The markets are flopping around aimlessly. Investors are confused. The media is having more and more trouble trying to whip up enthusiasm or maintaining credibility: the latest doozy to float through the market was the Hindenburg Omen (a technical formation which predicts equity crashes 25% of the time).

What is going on? Why are the markets so directionless? Are we staring into the abyss of deflation plus the second part of a double dip recession or will we have to dust off the 1970’s era Misery Index to describe the upcoming years of stagflation? With warning signs of both inflation and deflation in the economy, there is little wonder that professional and individual investors alike are confused by the signals.

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As we pointed out last week, the yield curve in the US dollar is just too attractive for any profit seeking financial institution to ignore. Until the trade becomes less attractive or something better comes along, expect continued US dollar strength. (DXY is the dollar index; UUP is an ETF which closely tracks the DXY).

Source: Bloomberg

Why is the yield curve so steep?

The short term (or left hand) end of the curve is anchored by government fiat (in the US through the agency of an independent Federal Reserve). Many pundits, experts and others expend tremendous resources to divine the inner thoughts of the men and women in charge of that decision. However, it does not take away from the fact that the Fed Funds rate is set by committee and not the market. The rest of the curve is determined by pure supply and demand. Will this always lead to a steep curve? No. Sometimes the Federal Reserve needs to squeeze inflation out of the system in which case, a higher than otherwise expected Fed Funds rate is decided upon. Under the right circumstances, that can lead to an “inverted curve” of high short rates and lower medium and long term rates.

Supply

On the supply side of the equation, with a US Federal deficit running well over 10% of GDP per annum for the foreseeable future, it is clear that we will not run out of US government debt instruments any time soon. Such a large and growing supply should and does fuel downward price pressure (and upward yield pressure) on the long end of the market. Those investors who fear that ever larger government spending programs will eventually lead to system wide inflation are amongst those who worry about the supply dynamics of the treasury market. When you hear a “Treasury Bear” argument which is framed entirely in terms of future supply, be careful with the recommendation because it is build upon only half the story. Supply is not the only factor.

Demand

Demand is driven by rational economic calculation and emotion.

The rational economic calculation is a long term estimate of growth and inflation rates by which investors weigh the purchase of a medium or long term Treasury against alternative investment options. Those considerations are well discussed in the market and tend to change slowly on a quarter by quarter basis. Has something fundamental changed in the last three or four weeks? Possibly. The Euro’s foundation has been show to be a lot weaker than previously expected. That doesn’t impact US treasuries directly but it does reduce the attractiveness of Euro Government Debt instruments that compete for investor attention. Right now, the biggest source of demand comes from the banks who are able to borrow at the short end rate and “lend” it back to the US Government in the form of 2,3 and 4 year Treasuries.

The emotional side is responsible for the short term moves. Emotional factors are almost always couched in fundamental terms. Sometimes those short term emotional excuses will become longer term rational economic calculations. However two things are for sure. They start out as emotions and investors often don’t realize they are reacting to emotions because they rationalize the decisions as fundamental changes in the economic landscape. Very rarely will a fund manager get on TV to announce that he or she is petrified by the market and plans to hide in two year treasuries for the time being. It is much more likely to hear the fund manager point out two or three recent datapoints as justification for making a mid-course asset allocation adjustment.

What are the emotional buttons today? Europe has certainly provided the bulk of them lately but one shouldn’t forget the employment figures in the US, the retail figures (both can be bundled into general “double dip” recession fears), China’s property bubble and a myriad of other worries lurk in today’s financial markets.

The Giant Sucking Sound

In the 1992 Presidential Campaign, Ross Perot warned that the NAFTA trade agreement would move so many jobs from the US to Mexico that the result would be akin to a Giant Sucking Sound. If Ross Perot were in charge of the European Central Bank, he might be hearing that sound today as European financial institutions fall all over themselves and other global players to participate in the US dollar yield curve trade. The reason we do not hear Mr. Trichet moaning too loudly is because a weaker Euro is precisely what political leaders in Germany, France and Northern Italy want to see. From luxury goods to machine parts to wine, cheese, ham and sports cars, Europe’s exports will receive a nice short term boost. With capacity utilization at 75% and rising however, the fun cannot be allowed to continue indefinitely as Europe’s banks will need to refocus on bread and butter loans. So, while it is fun to attribute some sort of deeper meaning to the Euro heading back to parity with the US Dollar, larger fundamental forces in Europe will likely remove some of the demand for US dollars when European manufacturers try to expand on the back of strong export sales.

So, what does this mean for investors?

A rising dollar means that commodities (mostly priced in dollars) are unlikely to rise soon. Part of that is the dollar price tag but another part is falling demand from the Eurozone. Oil in particular can be quite sensitive on the downside to a strong US dollar.

With petroleum products like gasoline not rising (contrary to what normally happens during the US summer driving season) and European imports on sale, expect the mushy US retail numbers to improve through Labor Day at least. Consumers won’t necessarily spend just because gasoline prices are low but if there is a sale on as well, wallets should open. Therefore, we are not surprised to see VCR and XLY in the top rankings of the system.

Will GLD perform well? Not likely. Short term Treasuries and Gold are competing for the attention of the panic stricken investor. If we toss in near term US dollar strength, the balance tips from non-yielding gold to low yielding treasuries. Of course, all of these conditions are reversible so if one sees gold correct nicely in the coming months ($800-900), a sensible investment opportunity may present itself on the next upcycle.

How about equities by region? Small caps are showing continued resilience in the US but there is not much conviction behind the trade. Large caps, as represented by SPY, are not going anywhere with a very slim preference for Value (slightly ahead) over Growth (slightly behind). Large Cap European stocks (FEZ, for example) are at the bottom of the rankings as the sovereign debt issues play out at large European banks, swamping the positive benefits accruing to the large export manufacturers. Emerging Europe is still promising as it will benefit from export driven outsourcing from Germany as well as M&A opportunities as mature European corporates are compelled to switch focus from expensive US dollar based assets to cheaper Euro linked asset markets.

Asia is a mixed bag. Japan’s equity market looks to be cooling off a bit as the Yen is the only other currency as strong as the US dollar. China is at the bottom of the list for largely internal reasons related to the unwinding of a property bubble while India is close to the top of the rankings. Other Asian markets, which are tied to the US dollar, are in the middle of the pack and can be safely underweighted at this point.

Despite all the positive press that China’s “Economic Rising” has garnered lately, investing in China has been a slog since August of last year. As one can see from the chart of the Shanghai composite below, China’s equity markets have been pretty sloppy since last August. China shares are not particularly cheap with most consensus forecasts suggesting P/E’s in the mid 20’s for a slice of the action.

From the System’s point of view, the high volatility and lack of upward direction has relegated China assets to the bottom half of the rankings for all the portfolios that include China for several months. However, after losing 13 plus percent in a month, China this week has tipped into the Short column in our Asian Index Long Short portfolio.

Source: Bloomberg

Why is this happening when the press reports are in near universal awe of China’s ability to navigate through the Global Financial Crisis? China, after all was swift to turn on the liquidity pumps at the banks to inflate a property bubble of impressive proportions. Despite the continued weakness in China’s primary export markets of the US and Europe, companies were eventually compelled to restock shelves in the past few quarters leading to a nice snapback in export orders.

But the markets are forward looking and if one scratches beneath the veneer of good news, there are problems a plenty. The largest problems are tied to inflationary pressures (primarily from an overheated property market) and the sustainability of economic recovery in China’s two biggest export markets (the US and Europe). But the latest drop appears to be anticipating something more specific. China’s banks have all been ordered to raise more capital (slowing down loan growth is not really an option) and China’s Agricultural Bank is slated to become the largest IPO ever at US$20-30bn. The initial idea is a dual listing in Hong Kong and Shanghai in July but over the past few sessions, there has been enough talk about Plan “B”s to suggest a bit of indigestion ahead. A shaky launch could be the catalyst to send China shares into a swoon (with impact on the Hong Kong market in general).

So what is the bet?

Defining what you are trading on is very important because there can be several outcomes. If you are unclear about the original conditions, it is unlikely that you will be able to react properly to the outcomes. The bet is that China’s regulatory officials feel comfortable pushing ahead with the Agricultural Bank IPO and other fund raising activities at a time when international appetite for risk is waning. That doesn’t mean the IPO has to fail miserably or even get launched at all. It means that the presence of the deal (the overhang) will cause indigestion in the market and cause prices to fall. Why are the Chinese authorities feeling confident? For one thing, property prices are rising in double digits in almost all the cities. For another, China’s leaders are busy trying to batten down talk of the “Beijing Consensus” or “China Model” as they swan around the world with a bit of a G2 swagger. In short, the bet is about a bit of hubris in the market which will be corrected in the time honored fashion of falling prices.

How to play this opportunity?

For the average investor, it is quite difficult to short the market. Products do exist. Proshares offers YXI and FXP, the inverse and double inverse of the FTSE Xinhua 25 index, FXI. However, one should read the well written and un-camouflaged health warning on the Proshares site carefully. Because the inverse ETFs are designed to track one day movements in the underlying index, a volatile market like China can lead to large tracking errors between the ETF and the target index over relatively short stretches of time. Some investors will choose to short FXI in a margin account to try to obtain a better tracking over periods of one month or so.

Should you play this opportunity?

If you decide to short anything, you need to pay closer attention to it than a long trade. For many investors, the extra attention to detail is the dealbreaker. If you are not sure, err on the side of caution. If you are ready to play, you first need to consider how FXI will diverge from SSEC (the Shanghai composite index). While it is true that the FXI is made up of the bluer chip companies that are able to meet Hong Kong’s listing standards and that the P/E ratio is lower (16.7 at the end of April) than those in Shanghai, the FXI is heavily weighted in precisely the same financials that will be impacted by a less than stellar Agricultural Bank launch.

For those who are unwilling or unprepared to go short, there is still a good opportunity on the long side. If IPO indigestion tanks the market, there will be a good chance to pick up shares in the second largest economy (and largest exporter) on the cheap. When will that happen? Watch the System rankings in the coming months. When China starts to move off the bottom of the list, there may be a good opportunity to catch a rebound. Why do we think there will be a rebound on the other side? Because our central investment premise is that markets move in cycles. If this cycle is a down one for China, it makes sense that the next one will move in the opposite direction.

Not perfectly correlated

Price Source: Reuters

Other trades this week

Not a lot has changed from last week. Emerging Europe, Japan, India, US Small Caps, Biotech and High Yield are still hanging in there. One subsector which has scored well lately is the Homebuilders (XHB) in the US. Homebuilders are reported optimistic despite phased out government incentives to new home buyers. In our commodities only ETF portfolio, Gold (GLD) and Silver (SLV) shine in an otherwise dull clutch of investment opportunities. However, in mixed portfolios, neither precious metal ranks highly.