Fed Almighty

July 3^rd 2012

Nick Hays

Dhaka, Bangladesh

Today - on The Long and the Short:

* Economic data dump: manufacturing takes a dive

* Bad news is good news

* Fed almighty

Risk assets rallying again today. Friday’s sharp relief rally (after the latest in an increasingly long string of supposedly “now-or-never” Euro-summits) faded on Monday but markets are resuming their move higher today, apparently on increased expectation of further Fed intervention.

Optimism that Bernanke et al will crank up the printing press once again appears to be founded on renewed signs of a weakening global economy. Yes it appears that once again bad news is good news – at least where risk assets are concerned.

Economic Data Dump

Central to the renewed sense of approaching economic doom was a raft of manufacturing data released on Monday. Firstly data from the ISM (Institute of Supply Management) showed a US economy in a state of deceleration verging on out-right contraction:

The data are negative almost without exception, but the standout data points in the above chart are:

·         collapsing new orders (down 12.3 % pts MoM)

·         prices down 10.5 %pts MoM

·         Overall PMI composite down 3.8 % pts MoM -- and perhaps more significantly, for the first time since July 2009 it breached 50, the threshold which separates expansion from contraction.

Another closely followed indicator added to the gloom on Monday, with the PMI from Markit/HSBC registering negative MoM growth in manufacturing activity for 16 out of 26 surveyed economies. Notably, Japan, Korea, Taiwan, Norway and South Africa all slipped into contraction territory in June.

In summary, not a good day for economic news.

That said, an ISM PMI reading below 50 is far from a sure-fire indicator of a coming recession. Examining historical PMI data shows a number of ‘false negatives’ during the past 60 or so years where the PMI has breached 50 but no recession has followed:

(Interestingly, these PMI ‘false-negatives’ have been occurring more frequently since the mid-80’s, probably in part a reflection of the evolution of the US economy and the increasing importance of the non-manufacturing sectors).

Bad News is Good News

Unarguably, however, the data are poor and the trend is worse. With such a raft of negative data being released, one might reasonably expect a re-pricing of growth-hungry risk assets such as equities and commodities.

In fact, the opposite is happening: risk assets are rallying in the face of a slowing economy as expectations rise of future Central Bank intervention in order to prop up growth.

Yet again we are observing the ‘good news is bad news’ phenomenon as traders punt on another slosh of liquidity courtesy of Berkanke and his pals at the Fed.

What this reinforces is the fact that for some time now the markets have been progressively de-coupling from economic fundamentals and becoming increasingly dependent on Central Bank policy.

An effectively functioning capital markets system this is not.

I fear we are storing up major trouble for the future as a result of this breakdown: malinvestment, misallocation of capital, excessive leverage and risk taking...if it sounds familiar that’s because it is. My concern is that the burst mortgage and property bubble of 2003-2007 is in the process of being replaced by something new and more dangerous. Hydra-like, one head is lopped off only for two more to grow back in its place.

Fed Almighty...for now

I continue to fight my longer-term bearish instincts and maintain the short-term expectation of rising asset prices over the next 3-4 months.

Federal Reserve intervention will continue to play an outsized role in driving financial markets and the likelihood of further money printing in the coming few months is high as the economy slows to a crawl.

With both the Presidential election and the dreaded ‘fiscal cliff’ approaching at the end of this year, the window of opportunity for such Fed action is closing rapidly before political inertia sets in, and I expect Bernanke to hit the switch sooner rather than later.

While I don't expect further montary easing to have much impact on the real economy, it would provide a further boost for risk assets as at least part of the freshly printed money is likely to find a home in equities and commodities.

It is wise not to stand in the way of this 'monetary freight train' but instead to either go with it or simply get out of the way. Longer term, however, ever-loosening monetary policy can surely not be immune to the law of diminishing returns and I expect that this fact will ultimately be exposed.

Once this occurs, and markets lose faith in the Fed Almighty, a major unravelling of confidence is possible and in that case -- watch out below. I suspect 2013 will bring us much closer to the endgame in this regard.

Hence looking beyond December 2012 I maintain a bearish outlook and am not committing long-term funds to risk assets. This increasingly feels like a market suitable only for short-term traders or investors with an ultra-long term time horizon. For those in between you have been warned.

Looking for the downside

March 11th, 2012

Nick Hays

Dhaka, Bangladesh

Today - on The Long and the Short:

* Shot of adrenaline for the markets

* Trading the VIX: approach with extreme caution

* S&P 500 breaking down?

* Monetary freight train

After a couple of weeks of fairly docile trading the market was given a shot of adrenaline this week, once again demonstrating the market’s ability to turn on a dime and catch out all but the most nimble of traders.

Tuesday’s sharp sell-off in equities (driven by a combination of ‘fear-factors’ which I wrote about here) reversed on Wednesday and Thursday, with the S&P 500 up 1.6% and recovering all of Tuesday’s losses as markets priced in the expectation of a positive outcome from the largest sovereign default in history. Friday’s trading saw the index up a further 0.4% up on Friday.

Additionally, the VIX ‘fear index’ has taken a beating, giving up all its Tuesday gains and suggesting that I may have been too soon in identifying a possible breakout here.

Last week is a perfect example of how dangerous it can be trading for the short-term if you don’t adequately manage your risk. This is even more to important to remember in the case of the VIX, as it essentially acts like a leveraged inverse bet on the S&P 500 – hence it can be useful as a hedge but timing it wrong will not look pretty. Case in point, during the past 5 trading days the VIX spiked 21% and then swiftly tanked 19%. Get caught on the wrong side of that trade and you are liable to have “your face ripped off” as the saying goes. (The VIX is now about 1% lower than when I first wrote about it in on February 24th)

The possible VIX breakout I identified was premature, and turns out to have been a so-called ‘head fake’. This is a good lesson – with hindsight I underestimated the significance of the 20.5-21 level on the VIX, which has been an area of significant support and resistance during the past 3 months. Had the index broken through this range then a break-out could have had legs. Chart below:

Despite last week’s trading, I am still watching for a concerted move higher by the VIX. One reason for this is something called ‘negative divergence’ and I’ve highlighted this in the lower section of the chart above. The RSI (or Relative Strength Index) is a measure of momentum, comparing the number and strength of ‘up days’ against the number and strength of ‘down days’ for any given stock or index during the previous ‘X’ number of days. It’s not rocket science.

Traders often watch for ‘divergence’ between the stock’s pricing movements and the RSI – that is to say if the stock is moving in one direction but the RSI is moving in the other. Some take this as an indicator that the market may be about to turn. If a stock or index is moving up but the RSI is moving down, this can be seen as evidence that the rally is running out of steam - this is called ‘negative divergence’. Conversely, if a stock is trending down but the RSI is heading up, it can be an indicator that the sell off may be overdone and is approaching a turning point. This is called – can you guess – ‘positive divergence’.

The VIX has been showing fairly strong positive divergence since December 2011, indicating that we could be reaching an inflection point at which the VIX makes a sustained move higher. (Note: the RSI is just one indicator - it’s very important not to rely on any single indicator, but to use multiple indicators to help you trade. I’ll be writing about other indicators as I come to them in later posts.)

While on the topic of the RSI, the S&P 500 is also showing a good example of divergence and this is one reason I’ll be watching this chart closely in the coming weeks, and keeping an eye out for possible pull-backs. Chart below:

  

As you can see from the above chart, since late December the S&P 500 has been trading upwards in a fairly obvious channel, as shown by the green lines. This channel has provided strong support and resistance at various points which I’ve indicated on the chart with the green and red arrows. (The non-filled arrows I’ve indicated are less convincing as support and resistance, because they do not quite touch the trend lines).

Two observations on the S&P: firstly, recent trading has seen the S&P break down below the support level of the trend line, eventually finding support at the 1340 level, a price which also held up the S&P on two earlier occasions in mid-February (shown by the thick red line).

Secondly, since the back end of January the RSI (bottom part of chart) has been trending downwards- this is an example of negative divergence and suggests the S&P rally may be getting old.

However as mentioned it's vital to use multiple indicators against which to test your theory. Another indicator I'm watching suggests some caution before betting on a decline in the S&P. Below is a chart of minute-by-minute S&P 500 data during the past 10 trading days, showing the correction from the intra-day high on Wednesday 29^th February to the low on Tuesday 6^th March:

The dotted red lines overlayed on the chart show the key Fibonacci retracement levels of 23.6%, 38.2%, 50.0% and 61.8%. More on Fibonacci in a later post but suffice to say many traders view these levels to be highly significant and closely watch how the market responds at these potential resistance and support lines.

As you can see in the above chart, the index encountered some resistance at Fibonacci retracement levels 38.2% and 61.8% (shown in the arrows above) but has since cleared these key levels with some ease. To me this suggests we should be very cautious before entering into any aggressive ‘short’ positions at this stage.

Monetary Freight Train

There's plenty of risk out there - as highlighted here and here - and signs that we could be overdue a more protracted correction.  I’ll be watching the S&P 500 for resistance at the 100% Fibonacci level of 1378. Above that, the lower band of the green trading channel I identified could become the next significant point of resistance.

However it pays to remain flexible and never become fixated on one point of view. This market continues to surprise on the upside and betting against the trend is dangerous. It’s become fashionable of late to question the current rally, and much of the financial media is calling for a correction – this in itself makes the contrarian in me cautious about betting on a sell-off.

It's important to understand that in large part the current rally is a product of the huge amounts of liquidity and ‘free money’ that is being injected into the banking system by the Fed, ECB, BoE et al. The scale of what is going on right now in central banks around the western world is absolutely unprecedented and getting on the wrong side of this monetary freight train could be extremely hazardous to your health.

“Eurogeddon” averted or just more can-kicking?

March 9th, 2012

Nick Hays

Dhaka, Bangladesh

Today - on The Long and the Short:

* Largest sovereign default in history confirmed: "Uncharted territory"

* “Eurogeddon” averted? Or just more can-kicking?

* The law of unintended consequences

* “No way out”

Tuesday’s sharp sell-off in equities, driven by a combination of ‘fear-factors’ which I wrote about here, reversed on Wednesday and Thursday, with the S&P 500 up 1.6% during those two trading sessions, recovering all of Tuesday’s losses in the process. 

In the same time frame the VIX ‘fear index’ has taken a solid beating, giving up all its Tuesday gains and suggesting that I may have been too soon in identifying a possible breakout. (I will be writing more about the VIX and S&P 500 in my next post.)

News flow out of Europe has been the dominant driver behind the price movements during the last couple of days, with fears of a disorderly default in Greece receding as negotiations for the PSI (Private Sector Involvement) reach a  conclusion. The PSI involves holders of E206bn in Greek government debt agreeing to trade in their existing bonds for newly issued ones of lower value. This write-down, or “hair cut”, equates to a loss of over 70% in Net Present Value terms for the bond holders.

Today it was confirmed that investors holding 83% of holders of Greek government debt have accepted the proposed bond swap. This beats the 75% below which the deal would have failed, triggering a disorderly default and likely financial chaos across the Eurozone.

The largest ever sovereign debt default, and the first for a Western European country in 50 years, this is huge news and analyst commentary on the deal is pouring in. The short-term market reaction is likely to be one of mild relief. However the longer-term picture remains far from certain and I expect it will not be long before doubts begin to resurface – to be sure, this has been the cycle for at least the past 12 months.

What comes next is very much up for debate as, in the words of Berenberg Bank’s Chief Economist, “We are in uncharted territory”.

Eurogeddon averted? Or just more can-kicking?

The aim of the debt deal is to reduce Greece’s sovereign debt burden from more than 165% of GDP to a more manageable level. Best-case scenarios project this deal will set Greece on track to reduce its debt levels to 120.5% of GDP, just above the maximum threshold of 120% considered sustainable by the IMF.

Longer term, however, considerable risk remains that this deal is little more than the latest in a series of can-kicking exercises, simply buying more time before the next crisis inevitably rears its ugly head. In fact the IMF itself sees Greece’s debt to GDP ratio on an “ever-increasing trajectory” and much doubt remains as to whether the debt burden can be reduced in the long-term. In fact, the new bonds are already trading at steep discounts to face value, indicating that the market still does not expect Greece to be able to pay back in full. 

The severe austerity measures ongoing in Greece are a painful but necessary step towards debt reduction for the country; but most economists agree that these measures must be accompanied by much-needed market reforms to improve its trade competitiveness. Deprived of the option to de-value its currency (aside from the ‘nuclear’ Euro-exit option) Greek competitiveness will have to be restored through a combination of a painful reduction in wages (making Greek exports more attractive) and removing the market-unfriendly policies and red-tape which currently throttle the private sector.

The scale of the reform required and the difficulty to implement it should not be underestimated. In this respect, Greece is like a patient requiring double heart bypass surgery, a lung and kidney transplant and chemotherapy all at once. Carrying out the necessary treatment to get Greece back on its feet undoubtedly means a lot more pain ahead for the country and its people: expect to see more urban violence, tyre-burning and pitched battles with riot police in the months ahead.

Street thuggery aside, the upcoming elections in May will provide a more constructive outlet for the Greek electorate to voice its frustration - and perhaps to vote in a new government on the back of promises to 'ease the pain'. This could mean scaling back on austerity measures, further debt default, a Eurozone exit or all three.

The road ahead for Greece will not be free of challenges, that much is clear, and the market’s relief resulting from the debt resolution will probably not last long. In fact I believe the deal itself sets a dangerous precedent and may result in a number of unintended consequences.

Unintended Consequences

Risk 1: Greek debt deal may encourage other sovereigns to follow the same path.

If Greece can reduce its debt burden by imposing a 'voluntary' default on its creditors, what is to say other nations won't also look to this approach? The other PIIGS nations - Portugal, Italy, Ireland and Spain - may well calculate default to be a more politically acceptable route to debt reduction than the programme of grinding austerity measures to which they have currently subscribed.

Anticipating this, credit markets would demand higher yields to compensate for the additional risk of default. Higher yields make the governments’ debt harder to service, with more and more output being consumed by interest payments. Hence their fiscal position becomes less sustainable and this in turn makes default all the more likely - a downwards spiral ensues.

Risk 2: Greek deal undermines the value of CDSs (Credit Default Swaps)

CDSs are essentially insurance premiums which investors and speculators can purchase to profit from a default on the debt obligations of a corporation or a government. One key difference between a CDS and an ordinary insurance premium is that you don’t have to own the underlying asset in order to buy the CDS – an analogy would be insuring a house against fire damage when you don’t actually own the house.

CDSs are economically useful because they enable bond investors to hedge their exposure, with the aim of reducing their overall risk. This ability to hedge their position and reduce risk makes investors more willing to invest in the bonds in the first place – all else equal, this increases demand, raising the bond prices and reducing the yield (yields go down as bond prices go up). The corollary of this is obvious: undercut the value of sovereign CDS and you raise the yields on government debt. When this happens, governments find it more expensive to raise capital or to roll-over maturing debt.

This is exactly the risk facing us today. Let me explain.

For all the talk of this being a "voluntary" write-down, the reality is that the private sector has been strong-armed into the deal, and was left with little choice but to take it. The message from the Greek Finance Ministry essentially boiled down to, "it's this or nothing": in other words, either everyone takes the "voluntary" PSI deal now or we proceed with an outright default and you get nothing.

The short-term consequences of an outright disorderly default would have been nothing short of catastrophic, certainly dwarfing any hedging gains from CDS payouts. Hence it should probably come as no surprise that today’s debt deal demonstrates the fact that Greek bondholders (on aggregate) have calculated that a 70% "voluntary" haircut and no CDS pay-out is preferable to a 100%  disorderly cut with a CDS payout.

But to call this "voluntary" is stretching the definition. The decision facing bondholders was like a man being given a choice between being hit by a car or by a freight train. Pausing for just a moment, the man responds, “Neither option sounds good to me, but on balance I'll take my chances and go with the first one...”

Essentially bondholders have not been given a choice at all. And what is more, in the process of accepting the "voluntary" default, bondholders may have surrendered their rights to any CDS payouts.

Whether to pay out on CDSs or not is the subject of discussion at an ISDA meeting (International Swaps and Derivatives Association) this afternoon. The committee (made up entirely of investment banks  and asset managers) requires a super majority (12 out of 15) to make a ruling. However regardless of the outcome of that meeting, the mere existence of doubt as to whether CDS payouts should or should not  be made in itself trashes the value of that instrument as a future hedge. To re-use the analogy, why waste your money insuring your house against fire when you expect the insurance firm will wriggle out of its obligation?

By undermining the value of default insurance (and all else remaining equal) bond yields will rise as traders price in the higher risk associated with holding a position which cannot be directly hedged. This has the potential to lead us to the same downwards spiral which I highlighted in Risk 1.

The long and the short of it?

Any relief rally associated with the Greek deal will be short-lived as questions of the country’s fiscal position resurface and investors begin to get to grips with the longer-term implications of today’s events.

Odds-on bet: we have not seen the last of easy monetary policy from central banks worldwide and we are likely to see a lot more of this in future. Governments and investors alike have become addicted to liquidity courtesy of the Fed, ECB, BoE and BoJ and, like an addiction, each time a bigger ‘hit’ is needed to have the same effect. As the Wall Street Journal wrote on 27^th February:

“All of the available signals point to the likelihood that the Fed will have to turn to more vigorous creation of new money (inflation) at some point—or face the possibility of rising market rates on government securities that sharply raise the Treasury's borrowing costs and devalue the Fed's enormous balance sheet.

No way out. No way out.”

EDIT:
Related Bloomberg article:
 “The rules have been changed here,” Gross, co-chief investment officer at Pimco, said in a radio interview on “Bloomberg Surveillance” with Tom Keen and Ken Prewitt. “The sanctity of their contracts is certainly lessened. Bondholders have that to look forward to going into the future.”

 

Market sweet spot or sugar rush rally?

February 24^th, 2012

Nick Hays
Dhaka, Bangladesh

Today - on The Long and the Short:

* Market sweet spot or sugar rush rally?

* The VIX - is the market underpricing risk?

* Forever blowing bubbles

Markets in the Sweet Spot?

The last two months have seen markets stage a powerful rally. Markets for risk assets have been buoyed by the convergence of three key factors: improved US economic data, reduced probability of a ‘disorderly’ default in the Eurozone and continued injections of massive amounts of liquidity by central banks.

The ECB, BoE and BoJ have all participated in recent bouts of liquidity since December 2011:

· ECB - €489 billion LTRO programme (December 2011)

· BoE - £50bn quantitative easing, or “QE3” (February 2012)

· BoJ - ¥10 trillion (US$129bn) (February 2012)

Future sources of additional central bank ‘pump priming’ will come in the form of the ECB’s second LTRO this week, which is expected to be worth an additional €500-750 billion according to Standard Chartered; the Fed is also widely anticipated to launch its own version of “QE3” later this year. Furthermore the Fed’s recent commitment to low interest rates through to 2014 has been another prop to risk assets.

It's a potent mixture. The result? Major equity indices are now up 20% or more since October. Yields on the sovereign debt of ‘peripheral’ European economies such as Portugal and Italy are down sharply since late January. In summary the risk-on rally has been very much back in play (see charts below).

S&P 500 index – 6 month chart (click to enlarge)

(The red arrow I’ve added highlights declining trading volume, demonstrating that the rally lacks broad market participation. For some this is an indicator that the rally lacks ‘conviction’. A major driver of this is in fact that average retail investors have been largely sitting on the sidelines and have missed the recent gains. Incidentally, a rush of retail investors to the market is a popular contrarian indicator. The AAII's Sentiment Survey can provide clues) 

   

Italian Government 10yr Bonds
(click to enlarge)

    

Portugese Government 10yr Bonds
(click to enlarge)

Sugar Rush Rally 

How much longer can we expect to remain in the market “sweet spot”?

Continued cheap money courtesy of central banks and the simultaneous improvement in the economic outlook surely will not continue in parallel indefinitely. One of these factors seems likely to reverse: either the economic data continue to improve and central banks reign in the easy money, or the data worsen. Either one of these events will result in the market losing a major prop to current prices.

For now, however, markets seem to be having their cake and eating it too. Are we approaching a come down after the sugar rush rally?

To help answer that question, one indicator I’m watching closely is the VIX, aka the ‘Fear Index’.

The Fear Index…and what it’s telling us

The VIX is a measure of volatility as implied by the price of options contracts for the S&P 500 index - essentially this is the cost to insure against large moves in future market prices. The VIX tends to spike during times of market volatility as investors seek to hedge positions, and drops during periods of relative calm. For this reason it is commonly known as the ‘Fear Index’.

Below is a 5 year chart of the VIX:

And here’s the VIX going back to 1990:

  

As you can see from the above charts, the VIX has dropped more than 50% since October 2011. Looking longer term, the VIX’s Friday close of 17.31 is below the average closing price from 1990-2012 of 20.56. (Excluding the period since the onset of the financial crisis, the average price from 1990-2007 was 18.97).

This tells us that the market is pricing in a relatively low probability of future volatility. While this may be a rational response to the current ‘sweet spot’ conditions described above, I believe that the market is betting on an overly benign outlook and there is a considerably fatter “tail risk” than is currently being priced in.

Fat tails and known unknowns…

A number of economic and geopolitical risks exist, each of which is capable of delivering a sharp dose of reality to the markets.

1. Good news is bad  news – continued improvement in US economic data would reduce the probability of the Fed launching another round of money printing (QE3). An uptick in inflation would likely have a similar effect.

      2. Europe not out of the woods yet - History suggests that the Greece bail-out announced last week is not the last we’ll hear on the Euro zone crisis. The recent Greece deal was met with little enthusiasm by the markets and analysts are already questioning the viability of the recent deal, including the IMF whose assessment is that the balance of risks is “mostly tilted to the downside”. Furthermore, the hard line being taken by Draghi and the ECB (i.e. the focus on austerity measures to achieve debt reduction) risks exacerbating the current slump in European output. The IMF’s view is that the current stance risks sending Greece’s debt  “on an ever-increasing trajectory”.

      3. China hard landing - efforts to cool an overheated economy in 2010/2011 appear to be taking effect, in particular dampening activity in the real estate sector.  Preliminary March data from HSBC’s Purchasing Managers Index indicates declining activity for the 4^th straight month. The risk remains that China will fail to engineer a ‘soft landing’.




HSBC China PMI

  4. Middle East conflict – Syria develops into a full-blown civil war, perhaps spreading into Lebanon and destabilising the region. Iran/Israel conflict. Oil prices surge, acting as a brake on a fragile economic recovery in the US.

Forever blowing bubbles

Is risk underpriced and are assets overinflated? That depends on your perspective. Examining the fundamentals alone, the answer may be yes. Among the signals that prices are a little rich at these levels, the Cyclically Adjusted PE ratio (CAPE) is now above the long-run average, and US corporate profit margins are showing signs of having peaked.

It seems that markets are increasingly reflections of central bank policy, rather than the long term underlying fundamentals. As PIMCO’s Mohamed El-Erian puts it:

Unusual policy activism on the part of central banks...has inserted multiple wedges between valuations and the underlying fundamentals. It has also altered liquidity conditions and affected the functioning of certain markets.

http://www.cnbc.com/id/46517952

Are central banks in the process of blowing yet another asset price bubble?

That may be so, but it may also be unwise to bet against the current tidal wave of cheap money. In the words of Warren Buffett , markets can remain irrational for longer than you can remain solvent. In other words, ‘don’t fight the Fed’.

Furthermore, can we even argue that the current market is pricing ‘irrationally’? To an extent, the market today is merely a rational response to two powerful trends: socialisation of risk by governments and loose monetary policy. These trends have been in place at least since the bursting of the dot com bubble, but have accelerated since the onset of the GFC in 2008.

For all the talk of ‘no more bailouts’ and breaking up the ‘too big to fail’ banks, banks are now larger and more concentrated than ever. The climate of moral hazard is alive and well and we must be alert to the effect on investment behaviour that this has.

The takeaway?

Markets may well be exhibiting some signs of ‘irrational exuberance’ in the short term and it may therefore be wise to tread carefully before committing any new funds to risk assets. My expectation is that lower equity prices will materialise in the near future.

However any correction which does come may be short lived. The current climate of easy monetary policy means that investors may need to accept a ‘decoupling’ of asset prices from fundamentals for some time ahead.

In the meantime, I will be keeping an eye on the VIX as a possible hedge against future volatility.

Constructive comments and feedback are very welcome below, or else you can contact me at nicholashays1@gmail.com