Choppy Trades

I expect the yields to be choppy. On one hand, the Fed has clearly determined to keep private sector borrowing costs low though a combination of quantitative easing and on the other hand, US dollar hoarding is bidding up the rates. If the rates are inching up, I do entertain the possibility of the Fed to increase the size and the pace of the Treasury purchase program beyond the initially announced $300bn over the course of six months.

That, I believe will put a temporary ‘cap’ on how high the Fed will allow yields to rise, but it will raise the upward pressure on implied volatility. Falling employment is gathering momentum in the US and Europe, now at 8.5% compared to 4.8% in the US and 7.2% in the Eurozone a year ago.

Over the past week, we had seen continued sell off on rates, but now the equity markets have done in consolidating the recovery and going forward, we will be able to make clearer assessment of what I call ‘second derivative’ of economic data. It would an interesting weeks to look forward to as most US banks will report in the second half of the month and the US Treasury should release the results of the ‘stress test’ on the banking system. The equity market has taken heart form the recent change in accounting rules and it would be good if some of the investment banks to post relatively good set of results, or if the announcement to exit TARP made. Let us keep the fingers cross.

It remains a big question if Fed will respond to 10y yields rising above 3% and that will lead us to the issue of credibility that could come back to haunt the Fed once the excitement about the start of a sharp economic recovery fades. The potential rise in implied volatility argues for a good delta hedging position, rather than buy-and-hold options. Volatility looks on the expensive side because yields are likely to be highly volatile not within the range. In response to this scenario, I like trades that have underlying in the 5-7 year maturity sector of the curve with relatively shorter expiry options, especially if the Fed’s Treasury purchase program slows or nears the end.

The situation could be far severe across the Atlantic. The ECB disappointed once again, easing its official refi rate by just 25bps. It is a missed opportunity to get ahead of the curve as it is continuing to buy time as it approaches the end of the traditional monetary policy easing cycle. I begin to see similar widening has already taken place in long dated BOR-OIS spreads with the sport three month differentials rising above 8bps last few days. Given this scenario, I disregard long-end euro rates to be attractive and any further rally in riskier assets would have positive effect on bond yields.

FX Update

I am still US dollar bear and the pressure gets intensify as the Fed hiking up its claim on quantitative easing. Global markets have not taking a significant change compared to ones that was reviewed last year.

My top concern for this update is EUR. There are several reasons still to sell EUR. The hairline crack in the foundation stone widens with a core story as German growth evaporates with the collapse in world trades. I still think there will be flows of bad news about financial sector in Europe, relatively speaking, than there is in the US and UK. I believe large parts of central and eastern Europe are on the cusp of synchronized currency crisis as the output gap widens very rapidly, hence that arguably that policy in the Europe has to stay that much looser for that much longer rises. This could play out partly as reserve managers, notably in Asia come to distrust the EUR foundations as a global reserve currency.

Do not be drawn into thinking that the pound somehow gets ‘rewarded’ for the pro-activity of the UK’s monetary printing policy approach. Also, still helping the greenback is a persistent global ‘bid; for it, partly as capital flows and stays home.

The yen has weakened sharply. However, risk of renewed yen downtrend look exaggerated as the international taxation reform of Japan starting April, which promotes larger repatriation of overseas profit by Japanese corporate potentially will limits yen’s downside. Unless widening losses on stocks leads to the large scale divestment overseas, the impact on the currency should be limited.

On commodity currencies, CAD, AUD & NZD have been underperformed with a loss of 3.3%, 2.2% and 4.0% in a race to zero for interest rate globally. Gone are the days where, at least for the AUD and NZD yield will be rewarded but there is a strong cyclical between emerging economies and overall commodity price baskets.

My base case for USD/CNY remains unchanged and it has continued to trade relatively steadily at 6.84 during the past month. I expect the PBOC will draw down FX reserves in defense of the currency, but a sharp drop in FX reserves is unlikely, though cannot be ruled out.

The Ringgit has finally decoupled from the CNY and is starting to buckle under pressure from slowing growth and falling commodity prices. The balance of payments position remains under stress on the back of heavy portfolio liquidation and resident capital outflows despite solid current account surpluses of 15% of GDP.

For this review, my key highlight is Korean won – the cheapest of all currencies I monitor. On a PPP basis, Won is 16% cheaper against the USD. Large under-ownership of Korea and abnormally high loan/deposit ratio for Asia (131% in Korea), it will benefit from a fall in credit spreads.

The Dam is Cracking

A rally in the global equity market has gained traction over the past month, but it really a big question to ask on what it takes to hold. Globally, some US$50 trillion in net worth has vanished, but Dow wrapped up its best four-week run since 1933 last week after the economy showed signs of improvement and world leaders at the Group 20 meeting in London pledged more than US$1 trillion to ending the first global recession since World War II.

Question – are we seeing a full-fledged bull market or temporary bear market rally?

Bear in mind, sentiment can change on a dime as the market continues to experience more volatility than they have at any time in recent memory. Much of the US financial sector is still teetering on the brink of insolvency. The housing market remains in free fall and the economy is on track for its longest recession since the Great Depression.

Friday’s employment report from the Labour Department was bad again with large job losses, even government jobs. In fact, the New York Times recently reported on this disturbing trend that prior months’ data were revised down again. The department keeps concluding that its initial estimates were too optimistic. On average, from August 2008 through January 2009, the first estimate was too optimistic by 112,000 jobs. Without a February revision, the unemployment rate reached a new high of 8.5%, notching the 15th consecutive months of job losses.

Many of the real time indicators that I follow, such as corporate bond spreads, credit availability, jobless claims etc are telling me that any rally we experience in the stock market is likely to be only temporary. Consumer spending – the heart and soul of the US economy – is plunging at an unprecedented rate of nearly 9% annually – the largest decline ever recorded. In another word, there could be many false starts and this seems to be the closest definition that one could find for a bear market rally.

On the other hand, there is a mountain of cash sitting at the sidelines right now. A total of US$3.6 trillion in retail and institutional money market accounts – that is an all time record high. We don’t need to actually see good news, we just need news that is no worse than before. So, if the news flow gets ‘less bad’ the rally can be guided against its long term fundamentals and that doesn’t mean the market has reached the bottom.

This week, investors will get a glimpse of the first batch of first quarter earnings reports. Aluminum producer Alcoa Inc will be the first Dow Jones industrial to kick off the first quarter earnings session. Investors are eager to see some sector specific results as well, especially banking and retail industries.

Friends in China

I met couple of old friends, who have been spending more than a decade in China last Sunday. I learned that there is a huge divergence between the economic performance of the coastal and inland regions and based on the anecdotal evidence, the inland provinces are faring much better than coastal provinces. Coastal regions, which accounted for around 60% of sales, have dropped to current 45%, according to a friend that worked for Qingling Motors.

I heard comments about residential property demand, as second-tier cities look more promising with government offering monetary subsidies to home buyers rather than building economically affordable housing for them. An absolute increase in supply will be largest in cities such as Shanghai, Guangzhou, Beijing and Tianjin. I was told there is some investment opportunity in tier 2 cities like Chongqing. In January this year, this province sold 5,000 units per week and in February 2009, a new record was created at 7,000 units per week. The city will see some 8 million people moving to the city centre from the Three Gorges Dam area while the average home price was RMB3,400/unit and family income was RM4,000.

Key reason for the optimism is the infrastructure investment with central government’s emphasis on people’s livelihood rather than traditional infrastructure. Today, China is in the middle and late stage of industrialization and its urbanization is accelerating. The rich provinces like Beijing, Shanghai, Zhejiang, Guangdong, Jiangsu that have the resources to invest heavily all recorded investment growth lower than the national average in 2008 and now the strongest growth has been seen in inland provinces. Infrastructure and industrial facilities of these provinces are well built – room for large scale investment is very small. In contrast, the inland provinces are just in the early stage of industrialization and urbanization – therefore there is more room to build.

Dollar Liquidity Tight

High cost of swapping local currency into US dollar is well reflected in basis swaps. Since the crisis started, it becomes difficult to raise dollars directly in cash markets and institutions with dollar needs have to turn to alternative dollar funding markets like the cross-currency basis swap market.

In this instance, institutions are forced to move from borrowing directly in the uncollateralized dollar cash market to the local currency’s uncollateralized cash market and then convert the proceeds into a dollar obligation through a foreign currency basis swap. This essentially translates into marked dislocations as reflected in the spread between the actual interest rate received on the leg of the swap and actual libor.

This indicates that the credit crunch is not yet over and it makes it expensive for foreign dollar-based issuers to tap non-dollar bond markets. If the situation persists, it would nto be surprised to see further unwinding of foreign holdings of local currency bonds and in combination with wider sovereign credit spreads, it makes dollar bonds issued by Asian governments to become more attractive relative to their local currency counterparts.

Volatility between on-shore and off-shore markets is expected to rise dramatically and that will lead to co-dependence of volatility regimes. Ongoing financial market volatility,
falling interest rates and concerns over the safety of bank deposits following the collapse of Northern Rock and Bear Stearns has focused institutional investors’ attention on their cash investments. Foreign order cancellations could also aggravate the situation as it could mean a need for foreign currency to settle the hedges.

It also presents an arbitrage opportunity for investors. Moreover, as a result of the credit crunch, it is extremely difficult for borrowers to issue corporate bonds offshore. Hedge funds, meanwhile, have stepped in to do Asian/dollar forward trades with Asian companies that are looking to hedge.

And, from another perspective, we have learned from different policy reactions to the currency speculation during the crisis, the subsequent high level of FX volatility has set the pace for the capital market liberalization.

Call for a CELEBRATION with Beers!

This piece is a cut and paste from an email sent by a friend.

It's fairly common knowledge that beer has a relaxing effect on the body and can reduce stress, but there are a myriad of other health benefits of this potent potable that are not as apparent at your local happy hour. There has never been better reason to enjoy a cold one.

Beer is good for your heart.
A Dutch study conducted by TNO Nutrition and Food Research found that a known reference for predicting future cardiovascular disease, blood C-reactive protein (CRP), declined by 35% after three weeks of regular beer consumption compared with levels after three weeks of drinking non-alcoholic beer. The same study found that levels of HDL or "good" cholesterol rose by 11% during the same period. Beer also contains vitamin B6, which prevents the build-up of an amino acid called homocysteine that has been linked to heart disease.

Beer will reduce the chance of stroke.
One drink a day for women or up to two drinks a day for men will reduce your chances of strokes, heart and vascular disease. Strokes are the third-leading cause of death in the U.S. and the leading cause of serious, long-term disabilities. It is said that light to moderate drinkers will decrease their chances of suffering a stroke by 20 percent.

You should give your grandma a beer.
Don't load her up a beer bong yet or take her to "kill a keg" night at your local pub, but in moderation, beer has been proven to have positive effects on elderly people. It helps promote blood vessel dilation, sleep and urination.

Beer is good for breasts.
Research by scientists at the Universidade do Porto in Portugal found that polyphenols in wine and beer appeared to decrease breast cancer cells significantly. Numerous other experiments have shown that certain polyphenols, mainly flavonoids, can protect against heart disease and have anticancer, antiviral and antiallergic properties. The Portuguese study concluded that xanthohumol, which is found in beer, was the most potent polyphenol over breast cancer cell growth; it showed its effect more rapidly and at a lower concentration than the others.

Beer could save the Three Blind Mice.
John Trevithick, Ph.D., and Maurice Hirst, Ph.D., of the University of Western Ontario, conducted a study that suggests beer reduced the incidence of cataracts in mice (but increased their propensity to "go wild" and get tattoos they'll regret later in life -- my own inference). If the same cataract protection occurs in humans, it would be especially beneficial to people with diabetes.

"Beer is proof that God loves us and wants us to be happy."

Fed in ‘All In’

The Fed said it will ramp up its purchases of Fannie Mae and Freddie Mac Mortgage Backed Securities (MBS) from $500 billion to a whopping $1.25 trillion in the coming months. The Fed is also going to double its purchases of Fannie Mae, Freddie Mac, and Federal Home Loan Bank bonds to $200 billion from $100 billion.

And for the icing on the cake ... the Fed will buy as much as $300 billion in longer-term U.S. Treasury securities. It's going to focus on Treasuries with maturities between two and ten years, and make purchases two or three times a week.

In short, printing money out of thin air at the central bank, only to turn around and buy debt securities issued by your Treasury, is the kind of practice you typically see in emerging market regimes.

Indeed, the Fed's actions sparked the biggest one-day plunge in the U.S. dollar in several years. Gold also surged, a vote of no confidence in central bankers' willingness to preserve our purchasing power. The yield on the 10-year Treasury Note, which had been flirting with the 3 percent level, plunged roughly 50 basis points in the blink of an eye. The last weekly survey from the Mortgage Bankers Association pegged the average 30-year mortgage rate at 4.89%. Consider that the lowest annual average mortgage rate seen in the 20th and 21st centuries was 4.7 percent, set right after World War II. In other words, this is just about the cheapest that mortgage money has ever been.

The Obama administration is going on the offensive in an attempt to rebuild confidence in its ability to lead the country out of its seemingly depending financial morass.

But don’t be too optimistic with the recent runs. The last time the economy was this bad - during the Depression - the Dow sank to 36 and gold rose to $36 - a 1-to-1 ratio. In 1980, after the huge stock downturn of the ' 70s, the Dow and gold met at 850. Today the Dow is rapidly falling, down 50% from its peak of 14,164 set in October 2007. Gold is soaring once again, retesting historic highs. If they meet somewhere in the middle, that point could very well be 5,000, according to legendary bear market analyst and millionaire investor Peter Schiff (the man who accurately called the last 4 major market corrections) . Indeed, he sees the 1-to-1 ratio returning again, and soon.