On February 14th — one month ago — we pondered “Long Bonds and Yen: Big Shorts for 2012?”
Japan’s currency (which we short around the time of those notes) has been in freefall the past four weeks, from 77 to 83 yen to the dollar. (As the yen declines in value, USDJPY rises.)
And now, this week, we may be seeing the long bond breakdown:
Treasury bonds, as you know, have long been the “safe haven” of last resort for frightened capital in a low inflation, low opportunity environment.
While the finances of the U.S. government are terrible, Treasuries have been a “least bad” option in a world of high unemployment, stagnating economies, and elevated risk.
What’s more, those who remain bullish on bonds (like Gary Shilling) foresee “more of the same” in terms of economic malaise, high unemployment, and general doldrums — not to mention slow motion crisis in Europe.
But 30-year yields around 3% have always been a temporary proposition. With any sign of genuine economic recovery, the risk to bondholders is a flight-to-safety reversal — a return to risk that sees investor capital pouring out of treasuries and back into stocks.
Tuesday’s widespread equity breakout, which came on the back of the best retail sales since September, a JP Morgan dividend hike, and a complacent Fed, have now taken the markets to pre-crisis levels.
The major indices are at their highest levels since June 2008. The Nasdaq, stretching back even further, has surpassed 3,000 for the first time since the year 2000.
Legendary investor George Soros has noted that a self-reinforcing market perception needs to pass a series of tests… and with each successful test, the perception gets stronger. Having overcome last week’s brief correction, conditions are now in place for a “melt-up” in which investors show more fear of being “out” than “in.”
Perceptions of an accelerating U.S. recovery are extremely negative for bonds, for the following reasons:
- Greater risk appetite increases the odds of capital rotation out of safe havens and into stocks.
- Perceptions of accelerating recovery against a low inflation backdrop, with rising inflation a long-term likelihood, makes low yielding treasuries finally appear toxic.
- Perceptions of accelerating recovery allow the Fed to hang back, providing less support for treasuries through its various buy programs.
The current backdrop is also an ugly one for gold. The yellow metal is performing poorly for at least a few reasons:
- Due to general economic weakness, this is still being perceived as a low inflation recovery, with accelerated inflation something to worry about far off in future.
- In an environment favourable to equities and dividend-yielding assets, gold is seen as second class for its lack of yield and lack of economic participation.
- As we wrote some time ago, gold is a kind of “credit default swap” — a form of catastrophe insurance taken out against risks of a world gone wrong. With Europe’s slow motion crisis more or less contained, the CDS aspect of gold is no longer appealing.
- The U.S. centric nature of the recovery, coupled with China slowdown fears and Europe’s troubles, mean that the dollar is slowly strengthening, even as the euro is more actively debased (think LTRO)… another headwind for precious metals.
Another way to look at it is like this:
Consumer retail and consumer tech have been the king of all asset classes. In spite of all the concerns over rising unemployment, a stagnating U.S. economy, and tens of millions of “left behinds,” the contingent of U.S. spenders with money have been out there spending.
This has led to dominant performance from specialty retailers, restaurant chains, department stores, and other domestic-based themes catering to the 30% of Americans who still have ample discretionary income.
This group has had the virtue of being isolated from European crisis, global slowdown threats, creeping oil prices, and other general concerns. In a sense, the purchasing power of the moneyed U.S. consumer has been “macro proof” — and an incredibly mild winter has only cemented this sense of invincibility.
Against such a backdrop — and with the weaker environs of the U.S. economy holding back wages, and thus holding back inflation — who needs to worry about gold?
Weak Europe, Decelerating China, Overbought Oil
It’s still a trader’s environment, though, because as we noted last week — in China, Brazil and Spain flip the script — global slowdown fears outside the U.S. are becoming a problem:
The global liquidity cycle has already rolled over. Assuming that no fresh action is taken, world economic growth will peak within a couple of months and then fade in the second half of the year – with grim implications for Europe’s Latin bloc.
Data collected by Simon Ward at Henderson Global Investors shows that M1 money supply growth in the big G7 economies and leading E7 emerging powers buckled over the winter.
The gauge – known as six-month real narrow money – peaked at 5.1pc in November. It dropped to 3.6pc in January, and to 2.1pc in February.
This is comparable to falls seen in mid-2008 in the months leading up to the Great Recession, and which caught central banks so badly off guard.
“The speed of the drop-off is worrying. This acts with a six months lag time so we can expect global growth to peak in May. There may be a sharp slowdown in the second half,” said Mr Ward.
– UK Telegraph, Global liquidity peak spells trouble for late 2012
And here is more trouble:
- China Has Biggest Trade Shortfall Since 1989 on Europe Turmoil (Bloomberg). The deficit was the first in a year and largest in data compiled by Bloomberg going back to 1990. The previous record shortfall during that time was $7.87 billion in February 2004.
- Report Shows Depth of Distress in Europe (NYTimes). “Financial conditions have improved, but they are still strained… there has been basically no growth in advanced economies in five years.”
- After half a century of trade surpluses, Japan is now in deficit (Economist). A sudden rise in bond yields could seriously worsen the government’s debt dynamics… If banks are forced to cut their lending, this would depress growth and lead to a withdrawal of liquidity from global capital markets.
So, weighted against a new positive sentiment breakout for U.S. equities and the U.S. domestic economy, we continue to see a real threat of global slowdown and economic drag from the malaise in Europe.
This dynamic is creating a tailwind for the U.S. dollar and putting pressure on European currencies — along with the Australian dollar (AUDUSD), which has become something of a proxy for China’s natural resource appetite and growth prospects.
A final interesting note on oil — how much of oil’s appreciation is purely speculative?
According to Tim Evans, an oil analyst with Citigroup, money managers now hold a record net long exposure to oil through 638,774 futures contracts, which at 1,000 barrels per contract equates to about 638.8 million barrels of oil. “That’s about 290 days’ worth of Iranian oil exports,” says Evans. “Which implies that we’ve already priced in a nine-month outage from Iran.”
And that’s without a single shot fired. In a way, oil speculators are betting on the likelihood of war with Iran. Because without a material disruption in supply, at some point the price will have to return to something more reflective of demand fundamentals, which aren’t terribly strong at the moment.
In the U.S., the world’s biggest oil consumer, demand is close to a 15-year low. China’s economy is set to expand at its slowest pace since 2004.
– Businessweek, Have Oil Speculators Already Priced In War With Iran?
A backdrop of global slowdown + firming dollar would not generally be considered oil bullish. Then add into the mix “OPEC pumps record volumes despite demand worry” (Reuters), and one has reason to wonder.
This may help explain why energy stocks have performed relatively poorly as of late. And a near term fall in the price of oil — perhaps on realisation that crude has been bid up more on speculation than logic — could be construed as further bullish for the “low inflation recovery” perception driving U.S. markets.
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