Archive for April, 2011

Pulling Batteries out of Smoke Detectors

In my house, I am the keeper of the smoke alarms. Like most sensible families, we have white plastic disks all around the house silently sniffing the air 24/7 thanks to the clunky 9 volt batteries that power them.

My relationship with the smoke alarms is a love-hate one. The love part is easy: I realize that they will probably save my family from smoke inhalation if something was to catch fire. The hate part is down to the way these little plastic disks behave when the battery runs down or it is my turn to cook indoors.

Let’s start with the 3am chirp that lets you know that the battery is about to die. Whoever designed these monstrosities spent a lot of time figuring out what unholy pitch of electronic chirp would penetrate through doors, walls, pillows, sleep and the hope that maybe this time your wife will volunteer to venture out from under the warm blankets. Why 3am? Actually that is a bit of an exaggeration. Over all the years that I have had to deal with smoke alarms, batteries have died at almost any time between 1am and 4am. The second aspect of the chirp is that it is infrequent and its location is very difficult to pin down. In a decent sized house with two floors, it could be any one of 10 different white disks. This is as close as I am going to get to employ the skills one can learn from a classic submarine movie. After about 5 chirps (or 15 minutes), the offending plastic disk is identified and it is time to teeter at the top of a step ladder to twist the plastic noisemaker out of its perch so that one can disembowel it of its dying battery. Getting the battery out of its hiding place and removing the connection (which is at once sealed to the top of the battery and incredibly flimsy) while trying to maintain some sort of silence is always a challenge. And of course, there is at best a 50/50 chance that one will have a fresh 9 volt in the drawer.If there isn’t, it could be a week before that smoke detector gets back to work.

The second instance where I hate the smoke alarm is when it is my turn to cook up some hamburgers or a couple of steaks. My much more culinary-skilled better half can prepare meals for months at a time without ever tripping the alarm but the kids know better than to stand in the kitchen when I am flipping the burgers. The tiniest wisp of smoke from the beef sets off a shriek that could bring bats down for several miles in all directions. Because I bear no particular ill will towards bats and any other creatures that I might be harming, I have learned to shinny up the step ladder and preemptively remove the battery from the smoke alarm before I turn my hand to indoor cooking. The funny thing is the kids have yet to figure it out and reckon that I am just getting better at flipping cheeseburgers.

Is there a risk to preemptively yanking the battery? Of course there is because the chance of me putting the battery right back in after cleaning up is considerably less than 50/50. Short term problem solved, longer term, another smoke alarm is out of action for at least a week.

What to smoke alarms have to do with markets?

There are plenty of smoke alarms perched in high places around the financial landscape and I feel like most investors are developing the same attitude towards them as I have towards my smoke alarms. They are either annoying or something to disable when we have something else to get on with. We know what we are doing after all and when it is safe to ignore the warnings, right?

These alarms are chirping and going off all around us. But at each stage, we are finding reasons to rationalize the noise. US to lose AAA rating? Everyone knew that. Greek interest rates going to the moon? Not a biggie, surely the Germans and Finns will pony up when it comes to crunch time. China pouring more lending fuel onto its property bubble fire? What does that have to do with me? QE2 about to end? Surely they will start talking up QE3.

One of the core investing assumptions rests on a weak and almost free (to borrow, if you are a financial institution) US dollar to fund speculative trades around the globe. This has been largely driven by the Federal Reserve which, along with the stimulative fiscal policies of the US Government, has been buying up 5-7 year Treasuries to free investor cash for more risky ventures. The result is a massive carry trade which has pumped up asset prices around the developing world from Hong Kong to Australia to Brazil and over to Russia.

But, looking over the past few weeks, my best performing asset has been SLV, the Silver ETF. The ratings on most of my other assets have been falling into the low teens as the breadth of the market has quietly shrunk this quarter. It looks like some of the sizzle is coming out of this latest rally.

It would not take much to knock the financial markets down a few pegs and with still high levels of leverage at almost every point, it would not take much of a change in the weather to turn a correction into something more serious. A reversal of the US dollar carry trade could result in a sharp reversal of currency flows and values which would throw a monkey wrench into many a well laid investment scheme.

In the next few months, the risk of things getting much better are well outweighed by the risk of a capital damaging correction.

What to look for?

The most obvious sign of a reversal would be strength in the US dollar. The US dollar is weak because the Fed is printing new ones to any bank willing to play. Euros, Yen, Aussies, just about anything that isn’t US dollar grounded has surged lately. Unfortunately, a big component of that game is about to change as QE2 draws to a close. If investors demand higher interest rates to pick up the slack left by the relatively price insensitive FED, the entire playing field for financial assets could shift and demand for cash (in terms of short term US Treasuries, for the most part) could surge. The shift back into the US dollar will likely be temporary (a few months) but the volatility and change of direction could force speculators to close out open positions and shift money to hedge exposures.

What should you do?

As assets roll out of the top rankings, there is nothing wrong with holding back 20% of the proceeds from the next switch. Putting a bit of cash on the sidelines is a good idea now because most of the risk in the markets is political rather than financial or economic. If we sail through the end of QE2 without any significant change in market direction, one will have missed out on a few percentage points of return. If, however, there is a short sharp correction, one can avoid some of the drop and have cash ready to redeploy in to cheaper assets during the summer months.

Carry Trade Ending?

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.

Business Loan Chart
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.

3m Swap
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.

3m Libor
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.

Presidential Cycles and Australia

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,

Living in Interesting Times

Looking back on the first quarter, an impressive amount of the big news has hit the market. The political unrest across Northern Africa and the Middle East has entangled the US Military in its third shooting war, Japan endured the triple disaster of earthquakes, tsunami and partial nuclear meltdown, the European sovereign bailout took political prisoners in German elections and the largest bond fund manager announced that it had cashed out of US Treasuries. In the US, the housing market seems to have sprung some new leaks below the waterline.

What will the next few quarters bring?

One great place to start is ECRI’s Weekly leading index series which shows that the positive momentum is starting to taper off.This does not mean another recession is on the way, just that the current surge in the leading indicators (which correlate highly with the discussion and implementation of QE2) appears to have lost its head of steam.

Source: Economic Cycle Research Institute

What does this mean?

Investors are right to wonder how the markets for risk assets can be bogging down when there is still an estimated one-third of the QE2 campaign to be injected into the system? Part of the reason is that the likelihood of a QE3 has become more remote as even FED governors start to question the need to continue pumping liquidity into the system. Another part of the reason is due to the fact that much of the newly created money was used by big owners of long dated treasuries (Chinese government, PIMCO and others) to purchase other assets. The increase in base money did not have the desired multiplier effect because it was not used as fuel to create new credit in the commercial banking system. In the land of M2 money supply figures where most of us live, QE2 was a fizzle.

Last Spike?

Source: St. Louis Federal Reserve Bank

Pushing on a String?


Just over 4% growth in M2


The other side of the coin

Yield CurveFor the big financial institutions who have access to cheap FED funding (or paying very little on demand deposits), the current state of affairs is still very attractive.But, as the situation remains very fluid, banks have shown a marked preference for Government paper (Treasuries, Agencies and Agency MBS) which can, in theory, be liquidated much more quickly than private mortgages and corporate loans.

But the banks are still burdened with a large backlog of toxic assets. Recent buoyant earnings reports and the cash flows behind them will not last if the whole yield curve gets shifted upwards by inflation or even just stronger economic performance.

Borrowing short and lending long works very well in flat or falling interest rate environments. Although we have seen lower interest rates recently, the FED has spent its political capital as quickly as it has built its balance sheet. Lower interest rates seem very unlikely in the medium term.

Sell in May and Go Away?

SADoes this mean we will reach another “Sell in May and Go Away” moment when QE2 runs its course? The numbers have been slipping from the 20’s to the teens in most of the Systems that we track, which suggests a cautious outlook.

As investments start to fall out of the top rankings and you look around for the new investment opportunities, it might be time to take a bit of money off the table and wait to see what opportunities arise after the next bit of bad news rattles the well priced equity markets.

The commodity sector suggests that not all of the optimism in the market is warranted. Most of the strength in the short term remains in Silver (SLV), which has just hit new multi-decade highs and traditionally serves as a store of value as well as an industrial metal. And despite exclusion from core CPI figures, the energy ETFs like UGA, USO, UHN and DBE are all running stronger than economic growth in the G8 economies might warrant (or appreciate).