I … Stocks Rallied This Week On Euro Yen Carry Trade Investing
Chart reveals that an unwinding euro-yen carry trade, EURJPY, began to cause disinvestment in the European stocks, FEZ, in November 2009 as concerns arose over Greece’s sovereign debt.
Chart reveals that on April 26, 2010, the European Shares, FEZ, sold off heavily on carry trade disinvestment and risk aversion caused by the onset of the European sovereign debt crisis with contagion spreading to European Financials. And Australian Shares, whose ETF is composed largely of banks and basic material shares, heavily sold off. It was at this time that the currency traders sold the world currencies against the yen, causing the US dollar to rise in value. Then on June 7, 2010, the EFSF Monetary Authority, was announced and the Euro rose in value and the European Shares and especially the Australian shares recovered. The chart also shows that debt deflation was harsher on the value shares than on the growth shares, as the value shares are highly dependent upon unhindered access to low-cost lending; from April 26, up until recently, specifically this last week, the spread between corporate bond rates and government bond rates had been increasing, thus deleveraging the value shares more than the growth shares.
Chart reveals that this week the currency traders loosened their spigot of investment liquidity, and went long the Euro, FXE, relative to the Yen, FXY, that is the EUR/JPY, in response to the stock traders going long the financial sector on Monday, causing world shares, ACWI, to rise 5%, European Shares, FEZ, 8%, Australian shares, EWA, 7%, Value shares, RPV 6%, and Growth shares, RPG, 4% — the value shares outperformed the growth shares on the expanded investment liquidity, and decreased spread between corporate bonds and US government bonds.
The Russell 2000, IWM, rose 5%, this week to close just under 63, which is the bottom edge of a massive head and shoulders pattern going back to March 1, 2010 as well as a huge broadening top pattern going back to December 21, 2009.
One of the most depressed ETFs, TAN, that is the solar energy shares, rose 14%, as did Spain, EWP, which rose 10% on the higher EUR/JPY.
Chart reveals Metal manufacturing, XME, Steel, SLX, and Basic materials, IYM, all rose 8% this week, on the higher EUR/JPY. And the chart of Newmont Mining, NEM, shows that it rose 4% this week with carry trade investing on its rather reasonable price to earnings ratio.
High Yield Corporate Debt, HYV, rose 3%, continuing a long rising beginning in June, supported by a what is rumored to be credit market support coming from the sale of puttable CDs issued by European Banks. This closed end investment is known for sharp declines; I cannot recommend investment in it at this time.
Gold, $GOLD, closed at 1,211; should stocks rise next week, it could easily fall lower to $1,180.
The 300% inverse of the 30 Year US Government Bond, TMV, rose 5% this week as US Treasuries fell; institution investors should start buying now on price dips. Once the current rally fails, which is likely when the Euro, FXE, strikes 128, an investment in the 300% inverse of the small shares, TZA, is recommended as debt deflation is going to hit hardest on these and the financial shares. The greatest financial reward by far is going to come to those invested short the small caps with SJH and TZA which are 200% inverse and 300% inverse of the Russell 2000.
The yield curve, $TYX:$TNX, weakened some this week; but risk aversion to US Government deficits, and the European Sovereign debt crisis, has been causing the yield curve to rise since the currency traders sold the world currencies on April 26, 2010, creating the rising investment demand for gold.
Now that the US Dollar, $USD, which traded by the 200% ETF, UUP, turned down June 7, 2010, and the yen, FXY, has turned down 1% this week. The dollar closed today at about 84, down from the June high of 88.7. We have entered into the age of competitive currency devaluation …. currencies, stocks and bonds, will all be tumbling lower together into the pit of financial abandon, albeit at fluctuating rates.
II … This Week’s News
Tal Bark Harif and Arnaldo Galvao of Bloomberg report on July 6, 2010: “Brazil’s bid to wean itself off floating-rate debt, a legacy of 1990s hyperinflation, is faltering as the central bank boosts benchmark borrowing costs from a record low. The percentage of the government’s 1.59 trillion reais ($894 billion) of debt that was issued at yields tied to the overnight lending rate, known as Selic, climbed to 33.6% in May from a record low of 30.7% in 2007.”
Shamin Adam of Bloomberg reports on July 9, 2010: “Singapore may overtake China as Asia’s fastest-growing economy this year, increasing the attractiveness of the city state’s stocks and putting pressure on policy makers to check inflation with a stronger currency.”
The stable India Rupe, INR, coupled with hot money flows chasing inflation in India, has resulted in India shares, INP, rising since late May 2010. Financial Express reports in article SBI Fears Liquidity Squeeze, Bets On Mega Deposits, that “State Bank of India (SBI) has changed tack to focus on mobilising large-size deposits as it braces for further tightness as the demand for loan is picking up. In the last fiscal year, when liquidity was ample, the country’s biggest lender repaid half of its high-cost so-called bulk deposits. Now, it has begun offering a premium for deposits of Rs 50 crore or above, officials said on Wednesday, forecasting demand for loans would rise. SBI will pay 6.5% interest on a minimum deposit of Rs 50 crore for one year or above. This is 50 basis points above the top rate for the standard bulk deposit of at least Rs 1 crore. Higher interest rate is offered on large bulk deposits for a limited period, said an official who manages bulk deposits of the bank.The bank in its website says it accepts deposits of Rs 1 crore and above for different tenures at 1.50-6.00%. The premium rate scheme for big bulk deposits was launched a few days before Reserve Bank of India hiked policy rates by 25 basis points on Friday. Another senior official said the focus on big sized bulk deposits anticipated tightness and RBI reducing liquidity support in the coming days. It was in line with SBI’s decision to borrow from the RBI in the 5.50% repo tender despite having Rs 30,000 crore surplus funds, which were invested in government securities. “Currently, we have no problem with liquidity and we have huge cash surplus,” the official said. However, the official noted “a pick-up in loan demand and excess liquidity is drying up fast”.
Wikipedia relates that “the State Bank of India is the largest state-owned banking and financial services company in India, by almost every parameter – revenues, profits, assets, market capitalization, etc. The bank traces its ancestry to British India, through the Imperial Bank of India, to the founding in 1806 of the Bank of Calcutta, making it the oldest commercial bank in the Indian Subcontinent. The Government of India nationalized the Imperial Bank of India in 1955, with the Reserve Bank of India taking a 60% stake, and renamed it the State Bank of India. In 2008, the Government took over the stake held by the Reserve Bank of India. State Bank of India is the largest of the Big Four Banks of India, along with ICICI Bank, Axis Bank and HDFC Bank — its main competitors. Its slogans are: With you all the way, Pure banking nothing else, The Banker to every Indian and The Nation banks on.”
The market in Brazil, EWZ, and especially the market in India, INP, are overheated. For institutional investors I recommend some limited investment in the Proshares 200% ETFs, BZQ and somewhat more INDZ. The greatest financial reward by far is going to come to those invested short the small caps with SJH and TZA which are 200% inverse and 300% inverse of the Russell 2000.
Michael Quint of Bloomberg reports on July 8: “New York Governor David Paterson delivered 6,709 vetoes — a stack of paper 31 inches high — to absent lawmakers, trimming $805.3 million of spending that still doesn’t close the state’s $9.2 billion deficit. With its Senate adjourned, the nation’s third-biggest state by population has a spending plan without enough revenue to pay for it.”
Michael Powell of the New York Times reports on July 6, 2010: “Even by the standards of this deficit-ridden state, Illinois’s comptroller, Daniel W. Hynes, faces an ugly balance sheet. Precisely how ugly becomes clear when he beckons you into his office to examine his daily briefing memo. He picks the papers off his desk and points to a figure in red: $5.01 billion. ‘This is what the state owes right now to schools, rehabilitation centers, child care, the state university — and it’s getting worse every single day,’ he says … ‘This is not some esoteric budget issue; we are not paying bills for absolutely essential services,’ he says. ‘That is obscene.’ For the last few years, California stood more or less unchallenged as a symbol of the fiscal collapse of states during the recession. Now Illinois has shouldered to the fore, as its dysfunctional political class refuses to pay the state’s bills and refuses to take the painful steps — cuts and tax increases — to close a deficit of at least $12 billion, equal to nearly half the state’s budget.”
Dakin Campbell of Bloomberg reports on July 6, 2010: “Citigroup Inc., State Street Corp. and U.S. Bancorp are among U.S. banks whose municipal bond holdings have reached a 25-year high just as state budget deficits swell to $140 billion … Commercial lenders added more than $84 billion to their holdings since 2003, according to the Federal Reserve, pushing total investments to $216.2 billion at the end of the first quarter. Bank regulators and ratings companies are ramping up scrutiny of banks most at risk … ‘There is a huge untold problem here,’ said Walter J. Mix III, a former commissioner of the California Department of Financial Institutions … ‘The economics lead to the conclusion that there will be downward pressure on these bonds.’”
Justice Little of Taiwan Publishing Group writes on July 9, 2009: It’s Chapter 66 As US States Face Bankruptcy
Doug Noland of Prudent Bear on July 9, 2010 relates: “U.S. junk and municipal debt markets were notable for lagging during this week’s rally in global risk assets. In particular, the cost of protecting against defaults by some of our largest states remained stubbornly high. The cost of California (310bps) and Illinois (332bps) CDS are significantly above the levels for Portugal (265bps) and Spain (213bps). If I am correct that market focus is shifting from European to U.S. structural debt issues, I would expect our expansive municipal debt markets to become a key analytical focal point. And the loss of Credit Availability for our marginal state and corporate borrowers would be a blow both to the U.S. recovery and the perception of the dollar as safe haven.”
Corey Rosenbloom relates on June 9, 2010 that “We’re facing declining market internals as the market continues its rally, which signals caution for the bulls and potential upcoming opportunity for the bears.”
III … We have been living in the age of debt liquidity for decades, now abruptly, very abruptly, we have entered into the age of debt deflation and the age of the end of credit.
A … We entered into the age of debt deflation, shortly after the Federal Reserve terminated its QE facilities, that is on April 26, 2010, when the currency traders sold the world’s currencies, against the Yen. There was a significant yen carry trade disinvestment as the Yen, FXY, rose to 113.19 on July 6, 2010, before closing at 111.74 on July 9, 2010, which caused the S&P, SPY, to close at 102.87 on July 6, 2010 and end up this week at 107.96.
Chart reveals that the greatest disinvestment came out speculation in commodities, specifically base metals, DBB, in part due to credit tightening in China, and oil, USO. Significant disinvestment came out of basic material stocks, IYM, which includes, metal manufacturing, XME, and steel producers, SLX, the Russell 2000, IWM, on the fall of the banks, KBE, and the widening spread between corporate bonds and government bonds, and European shares, FEZ, as contagion spread to European Financials, EUFN, especially banks in Spain, EWP, from the European sovereign debt crisis. It is very difficult for businesses in Spain to obtain loans, as banks there have lost their lending seigniorage. The rise in the Euro, FXE, has recapitalized, the European Financials, EUFN, as well as Spain, EWP, and Europe, FEZ.
The next stage of debt deflation will fall hardest on two groups: The first group to suffer the most will be Americans, who up until now, have witnessed an investment demand for US Government debt, as investors sought a “so-called safe haven investment” from the European sovereign debt crisis, with investing coming to IEF, and TLT, and ZROZ. But I expect failed US Treasury auctions soon, as concerns rise over mortgages held by US banks rise, and over concerns rise about US deficit spending. I see the yield curve, $TYX, $TNX, continuing to steepen. It has been steepening due to mortgage interest rates falling more rapidly than the longer out interest rates. But, soon a new dimension will cause the yield curve to strengthen even more, that being risk aversion to investing in the longer out US Treasuries, thus there will be rapid exit from the 20 to 30 year US debt, causing its value to quickly deflate, resulting in a fast rise in the 30 year rate, $TYX, compared to the ten-year rate, $TNX.
The second group to suffer the most will be the small US companies, specifically the Russell 2000, IWM, and the pure value companies, RPV, which rely on credit to meet payroll, buy inventory and pay accounts payable.
B … Annaly Capital Management, provides helpful insights on the corporate credit market, reporting: ”Ahead of the second quarter earnings season, paralysis and risk aversion are prevailing themes in corporates. One does not have to look too hard for the evidence. Investors are trading less, selling bonds, and improving portfolio quality. More precisely, monthly trading volumes are down 46% from this year’s peak, money is flowing out of high yield funds, and the highest quality corporates have outperformed their riskier peers. Concurrently, firms continue one of their most popular financial strategies of late: hoarding cash. Moreover, mid-cycle risk-taking activities such as M&A, the gearing up of capital expenditures and even returning cash to shareholders in the form of higher dividends and share repurchases have fallen short of the promise implied by the spring’s catapulting S&P 500 index. Collectively, this risk aversion and paralysis has caused credit to outperform equities in the sell-off.”
“One consequence of recent market behavior is a material shift in relative valuations between debt and equity. First, changes in demand preferences in the post credit crisis era have supported the performance of debt. Perhaps the most nimble of asset allocators, mutual fund investors, have been buying fixed income and selling equity since 2008. Likewise, corporate defined benefit plans migration toward liability driven investment (LDI) has resulted in a shift towards fixed income. Most recently, the prevailing force behind the demand and performance of fixed income is the growing recognition of a deflationary U.S. economy. The recent rally in the 10-year Treasury yield to below 3% is the best evidence of the sentiment shift. With respect to credit, the higher quality the bond the more it gets taken along for the ride.”
“Flows are also simply chasing returns. Market pundits make numerous analogies to the U.S. outlook being similar to the Japanese experience. Return data for U.S. equities tell us that the lost decade has already come to pass. On the bond side, the multi-year disinflation trend has captured declining nominal yields. In the table available in our online version, we compare the returns of the S&P 500, the Bank of America Merrill Lynch Fixed Income Domestic Aggregate (Treasuries, mortgages, Agencies, and investment grade corporates) and the BAML High Yield Bond Index. Over the past 10 years, for example, stocks have produced annualized losses of 1.6%, whereas the fixed income and high yield benchmarks have returned 6.5% and 7.4%, respectively. In the table, we also present the CPI index in a CAGR context. Clearly, the secular disinflation trend has supported the long-term performance of fixed income assets. At a time when there appears to be widespread capitulation on the rate front, it’s important to ask what next? One thing we know about bonds is that their returns are bounded by the fact that yields can only fall to zero. Total return is composed of price and income returns, thus with the Domestic Aggregate Index yielding 2.25% and priced at $107, one must ask about the upside.”
Chart of Vanguard mutual bond funds shows VUSTX, a long-term government bond fund ranging in maturity from 15 to 30 years, drawing up all bond funds, including the junk, WHEHX, and others VFIIX, VWESX, VFICX, since April 26, 2010 as investors seek a supposed safe haven. The long-term VUSTX turned down July 6, 2010; but the junk WHEHX has remained strong.
Candlestick chart of CFT shows a likely top has been made in the U.S. investment-grade credit sector of the bond market as defined by the Barclays Capital U.S. Credit index. Note the two cup and handle patterns followed by a week of resistance with two last days of lollipop hanging man candlesticks; click on chart to enlarge.
Weekly chart of AGG suggests we have reached the end of the age of credit liquidity; click on chart to enlarge
Weekly chart of CFT suggests the end of credit has been achieved; click on chart to enlarge.
The two-year chart of CFT compared to IEF, EWS, IWM and FEZ shows the volatility and loss experienced by equity owners compared to bond holders; click on chart to enlarge.
Chart of CFT compared to Exxon Mobil, XOM, shows how bond holders have maintained value and income, where as the stockholder in the once great energy producer have lost significant value; click on chart to enlarge.
C … The greatest investment deflation, and the most social suffering will come at the core, that is in KBE and IWM; and the least dislocation at the periphery, that is in China, FXI, and India, INP … Great deflation and suffering will also be experienced in heavily indebted emerging Europe countries such as Romania and Croatia.
1) … Both Anworth Mortgage Asset Corporation, ANH, and Annaly Capital Management, NLY win my kudos for being the most efficient companies of the year.
Chart shows Anworth Mortgage Asset Corporation, ANH, rose to its yearly high July 9, 2010. The corporation is a REIT which invests in GSE mortgage-backed securities, CDOs and other real estate securities, on a leveraged basis. There has been great demand for Anworth Mortgage Asset Corp’s services for a number of reasons, one of which is reflected in the value of mortgage-backed securities.
Lew Corcoran in article Massachusetts Mortgage Rate Trends and Forecast for July 9, 2010, writes: “The FNMA 30-Year 4.0% MBS coupon opened at 101.44 this morning – the same as yesterday’s close. Remember, on mortgage-backed securities (MBSs), as the price goes up, the yield comes down – and so do mortgage rates. The chart shows the price trend of the FNMA 30-Year 4.0% mortgage backed securities coupon over the past 30 days from 6-9-2010 to 7-9-2010″ — the MBS has risen from 100.50 to 101.44.
Annaly Capital Management, NLY, a successful competitor of ANH, in news release Annaly Capital Management Announces Monthly Commentary for July reports : ”According to Barclay’s, the Fed is most likely to engage in swapping Fannie Mae 5.5s for Fannie Mae 4.5s as they have the greatest float, the highest new issue volume and will likely have a shorter duration than lower coupons. As a result of these two new policy decisions Agency mortgage-backed securities should stay well bid for the foreseeable future.” This is definitely a positive for both NLY and ANH who market such securities.
Annaly Capital Management details two policy developments … ”The first, came on June 23, when Fannie Mae announced increased penalties for borrowers who walk away or strategically default on their mortgages. According to their release, defaulting borrowers who walk-away and had the capacity to pay or did not complete a workout alternative in good faith will be ineligible for a new Fannie Mae-backed mortgage loan for a period of seven years from the date of foreclosure” and ”Fannie Mae will take legal action to recoup the outstanding mortgage debt from borrowers who strategically default where allowable by law. Freddie Mac is thought to be considering a similar policy” … “The second policy decision, came on June 28, as the New York Federal Reserve announced their intention to engage in coupon swaps to help facilitate delivery of approximately $9.2 billion in currently unsettled thirty-year Fannie Mae 5.5% pools. The New York Federal Reserve plans to swap unsettled Fannie Mae 30-year 5.5% coupon securities for other Agency MBS that are more readily available for settlement, according to the release. This would potentially ease the fail problem present in the system which was created by the Fed’s purchase program which we spoke about in our last commentary. According to Barclay’s, the Fed is most likely to engage in swapping Fannie Mae 5.5s for Fannie Mae 4.5s as they have the greatest float, the highest new issue volume and will likely have a shorter duration than lower coupons. As a result of these two new policy decisions Agency mortgage-backed securities should stay well bid for the foreseeable future: the Fannie Mae announcement should lead to lower involuntary prepayments, and the Fed’s decision means the largest buyer in the space has its sights set on the fattest part of the coupon stack”.
Having given well-earned kudos to ANH and NLY, I recommend that institutional investors enter a sizeable short position at this time, as the proper time to enter shorts is at a market top. The chart of ANH shows an ascending wedge which I expect to be broken soon as I expect failed US Treasury auctions soon, as concerns rise over mortgages held by US banks rise, and over concerns about US deficit spending.
When US Treasury auctions fail, the US Treasury will not be able to continue to disbursements. Only strategic spending on national defense will be funded, discretionary spending will be eliminated, as will spending on the GSEs, Freddie Mac and Fannie Mae, with the result that there will be little demand for ANH’s services. The share price will rapidly plummet rewarding those who are short ANH and NLY. When looking at the weekly chart of weekly chart of ANH, one can see the significant rewards that came to those short ANH in July 2007 and March 2008; that is why I recommend a sizeable short position at this time in ANH and NLY, for institutional investors.
2) … An inquiring mind asks, who is going to buy $5 trillion of bank debt in the next 3 years? TheBurningPlatform carries the article The End Of The Age Of Credit where Ilargi of TheAutomaticEarth relates: “Banks have enormous funding problems, and even if they can sell debt, they’ll have to pay a lot more to do so, in the same marketplace that’s already drowning in sovereign and municipal debt. We will find out over the next few months that our banks are screamingly underfunded, and that not bailing them out will lead to bank runs and panics. How bad the situation already is becomes obvious through,” for instance Reuters’ James Saft, writes that in the next three years: “Banks around the world must refinance more than $5 trillion of debts in the coming three years” … Ilargi continues: “The banks have two additional Achilles heels that everyone conveniently fails to address these days. First, as stock markets continue their way on the downward slope, financial institutions will see their shares tumble to precarious levels, which will bring along a whole new set of negative issues. Second, they all still have huge amounts of ever more worthless paper on their books and balance sheets, much of it at face value while its real worth is pennies on the dollar. The term “toxic assets” will return with a vengeance, since you can’t mark to fantasy forever. The resistance to mark to market valuations has thus far been defended with the magical everlasting growth line of “reasoning” (and the paper will be valuable again), but one day we will truly need to realize that it is but a mirage. The bond markets will make sure we do. And don’t be surprised if in the meantime these markets will suffer a complete breakdown. If every country, city and company needs to sell more debt in order to survive, there must inevitably come a point when there are no buyers. Prior to that, though, there’ll first be sharp increases in interest rates on the debt, and volunteering to pay those rates appears utterly futile when you realize that for instance in the US, every dollar of additional debt only returns a few pennies. A fine messy web we weave. Welcome to the end of the age of credit. This baby’s going to hurt.”
3) … I believe pain will be experienced in the indebted emerging european countries, GUR, such as Romania and Croatia. Edward Hugh writing in article Croatia: On the Brink of What? relates: “After living for many years on borrowed money and borrowed time, running a significant current account deficit and accumulating a large external debt, Croatians are now likely to be faced with the harsh reality of living in a rapidly ageing society at a time when external competitiveness has been severely undermined.”
D … Gold has risen as the sovereign currency and store house of investment wealth. I expect this week’s rally to continue into next week on a higher euro-yen carry trade, with a failure and market downturn as the Euro, FXE, approaches 128 from its current 126 value. Personally I believe a liquidity evaporation, is coming where I as an investor may have difficulty obtaining funds in money market accounts and at brokerage accounts, therefore, I have decided to invest in gold coins.
E … The soonest a decision will be reached on the EFSF Monetary Authority will be Thursday July 13, 2080 when Slovak Prime Minister Iveta Radicova has penned in her first meeting with EC President Jose Manuel Barroso on Thursday, July 13, 2010, in Brussels as Chris Garden reports in TheDaily.dk article Slovakia PM Radicova Sets Date For Brussels Visit.
F … European Bank stress tests are irrelevant as banks do not use mark-to-market valuations. EuroIntelligence comments that Robert Peston of the BBC has made an interesting observation about the stress tests. Apart from the fact that all UK banks will pass those soft tests with flying colours, there is also an accounting problem related to the impact on a haircut of Greek debt. If a bank doesn’t use mark-to-market valuations for of their government bond holdings, then this would be an irrelevant test no matter what discount is applied. So they should not be stress a meaningless – and too small anyway – discount, but a genuine haircut.
IV. The likely outcome of the debt deflation and competitive currency deflation crisis is that the financial sector and governments will merge where the government becomes both sovereign debt and credit seignior.
John Mauldin, Editor, Outside the Box, in Investor Insight article Europe: The State of the Banking System writes: ”As long as Europe faces both austerity measures and reticent banks, it will have little chance of producing the GDP growth needed to reduce its budget deficits. If its export-driven growth becomes threatened by decreasing demand in China or the United States, it could also face a very real possibility of another recession which, combined with austerity measures, could precipitate considerable political, social and economic fallout.”
I believe that there is coming an evaporation of liquidity, and the result will be an elimination of the investment banking function of securitization, and a combination of the banking sector and government to form ten regions of economic governance as suggested by the Club of Rome in 1974. Monetary and banking seigniorage will come through government. Each one of the ten regions will be sovereign, superseding the authority of national leaders and parliaments. Regions that will manifest first will be Europe, North America, and Asia. Leaders in North America will formally announce implementation of the Security and Prosperity Partnership of North America, the SPP, which was initially announced by the triumvirate of North American leaders on March 23, 2005 at Baylor University.
Disclosure: I am invested in gold coins
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