International Interests: Dollar Carry Trade

Will the dollar soon take the place of the yen as the preferred funding currency for leveraged speculators? Probably not too soon but the continuing slide in the green back which many have been calling for could be the world’s new whipping boy. As you know we have been looking for a spot to get long the dollar and short the euro. Our patience continues to be rewarded but we are actively looking for a spot to enter the trade. Hearing cocktail party talk of the weak dollar has us hungry and we expect a magazine cover and political candidates to raise the issue before a meaningful bottom. They likely will discuss after the low. Watch the dollar puke with caution and remember it won’t feel good to buy the low. This week’s economic data and ECB/BOE meetings could be important. This acceleration in the euro is starting to irritate exporters and we think a top is near.

Cost of Capital:

The 5YR note continues to perform well despite the pullback in the long end of the curve and we feel comfortable owning the belly in bullish and bearish scenarios. We still prefer to await a further pullback for new money as we think 4.50% could get retested. That being said (see Ex Ante Factor) there could be a big rally in the coming months and the 5YR sector could lead.

Beta Maximus:

Stocks remain in their tight post Fed ease range. Leadership from the material, energy and technology sector is in tact but we don’t want to chase the commodity sectors as we believe they are purely benefiting from a weak dollar which we expect to bottom soon. Our barbell strategy has worked well with low volatility and we will stick with it until we see evidence the economy will be picking up steam in the coming quarters. Currently we are long staples, health, industrials and tech in equal weightings with a small position in Japan, the most unloved international market. While we are getting more defensive on this push towards the old high the market could grind higher than most expect if we can get through some pending issues like retiring the $375b in LBO debt. Recent news of collapsed deals (Sallie Mae and Harmon) tells us the appetite for massively leveraged balance sheets is waning. This is an indication that further deals will fall apart in the coming months.

Duke & Duke: Gold Doesn’t Grow on Trees

Thanks to “helicopter” Ben Bernanke’s ease last week the dollar is falling apart and commodities are spiking with parabolic markets in wheat, beans, metals and energy. Just what you would expect from these markets but not what the Fed wants to see on Bernanke’s first ease. We are cautious on commodities up here as we expect this recent price action will cause the Fed to be tighter than they would like and the dollar should be bottoming soon.

The Ex Ante Factor: See Liquidity Trap

The government bond market is largely regarded as boring among most equity traders and investors, offering little upside with meager rates of return. They watch the 10YR note and cite the Fed model which always seems to yield a buy recommendation (equity capital should always yield more than risk-free debt). They follow central bank speak and discount monetary policy as bullish or bearish for the economy. To the extent that yields start affecting DCF models the bond market might garner some attention but that is usually at extremes. This is ironic because in reality, the stock market is at the mercy of the bond market. It’s no coincidence that the largest equity bull market in history corresponded with an even larger bull market in bonds. In an interview, an equity sales trader once asked me: “why would anyone want to trade bonds?”

I replied: “the bond market is everything.”

The flattening and subsequent inversion of the yield curve (assume the 2s/10s spread) while the Fed was raising its discount and target rates confounded Greenspan, who called it a conundrum which in turn Bernanke concluded was a product of a global savings glut. There is no question many of the dollars we export get repatriated into our treasuries and other assets. Foreigners hold $2.2t of treasuries which represents approximately 50% of the total outstanding. China receives all the attention due to our trade deficit but they are in second place, owning $400b, behind Japan which owns $610b. The UK is third at $210b with the classification of oil exporters (petrodollars) owning $120b. While these numbers seem large, consider that China’s holdings which everyone fears to be for sale, represents a similar total to the outstanding LBO debt that needs to be absorbed by banks and the corporate debt market in the coming months. Regardless of these sums, assuming foreigners are pushing long-term rates lower than they otherwise would be, assumes they have no economic interest. This is a dangerous assumption and insulting to our lenders as it implies they are blindly making loans below the rate of growth and inflation, i.e. losing money.

In my opinion, the bond market is the most efficient of all asset markets. One could point to short-term movements in the 10YR note yield and claim that it’s too low or too high relative to expected monetary policy or economic growth, but over time the yield curve doesn’t lie. Inflation is a fixed income holder’s worst enemy and the bond market will always contain an inflation premium in the term structure (even if negative). Since the yield on treasuries has no credit risk the spread reflects time and inflation risk. Thus it can be said that term premiums, the yield offered above overnight funds for holding the asset until maturity, provide a market discount for expected nominal economic growth within the individual time period. The term premium can also be thought of as gauge of risk appetite, rising when volatility is elevated and falling when volatility is subdued. This is explains why the curve tends to flatten when the Fed is tight (low inflation risk) and steepens when they are easy (high inflation risk).

The current 10YR note closed at 4.59% Friday. Trailing six month nominal GDP growth is running at around 4.60% annualized rate. Since Q2 2002, nominal GDP averaged roughly 5.40% growth. During the spring months of 2002 you could have purchased the 10YR at anywhere from a 5.40%-5.00% yield. That’s a pretty close discount considering the volatility during that period and that growth is now decelerating which should bring the average growth rate lower over the next 5 years. Despite what pundits, economists and central bankers claim as anomaly, my work suggests the bond market and slope of the yield curve have an exceptional track record when it comes to discounting future growth and inflation. As free market capitalists we should assume that participants do have an economic interest and that an investor in risk-free bonds presumably would not own an asset that did not at least compensate for the expected return of nominal GDP growth.

In light of the recent Fed ease and subsequent free fall in the dollar to uncharted territory with a parabolic rally in commodities, we thought it would be a good time to take a look at the market everyone loves to ignore to see what the pattern suggests about the future discounting of growth and inflation.

In The Intimidator we pointed to the 10YR contract potentially finishing a 5 wave impulsive advance and that we were removing longs and looking for consolidation. We were a bit early in our call but now that appears to be unfolding with the 10YR having already retraced .382 off its early September high. With the dollar weak and the curve under pressure we are looking for one more leg lower potentially to the .618 around 107-00 before launching an explosive rally that would at a minimum target the 2005 highs. Next week’s heavy calendar of economic data kicks off with the ISM manufacturing index on Monday followed by ISM services Wednesday and payrolls on Friday which should make things interesting for traders and considering the new highs in EUR Thursday’s ECB and BOE meetings could also drive increased volatility.

That brings us to the long term pattern in the bond contract we have been following at TTC, which served us well during the spring when rumors of Chinese selling and a subsequent Bear Stearns hedge fund blow up saw prices collapse and volatility spike. We were monitoring a potential contracting triangle and looking for worst case support at the previous 2006 low near 105-14. Losing that low would have us short while holding it gave us a great risk/reward long entry point. Like the 10YR, bonds are coming off the recent low in a 5 wave advance which now has us looking for higher prices after consolidating towards support potentially at the long-term trend line near 109-00. This chart interpretation gives us a contrarian perspective in the face of recent inflation fears and massive curve steepening which likely has bond traders defensive. A thrust out of a contracting triangle that takes out the previous September high which also lines up with the 2006 high at 115-00 would be a strong indication that we are in a powerful 3rd wave advance. This has important implications for the economy and corporate profits because it puts the old 2003 highs in play which corresponded with a 3% 10YR note yield. Under that rate environment expect credit contraction, little to no growth or demand for money spawning deflationary conditions a la Japan.
See: Liquidity Trap

Bernanke has a big mess on his hands with the dollar puking and commodities spiking as a result of his easing campaign and likely will need to remain relatively tight to avoid would could turn into a rout. These conditions line up perfectly with the idea of new highs in bond prices as a tight Fed keeps the curve flat as the market continues to discount slowing growth, de-leveraging at discounts and evaporation of shareholder equity. A bottoming of the dollar would help confirm this thesis.

Conversely, if we are mistaken and start to lose support presumably driven by a steeper curve, bond yields could be headed north of 6% which would imply the market is discounting further weakening in the dollar and a higher inflation premium. Friday as the dollar was making new lows, I mentioned in chat that the bond market may take matters into their own hands by pushing the curve and yields higher. If that happens, “helicopter” Ben will lose what little control he has left and may have to call in Paul “the inflation hammer” Volker to stop the death spiral.

This is about to get interesting.

What is the discount?
Credit spreads continued to recover this past week pushing yields closer to their 2007 average. With stocks trading sideways the equity-debt spread widened out 15bps giving equities some relative value going into this week. Still with compensation for holding equity capital far below the average for the year it’s not a great time to be putting new cash to work and we would instead wait for pullbacks.

Bottom Line: The extreme move in currency and commodity markets this week highlight the moral hazard and inflation risk facing the Fed. Now other central banks may be forced to ease just to keep their currencies from strengthening too much restraining trade. We have been looking for a major bottom in the dollar all year and this litmus test for Bernanke will likely keep him tighter than he otherwise would be for years to come.