Interest Rates Archives

Happy New Year

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.

Beware the “Three Handed” Analyst

There is an old saw that one should have the ability to tie one of the analyst’s hands behind his or her back before any presentation. That way, one can avoid the inevitable “but on the other hand” backslide that allows most analysts to claim that they are almost always right.

As we approach the end of a volatile year, it isn’t hard to spot the emergence of a new beast: the Three Handed Analyst. These very erudite types will explain carefully that there are three possible outcomes: total meltdown, muddle through and return to strong growth. The recommendation is that somehow one should prepare for all three at once with a diversified portfolio of silver bars, ammunition, spam, US Treasuries, income producing apartment blocks, dividend paying stocks, some high beta growth stocks and a bit of AAPL on top for good measure. Confused? Well, you are in good company. But don’t let that get in the way of a sensible investment plan.

So what will happen in 2011?

Although all three possibilities do exist in theory, in reality only the muddle through scenario makes sense. The global economy is on the mend but like an older patient, the healing process will take a bit more time than usual. The main reason why we will not fall into a “Mad Max” hyperinflationary cycle is because the US and Europe are recovering from a financial crisis. The same reason explains why we will not see Global GDP surging ahead at 5%. In both cases, the major developed country banks are nursing years of write offs and receiving massive Central bank support. The write offs are a strong deflationary drag on what would otherwise be an overly accommodative monetary policy. And there are natural limits to the Central Banks powers. After QE2 resulted in higher rather than lower interest rates, it is hard to argue that the Federal Reserve will be able to print money without restraint. The Bank of England and the European Central Bank have already backed away from quantitative easing programs.

Let’s take it by regions.

The biggest piece of the puzzle is the US. Many bits have been spilled on the subject by far more qualified observers so I will just simplify it to a few indicators. I expect that we will see very sluggish consumption through the year which will be accompanied by a persistently high unemployment rate and weak overall housing market. Exports will do reasonably well but the effect will be crushed and amplified by the inventory cycle which I would expect to be fairly volatile (building inventories increases GDP, selling them down decreases GDP). Interest rates will bounce around but generally head a bit higher. What would I look for? Mostly positive signs…lots of M&A activity would be a key sign that corporations are starting to spend their cash hoard at what they perceive to be the bottom of the market. In the initial stage, I would expect to see industry consolidation rather than conglomerate building.

The EU is equal in size to the US in terms of GDP but institutionally, it has unique challenges. The Union is being tested to its limits by the financial woes of its peripheral states. The problems will not go away quickly and the regions affected will take years to regain competitiveness to start paying back the debt. This means that Europe is hardly going to be driving the global recovery. Germany is doing well and France is holding its own but the banks in those two countries are heavily exposed to the sovereign debt of the troubled countries. Interest rates have already increased but one should be on the lookout for mispricing. Neither Germany nor France can afford to let the Euro implode so a panic may afford some short term opportunities in five to ten year government bonds. If Europe moves to issuing “blue” Eurobonds (that are within the prescribed debt limits) and “red” sovereigns (for the excess), we could see a very exciting bond market develop (which may account for the enthusiasm for this idea amongst bond traders).

Asia is interesting because it has been supported by the massive investment led stimulus of the Chinese economy. The investment boom sustains demand for commodities from Indonesia, Malaysia and Australia (Thailand to a lesser degree). India’s growth is more of an internal affair. It is sucking in imports to support healthy growth but seems somewhat out of sync with the rest of the world. Although Japan is no longer a dragging anchor on Asian growth, it has yet to turn positive. As a result, China has surpassed Japan to become the second largest economy in the world and the one to watch in this region. How long will the property bubble last in China? There are signs that the government is taking serious steps to rein in bank lending, the primary fuel of the boom. So far, the tightening is mild compared to Zhu Rongji’s 16 point program which brought China to a screeching halt in 1995. But, if inflation persists, the government may be forced to take crude measures. How about the undervalued Chinese Yuan? Don’t look for anything more than a token revaluation. Most exporters are already suffering from higher wages and higher input prices which are cutting into their razor thin margins. Anything on top of that could result in very unpleasant economic repercussions. The interesting development in China is the wage inflation that is roundly bemoaned by the export sector. The US has asked China to develop more internal consumer demand for decades. It seems that China’s workforce has taken the project on by themselves.

Latin America looks well placed for another year of growth. Thanks to improving trade links, demand for commodities out of the big exporters (Brazil, Chile, Argentina) is set for another strong year. A new administration in Brazil will look to carry on the economic policies of Lula so despite some worries about hot money and capital controls, we are unlikely to see any disruptions in trade. Like Australia and Canada, the region is vulnerable to a big slowdown in Asia (China in particular) but a cooling off is unlikely to make a huge difference.

There is even some good news coming out of Africa as local multinational groupings supervise elections and hold leaders to the results. Foreign Direct Investment is rising and not just in South Africa. Even HIV/AIDS which has devastated working populations in a number of big African countries appears to have peaked out.

So, while the doomsday scenario does capture headlines, it is unlikely to unfold. The reason it sells well is because most investors (including most professional investors) were caught unaware by the severity of the financial meltdown in 2008. The rebound of risk assets in 2009-2010 is confusing to most because the recession is not typical. Rather than corporations being left hung out to dry by an inventory recession, this has been a balance sheet recession that took place in the household and banking sectors. Corporations that were not overextended were able to float through this period largely untouched. With the global economy well stocked with capacity, corporations have been able to keep more of the cash flow on their balance sheets as investment requirements shrunk.

Expect some of these factors to unwind this year. Corporations will start spending their cash hoard and that will impact valuations as new investment or acquisitions are initially dilutive to earnings.

So that is the one side of the ledger. What about the other side…investor demand? Interest rates are too low for most pension systems. Although there has been a big shift to defined contribution plans, there is still a significant amount of pension liabilities which are to be met with currently unrealistic investment return expectations (6% – 8% is hard to find in risk free Treasuries these days). From that most conservative group all the way to hedge fund investors, the desire for better investment returns will keep money shuffling back and forth between higher risk assets. Appetite for risk will remain healthy although it could suffer from bouts of indigestion.

How should you invest?

Although financial markets overall will be largely trendless, look for trends in subsectors and segments of the financial markets. Gold/Silver, Treasuries, Bonds, Stocks and Commodities will all enjoy periods of brief enthusiasm followed by slow returns to earth. Do not be shy about taking profits and cutting losses during the year. Bombed out sectors could become high flyers in a quarter or two so keep your investment universe as broad as practical. And, whatever you do, remember to separate the asset selection and trading processes.

Seeking Alpha Portfolio

SAweek05 Beware the Three Handed AnalystWe sold our DBA for a small profit of $448.10 and put the proceeds into 160 shares of EWW, the Mexican ETF. For the week, TUR continued to weaken, particularly on Friday so we ended up with a loss of 1.32% on the portfolio for the week. Overall, the portfolio is down 6.8% since the middle of November when we started.

Although one always hopes to make gains rather than losses, the portfolio should be well placed for a “January Effect.” This year should see a moderately strong January Effect as institutions place money back into risky assets in the New Year.

Since there are no changes in the ranking, we will ride through the holiday season with Turkey, Hong Kong and Mexico.

Year End Prediction Follies

As we approach year end, we can confidently expect the number of predictions for the markets in 2011 to rise. Some of it is good harmless fun (why think of the big picture only once a year?) but most of it is based on rigorous research, hard work and solid preconceptions. Since most of the research and work is focused on supporting the preconceptions, the result is the usual range of expectations that plot along a broad spectrum from the dire to the hopelessly optimistic.

Which one should you choose? Frankly, any one you like. It does not matter because the financial markets will probably steer another wobbly course like it did this year. Fortunately, that course was generally positive in 2010. There is no guarantee that it could not be mildly negative in 2011.

Bond Vigilantes

We are not looking for any particularly dramatic outcome next year. The bond vigilantes have pushed 10 year government paper up a bit around the globe and might push interest rates up a bit further but there is no serious demand for credit. You might scratch your head and wonder how that can be. In the land that invented the modern credit card, take a look at the falling balances.
Revolve Year End Prediction Follies

Central Banks to the Rescue?

3CardMonte Year End Prediction Follies
What about all the government debt that is being issued? Well, much of that is being issued to bail out banks by buying dud assets (Irish sovereign debt, anyone?) at or near par value. There is a big accounting game going on in financial centers all around the world to make sure that the banks do not start falling like dominos. If you need to brush up on the game, I found a fun site that took me back to my days as a runner on Wall Street (back when stocks and bonds were printed on paper). I actually won $20 once as the “mark.” OK, OK, I lost it back later that week.

Confused Like Chairman Bernanke?

It is OK to be a bit perplexed but one does not expect confusion from the Chairman of the Federal Reserve, Ben Bernanke. In the space of 21 months, he appears to have executed a complete 180 on the impact of Quantitative Easing. For a man who has built his substantial academic reputation in Economics on what he identified as the central mistake of the Great Depression (failure by the Fed to provide sufficient liquidity), this is not a trivial issue.

Last week, we posted the recent 60 Minutes interview where Mr. Bernanke defended his decision to embark on a second round of Quantitative Easing (QE). The strong denial of “the myth” that QE had something to do with “printing money” was a surprising statement to say the least. I actually replayed it several times to make sure that I had not misheard. As a reader of a blog called Pragmatic Capitalism, I thought Professor Bernanke was engaging in a bit of academic “hair splitting.” Perhaps he was talking about Modern Monetary Theory (MMT). But the answer (or at least clarity) came from an unexpected source: the comedy writers at The Daily Show. In a three minute segment, Jon Stewart played a part of the recent 60 Minutes interview which showed Mr. Bernanke saying “we’re not printing money” in reference to QE2. Then he played a previous 60 Minutes interview which showed Mr. Bernanke saying “it’s much more akin to printing money” with regards to QE1 in March of 2009.

At best, Mr. Bernanke appears confused about what Quantitative Easing means to the financial system and the economy. At worst, it looks like he is trying to pull a fast one. Which is it? Unfortunately, it is a bit of both. QE was the prescription for Japan proposed by Mr. Bernanke as well as others throughout most of the 1990s. Although it has been argued that the BoJ did not execute correctly, QE failed to produce the expected results in Japan. John Hussman’s November 1st letter argues that any increase in reserves is taken away with lower velocity of money (Heading “Fed Policy and QE”, second paragraph) suggesting that it is unlikely to work anywhere. As for pulling a fast one, the truth is that the Fed has almost no leverage to restart the economy with short term interest rates near zero. With low, flattish velocity of money and bank reluctance to lend against reserves, QE2 really does just change the structure of the Federal Debt at this point.

So what does that mean for 2011?

Next year will probably be look a lot like this year: most of the predictions will be wrong and the markets will be volatile. We expect investor sentiment to swing from bullish to bearish with little pause in the middle.

At the end of 2009, investors were worried about economic growth (Global GDP will probably come in well above expectations at 5%), inflation (there is some but there is also deflation), double dip recession (US growth surprised on the upside), a hard landing in China (someday, perhaps) and currency devaluation (the US dollar actually rose slightly after a big rise and fall).

In 2011, the Global Economy will continue to grow but the average will mask large variations. Large developed economies will continue to struggle with “too big to fail” banks that face massive asset writedowns. Until the bad debts clear the system (by being written off or paid back), the financial markets will remain in flux. Emerging markets are struggling with the massive fund flows which threaten overheating in some countries and malinvestment in others. With signs of inflation, deflation, hyperinflation, sovereign credit risk and sluggish consumer demand all vying for market attention through the year, expect another roller coaster ride. The net result should be fairly pedestrian but there will be plenty of ups and downs to keep blood pressure medicine sales on track for a bumper year.

Given the decent returns and lowered blood pressure readings we have achieved with the Fund King System, we will carry on regularly rebalancing our investment universe to put our money to work in the most promising asset classes.

Seeking Alpha Portfolio

SAweek04 Year End Prediction FolliesThis week, the Commodities ETF (DBA) drops out of the top three which signals a switch into the Mexico ETF (EWW). Unless there are some dramatic moves on Monday, that will yield a small gain on our DBA.

What do we know about EWW? Although one could wax eloquent about the broad macro-economic shifts in the global economy and how the developing world productivity is quickly catching up to developed world standards, the story of EWW is best demonstrated by its largest holding (24%), America Movil (AMX, see all holdings on this page). One need not be a chartist to see the correlation in this chart on Yahoo Finance. America Movil is owned by Carlos Slim and has substantial mobile phone franchises throughout Latin America as well as big prepaid services in the US.

We plan to sell our 320 shares of DBA and buy around 160 shares of EWW on the Monday market close.

Bernanke on 60 minutes

At 6 minutes into the interview, he says that QE2 will impact interest rates but does not change the money supply (although he made a reference to currency in circulation…hmmm). It sounds like a Bill Clinton moment (“I did not have sex with that woman.” which I remember him saying that straight into the television camera.) I understand that the Treasury is the organization that actually applies ink to paper and calls it currency. But to pretend that money creating exercises like QE2, which is a specialized form of Open Market Operations, have no effect on the money supply stretches the truth a bit too far for me. Have a watch.

Cleaning up the tax code is a good idea. But, that feels like a bit of misdirection since it does not fall anywhere near the Federal Reserve’s mandate.

QE2

Perhaps it is appropriate that the name of the latest attempt by the Federal Reserve to “print our way to prosperity” shares a name with Cunard Lines’ famous flagship, the Queen Elizabeth 2.

QE2 QE2

The QE2 was launched in 1967, just under three years before the commercial launch of the Boeing 747. While the QE2 was renowned as the most luxurious way to cross the Atlantic, she was an anachronism in the “jet age” which had already started in the late 1950’s.

The Federal Reserve, under Mr. Bernanke’ s guidance, looks poised to launch the just the wrong kind of ship, Quantitative Easing, Part 2 (aka. QE2). While there was little doubt that the financial system needed a liquidity injection in the dark days of the Global Financial Crisis in 2008, one wonders what use further money creation will serve in a financial system that is not demanding more money.

What we as investors need to do is:

  1. Understand why this is happening.
  2. Adjust our portfolios to take advantage of the newly created money.

We do not need to struggle with the question of whether QE2 is good economic policy. The answer is simple: it is not. As Vincent Reinhart told Bloomberg:

“If you were to write down a list of the 15 things that could come out of Washington to help sustain the recovery, quantitative easing is 15th on the list,” Reinhart said. “The problem is that items 1 through 14 are off the list because they involve tax policy, changing the laws. Nobody realistically thinks that’s going to happen.”

If you want a pretty good analysis of the situation, try Mr. Mauldin’s Outside the Box post for this week. If you want to read a more positive view, Stratfor thinks this is all a set up for the G20 in Seoul.

Why is this happening?

Because the Federal Reserve can get away with it.

The US economy, not unlike other developed economies, is in need of fiscal, financial and structural reform. These reforms are painful because they must be implemented in a crisis. The joke, however, is that reforms are rarely contemplated when times are good, so reforms almost always fall due during a crisis.

The choices are stark. The US suffers from massive fiscal and current account deficits. Unemployment is high, demand is low and businesses are hording cash. Rather than raise taxes, reduce spending or promote investment in export oriented businesses, the Federal Reserve is determined to devalue the dollar. Using the laws of supply and demand, one simple way to do so is to increase the supply of dollars well beyond what is demanded.

If successful, the US government can settle its obligations (aka Treasuries) with cheaper, more plentiful dollars, imports will become expensive enough to encourage domestic substitution and US products will find new export markets.

Problems solved? Maybe. However, it would be safer to bet on something called “unintended consequences,” which will surely throw a massive monkey wrench into the Federal Reserve’s plan.

Portfolio Adjustments – follow the money

The next question is what should we do to our portfolios? Let’s look at one example in Asia. Check out the rating difference between FXI (the Xinhua 25) and EWH (MSCI Hong Kong).

As mentioned above, there are sure to be strong reactions to this blatant act of currency sabotage. China is vulnerable no matter what it does. If it agrees to let the RMB float upwards, it threatens to wipe out the narrow operating margins its exporters operate on while taking an immediate hit to its foreign exchange reserves. For a country that was recently poor and saw the way the Asian Financial Crisis ravaged the economic landscape, neither of these are attractive points of contemplation. Of course, if the People’s Bank of China tries to hold the exchange rate, there is little doubt that the US congress will initiate some sort of trade war.

So, if you don’t feel like loading up on Chinese equities today, the Fund King System is showing you that there may be a better way to play in the neighborhood. Hong Kong, for example, might be just the ticket. With a hard link to the US dollar (which will drive interest rates even lower) and a fast trading property market (which serves as a piggy bank for the locals and wealthy Chinese over the border), the excess money created by Mr. Bernanke looks poised to flood in and push asset prices further in Hong Kong.

Other ways to play?

With the developing markets growing faster than the developed markets, a load of fresh dollars hot off the printing press and looming trade and currency wars, the one thing we can be certain about is that there will be more market volatility, asset class and sector rotation. The Federal Reserve’s actions will have repercussions around the financial world as companies, central banks and investors react. Don’t forget that QE2 is one of the most anticipated Fed moves in history. Many of the bets one would associate with QE2 are already laid on. Keep an eye out for profit taking and reversals (even the US dollar) which are very likely in the coming weeks. As we enter the final two months of the year, it makes sense to pay extra attention to your portfolio and be ready to rebalance. Don’t be shy about locking in profits.

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