Out of the Frying Pan, Into the Fire

Summary:

Part of our message has been that despite the heroic Fed and Treasury efforts that brought the economy down to a hard, but safe, landing - something akin to the Jan'09 Miracle on the Hudson, those efforts, in combination with completely misguided and irresponsible attempts to expand the federal government's role in the private economy, could actually morph into a substantially worse situation - something akin to the Titanic catastrophe - wherein the damage to the financial system bleeds through to and compromises the entire system. In such a scenario, the international community increasingly questions the solvency of the US government and the US dollar-based global financial system adjusts in a disorderly manner. Both themes were highlighted last week, with some experts calling on the end of the recession and other experts heralding the demise of the US dollar as the global reserve currency. We think markets are overreacting to both situations.

Asset Outlooks -
• Equities - Protect long equity exposure, as equities are overbought.
• Currencies - protect pro-growth trades and should equities correct, NZD/JPY and AUD/CHF look most at risk.
• Eurodollar interest rate futures: look to establish long positions. Market overestimating Fed hikes.
• Treasuries - neutral. Curve - neutral short-term; flatter in 3 to 6 months.

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End of the Recession - The Devil's in the Details

Goldman Sachs early last week issued research stating that the recession was ending "about now". Fed Chairman Bernanke went further, stating that the global economy was starting to emerge from recession due to the stimulus efforts of governments worldwide. Bernanke was echoing a statement made earlier in the week by the OECD, which stated that leading indicators from the major countries suggest that the low point of growth for its 30 member countries had recently or was about to be reached.

Much of the data last week corroborated the notion that The Great Recession was ending. Japan's GDP was reported as having grown in Q2, the first positive print in five quarters. In Europe, the German ZEW survey jumped from 39.5 to 56.1, a three-year high, and the German services PMI jumped to 54.1, the first expansionary print since Sep'08. In the US, both the Philadelphia Fed and Empire Manufacturing surveys for August not only surprised to the upside, but did so by registering their best expansionary prints since late-2007 and early-2008, respectively. Looking more generally and farther out, the leading indicators rose strongly (0.6%) in Jun, suggesting economic activity will expand into Q109. Evidence that the housing is beginning to clear came in the form of existing home sales for Jul, which spiked 7% to an annualized rate of 5.24m, the highest rate since Aug'07.

But there's dark linings in them thar' silver clouds!

The Cash for Clunkers program is being hailed as a smashing success and wound up ahead of schedule. The $3bn in rebates allocated for the program will likely be entirely used up. As we stated in detail in our Aug 21 morning commentary, however, the program also represents threats to growth. It boosted sales and production at least partly at the expense of future sales and production, and so both will fall below even recent rates several months down the road. By artificially boosting sales and production, the program interrupted the much-needed reallocation, or creative destruction, of excess capacity in the auto industry. And finally, the program caused the most vulnerable people in the economy, the lower, middle and middle class owners of older vehicles, to lever up on debt and depreciating assets at a time when these people should be shoring up their balance sheets in the face of rising unemployment.

The housing data are not all positive. Even the existing home sales report showed that 1) those sales came at a price discount, as the median price fell from $182K to $178.4K and 2) the sales are apparently causing inventory that had been held off the market to be released, as despite the rise in sales, the month's supply stayed steady at 9.4 months because the units available for sale jumped 7.3%. Furthermore, the mortgage delinquency rate for Q2 rose yet further to 9.24%, and this rate is likely to remain elevated as more homeowners end up upside down in their homes (mortgages for more than the value of the home) and unemployment rises. Finally, housing starts and building permits failed to rise as expected, and both rates remain mired at depressed levels.

The labor data last week were discouraging. Initial jobless claims unexpectedly rose, and continuing claims rose more than expected. Initial claims continue within a downtrend from their March peak, but are proving stickier than hoped, while continuing claims are merely holding steady rather than downtrending. The continued job losses will weigh on the US consumer and housing, holding back the sustainable pace of growth.

We remain of the opinion that growth in H2'09 will be unsustainably high and so a "V"-shaped recovery is out of the question. Rather, if lucky, growth will trace a saw-toothed pattern, but policy mistakes, including increased government intervention and/or excessive tightening of policy, whether via termination of asset programs, increasing of the Fed Funds rate, or tax increases, make a "W"-shaped economic growth trajectory possible.

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Trash Talking the Dollar - Careful What You Ask For!

Early last week, we wrote about the dangers and problems associated with a decline in the dollar and the tectonic shift in power that would accompany it. Subsequent to our writing, based on comments by Warren Buffett and PIMCO's Curtis Mewbourne, PIMCO's El-Erian came out with further comments against the US dollar (can't they get red-carded for that!?), suggesting that the increasingly disjointed policy response of world leaders could precipitate a disorderly decline in the US dollar. Nobel Prize winner Joseph Stiglitz went the furthest, however. Not only did he plainly call out the "king" (dollar) for having "no clothes" when he noted the low US yield and increasing risk associated with US debt, he characterized the global US dollar-based financial fabric as fraying and judged American-style capitalism a failure.

We deem calls for the demise of the US dollar problematic and rhetoric regarding the failure of the US dollar and US system dangerous and irresponsible. In terms of being a difficult call, it is one thing to call on the diminution of a leader's position, but another thing entirely for someone to actually step up into the place of the leader. After all, don't we all love to bash the boss? But who really wants their job? The appreciation of other currencies as they shoulder a bigger responsibility on the global economic stage is something that will strain domestic economies, perhaps to a degree that policymakers balk and begin to intervene. China, Australia, and Japan are just a few of the countries that come to mind.

We have repeatedly stated that despite the intellectual and theoretical arguments of academics that human beings have somehow advanced to a degree of heightened rationality that allows for group-optimizing behavior, the reality of the "street" is that ultimately a currency's strength and dominance is maintained with the tip of a spear or muzzle of a gun. Human nature has changed little since either the Roman or British Empires, and a glance at the current situation in the Middle East and reflection on the carnage of the 20th century should disavow us of such smug, smoking-parlour ruminations.

A multi-polar financial order based on mutual strength, respect and similar mores is difficult enough, especially when trying to meld European, American and Asian philosophies on human rights, government, and economics, but approaching it when one or more parties are in crisis is a recipe for disaster. Unfortunately, US policy is currently unable to get out of its own way in that the leadership has consistently failed to manage its fiscal responsibilities, and we are stuck enduring a tectonic shift in global power while in a self-induced crisis.

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Asset Outlooks
Equities - Yes, That Lamp Shade Does Look Ridiculous!
Stocks closed Friday on the year's high! FADE IT! Our only response to the rally and stock market bulls is the unsatisfactory, "markets can stay irrational longer than traders can remain solvent (or portfolio managers employed)." The danger signals are flashing.

ChartoftheDay.com notes that the current S&P500 PE ratio, with 97% of companies reporting, stands at 129 - well above the peaks in the low 20s observed from the 1930s to the 1980s. The peak of the internet bubble was around 40. The Merrill Lynch survey of fund managers found that the average cash balance had fallen to 3.5%, the lowest since Jul'07 (just before the commercial paper market seized), and 34% of managers are overweight stocks, the most extreme since Oct'07, when the equity market last peaked. The AAII Bullish indicator peaked on Aug14 at 51.0. The two previous times the reading peaked above 50 were in Oct'07, when the S&P500 peaked, and May'08, when the S&P500 was ending a countertrend rally. Finally, Trim Tabs notes that the insider sell/buy ratio has spiked to 32%, the most extreme level in data back to 2004. Percentages of 6 to 28% during 2004 were associated with a flat S&P500 during the first 10 months of that year. Calling tops is difficult and unprofitable in an upwardly biased series like equity prices. However, we repeat our calls for managers to protect existing equity exposure and not initiate new exposure.

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Currencies - Neutral USD - Wary of Pro-Growth Trades
USD Index - Neutral. Fighting the massive weight of global opinion is a loser's game. The market is rooting for the demise of the dollar. That is a form of madness, given the uncertainty it will unleash for investors and policymakers globally, but US leaders are doing precious little to shore up confidence. The government continues to spend, assuring that its programs will be cost efficient even as it fails to confront the failures to manage the costs of past programs (Social Security and Medicaid/Medicare). The rest of the world is looking to diversify away from dollar assets at every opportunity. Even the Fed is backing away from its Treasury buying program. Along with US-centric issues are foreign-centric ones. The Japanese could be looking at increased government spending (elections in late-August), which will drive up their interest rates and create competition for Treasuries. The Chinese banks are cutting back on lending, which means less excess money will find its way into not just the Chinese stock market, but also the US asset markets.

Despite the negativism on the US dollar, it is hard to get too bulled up on other currencies. The UK is in an even deeper crisis than the US, Europe is looking at its own credit crunch. And other currencies look overbought, both on a positioning and technical analysis basis. However, should things go "pear-shaped" and equities roll over and begin to fall, the US dollar will likely begin to appreciate as 1) traders unwind carry trades and 2) investors retreat from the view that the rest of the world is ready to face the brave, new world in which the US dollar is no longer "king". In a normal world, we'd be long the USD on a contrarian play. Unfortunately, we no longer inhabit a "normal" world.

Other ways to play a turn in the equity markets and/or a rethink of global growth due to Chinese tightening would be to short either NZD/JPY or AUD/CHF, as both these crosses tend to correlate strongly with equity prices and global growth. Furthermore, both of these crosses are extremely overvalued relative to trend (26-week moving average). At the very least, we would be snugging up stop-losses on pro-growth positions in AUD, NZD and CAD, or selling calls or buying insurance puts.

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Eurodollars: Look to be long short-term interest rate futures

The futures markets continue to price in too much in Fed Funds hikes during the next year. Using the Taylor Rule (Deutsche Bank version) and the Bloomberg median forecasts for core PCE inflation (to bottom at 1.30% in Q1'10 and unemployment (to peak at 10.00% in Q1'10), the required Fed Funds target rate would bottom at -6.68% in Mar'10. Yes, NEGATIVE 6.68%. The strong negative reading supports the myriad asset purchase programs that the Fed has put in place even after having put the Fed Funds rate about as low as it can go (zero to 25bp).

Perhaps the old saying about every problem looking like a nail to someone armed only with a hammer applies here. Fed Funds and Eurodollar futures traders bet that the Fed will tighten in coming months. Indeed the Fed has communicated it will. The Fed is already reducing its support for the Treasury market. As the crisis rolls through other parts of the financial sectors and economy (i.e. commercial real estate), the Fed will unwind programs that are no longer needed even as it ramps up new ones and extends others. However, those programs will be where the changes come - not in the blunt tool of the Fed Funds rate. The Fed has continued to communicate that the dire situation warrants an exceptionally low Fed Funds rate for a long time, and the outlook for inflation and unemployment support this statement. The Fed Funds futures price in roughly a 40% chance of a Fed hike by the January meeting and roughly a 70% chance of a Fed hike by the March meeting. Neither outcome is plausible based on historical Fed behavior and the outlooks for the economy. The March 2010 Eurodollar futures contract appears to be correcting lower from recent highs. We recommend using a pullback to establish long positions.
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Treasuries: Neutral Yields - Like Longer-Term Flatteners

After testing new lows since early in July, Treasury yields spiked on Friday along with equities. Treasuries have a bigger problem than just whether stocks go up or the economy rebounds. Buyers are balking. True, from January to June, net foreign holdings of Treasuries rose $200bn. However, the TIC data for June released last week showed that China decreased its net holding of Treasury bills, notes and bonds by $25.1bn, or 3%, to $776.1bn. Entities using Caribbean financial centers reduced their holdings by $5.1bn - the 3rd consecutive month of net selling. Russia dropped its holdings by $4.6bn - also the 3rd consecutive month of net selling.

And note that against the $200bn of foreign buying from Jan to Jun, the US Federal Reserve chalked up $170bn in buying. Further, the Fed has subsequently purchased another $85bn in Treasuries. But the Fed is now winding down its Treasury purchase program and turning the market back over to the market. Unfortunately, the market does not seem like a friendly place for US Treasuries right now. Rumors have circulated that PIMCO jumped in to save one of the recent Treasury auctions. Stronger economic data would combine with supply/demand worries to push yields higher. While a turn lower in equities would cap such a move.

We remain very concerned about the Fed winding down its Treasury purchasing program. With traditional buyers backing away from the market, a failure by the Fed to put a cap on yields (a buyer of last resort) would mean that Treasury yields could eventually push up mortgage rates, and this is going to put a nascent stabilization in the housing market at risk. The spread of the average of the 5- and 10-yr Treasury yields over the 30yr FNMA mortgage commitment rate has dropped to 176bp, among the lowest levels of the crisis (the low was 156bp in May'09. In May, the rise in Treasury yields and compression of the mortgage rate spread caused mortgage yields to jump over 100bp in roughly three weeks.

Friday's spike in yields put the 2yr and 10yr yields (1.09% and 3.56%, respectively) around the middle of their recent ranges (0.85-1.45% and 3.30-3.80%, respectively). We would be neutral on the yields.

As to the curve, at 247bp, the 2s10s curve is also around the middle of its recent 240-260bp range. Eventually, we see this curve flattening. This assumes that either the Fed continues to exert pressure on Treasury yields and that Congress learns some self-control on spending, or alternatively, that the economy and financial sector normalizes and the market begins to price into Fed hikes.