Friday, July 1, 2011

Economic Commentary: New Trends by Ari Paul

The last two weeks have presented a number of critical turning points. First, treasury securities may have finally ended their interminable bull run. Several treasury auctions "tailed" meaning that the government had to sell the treasuries at a significant discount to market value to complete the sale. This coincided with the end of QE2. It sounds too obvious that when the Fed stops purchasing treasury securities we get treasury weakness, but this caught many bond traders off guard. For the past two years I've patiently waited to short treasury securities, always thinking the time was near but not yet at hand. I'm far from certain that treasuries have topped out, since I remain skeptical about US economic fundamentals; If we get a severe recession in the next two years, treasuries may revisit their highs. However, I think shorting treasuries is now an attractive risk/reward proposition as a long-term bet.

The second theme has been gold and silver weakness. Contrary to popular belief, gold does not closely track inflation. Rather, it can be viewed as a hedge against negative real rates of return. When market participants see investments they like (positive real rates of return), they don't want to waste their capital holding an inert metal. When inflation is outpacing the return on capital, investors are content to hide their money under their mattress in the form of gold. Economic strength causes equities to rally, treasuries to sell off, inflation to increase, but gold price to fall. To beat a dead horse, the inflation that comes from a stronger economy does not produce positive gold returns. I own silver puts that settle in 4 months.

Equities have been very strong over the last week. Some of that is likely from end of quarter rebalancing and the (temporary) resolution of the Greek crisis with an apparent bailout agreement. We're likely to get some good corporate earnings announcements in July which could provide further strength. The same basic dynamic that has been in place for the past two years remains in force: corporations are healthy and possibly undervalued from a bottom up analysis, but the world economy remains in a "ponzi" state. The Eurozone, Japan, China, and US financial situations remain unsustainable and can be counted on to provide additional crises.

Long-term, the fundamentals of crude oil remain very bullish. Shorter term, there are many crosswinds. The IEA announced they will release 60 million barrels of crude oil; to put that number in perspective, the world consumes roughly 85 million barrels of crude a day. OPEC is struggling to maintain cohesion as Saudi Arabia is increasing production unilaterally after a failed OPEC meeting. The other OPEC members may move to tighten production to offset Saudi Arabia and such a headline would temporarily be very bullish for crude; I say temporarily because most OPEC members can't afford to reduce production since they need the cash flow. If you expect the global economic recovery to continue unabated, buying crude oil is a good bet and it will likely outperform equities. I'm hoping we get a dip to the $83-88 range before I buy.

Agricultural commodities have been very weak on the back of bearish crop reports. Basically, the weather for the previous two years was crummy and this year it's a lot better. I still like the long-term bullish agg story, but a safer way to play it at this point is via fertilizer producers.

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