When most people think of the carry trade they think of borrowing in Japanese Yen at near zero interest rates and investing in Aussie, New Zealand or Canadian fixed interest instruments to pick up the yield difference. (Click here for an excellent Financial Times illustration) If a hedge fund can wrangle 10:1 financing from its prime broker, that difference can be magnified tremendously. The risk in the trade is that exchange rates will move in an unfavorable direction (in the Yen carry trade example that would be a strengthening Yen).

However, the biggest game in the last two years has not been the Yen but the US dollar. There are actually two separate “carry trades” going on in the financial markets right now.

Carry Trade #1

The first is with the big “money center banks” which can borrow at less than ¼ of 1% in the short term from the Federal Reserve and lend it to the US Government by buying Treasuries that yield many times the borrowing cost. The trade is protected on the currency side because both are done in US dollars. The trade has been further protected by the Federal Reserve which has been using its QE2 mandate to buy up longer dated Treasuries in the secondary market. One of the unintended consequences in the US is that money center banks have actually curtailed their commercial lending operations as a result.

Source: St. Louis Federal Reserve

Carry Trade #2

The second trade is with currencies that are closely linked to the US dollar. In the case of the Hong Kong Dollar, the link is explicit (and the property market is booming) but throughout the exporting nations of Asia, the link to the currency of the biggest market for finished goods is well understood. The flows of money have been so strong as to kick off secondary waves of capital movement (eg. Chinese M&A and property purchases in Australia). In this second trade, the risk of currency movements is present but not significant (think Chinese reluctance to revalue the RMB) and more than made up by the trading opportunities in these markets. With short term borrowing costs well below the 1% mark, many projects look viable even at very inflated costs.

So, in one sense, the QE1 and QE2 programs have been a resounding success but thanks to the globalization of capital movements and bank reluctance to extend new loans, the beneficiaries have not all been in the US.

But, that looks likely to change. As we approach the end of the Quantitative Easing Program, Mark 2 (QE2), it is time to think about what might happen to interest rates and liquidity when the status quo changes.

The status quo to which I refer is the US dollar 3 month swap rate which is the rate at which major financial institutions around the world borrow US dollars from one another.

Source: Bloomberg

As you can see from this chart, the rate has been kept at less than 0.25% for more than two years now.

And the game has not been limited to financial institutions. Large credit-worthy multinationals have also been able to borrow at very preferential floating rate terms (usually a small margin over 3m LIBOR) which has largely mirrored the 3m Swap.

Source: Bloomberg

What should investors watch for?

The question for investors is how long can these rates stay down at these levels? The advice given to all young traders when they first start in the business is: “Don’t fight the FED”. And the last two years have shown that the FED can still pull off the neat trick of reflating the global banking system. The question now is where will these rates go and how will the big financial players react when the cost of funding makes their more speculative positions unattractive?

Stability leads to instability

Hyman Minsky (1916-1996) was a neo-Keynsian economist who was the first to note that financial stability leads investors to gear up and sow the seeds of the next bust. The Minsky Moment (the tipping point coined by PIMCO’s Paul McCulley to describe the ’98 Russian financial crisis) may be a rise in short term interest rates once the FED stops pumping up base money with the QE2 program.

Mark your spot on the sidelines

Although the financial press and the regulators have been at pains to talk up the financial stability in the system, it seems obvious that much of the apparent stability and record profits at Too Big To Fail Banks have been secured on the back of a two year fire sale on short term money. When that sale ends and these two interest rates start to return to more realistic levels, investors may wise to spend a few months on the sidelines with cash waiting for bargains.

This week, there will be no newsletter as we are on the road in Australia.

What does Australia and year three of the US Presidential cycle have to do with each other? Usually, there would not be much of a connection.

But this year, there is a connection.

To over simplify, we are in year three of the cycle, the time when an incumbent President has to make sure the economy is as stimulated as possible so that the voters will give him another four years in the White House. As a result, it is often a good year to invest in risk assets like equities.

In this cycle, growth is coming from government spending and monetary expansion. And, while the Republicans may still get to repeat their temporary government shutdown routine (maybe they can avoid the political backlash this time), the expansionary policies at the FED are harder to stop.

That means we will continue to see inflationary money creation in the world’s reserve currency. And, since the money cannot all be put to work in the US economy, it will continue to fuel asset and commodity price growth around the globe.

How does that money get around the globe and into local economies? Primarily through Central Banks’ efforts to keep currencies from moving up against the US dollar, the FED’s accommodative policy is being exported to countries (like China) where inflationary expectations have already taken hold.

Australia is one of the places where these pressures will become most evident. As a major producer of agricultural and industrial commodities, it is a secondary beneficiary of the FED’s inflation creating policies. Not only has China’s boom created strong demand for iron ore, coal and other resources, it has also sent a wave of investment capital towards the continent sized country. This has ignited a surge in M&A activity as well as frothy real estate markets. The Reserve Bank of Australia has moved short rates about as high as politically possible (mortgages are mostly floating rate) so the next thing to go is the currency which has just crossed the 1.05 mark (FXA). If the Aussie dollar continues towards 1.10 and 1.20 as local investors expect, that’s a strong signal that one’s investments need to be well placed for an inflationary environment.

This week, for example, the base metal ETF (DBB) nudged the S&P 500 ETF (SPY) out of the top 3 in the Seeking Alpha ETF Portfolio. The main aim of the Fund King System is to track major investment flows to keep one’s money deployed in the most promising corners of one’s investment universe. Right now, it looks like major investors are positioning even more towards the inflation trade,

SLV has had a nice run since breaking north of $30 in the middle of February. That is not news but a checkable fact. For those investors who noticed that SLV was at the top of their rankings since July 12th of last year (when SLV closed at $17.62), it was a good opportunity to make money in a relatively non-correlated asset class. The only time it got sticky was at the beginning of this year when the price corrected.

The reason that we bring this up is not to brag. While SLV has done well, other investments that have made it into the top rankings have fared less well. The point is that most of those investments were eventually replaced by new market movers while SLV has hung in at the top of the lists despite the 10% correction that we saw in January. While we may have worried in these posts that the rerating between Gold and Silver may have run most of its course, the System kept pointing out that there was strong momentum behind the asset and that there were not that many more promising assets out there at the weekly measurement points.

My only slight regret…not swapping GLD for SLV a few weeks back when I was adjusting my Seeking Alpha ETF Portfolio. I would have looked very clever. But, in calmer moments, I realize that the regret and the emotion behind that regret is precisely why one should use an unemotional system to help execute one’s investment plan.

So, should you buy SLV now? Well, that all depends. Does it make sense as part of your universe? And, if it does, ask why? Make sure that you are not adding at this point because of past performance. Make sure that it is in there because you think other investors are worried about the US dollar or you think there is a chance that the Biomedical uses of silver are poised to go through the roof. In short, remember to separate the Asset Selection process from the Asset Trading process. And what happens when something better comes along in your universe? That’s easy, switch.

A Tarnished Example

Now that PIMCO has finally gotten it through to folks that, yes, they really are not keen on US Government paper (no link…too many choices), let’s look at how two bellwethers fared in the Fund King System.

TLT (which tracks 20 year plus US Treasuries) has been at or near the bottom of the US Sector ETF Universe since the beginning of November 2010. And less long term TLH (tracking 10-20 year Treasuries) has joined the bottom of the pile in another ETF portfolio since the end of November.

So, whether you were in the “Don’t Fight the Fed” or “Hyperinflation Around the Corner” camp, the Fund King System told you to steer clear of the asset class for the last three months. Even the FED could not buy up enough long dated Treasuries to keep TLT from dropping 10% over the period. Mr. Gross, the head of PIMCO noted in his newsletter that the FED has been buying as much as 70% of the newly issued Treasuries of late.

What does it mean?

There is nothing wrong with SLV , TLT or TLH in absolute terms. Each of these ETFs represents claims on perfectly good assets. The deep meaning to take away from these two examples is that it does not pay to fight the trends. If investors (on balance) are shifting money out of US Treasuries and into hard assets like Silver, there is little point in trying to stand in the way. At some point, the tides of money will change directions and other asset classes will get swept up or down. When interest rates rise a couple hundred basis points, Bill Gross and his PIMCO colleagues will be back on the bid side. Why? Because they are in the business to make money; and money is made by buying low and selling high.

An interesting read

Supporters of Ron Paul can sometimes be a prickly bunch. But, they occasionally come up with very thought provoking concepts.

I like a good bash so when I came across an article entitled: “How to End the Federal Reserve System” by Gary North, I was prepared for a rehash of the old arguments about an evil cabal on Jekyll Island in 1910. But the real strength of the article comes about halfway through when Mr. North analyzes the demise of a government agency which had also been granted monopoly powers: the US Postal Service. He draws some interesting parallels about what technology could do to the Federal Reserve System long before Ron Paul and his supporters in Congress are able to rescind the Fed’s legal mandate.

Basically, the ability to move into other currencies with a few well place computer key strokes or even to develop new mediums of exchange means that even an institution as powerful and influential as the Federal Reserve is not immune from obsolescence.

Part of the appeal of ETFs like GLD and SLV is that they are theoretically redeemable into a fixed amount of Gold and Silver respectively. While pitched as a new idea, the concept of convertibility into precious metals was once the cornerstone of the US dollar’s value (and most other currencies before that). In an interconnected world that can work with services like PayPal, it’s probably only a matter of time before someone reinvents a multinational global fractional banking and payment system backed by gold, silver or some other store of value. If it is tied into Visa, Mastercard and American Express, one need not worry about carrying about sacks of heavy metal to the grocery store. Just as email eclipsed the first class letter (something that was unthinkable as recently as 20 years ago), there is a risk of a new currency system taking the premier spot occupied by the US dollar today.

Just because the risk exists, however, does not mean it will come to pass. The biggest difference between the US Post Office and the Federal Reserve is that the latter is a privately owned, profit seeking entity. Long before we are all paid in PayPal credits or Googles, the Federal Reserve (which is owned by and represents the largest US banks) will feel compelled to take steps to shore up the value of the US dollar. That more than anything else will lead to a change in policy that will likely see higher interest rates in the not too distant future.

While you are pondering your long term investment strategy, make sure to include a plan for higher interest rates.

What happens to Japan now?

The earthquake and tsunami that hit Japan on Friday will impact the country and the economy in ways that are hard to foresee at the moment. Despite the shocking video and photos, however, the natural disasters are unlikely to have a significant long term impact on the economy. As long as the authorities can keep the nuclear fallout to a minimum, the biggest issue will be reconstruction and who will buy the fresh batch of JGBs. That points to another force for higher than near zero interest rates in the world’s #3 economy.

From an investors’ point of view, the Nikkei 225 was the best of a weak bunch (Asia has lagged since November of last year) in our universe of 11 Asian indices as of Friday’s rankings. The earthquake and tsunami do not significantly change the long term public finance fundamentals of the country and most of the familiar exporting names have transferred significant portions of their manufacturing base to locations around the world in the last few decades.

Should you buy? If your universe is only Asian Equities: then perhaps. But, if you are looking at a broader range of asset classes, there are quite a few commodity based ones that look more attractive. As Japan is import dependent for almost all of its commodity needs, there are better places to invest your money.

As we pan across our portfolios, we notice a definite lowering of the numbers that the System is throwing out in the rankings. The last time this happened was in April/May of 2010 and it definitely foreshadowed a weak stretch for assets at the higher range of the risk spectrum. The numbers remained flat through the summer and started to recover in September of 2010, which coincided with a strengthening of sentiment that carried through until recently.

But what about all the reports of bullishness?

There have been a number of recent articles in all the right papers which have pointed to a general bullish sentiment in the market. These reports are couched in caveats but generally reveal that asset allocators are overweighting equities and bonds and underweighting cash. But the market is not all one way; there are still magazines to sell and as we approach the second anniversary of this strange bull market, we get think pieces like this in Barron’s. Unfortunately, the thinking is not terribly original or prescient.

The problem with these approaches is that they either measure what people say (asset allocation intentions, bullish/bearish sentiment polls) or the way they think things should be (articles bemoaning the historically high CAPE, the Cyclically Adjusted Price Earnings ratio or why Gold should be trading at $5,000). They are not measuring what people are actually doing with their money.

Let’s think about how this works. If one owns equities (or property, or bonds, or gold bars), one is by definition bullish. But this is a lagging indicator because the actions surrounding the bullishness have been taken in the past and are unlikely to contribute to further upward price action in the short and medium term (unless the market has been cornered). So, after a run up, which by definition must mean a bunch of new investors have been bidding up prices and filling their portfolios with the asset-du-jour, one would hardly expect those avid collectors to “talk down” the price of their newly acquired assets. The trend can continue only with new money being attracted to the asset in question. That money can come from other asset classes, from the real economy via savings or, in the case of QE1 and QE2, from credits which materialize from FED activity on bank balance sheets. Once the new buying abates, the market pauses and often corrects.

While we make no claims that the Fund King System has any “crystal ball” properties, one of the things it will measure is the momentum of money as it flows into and between the various financial asset classes.

In this week’s survey, the assets still attracting investor favor are Energy, the US, Small Caps and Agriculture. Silver appears to have topped out after rushing to catch up to a more traditional valuation against Gold. It still ranks highly in some of the longer term portfolios but it has been dropping down with Gold on the shorter focused portfolios.

Our advice? It is time to watch the numbers a bit more closely than usual. We could be at the start of a larger correction in risk assets or it could just be a pause to see how some of the latest events turn out. The big issues are, in order of importance from an investment point of view, the level and sustainability of growth in the US, the risk of a slowdown in China induced by inflation fears and an ugly resolution to the Egyptian unrest which would upset the balance of power, peace and trade arrangements in the Middle East.

Inflation Sneaking In?

While trolling through the 24 hour news channels, one thing to watch out for is the quiet risk of inflation. The fact that the best looking assets are in the energy, agricultural and materials sectors leads one to conclude that there is more inflation running through the system than government statistics might suggest. There is no way to properly quantify how much inflation because the two most common measurements (Government Statistic and Personal Observation) are both flawed. The former is flawed because Governments collect and report the data which they use as a yardstick of successful governance. There is no question that the BLS has changed the rules over the past few decades to make the data as flattering as possible. The latter is flawed because our personal viewpoint is too narrow and we tend to focus on the things that are causing us the most anxiety. We tend to overlook those prices which are going down (unless it is our salary or house).

But how can we have inflation if growth is only in the 3-4% zone? Most of us have been schooled on the idea that inflation can only come about when the economy gets overheated (too much money chasing too few goods). When the economy is well below potential, there is little risk of inflation creeping in, right? That is the crux of the FED’s stimulative policy argument. But there is more than one way to create a bit of inflation. If we look at Zimbabwe, for example, its bout of hyperinflation did not come about from extremely robust economic growth. It came from printing up too many pieces of paper (too much money chasing too few goods).

One might be tempted to take comfort in the relatively low yields on long dated US Treasuries. But then again, one needs to look carefully at who is buying the paper. The FED is hardly going to demand an inflation premium on the US Treasuries it is buying with newly created money it created when one of its two mandates is to maintain price stability. I am not accusing anyone of “window dressing” but there is little incentive for the FED to haggle for the best price while it fills its shopping cart with long dated Treasuries.

Shadowstats has an interesting take on inflation by taking the 1990 methodology and contrasting that with the current BLS methodology. There is no doubt that some spending patterns have changed since 1990 but it is interesting that the adjustments to the methodology have served to consistently show the US inflation picture in a flattering light.

I hope that everyone is enjoying the festive season and taking advantage of this period to spend time friends and family.

New Year Thoughts

I am cautiously optimistic about 2011 but in the developed markets we still have wounded banks and governments with huge financing needs while in the developing world, excess money is putting pressure on inflation, interest rates and asset prices. With Europe’s problems largely out in the open for all to see, the next area of concern is the world’s second largest economy, China.

The story this year will most likely turn out to be about rising interest rates. Now that the worst of the Global Financial Crisis has been laid out for all to see, expect fixed income investors to climb out of their fallout shelters and start demanding a bit more interest. The market for capital is truly global so a sluggish US economy may not be enough to keep the bond vigilantes at bay. Central Banks will “lean against” the trend but there is little that even the Fed can do to keep interest rates at their current low levels.

Adding extra space in the Portfolio Management feature

If you have logged on lately, you will notice that we have added two more portfolios for you to store tickers on the Portfolio Management feature. This is in response to several requests that we have received from customers who would like to check several different portfolios without having to retype the tickers. While theoretically this feature should be able to support unlimited portfolios and unlimited tickers, in practice we are limited by bandwidth and other factors to four portfolios that you can select and three that we will recommend. Unfortunately, our attempts to increase the number of tickers beyond 20 at a time resulted in unacceptable levels of instability. Therefore, that part of the expansion will be put on hold until we can code our way around the problem.

Please keep the comments coming as this helps us to focus our efforts on the areas that you feel most useful.

Seeking Alpha Portfolio

Although I should have anticipated it and added plus one or two to the ‘tweak’ on the Seeking Alpha Portfolio, we have another switch this week. Turkey (TUR), which has been a turkey since we started the portfolio, has finally dropped out and made room for the Taiwan ETF (EWT). For the record, we sold 130 shares of TUR at 66.04 for a net loss of $1163.80 on the Monday close. That got us 550 shares of EWT at the price of 15.18 which leaves our cash position at $620.75. For the week, the portfolio climbed back 0.93% so we are still down 5.99% from the middle of November.

What does EWT have to offer? Quite a lot actually if you think that cashed up corporations may start spending money to maintain productivity gains in 2011. Information Technology makes up 58% of the ETF (iShare info page here) and that is the primary driver of the market. Although local brokers will occasionally make noise about the number of mainland Chinese tourists that are allowed in Taiwan, for now and the medium term future, the big question is how many Android phones and iPads will move in the marketplace. But Taiwan is not all consumer electronics. TSMC (which makes up 13% of the index) is the world’s largest and probably most advanced fabrication facility for custom made logic chips.

If you don’t like Taiwan or are worried about investing overseas, there is a very close correlation between the EWT and Nasdaq Composite (ONEQ) which you can see in this 5 year chart from Yahoo. While there is no guarantee that it will track as closely in the future, I would be very surprised if we did not continue to see strong correlation.