Divergence caused by the “PIGS”?
Safe, flight to quality, risk averse; all terms used to define the economic allocation that has occurred in global currency and sovereign credit markets to ease investors during the latest European debt crises. It happened in April with the Greeks and most recently during November with the Guinness boys from Dublin. Portugal’s ratings were cut and Mr. Shoe store “Zapateria” answered for the Spaniards calming fears, but not before credit markets reacted, pricing credit default swaps higher and cash bonds lower to compensate for the risk of potential sovereign defaults. Whether it was Portuguese, Irish, Greeks or Spanish, otherwise known as the PIGS causing trouble, the Eurozone’s unit of financial measurement, the Euro, significantly declined.
Global markets turned away from the PIGS and their currency, to allocate their funds to what they believe to be safe assets. In other words, it was a flight to quality and any appetite for risk became kosher. Investors began selling the PIGS’ debt and any buyers required significantly higher returns to compensate them for the risks born by the notes. An allocation to safety was next. Euros were sold, as were Yen, British Pound and just about anything but US dollars. In fact, US dollars, in particular, US Treasuries were the flight the quality. Other than the kosher appetite of European sellers, US Treasury securities had other buyers. Attempting to alleviate the lack of growth in the US and jump start job growth, the Federal Reserve Bank of the US announced a Quantitative Easing II (“QEII”) program. A double-whammy of buyers of US Treasuries lead to sinking US Treasury yields and created a tremendous long-term buying opportunity for a believer in the eventual economic recovery, healing of the oinkers, and inflationary exuberance created by stimulus after stimulus combined with a thirst for limited resources by emerging economies across the globe.
Healing oinkers: higher yields to catch up with inflation
Eventually, markets turnaround. Eventually, problems get resolved and eventually, the act of printing US dollars gets priced into asset valuations. Silver and gold reflect on the two year chart below are reflecting the inflationary pressures created by the Fed and the limited availability of the resource as emerging markets continue to develop. The S&P 500 is rallying in anticipation of QEII and maybe a QEIII bringing improvements in the future. An efficient market prices a recovery as soon as news is available. Obviously, 9.8% unemployment is not news worthy of a recovery, but stimulus (aka QEII) is this news, and the markets like it. From the chart below, the ProShares Ultra Short 20+ (Ticker: TBT) tracks the long-term US Treasury bonds. A fall in their price is a 2x return in this security. In April 2010, when the first of the PIGS, got sick, there was a divergence from the rally of the commodities as a result of inflation, and the S&P 500 as a result of future expectations of a recovery and TBT. The double-whammy artificially deflated TBT and created a buying opportunity as eventually, the double-whammy of buyers will dry up. They will dry up, because the Eurozone will heal. They will dry up because the US economy will begin adding jobs and alleviate the need for further stimulus.
The simple idea of regressing back to the mean, makes it plausible to see a 30 year US Treasury yield rising from 4.45% on 12/23 to near 8% (historical mean). Obviously, an extension beyond this average yield is possible, given the inflationary pressures that exist once economies get going again, but a near 100% return in the yield from today’s levels, makes a near 4x return in TBT look very enticing. Go long and enjoy the ride.
Disclosure: I am long TBT.