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.

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

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With Christmas only hours away we thought it appropriate to give Santa something to mull over as he flies around the world giving all the good kids presents.  Here is our Christmas list and to hoping that we were good enough this year to get any of them.

-European leaders to realize that this is more than a liquidity problem.  Alternatively for European leaders to lead instead of the ridiculous statements that have been coming out of that continent for over  year now.

-Democrats and Republicans to find some competence.  Currently they seem to be trying to make stupid seem smart.  We realize that this is a tall order for Santa but if we got this present we would be content for years.

-Correlations to drop.  This past year everything has been trading with a correlation of either 1 or -1, neither of which is conducive to directional trading.  We like buying good industry groups, shorting bad ones, buying certain commodities, and selling others.  This past year has had us either buying “risk” assets or buying USD and Treasuries.  Santa please fix it as this is getting old.

-For the hyper inflationistas to STFU.  Yeah we said it.  I am completely sick of people like Peter Schiff coming on my TV and radio to tell me that hyper inflation is hiding right around the corner.  You have been yelling for four years and so far we have had mild inflation at best.  Please Santa if you would like to shut these people up it would be a great Christmas and New Year.

-Teach financial writers how to write headlines.  ”Market is down .01% on housing numbers.”  If the market barely moved then why do you have to apply a reason for it?  Just say that the market is up x% today and then list off what happened that day.  We don’t need a made up reason that only annoys us.

-An Energy Policy.  We realize that this present is as hard to deliver.  After all since WW2 every single president has said that we will be energy independent in X amount of years and yet after they are in office they do nothing, absolutely nothing.  Even though we realize that this present can’t fit under the tree it would be amazing to finally get it.

That’s it.  We already have our Red Ryder BB gun, our Radio Flyer wagon, a snuggy, etc.  This Christmas we would love for some of these problems to at least be addressed if not solved.  World Peace would also be awesome but we would be more than happy to settle for any and/or all of the above.

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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  Not only did China stall out in mid-2009 but it has now surpassed the lows set in mid-2010.

Shanghai Index

 One of many indicators pointing to more troubles ahead, the port data out of LA and Long Beach is showing that trade has been slowing down for some time.  Usually traffic peaks in August-October but this year we hit a high in May that we were not able to break.

LA and Long Beach Port Traffic

The bottom line is that Europe may be getting all of the headlines but China has been slowing, is still slowing, and looks as if it will continue to slow.  With Europe and China basically in recession how much longer can the United States hold out?

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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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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While the crisis in Europe and the slowdown in the United States seems to get all of the attention lately, the other big story is of course China.  China has been a leading indicator for global markets for some time now and as you can see in the chart, and hopefully have noticed for some time now, they peaked over a year ago.  We are seeing the same signs in raw materials such as copper and oil just as we are seeing them in everything but US Dollars and US Treasuries.  Until we see a firming up in either the US, Europe, or emerging markets most notably China we won’t be seeing a lasting rebound in global equity markets.

Shanghai Stock Exchange and SP500

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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Many new traders spend a lot of time looking for the holy grail of trading.  The secret Gann angle, the right wave count, the perfect valuation model, etc.  What we have found is that while a lot of new and even old traders spend countless hours searching for the holy grail very few, if any, successful traders have found it.  Instead they figure out at some time or another that instead of a magical tool they should spend their time looking for useful tools that do a reasonable job of either lowering risk, increasing return, or increasing their hit rate.

One tool that we have found useful in looking out towards the future is that of the ECRI Weekly Leading Index.  While by no means a holy grail it has historically done a fairly good job at forecasting stock market returns.  As you can see in the chart below it has been very accurate over the past few years as it has led the SP500 by several months at important turning points.  (Click on chart to enlarge)

SP500 Year Over Year % Change and ECRI WLI Growth Rate

So what is the WLI saying right now?  Going along with our long held deflation thesis the WLI is now pointing towards slower growth in both the economy and particularly in the so-called “risk markets”.  This of course matches what we are seeing in several other indicators and relationships that we follow.  We have covered a few indicators in previous posts such as how junk spreads point to higher unemployment claims and how the PMI is pointing towards slower growth.  In addition to these we are seeing many other signs such as the drop in commodities, take a look at the CRB Raw Materials Index, and in the rise of the US Dollar.  Of course none of these are holy grails, just signposts in the fog.

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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We saw this headline-

August is another cruel month for hedge funds-(Reuters) – Most hedge funds lost money again in August as hundreds of managers, including some of the industry’s best-known names, stumbled when stock markets swooned anew.

-and then we laughed.

Hedge Funds are no more an asset class than mutual funds are.  There are several “general” classes of funds investing in anything from stocks to bonds to art.  Long, short, long and short, arbitrage, levered, etc.  There are a gazillion different strategies that are employed so headlines like the above are not helpful for much more then a useless sound bite.  But onto the part that we actually liked.

One line mentioned how Global Macro was up 2.16% for the month of August which would indicate something less then cruelty for hedge funds, including some of the industry’s best-known names, but hey that’s just us.  Anyways how is Global Macro actually doing?  Well depending upon which macro index you use the numbers will be a bit different but for the most part this specific corner of the market is flat give or take a percent or so.  While we, we being our newsletter The Macro Trader, do not try and hug our benchmark it would appear as though this year we have.  In the table and chart below we show how our newsletter had done against the HFRXM and SP500 indexes.  The table has the raw numbers and the chart has the performance of $1,000 year to date. (Click on charts and tables to enlarge)

Performance

$1,000 Invested Year To Date

How do we explain our relatively high correlation to the HFRXM Macro Index?  Well we think that the next chart probably does a good job of answering this question.  But in case the chart is not clear enough the answer is risk management.  Global macro as an asset class has long held up well in any market with a penchant for bad markets.  In other words we tend to outperform in bad markets and do decent in good markets.  In the chart below you can see how our drawdowns compare to the SP500. (Click on chart to enlarge)

Drawdowns Year To Date

A few other observations that may or may not have anything at all to do with the initial subject of this post-

-We have seen few opportunities this year that have warranted an oversize allocation

-The SP500 is way to risky for the returns that it generates

-If markets are efficient how was the SP500 above 1250 for almost a year and then at 1100 a few weeks later

-There is no reason that you need to do what everyone else is doing

-Bill Gross is smart but he too can be wrong

-Warren B is also smart and can also be wrong

-95% of news is noise but we read it all in hopes of recognizing the 5%

-Anyone with the nickname Helicopter Ben is just looking for reasons to drop money from the sky

-If you aren’t at least semi-comfortable in Excel there is a high likelihood that you do not even know what due diligence is

-It is clean looking but so far Google+ is not Facebook

-More Money Than God is a great book

-The New Market Wizard interview of Stanley Druckenmiller is read by this author at least once every month or two

-Major bottoms and tops take more then a few days to form

-Yellowstone is awesome and everyone in America should go at least once every five years

Have a great Labor Day Weekend!!!!!!!!!!!!!!

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-We are long Friday both the day and the excellent song by Rebecca Black .

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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