Friday, July 29, 2011

QE3 and debt ceiling - Ari Paul

A month ago, Bernanke hinted at a possible third round of quantitative easing in response to weak employment and manufacturing data. It's just a hint for now but he appears more open to the idea than most pundits expected. It was this hint that sent gold and silver flying and provided broad support to most risk assets.

With QE1 and QE2, the Federal Reserve was the effective buyer of 95%+ of new mortgages and 100%+ of new treasury issuance; this kept interest rates low and prevented further declines in housing prices. The fed purchased these massive quantities of securities directly from the big banks at prices above market value, thus generating quick profits for the financial sector at the expense of taxpayers. The flood of cash also helped prop up commodity prices and trickled into just about every risk asset on the planet.

Most pundits believe a third round of quantitative easing is unlikely for political reasons, but most (myself included) were saying the same thing about QE2. A month ago, Bernanke hinted at a possible third round of quantitative easing in response to weak employment and manufacturing data. It's just a hint for now but he appears more open to the idea than most pundits expected. It was this hint that sent gold and silver flying and provided broad support to most risk assets.

The second key theme has been the US debt ceiling. I believe the risk of the US entering a state of actual default to be exceptionally low, but the market is hoping for a sustainable solution in the next few days. A good primer on the issue can be found here. The assumption, probably accurate, is that a solution that produces a sustainable long-term budget will result in a significant short-term equity rally. However, spending cuts and tax increases directly reduce GDP. To illustrate the point - an immediate reduction in government spending of 10% would induce an immediate recession. Admittedly, any plan will reduce spending gradually, spread over a long time period. Bulls can also argue that the greater certainty and confidence in US finances will promote corporate spending and hiring (a practical version of Ricardian Equivalence). Many business leaders have taken to bullhorns lately to explain that they are hoarding cash because they are worried about the unsustainable deficit; perhaps a resolution will loosen their purse-strings.



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.