My Diary 660 --- Good and Bad vs. Event Risks; The Search-for-Yi

My Diary 660 --- Good and Bad vs. Event Risks; The Search-for-Yield Mania; An Update on China; The Question for USD

Sunday, November 07, 2010

“The Mad Professor & Bernanke Put vs. Greenspan Put” --- How many of us remember the Greenspan Put? That idea, ingrained in investors' minds in the late 1990s and early 2000s, was that they need not worry about market declines because then-Fed Chairman Alan Greenspan would always be there to bail them out with rate cuts. The truth is that the Greenspan Put didn't end well. Many attribute the asset bubble that fueled the recent crisis to the widespread belief that the Fed would rescue investors. Well, now we've got the Bernanke Put, after he geared toward another round of QE, to add to the USD1.7trn in Treasuries and mortgages that the Fed purchased after the crisis. How do the market participants like it? On one side, Christopher Wood, the top-ranked Asian strategist, titled his latest《GREED & fear》--- “The mad professor”. Jim Rogers (68) said in Oxford that “Dr. Bernanke unfortunately does not understand economics, he does not understand currencies, he does not understand finance…All he understands is printing money.” I thought Jim should thank for Chairman Bernanke as without his greatest put, Jim’s commodity trades will not make so much money as otherwise.

On the other hand, outside of the climb in equities (3.5%) over the week, I saw VIX (18.26) went down 14.3% and back to below 19 handle. I also watched USD weaker again (DXY -1% to 76.55) and commodities soar. Copper is up 5.5% to USD8655/mt, a cyclical high and just 4% away from the all-time high that was hit in Jul2008. Oil is up 6.5% and has broken convincingly above the upper end of a range that has held since early-August. Gold traded at a new record above $1390 ($1396 current). CDX IG index (83bp) is now trading below 90bp for the first time since April this year. More significantly, the correlation (30 days) SP500 and 10yr UST yield has plummeted to -0.05, the lowest since July 2007, from 0.66 at early this October and a record 0.89 in June. The figure for SP500 and DXY sank to -0.68. All the breaking-down of asset correlations are attributed to the Fed, manipulating the Treasury markets. Meanwhile, the liquidity/equity boom has encouraged companies of all sizes and from sectors ranging from retail consumption to heavy industry, to replenish their coffers by selling new shares. In the past two weeks alone, there have been 42 IPOs raising a total of USD30.3bn on stock exchanges in APxJ, according to Dealogic. PARTY ON!

That being said, a basic question is why do we need QE2? The FOMC Statement itself explained the reasoning for QE2 --- unemployment is well above and inflation is well below levels the Fed believes are consistent with its "dual mandate." Chairman Bernanke adds more after the passage from his open-end QE program --- “this approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion." However, in my own view, the rationale behind this is that US is sitting in a debt mountain that without money printing would collapse under its own weight. Back in the mid-90s US debt/ GDP was around 250%, still high relative to history but perhaps more sustainable. Since then the ratio has gone up to ~350%, an increase of effectively a whole year's worth of GDP (USD15trn). According to economist projection, the country would need 5-6 years of 5-6% nominal GDP growth to get back to 250% debt/GDP. With UNE rate at around 10% and GDP growth at 2%, it seems mission impossible!

The next question is how big the QE2 is and what are the potential impact to the economy? FOMC statement headlines saw the USD75bn outright QE2 purchase level - below the USD100bn expected. However, if one reads closer, it was USD600bn in new buying by the end of next June plus USD35bn per month in their mortgage cash flow top-up placing total buying up to USD850-900bn over the next 7.5 months. Instantly after that came- an average maturity buy of only 5-6 years - and on top of that relaxing the SOMA 35% requirement told us that Fed will buy no bonds before its time - in other words bond buying is for QE3, if QE2 produces only negligible effects on the economy. Ultimately, Fed will be buying USD110bn per month or USD5-6bn per day with about 86% of that buying concentrated in the 3-10yr maturity bucket. US Treasury is set to issue about USD118bn in 3-10yr maturities per month but Indirect buyers alone by 30-50% of each auction - leaving not enough new issuance in the belly to keep pace with the Fed buying. More importantly, the Fed said that is will "regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability."  Obviously, that leaves open the possibility of an extension of debt monetization past June 2011, although it can also be interpreted as leaving open the possibility of a scaling down of the program if economic conditions improve and inflation moves higher.

I reserve my own view on the possibility of the success of quantitative easing in the mid-term because if it is so easy to promote prosperity by printing money, then we should not need the QE2 at this stage.  Thus as investors enjoy the ride for now, we all should remember the uniqueness of this experiment -- We don't yet know the full consequences. That being said, the practical part of QE2 is that FOMC moved to make their asset purchases conditional on the state of US economy, effectively introducing a Taylor rule for the size of the Fed's B/S. In other words, the forward guidance on asset purchases now has a similar structure to the guidance on the path of FFTR. If we could think in fed funds rate parallels, the latest QE2 was about a 75bp rate cut, which would get Fed closer to where they might want to be. Macro wise, a more optimistic view suggests that QE2 could lift US GDP by 0.25%-0.5% in 2011 and 0.75% or more in 2012. It could also raise headline CPI by 0.75% over the year ahead. Interestingly, the failure to pass a fairly broad extension of Bush's tax cuts would depress GDP by 1% in 2011, easily enough to swamp the estimated beneficial effects of QE2 over the year ahead. Globally, QE2 has made major central banks stay on bays with BOJ holding its key interest rates and cash provision targets unchanged. BOJ provided further details on the JPY5trn the ETFs and J-REIT purchase program and will start buying government debt early next week. The BoE said it kept a GBP200bn ($324bn) asset-purchase plan and the ECB left rates at a record low over the week.

Just like any policies which have both pros and con, the world also gets into many problems of QE2 --- 1)  US economy usually slows down following periods when the yield curve flattens. By purchasing a large amount of USTs in 7-10yr maturities, the Fed is effectively flattening the yield curve. Like most demand-side oriented policymakers, Chairman Bernanke focuses on the supposed benefits of lower rates at the long end. His sights are set on making life easier for private borrowers. However, the biggest borrower now is the US Federal Government, which faces much less market discipline as a result of the Fed's policy of boosting Debt Monetization. Scarce capital will continue to be borrowed by the government and siphoned from the private sector. Moreover, a flatter yield curve removes incentives for investors to reach out along the curve and take duration risk. Ultimately, this makes less capital available for long-term investment. Investors have an incentive to seek out higher real rates of return in faster growing regions of the world. After all, the real yield in US – measured 10yr TIP -- has fallen to an historic low of just 0.3%. This is the real engine driving capital into EMs for higher returns. 2) The QE2 is based on the assumption that "…higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."  Obviously, this is the wonders of the printing press! But, as I write above, if printing money is the key to economic success, then why did Fed wait until now to increase the pace? The bottom line is that prosperity does not come from the flick of a switch on the printing presses. It comes from effort, ingenuity, and investment of accumulated capital. It comes from the supply-side of the economy. A policy of aggressive Debt Monetization does nothing to encourage the supply side. 3) Attempting to fulfill its dual mandate (maximum employment and price stability), QE2 represents the Fed’s efforts to revive a flaccid recovery and provide relief for the 14.8mln unemployed, after the Republican won the House. However, it is calculated that the USD1.75trn worth of purchases from QE1 (commencing in December of 2008), generated USD1trn worth of excess reserves in the banking system. Given that these funds have yet to extensively spur the economy in the way the frustrated jobless wanted it to – namely consumer spending and business investments— a second, incremental, smaller-scaled purchase is subject to skepticism whether it would actually help to lower the UNE rate loitering at 9.6% and may even sacrifice the Fed’s credibility should this loosely defined program raise inflation in the long-run.

X-asset Market Thoughts

Over the week of QE-2, global equities moved up 3.45% with +3.5% in US, +2.28% in EU, +3.1% in Japan and +4.47% in EMs. Elsewhere, all but 10yr USTs saw yield spike with 2yr rose 3bps to 0.37%, 10yr declined 7bp to 2.53% and 30yr added 14bps to 4.12%. In the Europe side, the tough Franco-German push on that private investors shoulder more of the costs of future sovereign bail-outs under a new rescue system has kicked 10yr Greek-German spread widened 100bp (wow) to 904 and Irish-German spread widened 80bp (wow) to 520. 1MWTI Oil added 6.5% or $5.42/bbl to USD86.85/bbl, along with CRY index rising +4.23%. EUR strengthen 0.63% to 1.4032USD, while JPY weakened 1.07% against USD from 80.62 to 81.26. That said EUR effective FX rate tumbled ~1% to close out the week, though it remains up 5% since late August. 

Looking forward, there are a few important thoughts worth for a note here --- 1) what the chances for another round of QE are -- call it QE3?  I think chances are very good. There was a very interesting article on the Market Watch news in which it called upon the advice of Buffet, Gross, Grantham, Faber and Stiglitz - all favored selling Bonds as QE2 was doomed to fail. The article posits the view that the Fed should stick to maintaining price stability and stay out of the business of trying to rescue the economy. Given that the Fed will not listen to these words of wisdom near term, one can expect another round of QE, assuming that former Fed Meyer and Goldman Sachs are right in their views that a further USD4tn-5tn is needed. As just discussed, the main contention with QE has been that it won’t work while the private sector is in debt (little no money supply growth). Banks won’t lend as they are indebted as well and will therefore hoard funds - like the banks in Japan did and are doing - and play the yield curve. One economist termed the economic malaise in US as a balance sheet recession - arguing that using massive amounts of liquidity will only set the scene for another bubble further down the track. 2) That said, political side, there could see some upside from the big Republican victory ---a greater probability of tax cuts (hugely important given the current state of US consumer) and a more business-friendly government. Looking ahead, the 2011 tax cuts is key for US equities.

Nonetheless, the question for EM investors is whether the Fed announcement signals another leg in the exporting of liquidity. I think the answer is YES, based on the latest market reactions and Asian policy marker’s responses. In short, under a world of ample liquidity, in large part generated by the Fed, the domestic demand led growth opportunities will attract inflows. As a result, there is further room for EM currencies to outperform DMs, especially relative to USD. However, the interest rates in EMS remain a difficult call as the Fed may be sowing the seeds of inflation in EMs as already the output gap of EM economies has nearly closed. But since August major EM Central Banks have paused, slowed a tightening cycle. Thus, we will continue to see the broader EM rate markets are torn between positive factors of looser policy rates and still strong inflows versus the risks of demand and supply side inflation and higher core market yields. With regarding to Hong Kong, there are more signs of snowballing impact in the local asset markets. Theoretically, because of its dollar-peg, HK faces the “Impossible Trinity”. It can't have strong growth, loose monetary Policy, a weak currency and no asset inflation. Something got to give. And that means asset price appreciation.

Good and Bad vs. Event Risks

The week saw US Pending Home Sales came in softer than expected at -1.8% vs. 3.0% (consensus), leaving the index at an extremely low level. However, NFP surprised on the upside with 151K vs. 60K (consensus), mainly due to the increase of private payrolls of 159K. Earlier, initial jobless claims increased 20K to 457K,  bringing it back near the average level for 2010 (464K) just one week after claims hit the lowest level reported since 2008. The 4WMAVG has been little changed throughout October. The data on continuing claims continue to look encouraging, with 4WMAVG declined in the last five reported weeks, dropping a cumulative128K since the week ending Sept 18. In contrast, I saw the Euro final manufacturing PMI surprised with a 0.5% upward revision to 54.6. The outcome was driven by a similar revision to Germany's PMI (56.6). As a result of strong economy indicators, ECB President Trichet aired a tone of exit strategy in stressing that all liquidity measures are temporary and that a decision regarding the current unconventional measures would be made at the December meeting. At the same time, he also stressed that unconventional measures were independent from the ECB’s rate policies, conveying a “low-for-long” message and that growth risks remain skewed to the downside. Lastly, Trichet felt little pressure from the Fed’s reopening of the QE tap and was confident in the US’s commitment to a strong-USD policy in the medium-term.

Across the ocean there are hints of slowdown in Asia. For countries that produce monthly PMIs, the four weakest - all below 50 - are in Asia: South Korea, Japan, Taiwan and Australia. None of these points to Asian recession as the biggest Asian countries (China, India and Indonesia) remain strong. However, it signals that the manufacturing recovery in the region has passed the V-shaped phase. Given that Fed QE2 is likely to encourage a further transfer of liquidity to Asian markets, event risks surrounding capital controls remain high even if such measures are unlikely to deter long-term flows. Regulatory concerns in Korea and a potential BoK rate hike are likely to negatively affect the markets, whereas similar concerns in Thailand are relatively less adverse. In Indonesia, a milder policy response makes it a potential target for a reallocation of capital flows from other regions with tighter controls. A more tolerant policy towards currency appreciation is likely Malaysia due to the already steepened bond curve.

The Search-for-Yield Mania

The game of bail-out between financial markets and EU leaders has intensified. The German government is pushing to ensure that private bondholders and investors shoulder more of the costs of future sovereign bail-outs under a new rescue system. I think Few in the market disagree with the logic of making investors share in any costs were a country to default in future. The problem is one of consistency. Coming along a few months after the European Union shifted from the markets’ view of a “no bail-outs” policy to one of “no defaults”, investors are pondering the latest shift --- What are the implications? Clearly the plight of European peripheral sovereigns is once again becoming a key focus for financial markets as their CDS spread widened 30-50bps.

Just as unknown as the new rescue system in Europe, many people, even some within the Fed, have argued that additional asset purchases will not “work” for a variety of reasons. Question is how do we know the QE2 is working? As noted above, it is difficult  but a better question is -- how will we know if the recovery is gaining traction as a result of QE2 and the combined weight of past policy stimulus? The main indicators to watch are --- 1) Broad money growth: an acceleration in M2 growth to 10% would suggest that private sector demand is reviving and that headwinds from the banking sector are abating; 2) An upturn in US and global LEIs and a continued rise in ISM new O/I spread would be positive signs that policy stimulus is generating stronger growth. That being said, I think arguing “QE2-not-work” misses one key point. The Fed is trying to avoid a decline in inflation expectations that could raise real interest rates, as occurred in Japan. Just the announcement of QE2 alone has worked in the sense that long-term inflation expectations stopped falling and have backed up --- 10yr BE inflation jumped from 1.5% in August 25 to 2.10% as of Friday. Moreover, reducing the downside tail risk of a Japanese-style economic outcome has boosted the price of risk assets and household financial wealth, providing further support for the economic recovery. Confidence is critical in this situation. Meanwhile, since the Fed will be removing a substantial amount of duration from the market over the next year, investors will have to buy other assets. Looking ahead, The Fed is not only reducing the downside tail risk for the US economy, but also is intensifying the “search for yield”. Many bond investors will be forced by low government yields to shift into non-government issues. In a low, but positive growth environment, corporate bonds and other spread product will remain attractive as investors search for yield. Corporate bonds may join EM stocks and commodities in a speculative mania.

An Update on China

The domestic A-shares will complete its 3Q10 results season by end-October. So far, for the CSI300, 74% of FY10E EPS was reached by 3Q10 and 3Q10 yoy growth was 23%. Sector wise, transportation (92%), banks (84%) and utilities (81%) are running well towards FY10E estimates, while hardware (43%), property (48%), telecom (42%) and media (42%) are not trending well. Market wise, CSI300 earnings have been revised up around 4%, with consumer discretionary and industrials (including transportation) the sectors seeing the most upward revisions, and utilities, telcos and materials seeing the most downward revisions. As a result, the MXCN earnings estimates could see further upward adjustments as well.

That said, China manufacturing posts biggest gain in six months with PMI from the logistics federation rose to 54.7 from 53.8 in September, with input prices climbing the most in six months. A second PMI, from HSBC jumped to 54.8 from 52.9. The stronger data not only signal healthy momentum in the economy in Q4, but it should further work to counter concerns that China's unexpected rate hike two weeks ago would put a larger dampener on growth, as well as risk. Looking ahead, China’s growth momentum is to pick up steadily in coming quarters, with further solid expansion on the domestic demand front in particular. As local governments are to start new projects early next year, together with the central government’s efforts to meet the 5.8mn unit housing target, solid private consumption and investment demand, gradual fading of the inventory drag and the largely accommodative monetary conditions, there could increase the risk of overheating by early next year. The market forecast for China’s 2011 GDP growth stands at 9.0% yoy on average. On the policy front, OBOC’s 25bp rate hike two weeks ago seems to signal that the central bank is keen to contain inflation expectations. On the inflation front, headline CPI inflation is expected to peak (4%) in coming months, with the inflation rate gradually stabilizing at 3% by early next year. Given low for longer rates in the US,  PBoC would be somewhat constrained to undertake further rate hikes. . .Lastly, regional wise, MSCI China is now traded at 15.3XPE10 and 29.6% EG10, CSI 300 at 19.6XPE10 and 28.7% EG10, and Hang Seng at 15.8XPE10 and 30.2% EG10, while MXASJ region is traded at 14.6XPE10 and +40.2% EG10.

The Question for USD

The critical question for USD is whether the QE2 was fully in the price. My answer is NO, based on several observations ---1) More QE means that US short term rates will remain near zero for much longer. This has placed downward pressure on US swap rates vs. the other major economies. Both the dollar’s DXY index and the EUR/USD exchange rate (the biggest component of the DXY index) have significantly lagged the trend in the 2yr swap differentials (116bp), suggesting that USD  could have another 10% potential downside; 2) This week’s announcement may only be the first installment of QE-2. If growth is too tepid to lower UNE, the Fed stands ready to ease further. Political gridlock following the mid-term US elections greatly reduces the chances for another significant fiscal stimulus package. According to the OECD, the US is set to experience the biggest fiscal drag among the G4 economies. Monetary policy may be the only lever left to support the U.S. economy; 3) the newly “printed” dollars by the Fed will very likely leak outside of the US If the Fed is successful in averting a double dip recession, the US trade deficit should continue to widen in the months ahead. With growth much stronger abroad in EMs, US investors will seek out these higher expected returns. A combination of a widening trade deficit and domestic capital outflows will work to weaken the dollar. 4) Although U. policymakers will never say it outright, the Fed is in all probability pursuing a policy of dollar weakness. The Fed’s QE is unlikely to support the US economy through lower interest rates (they are already low!) or an increase in credit availability (households don’t want to borrow). Rather, QE will have the biggest impact on the economy through asset price inflation (i.e. the wealth effect) and dollar weakness.

On the eve of another round of quantitative easing (“QE2”), gold prices are up $190/oz since the beginning of August and up 315/oz yoy. In fact, the uptrend in gold has been in place since the beginning of 2002 and the only significant correction in the yellow metal took place during the 2008 credit meltdown. More disturbingly, an overlay with the 1970s gold mania suggests that the uptrend is well advanced. Currently, gold price still is $155/oz above the 40WMAVG, even after the selloff of the prior two weeks. Thus, a correction in gold and silver prices would be no surprise after the run-up.

Good night, my dear friends!