, essentially the bond markets VIX, typically trades between 128 and 79. Anything outside of those two lines is at least one standard deviation from the mean. As you can see in the chart below we are currently more than one standard deviation below the mean and look to be headed lower. (Click on chart to enlarge)

MOVE Index

Of course the interesting thing about the MOVE Index is not what level it is at but what tends to happen when it reaches certain levels.  Essentially whenever the MOVE Index drops below one standard deviation something blows up. Apparently bond market investor complacency is a better gauge of “too complacent” than other volatility gauges.

Drops below the lower one standard deviation have preceded the following events

-First Gulf War

-Asian Contagion

-LTCM bailout/Russian Default

-.Com tech crash

-Housing/Credit crisis

While it is not a crystal ball, see the extended period below one standard deviation preceding the credit crisis, the MOVE index is still a good risk gauge with a solid track record of saying investors are too risk averse or that we are too complacent and therefore not really aware of the risks on the horizon.  Consider this the yellow light, its not saying stop but its not saying go either.

Happy Trading,

Dave@TheMacroTrader.com

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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