MARKET RECAP: Tight Ass Fed

This week has been on our radar for a potential turn in the major markets and we certainly got a taste on Thursday after the Fed was out of the way, with a sell off in stocks, gold, euros and sterling. US retailers reported tepid same store sales data and the wider than expected trade deficit could lower the already weak Q1 GDP. The Fed, ECB and BOE which all met this week were still holding the line on inflation with the BOE tightening by 25bps. The ECB is expected to tighten 25bps in June. On the flip side, US 6 mos treasury bills traded to 4.90, their lowest level since the Fed stopped tightening in 2006 and suggesting the bond market is anticipating some easing by Autumn. As I have mentioned before the nominal GDP dipped below the treasury curve for the first time since late 2000 indicating money is too tight.

The question facing investors is whether this move was a tradable turn or just a pit stop in a continuing trend. We have a tough time believing that Thursday’s turn was a big top in stocks and continue to stick with our patterns as all markets are according to the plan.

INTERNATIONAL INTEREST: Polishing the Queen’s silver

Central banks were on deck this week as the FOMC, ECB and BOE all met to decide their respective country’s monetary policy. The elevated hawkish tone from these guys amuses us at this stage in the cycle and reminds us of the 2003 period when they all rushed to ease credit at the low. We applaud holding the line on inflation but were it not for excessive easing in the prior cycle they may not be in this predicament. With the BOE tightening by 25 bps on Thursday, it bumped their target rate above the US FF target rate. Despite this move sterling lost ground against the dollar and seemingly broke both a rising trend line and longer term support at the 1.985 level. This could be classic sell on the news action but it bears watching as the 2.00 level was a bit of a milestone and brought out the media reports that are often associated with a turn.

We are in the camp that the Fed will need to ease by the second half of this year with the growth rate of the US economy continuing to decelerate which would potentially put more pressure on the dollar v sterling and the euro as their respective central banks are still in tightening mode. A 1.40 target on the euro was mentioned here two weeks back but we noted that it likely would need a breather before resuming the ascent. This also made sense as the dollar index was attempting to test the 80 level which is multi-decade support. This appears to be what is happening as the dollar bounced while sterling and the euro backed off but we expect these currencies to regain favor among FX traders in the coming week as the presumed June tightening by the ECB will provide more allure for petro dollars and more fuel for the yen carry trade both of which has been driving stock prices higher.

Bottom Line: The currencies that have been leading the charge higher in recent months took a breather this week but we still think there are some higher prices to come before a major turn.

COST OF CAPITAL: Choppin’ Broccoli

The bond market remained confined to the range as traders continue to get whipsawed by weaker than expected economic data which is ideally bullish for bonds and the leveraged speculation in stocks and corporate bonds via currency carry trades which has been bearish. Bonds couldn’t even catch much of a bid on Thursday’s stock market sell-off which probably indicates there wasn’t much concern nor pairing of risk from the leveraged community.

One of the more interesting developments this past week was the move in 6 month t-bills which traded at the widest spread to 90 day LIBOR since 2001 when the Fed was beginning its massive easing campaign. The wider than expected trade deficit that was announced this past week is anticipated to be a further drag on an already decelerating GDP. The red Eurodollar strip looks to be only discounting a 25-50bps ease for next year but if this trend continues it will be more evidence the Fed will need to ease by Autumn.

There isn’t much else to say other than, while getting sloppy, the long bond looks to still be sticking with the plan and contracting triangle pattern we have been following. Where the final range shakes out is not nearly as important as what happens when it emerges from the consolidation. We have been looking for a rally out of the triangle and with economic growth decelerating, inflation peaking and a tight Fed the risk/reward to us is better to the upside. As credit contracts and reverses the cycle this should benefit bonds and quality.

Bottom Line: Bonds have been in a messy consolidation range that is gearing up for a break out. We are leaning towards higher prices lower yields as the bond market discounts a Fed ease in the second half of 2007.

BETA MAXIMUS: From the back seat.. DADDY, ARE WE THERE YET?

Stocks traded higher into Wednesday’s FOMC meeting and we got the turn we were looking for as the non-event Fed move was all the catalyst they needed to pull the trigger. CNBC blamed the selling on weaker than expected SSS from retailers and the Fed’s signal that they would remain tight. Funny cause Friday’s rally was credited to the softer PPI which would allow the Fed to ease. What a joke. In any case we bounced up into resistance as some morning programs drove the weak shorts to cover and we closed at the high of day. Surly shorts must be getting tired of the squeeze play which probably means we are close to a top. If we are doing and ABC correction off the high it likely is a larger 4th wave that should coincide with the late Mar correction which would then be labeled a 2nd wave. Friday’s grind would be considered the B and next week’s option expiration should see the C down to the 1480 area which was the level of the previous 4th of a lesser degree. The alternative is that the 1480 doesn’t hold and we continue lower perhaps near the 1410 area which would no doubt bring out the bears just in time for another short squeeze rally.

As we have previously mentioned stocks are not in charge of their destiny so we should instead focus on the markets that will drive their price action. That leads us to the FX market which is financing all the speculation via carry trades. The S&P just happens to be in the back seat for the ride. That being said traders and investors should continue to watch the euro/yen for clues as it is the pair that seems to have the highest correlation and with the DAX leading all equity indices higher it only confirms that thesis. As we mentioned above it appears to be gearing up for one more run higher as the Euro shoots for the 1.40 target and it will likely pull the S&P along for the ride as it approaches the all time high from 2000 at 1451.50.

Bottom Line: S&Ps turned as we expected after the Fed meeting but we believe it was an intermediate move to gear up for the march back to the 2000 all time high.

DUKE & DUKE: Has Gold Topped?

We noted last week that there was a potential “golden” opportunity to get short bullion coming out of the multi-month b wave off last year’s low. We also posited that gold would be the first asset to show signs of the credit/liquidity cycle reversing. While we can’t be positive gold has topped here as one more high could be in order, there is a strong case to be made that the rally has ended.

Note the chart and the attempted retest of the previous week’s break down which failed and sent prices lower on the same day stocks and the euro/yen reversed. We do not think this is a coincidence but a signal some of the speculative money is being removed from the market. Since we are expecting higher highs in the euro and in stocks indicating further leveraged speculation we aren’t sure what it implies for gold. Our initial thought is that this would allow for another high and we wouldn’t want to be short, but it would not surprise us to see gold continue to fall while stocks and currencies make their highs. The financial media will be pounding the table on the benefits of falling inflation on asset prices but we will know that it only will be nailing the coffin of the credit cycle.

Bottom Line: Gold may have sent a shot across the bow in the credit/liquidity trade as it appears to be finishing off a large B wave. We think this is indicative of the air coming out of the credit cycle.

THE EX ANTE FACTOR: CASH is KING

Not much has changed with our thesis as the markets continue to trace out patterns that are consistent with our plan. We do expect these highly correlated markets to show some divergences but as of this week they all seem to be locked in with one another. Friday’s bounce in the stock market seemed to rally tick for tick with the Euro/Yen.

Gold seeming to break out of the diagonal pattern should be viewed as a shot across the bow as arguably the most sensitive asset to the global liquidity story is the first asset to show signs of weakness. The widening of LIBOR and T-bills is further indication that investors are anticipating a Fed ease as monetary conditions are too tight.

Stocks took a breather from the torrid rally after the Fed meeting got out of the way and traders finally ran out of excuses to buy. We have been following 3 main patterns in the S&P and the new high this past week may be able to eliminate the larger triangle we were looking for to waste time this summer. The 2 patterns that are left are the diagonal triangle that should be grinding higher into a top late this summer/early fall and the impulsive rally that seeks a new high in the coming weeks. The beauty of this plan is it gets clearer in the coming week with a potential retest of the 1480 area on ESM7. If this area can hold and rally then we should be focusing on the impulsive idea. If the 1480 area gives, we could be headed lower in one of the consolidation moves of the diagonal. Next week we are looking for a move lower prior to the option expiration and a test of this area but expect a big reversal as traders loaded with puts are again forced to cover into expiry wiping out all volatility gains. While we are not prepared to marry either idea at this point the contracting triangle we have been following in the long bond and a 1.40 target high in the euro would both favor the impulsive scenario as the last leg of its triangle and final rally in the euro would coincide with the last gasp rally in the S&P.

What is the discount?
With the stock market basically unchanged this week so too was the implied return of 7.22%. This is 29bps below the average for 2007 and as I mentioned last week the lowest reading for the year. Granted we are at new highs. The risk premium fell by 2bps on an up tick in 10YR yields. It is 18bps below the average for 2007 and 7bps above the low of the year in the week of 1/26 which offered 2.48% over the 10YR.

These equity yields are in line with what you would have returned had you invested in the S&P 500 ten years ago. You can see by the change from the previous month, 5/97 saw a nice rally. Our current annualized implied return is 30 bps below this time last month so we too are seeing a robust May rally as they did in 1997. Amazing that ten years later we are approaching the previous 2000 all time high of 1550 and are staring at the same future returns. What happened to the 15% all the brokers are quoting?

The key for investors going forward is obviously the actual earned risk yield and not the implied premium. Are our 10YR treasury yields too low or is the earnings yield too ambitious. If the earnings yield needs to fall that would imply a higher P/E. Does the P rise or the E fall? Most pundits are looking at this spread and conceding that earnings growth is slowing and the multiple expansion will provide investors with most of their upside return. We think this is a questionable bet and would point out that in 2001 we got a spike in P/Es as earnings collapsed faster than prices but it wasn’t necessarily a good time to be invested. Since the treasury yield is discounting nominal growth for the economy we assume the E will be falling and for it to be a bumpy ride as these spreads converge.

Bottom Line: In our opinion, the credit cycle has peaked. How convenient that this week’s Barron’s cover credits Goldman Sachs as the number one generator of cash among corporations as they have been the poster child for the benefits of leverage, credit and speculation generating ever higher returns from trading than their more traditional source of banking revenue. Despite the pundits’ and strategists assertion that it’s different this time and obnoxious continued citing of the “global liquidity” boom, we have been seeing signs of a reversal in the credit cycle everywhere from the inverted yield curve to the housing bust to peaking commodity prices. All assets benefited from this extended reliance on credit and the associated rising collateral values that has supported our economy and as baby boomer start retiring we believe that savings will rise, the trade deficit will narrow, the dollar will rally and Cash will out perform all asset classes. If your local bank is still offering 1YR+ CD rates above 5% I would encourage you to lock in for a couple of years in a laddering strategy. The action in the short end of the yield curve is suggesting that a Fed ease is around the corner and the banks haven’t yet adjusted their rates. You don’t have to pay a broker or financial advisor an excessive fee and it’s risk free ($100,000 FDIC insured limit).