MARKET RECAP: Don’t Know Much About History….

This holiday shortened week was an economic smorgasbord with top tier reports such as the Chicago PMI, the ISM index and non-farm payrolls both released on Friday. The trends over the past few weeks remain in tact as bonds traded below the 5% support level while stocks rallied to get the S&P 500 to an all time closing high. The dollar rallied up to a fraction of its previous Feb high v the yen and the euroyen pair continued its upward bias as carry traders were not concerned over the correction in Chinese stocks due to the government levied tax on trading. In commodities gold saw the bounce we were expecting out of the falling wedge though it is unclear if it wants to make a new high.

INTERNATIONAL INTEREST: Domo Arigato Fukui-san

The dollar traded higher this week v the yen as the bond market pushed yields to their highest level of the year. Economic data was mixed with a weaker than expected revision to Q1 GDP being offset by stronger manufacturing data and employment, which are expected to keep the Fed on hold through the remainder of the year supporting flows into the greenback. The euroyen pair, our favorite indicator for speculative flows remained at its elevated level making a slight new high earlier in the week though seemed to diverge from the speculative flows that took to the Dax on its parabolic ride this week.

We will be closely watching the yen contract this week as our attention moves from the cash to the futures. The JPY contract (CME) made a new low this week and appears to be finishing off a 5 wave move down resembling a falling wedge triangle. These patterns can be indicative of an imminent reversal as selling dries up. The fact that the dollar yen looks to be also finishing off a pattern higher and the euroyen has cooled its advance while selling in the yen contract seems to be waning is driving us to be on the watch out for a rally in the yen potentially driving carry traders to de-leverage.

The euro would be expected to see a bigger move than the dollar due to its higher beta but since we are still looking for another high in euros v dollar we are not confident this will unfold. Instead, we think sterling presents and interesting opportunity in this scenario as the BOE has continued to raise interest rates (5.50% and rising) surpassing the Fed’s target rate and well above that of the ECB. We think all yen pairs will be under pressure but sterling should outperform the euro and dollar on a relative basis in a de-leveraging situation as they provide the highest yield of the three countries.

Bottom Line: The yen contract looks to be finishing off a pattern at a new low and any reversal out of the falling wedge could have implications on carry trades and market liquidity. We view the euro as slightly more vulnerable than the dollar due to its recent higher beta but would prefer to hide in sterling as the BOE is currently the most hawkish.

COST OF CAPITAL: There’s a Hole in My Bucket, Dear Liza

The bond market took it on the chin this week as the slide in prices continued pushing yields to their highest level in a year on a flattening sell-off due to better manufacturing and employment data. The 2YR note traded back towards the 5% level and the Eurodollar strip removed all of their easing discount. This price action has been consistently cyclical as we have pointed out in the past as the bond market has been easing to stimulate activity in one quarter only to tighten the following quarter when the economy reflected the easier conditions. With the entire coupon curve back near the 5% area, we expect there to be a slowdown in real estate activity, especially commercial deals which tend to price on the short end. Commercial real estate has remained fairly robust despite the problems in residential market as 1031 money continues to buoy activity. We would point out, however, that a tight Fed and relatively high short rates can not only cut off financing for many deals in the pipe but also cap price appreciation and thus capital gains which in turn remove the incentive for a 1031 exchange back into more real estate transactions. As prices plateau expect less stimulation from one of the prime catalysts to the real estate boom.

We have been looking for a good entry point in bonds for the past few weeks only to see further selling and higher yields. We are sticking to this game plan as we are skeptical of the recent “surge” in economic data and can easily attribute it to a dead cat bounce driven by the prior quarter’s favorable interest rate levels. There is good support at the rising long term trend line near the 108-00 level on USU7 where the potential C wave (of larger degree B) we are watching equals the Feb low A wave. This level would also coincide with a roughly 5% 10YR yield which seems to be a magnet for traders. If the bonds can hold this trend line the probability of a strong rally increases as the pattern implies a break out to new highs.

Bottom Line: We think there is a pretty consistent cycle occurring in the economy as the bond market injects and withdraws stimulus as activity ebbs and flows quarter to quarter. We think this recent back up in yields will cool any acceleration in economic growth as the highly leveraged economies are more sensitive to higher bond yields. The long term support at 5% on the 10YR and 108-00 level on the bond contract has us again looking for an entry point that has a very favorable risk/reward.

BETA MAXIMUS: It’s an Eminence Front

With all the excitement surrounding the new closing high in the S&P 500 you would have thought the US market was seeing all the action but considering the dichotomy between the 5%+ correction in Shanghai and the parabolic advance out of the leading German Dax, we would not be focusing too much on the US market milestone. We have been following the euroyen as the main reflection of the carry trade and the speculative flows in Europe. This week we noticed some big time divergence as the favored currency pair for carry traders did not participate in this week’s parabolic advance in the Dax. While we can only speculate on the divergence it is interesting to consider the idea that some smart money could be de-leveraging positions under the surface while the shorts and late comers bid the Dax to new highs. Removing the bid from the carry trade could with draw a lot of liquidity from the market at a time when a reversal from a new high could be in order.

While the US markets continued their advance this week with the S&P finally closing above the previous closing high in 2000, the rally seemed to have stalled on perhaps the best news of the week, better than expected employment as the selling in bonds sucked out some of the wind from the sails. We saw this before in 5/06 when rising bond yields proved to be the catalyst for a correction in stock prices. This time, however we feel like there are more moving parts and less margin for error due to the increased amounts of leverage in the system. While we don’t expect a turn in stocks just yet it is not time to be committing new cash to equities but rather we recommend investors peeling out of longs and raising cash as this advance seems to be in the late innings and the prospects for a more severe decline arguably tilt the risk to being long stocks.

Bottom Line: The US stock market gets all our attention but remains in the back seat in the global credit induced liquidity trade. Excuses and catalysts for the rally change daily from M&A to PE to liquidity to shrinking supply to interest rates to economic growth as momentum trumps rational behavior. This has us on the defensive as we believe equities are not in charge of their own destiny.

DUKE & DUKE: Metal Health Will Drive You Mad

If we had told you the dollar/yen traded near the recent highs, the curve flattened in a sell-off with 2YR yields at a high and Eurodollars removing the Fed ease discount you probably would not have expected much of a rally in gold prices as all markets are reflective of tight money. Instead, the bounce we were expecting out of the falling wedge happened this week sending gold surging, retracing over 50% of the sell-off from the top in late April. While we may see higher prices and potentially a retest of the previous high, we cannot recommend investors maintain an allocation to gold at this stage in the cycle with cash yielding the highest on the board and would be using any strength to reduce exposure. It would not surprise us to see one last advance potentially coupled with some disruption in global markets or an increase in the monetary base as the economy is decelerating, but we think the risk/reward is modest at best.

Bottom Line: Gold defied economic and market logic this week as traders got caught selling into a falling wedge that looked to squeeze some weak hands. We believe this market volatility will remain elevated and caution investors who dare to gain an edge. We would prefer to use strength to lighten up positions, rotating into short term treasuries and cash.

THE EX ANTE FACTOR: Everybody Wang Chung Tonight

We had been eyeing this week’s slew of economic data as a potential catalyst for a turn in many of the markets and trends we have been following and while they remain on course we did see some activity that shouldn’t go unnoticed. The hiccup in China and the parabolic advance in Germany coupled with the divergence in the euro/yen has us on alert. It is not unusual to see more speculative markets show signs of reversal prior to more mature markets and investors can often rotate out of emerging markets and into higher quality developed markets. We got a taste of this last year when we saw similar speculation in the Middle East reverse prior to the top in US and Europe. We continue to follow our favorite indicators and point out that just because they are diverging doesn’t mean they aren’t working. The yen contract and bond market will move to the front screens this week as we believe they are close to a trend reversal. Whether the higher interest rates or the yen reverse stocks or it’s the other way around is unclear. What is clear is there is excessive leverage in tight spreads with little margin for error and any drying up of liquidity prior to a correction could have an exponential impact. We are not looking to join this party in the late stages but prefer to pick up the pieces after they turn out the lights. In order to take advantage of this de-leveraging investors should consider that cash is the highest yielding asset and when liquidity is tight, those that own it have opportunities to profit from others who need it.

What is the discount?
This week with the rising bond yields and continued rally in stocks, the implied risk premium fell to the lowest level of the year. The implied equity risk premium (the extra yield offered for investing in stocks v bonds) came in at 29bps when measuring against interim grade debt. While there is no doubt these spreads could narrow further, they do indicate that stocks are the most expensive relative to bonds all year. The implied return has averaged about 7.5% all year and with the S&P +8.5% ytd, the upside appears limited.

Bottom Line: Play defense, use rallies to raise cash and focus on quality assets.