This post is featured from The Commodity Analyst newsletter.  Originally sent to subscribers Monday November 21, we are sharing portions of the content a few days delayed here.  For details and samples of the newsletter, see here: http://realfinancenewsletter.com

The past week saw an abatement of buying pressure on all risk assets, and potentially a trend-changing reversal. There were not any immediate headline reasons for such a selloff, which bodes well for the trend continuing to the downside, as investors continue to take risk off the table. Also, we finally saw a breakdown in inter-asset correlations, which also could mean that fundamentals are returning to the market, making our job of identifying macro fundamental trends much easier.
The following charts show the CRB Raw Industrial index as well as the GSCI Total Return index.

The CRB RIND index made a new yearly low on Thursday, a phenomenon to which we are now accustomed.  Interestingly, it appears that the GSCI index is finally playing along, falling 2.6% for the week and now negative for the year.  To us, this convergence will most likely continue, with the GSCI index falling to play catch up to the CRB RIND as fundamentals in Europe and emerging markets continue to deteriorate.

Europe

The European situation continues to evolve into a nightmare.  From anecdotal evidence, it appears that the ECB needed to step in and buy bonds each day this week to prevent a complete meltdown.  Even still, European bonds had a rough week overall.

The following charts show this week’s action in Italian, Spanish, and French 10 year bonds.

All three countries were under heavy selling pressure this week, causing the ECB to step in at multiple junctures.  To highlight the fever pitch of the action, Thursday’s chart tells the European debt story.  The ECB bought bonds, in a presumably very large size, directly before debt auctions by Spain and France.  The ECB tends to concentrate their bond buying immediately preceding debt auctions because they are trying to drive down the yields so that investors will accept lower yields at the auction.  However, it is becoming painfully obvious that the ECB is the only party supporting these bonds.

As we have stated before, European banks have about 1 trillion euros of debt coming due over the next year, and are also being forced to raise capital ratios by June 2012.  What this amounts to is massive forced selling of debt.  Because European banks’ non-sovereign holdings are concentrated in proprietary loans that are illiquid and difficult to value, the first thing they will sell are their sovereign debt holdings.  Add to this fact that sovereign debt is becoming increasingly volatile and losing value quickly, and you can see that it won’t take much to set off everyone rushing for the exits at the same time.  Banks from Soc Gen to BNP to Deutsche Bank have all indicated their intention to continuously decrease their sovereign debt holdings.

At this point, the only idea keeping the markets where they even are is the notion that the ECB will reverse their stance on monetization of the debt, and start printing euros to backstop Europe’s sovereigns and banking system.  Literally everyone in the market is banking on this, from the bulls buying stocks, to the bears shorting the euro.  As contrarians, we are forced to ask the question, what if this doesn’t happen?

While admittedly we are still in the camp that the ECB will most likely print, there have been some important signs lately that this may not necessarily be the case.  First of all, German and ECB officials are now saying on a twice-daily basis that monetization of the debt is not an option.  The market is wholesale betting that this is merely just posturing, but it is worth considering that maybe these officials are trying their best to indicate to the market that monetization of the debt is not a possibility.

However, even more concerning is Germany’s recent political overtures.  A leaked document (http://www.telegraph.co.uk/news/worldnews/europe/eu/8898213/German-memo-shows-secret-slide-towards-a-super-state.html) this week showed that Germany is making plans multiple sovereign insolvencies, which would then trigger “European Union” (read: German) control over those countries’ politics and economics.  If this happens, it would be more shocking than a Lehman moment ever was, in that essentially Germany would stand idly by as more and more countries fell, only to completely exert their political will on them.  Already, Italy and Greece have forced out their leaders for essentially EU puppet governments.  In a hugely perverse system of incentives, it may actually benefit Germany for these countries to experience more sovereign debt troubles.  While the world would be thrust into a renewed recession, politicians are much more concerned with increasing their power rather than doing what’s best.

If Germany could usurp Europe’s sovereignty by way of withholding further financial support, this may prove too enticing a prospect for their politicians to resist.  With the German population already disgusted with the perceived bailout of other European nations, this seems a golden opportunity for Germany to exert their political will for generations to come, even if it means enduring short-term financial pain.  As it becomes clearer that there is no solution other than money-printing, and that a European depression is unavoidable, Germany could easily decide that they might as well support their own banks, allow these other sovereigns to go as they will, and pick up the pieces afterwards in return for a complete sacrifice of national sovereignty.  Such a scenario has not even been partially priced into the market, and could cause catastrophic consequences.

Germany’s horrific experience with hyperinflation, specifically referenced by German officials this week, is also extremely strong motivation to not go down the money-printing road.  In fact, one of the reasons that the ECB was created in the first place was to ensure that this type of monetization does not occur.

When viewed from this angle, it is not surprising that the euro is as high as it currently is.  Considering global currency wars, the euro is actually the most “hard money” currency there is right now.  The US, Britain, and Japan have all engaged in massive quantitative easing, which is just a thinly-veiled form of currency devaluation.  Japan has intervened three times this year (all unsuccessfully) to weaken their own currency.  Excluding Europe, the developed world is literally trying to devalue their way into prosperity.  Even the former safe haven Swiss franc has drawn a hard line in the sand and warned against investors owning their currency.

Ironically, even though the ECB is easily the most hard money of the major currencies, it has still lost value against all major currencies this year.  The current decline can be attributed to investors anticipating a reversal in ECB hard money stance, as well as investors liquidating euro-denominated assets due to impending recession in Europe.  Given the Fed’s constantly-looming guillotine of further QE, it is not surprising that international investors have been reluctant to turn to the dollar as an alternative.  Instead, they have turned to gold, crude oil, and other commodities, as evidenced by gold’s incredible performance on the year, as well as crude’s incredibly stubborn advance.

However, eventually macro fundamentals will come back into play, and the dollar will strengthen, causing commodity speculators to greatly cut their longs.  In scenario 1, the ECB will print money, causing the euro to drop hugely in value against all competitors, with the dollar being the primary beneficiary.  In scenario 2, the ECB will not print, causing a major depression in Europe and multiple sovereign bankruptcies, which will cause investors to liquidate European assets and invest elsewhere.  The downside for the euro is much greater in scenario 1, and certainly this is scenario that the market is betting on.  But the euro should suffer from pure macroeconomics in scenario 2, even if it is only in the short-term because the Fed will initiate more QE in response to a deep European/global recession.  This is why the net short position on the euro reached the 2nd-highest level this year this week.  Investors shorting the euro are betting on a heads I win, tails I win scenario.

While we believe this is the case as well, the extremely large net short position in the euro is worrisome.  Any perceived good news for the euro (or bad news for the dollar) could cause a powerful short-term rally.  Also, if the ECB maintains their hard money stance until the end, the euro could actually trade higher in the long-term due to almost assured renewed easing from the Fed, even as European stocks and European sovereigns get decimated.

Trade Recommendation

For the reasons discussed above, we recommend covering euro shorts at a price of 1.35 or better.   To be sure, this is not because of a bullish view on Europe, but rather an acknowledgement of how crowded the trade is, and the fact that there are other, better shorts in the market right now that play off the same theme.

Investors who wish to maintain exposure could switch their short futures exposure to long put spread exposure instead to maintain a degree of short euro positioning with limited downside.

Furthermore, the short euro trade could be hugely adversely impacted by the ongoing US debt supercommitee negotiations.

US Debt

Attention has been shifting recently to the negotiations of the Congressional debt supercommittee.  The committee is charged with finding $1.2 trillion of budget savings, or else have automatic spending cuts enacted in 2013 consisting of cuts on both defense and Medicare/Social Security.

While this situation is not nearly as deadline-focused as the debt ceiling issue back in August, there is a strong possibility the US could face a further debt downgrade from Congress’ continued inability to effectively get anything done.  S&P indicated in their August 5th downgrade that the US was still on review for further downgrade, and cited political inefficiency as a primary determinant of whether another downgrade would occur.  Similarly, Moody’s has indicated that the US is still on negative credit watch.  Even if none of the credit rating agencies downgrade the US again immediately, it is fairly obvious that a deadlocked supercommittee cannot be construed as good in the eyes of the raters.

Ironically, Congress doing nothing over the next few yearswould actually be hugely beneficial for deficit reduction.  By some estimates, the enactment of sequestration under the August bill, combined with planned expirations of the Bush tax cuts, payroll tax cuts, and other temporary tax reductions, would actually reduce the budget deficit by $7.1 trillion over the next 7 years.

However, a do-nothing Congress would certainly not be viewed favorably by the rating agencies, even if it meant that the deficit would be substantially reduced over the next few years.  Indeed, even if US debt is downgraded, this will have no effect on US treasuries or the market’s perception of US creditworthiness.  What it will have an effect on is the price of gold and the US dollar, at least in the short-term.

Another debt downgrade could potentially trigger massive short-covering in the euro as investors get away from the dollar, and also trigger a surge in gold prices.  The following charts show the performance of the euro and gold on August 8th and 9th following the August 5th downgrade.

As can be seen, the euro opened more than a full percent higher against the dollar, while gold climbed an impressive 4.5% on August 8th alone, preceding a march to above 1900 over the next couple weeks.  While the euro eventually fell precipitously after the initial rally, we believe this was more due to the greatly heightened tensions in Europe rather than a reversal of thinking.  That day marked huge ECB buying of both Italian and Spanish bonds, along with heavy European equity selling.

On August 2nd, the speculator futures position on the euro stood at net long 6,099 contracts.  Today, the figure stands at net short 108,471 contracts.  The euro rallied a full percent against the dollar even as speculators were already net long the euro.  If a similar situation occurred today, with the massive net short position built in the euro, the euro could appreciate by 2-3%+ easily, even if it later fell back because of European concerns.

Similarly with gold, investors will pile into the yellow metal as an alternative to the US dollar.  However, viewing silver prices shows an interesting divergence.

As can be seen, silver initially spiked as a correlation trade to gold’s rise.  However, silver continuously fell over the next 2 days while gold continued to rise.  The reason for this is silver’s much less accepted status as a monetary alternative, and its high industrial demand exposure.  For this reason, we believe a short silver position, especially one enacted on an immediate knee-jerk spike would be a highly prudent trade.  We remain short silver for clients, as we believe even in the absence of a US downgrade, recessionary dynamics from Europe will continue to have deflationary pressure on industrial metals.  We are also short gold, but we will be quick to cut this position in the face of a renewed gold rally.

While the euro and gold would benefit from a US downgrade, many other assets would not.  The following charts show a few other assets during the same time frame as above, directly after the last downgrade.

As can be seen, both the Australian dollar and crude traded down immediately after opening on news of the US debt downgrade. Both these assets fell continuously, with crude dropping an incredible 15% in just 24 hours.

While the Australian dollar is a currency alternative to the US dollar, it is much more linked to risk assets due to Australia’s status as a resource provider for emerging economies. Even if the US dollar were to generally trade down after a US downgrade, the Australian dollar would lose value against the US dollar.

On crude, while some investors do own crude as a currency alternative, concerns about economic slowing would greatly override any need to diversify currency holdings in a debt downgrade. Those investors who want to turn to hard assets would much rather own gold in such a scenario.

The chart of the DAX and NQ futures shows investors’ general risk aversion after the debt downgrade. Also, the DAX shows that European concerns were even worse than US, with the DAX falling by over 12% in the day and a half after the downgrade.

Trade Recommendation

For the reasons we mentioned above, we believe shorting the Australian dollar and crude are the best risk/reward trades going forward. We recommend shorting more Australian dollars at a price of 1.00 or better, as well as shorting WTI crude at $97.67 or better. As we discussed in a previous letter, the carry rate differential on the Australian dollar and the US dollar will most likely continue to compress as the RBA drops interest rates. Also, it does not benefit many parties to have the Australian dollar rise, unlike the euro. The Australian government would support a depreciated Australian dollar as a boon to Australia’s export-dependent economy, and so would China as an indirect measure of cheapening commodity prices by decreasing cost of production. The following section discusses our thoughts on crude oil in greater detail.

Crude Oil

Crude oil has recently disconnected from the rest of the risk asset complex, continuing to rise another 8% after October 27th even after the euro, Australian dollar, and equities all peaked. Contributing greatly to crude oil’s rise was the rumor and eventual news of the reversal of the Seaway pipeline, opening a direct line of transport between Cushing, OK and the Gulf of Mexico.

Such a development is important fundamentally because accelerating oil production in the Bakken shale in North Dakota as well as Canadian production was becoming bottlenecked in Oklahoma, causing WTI prices to come under pressure even as Brent crude prices stayed fairly stable. This phenomenon caused WTI crude to trade at a record $27 discount to Brent on October 14th. Since then, the spread has narrowed all the way to $10, hitting a low of $9.29 on Wednesday.

While the Seaway pipeline should help alleviate the inventory buildup in Cushing, WTI’s rise over the past month can largely be attributed to the breakdown of the spread rather than favorable demand dynamics. From its October 4th trough to today, WTI is up 30%. In the same time span, Brent crude rose only 8%. Considering Brent’s much wider use (Brent is used by China, Europe, etc.) Brent prices are a much better gauge of crude demand than WTI. Indeed, RBOB gasoline was actually down 0.5% in the same time span, indicating that increased gasoline demand did not accompany crude’s rise. It appears that WTI’s rise is primarily being caused by a massive unwind of the long Brent, short WTI trade, as well as a generally increased long posture by Managed Money.

The following charts show the price of WTI against Managed Money longs, as well as the gross Managed Money short position.

As can be seen, crude Managed Money net longs remain at an elevated position, but most striking is the collapse in Managed Money shorts. Managed Money shorts reduced their position to the lowest since May 17th. This short covering certainly contributed to crude’s incredible recent rise, but given the deteriorating macroeconomic environment, we believe crude shorts could shoot right back up.

Further lending credence to the view that energy demand remains weak is a comparison of WTI crude and RBOB gasoline prices.

As can be seen, while WTI and RBOB usually move in lockstep, the performance of the past month has been an anomaly. RBOB has shown weakness while WTI has been on a march straight upwards. While this could theoretically give way to both rising together, we believe the larger macroeconomic picture favors the downside. With US consumers stretched, deleveraging, and completely devoid of confidence, further prices increases will destroy demand for energy, a fact reflected in RBOB’s continual downward trend. We expect WTI to reverse course presently and follow RBOB downwards.

Trade Recommendation

Given its stretched Managed Money long positions and the general negative macro environment, we view WTI crude as an ideal short. As stated above, we recommend shorting WTI crude at a price of $97.67 or better. To contain risk, investors could place a stop-loss order slightly above the 61.8% Fibonacci retracement level of $99.60, with the Fibonacci retracement drawn from the April 29th high to the October 4th low.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

This post is featured from The Commodity Analyst newsletter.  Originally sent to subscribers Tuesday November 15, we are sharing portions of the content a few days delayed here.  For details and samples of the newsletter, see here: http://realfinancenewsletter.com

The past week saw sideways, albeit volatile, movement of risk assets. While last Wednesday was a large selloff, the indices made back almost all of what they lost on Thursday and Friday, with the euro and Australian dollar recovering as well. Despite the seemingly lackluster action in equities and risk assets, fixed-income market fundamentals continued to deteriorate, and we believe a collapse in asset prices could be imminent.

The following charts show the CRB Raw Industrial index and the GSCI Total Return index.

As can be seen, the breakout of the GSCI index has hardly been confirmed by the CRB RIND.  While the CRB RIND has at least slowed its pace of decline, it still remains within a quarter of a percent from yearly lows, while the GSCI index has rallied magnificently since October 4th.  As we have indicated before, this continues to signal a preponderance of speculation on a recovery rather than a real recovery.  Given that the CRB RIND rebounded well before equities themselves bottomed in the 2010 summer correction as well as the 2008-2009 bear market, we believe the CRB RIND’s stubbornness in turning upwards indicates a continued fall in aggregate demand that is afflicting developed markets, not a simple lack of liquidity that the ECB and Europeans would have us believe.  On that note, let us turn to our now weekly practice of dissecting the latest news (or lack thereof) out of Europe.

Europe

The ECB had to again buy sovereign bonds in the secondary market this week to calm investor fears about Italy’s insolvency.  However, the more bonds the ECB buys, the less liquidity there is in the sovereign market and the less confidence investors have in the sovereigns.  Shown below are charts of the Italian and Spanish 10 year bonds.

As can be seen, Italian yields went absolutely parabolic on Wednesday of last week, rising to an astonishing 7.5% before ECB buying on Thursday and Friday drove them down to 6.5%.  However, yields rose back up to 6.7% today as the ECB stepped away.  Interestingly, while the Italian bonds at least showed a respite from selling for 2 days, the Spanish bonds did not.

As many have surmised, speculators and hedgers alike will move from country to country, much too fast for the ECB to keep up.  Even though the ECB was able to somewhat calm Italian yields (for a whopping 48 hours), investors simply moved to shorting Spanish bonds.  In essence, shorting Greek, Irish and Portuguese bonds is no different than shorting Spanish, Italian or even French bonds.  All of these countries suffer from the same problems: lack of growth, massively bloated financial system and overindebtedness on the sovereign, corporate and individual levels.  To top all of it off, none of the Eurozone countries can print its own currency and monetize its debt.  The only difference between a France, Italy or Spain at this point is what stage of the crisis they are in.  Indeed, even German bonds will likely come into question at some point if the ECB maintains their “virgin” stance.

At this point, most every investor, economist and analyst expects the ECB to print money, and therefore save the world economy.  However, the market is getting far too ahead of itself here.  As long as the status quo in the equity markets persist, the ECB will not be nearly motivated enough to embark on such a departure from their sacred covenants.  We know this from the daily, deliberate statements by ECB officials that they will absolutely not monetize Europe’s debts.  It will take a renewed deflationary crisis to get the ECB to finally move off their hardline stance, and we are nowhere near this point.

Today’s news that Germany has approved legislation to allow countries to exit the euro, as well as Fisher’s statements that US growth remains strong enough to discourage further easing attempts show that regulators and politicians are clueless as to the environment we are entering.  While QE out of the US and Europe will eventually happen, they absolutely will not while markets remain at these elevated levels.  If and when the S&P 500 reaches around 1000 or the euro-dollar cross goes below 1.20 or so, the respective central banks may be inspired to act, but there is not even a chance of this at current levels.

US Stocks

While US stocks remain at fairly elevated levels as compared to early October, they are showing signs of cooling off.  The S&P 500, the euro, and the Australian dollar have still not exceeded their October 27 highs.  From a technical perspective, this break in upward momentum is bound to be a bearish signal for traders.

Posted below is a chart of the AAII Bullish sentiment readings divided by Bearish sentiment readings, as well as a chart of just the Bearish readings.  These are surveys conducted with individual investors on a weekly basis.

As we reported 2 weeks ago, this index is very useful as a contrarian indicator.  2 weeks ago, this index was at 1.72, meaning 1.72 bulls for every bear.  The index then promptly lost 6% over the next 3 trading sessions.  Today, this index stands even higher at 1.82.

The last time the index was slanted this bullish was February 17th of this year.  As shown by the chart above, the S&P lost 7% almost immediately after this reading.  Also, the last 2 times there were this few bears in the survey (as denoted by the AAIIBear Index chart above) were on February 17th and July 7th.  The S&P posted losses of 7% and 19% very soon thereafter both of these readings.

While these are purely technical sentiment readings, they are indicative of the complacency in markets nowadays.  It seems as though individual investors as well as commodity investors have decided to largely ignore the macro risks for the time being and focus on the upside.

While the S&P 500 at large is trading at a fairly cheap 13.2x earnings, a deeper look into the market reveals a not so necessarily cheap market.  The Dow Jones US Financials Index is trading at around book value and 12x earnings, which is not all that cheap considering assets on banks’ balance sheets from the bubble years are still held at book value, not to mention the systemic risk of contagion from the European banking system.

The Nasdaq 100 is trading at a 16x P/E, which is low historically, but certainly does not sound all that low in a vacuum.  Especially considering that Apple makes up 14% of the index, and that Apple, the world’s largest company by market cap, trades at a premium multiple to the stock market at large, stocks do not look priced for a recession.

The energy services sector seems to be the most frothy.  The OSX is now trading at a 19.50 P/E, significantly above the 5x it traded for in the depths of 2008.  With WTI crude at 98 and Brent at 112, crude itself seems overpriced, and the services sector may be even more overpriced.  Both could endure swift falls in the case of renewed recession.

Trade Recommendation

Traders can take advantage of the implied to historical volatility disparity in the energy services sector.  We recommend purchasing the January 2012 119.1 put for $5.35 per contract.  With the current 30 day historical volatility at 51.26% and the implied volatility of this option at 44.62%, this option can be purchased at somewhat of a discount, given the assumption that recent volatility continues.

Crude Oil

WTI crude has gone on an amazing run since October 4th, rising an incredible 31.22%.  While this is somewhat in line with the rest of risk assets, crude has had an especially good run.  The last few days can most likely be chalked up to speculators buying due to a perceived geopolitical risk from Iranian hostility.  However, just as in the Arab Spring, these speculators will eventually need to liquidate, taking prices down significantly from current levels.

The following chart shows the price of crude in orange and the Managed Money net long position in white.

As can be seen, the managed money position has grown to a high level, in the 91st percentile of readings going back 5 years, with prices only in the 79th percentile.  This indicates a preponderance of speculators driving prices up.  If and when there is an easing of geopolitical tensions and/or signs of economic slowdown, speculators could exit the crude market very quickly, driving prices near recent lows around $75/barrel.

Trade Recommendation

We recommend shorting crude oil futures at a price of $98.50 or better.  A stop could be placed at the $100 level or just above, as this is psychological support/resistance.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

This post is featured from The Commodity Analyst newsletter.  Originally sent to subscribers Sunday November 6, we are sharing portions of the content a few days delayed here.  For details and samples of the newsletter, see here: http://realfinancenewsletter.com

The past week was packed with fresh concerns over Greece, combined with renewed ECB Italian bond purchases and RBA and ECB interest rate cuts…and that only got us to Thursday.  Despite the relative strength of equity and risk markets, the economic situation here in the US and abroad is tenuous at best, and we believe the next few months will turn fears of renewed recession into reality.

The following charts show the CRB Raw Industrials as well as the GSCI Total Return index.

As can be seen, the CRB RIND continues to show no signs of rallying despite the GSCI index as well as the S&P 500 remaining at elevated levels as compared to early October.  This ongoing situation is consistent with our view that the global economy is suffering from a lack of aggregate demand rather than simply dealing with the European debt crisis.  By contrast, the equity and speculative commodity markets have already priced in a fairly rosy economic future after October’s spectacular run.  As we will discuss below, it is our view that the bulk of the economic softening has yet to begin, and that this optimism will quickly fade as recession becomes reality in the developed world.

Europe

The following charts show the German, Italian and French Purchasing Managers Indices.  This is a survey of purchasing managers in these countries, and is frequently used as a forward gauge of economic activity.

Viewing these charts is downright scary given their aggressive, vertical dropoffs recently.  Italy and France are trending almost straight down, with multiple months under 50, which signals contraction.  Now, even Germany has crossed below 50.  These figures are consistent with Europe re-entering recession.

Indeed, even Mario Draghi, the new ECB President, indicated that Europe is headed for a “mild recession” by year-end.  Considering how massively overleveraged both Europe’s banks and Europe’s sovereigns are, is there really a possibility that this recession will simply be “mild”?  Given how deeply even countries like France are now cutting spending, these austerity measures will cut deeply into European GDP and cause already weak economies enter protracted recessions.

Also, European banks must refinance 1 trillion euros of senior debt in the next year, a truly staggering amount.  The drastic coincident dropoff in bank lending that is about to happen in Europe will cripple growth in the region for years.  As we detailed last week, European banks are massively overleveraged and undercapitalized as compared to their American and Asian counterparts.  Because of the concern around European banks, there has only been one debt deal done by a European bank, Deutsche Bank, in the last 3 months.

The European Banking Authority has already asked that the EFSF be used to guarantee some bank debt to jumpstart the bank debt market, but there is absolutely no money for this.  The EFSF is already stretched to its limit (and much farther in our opinion) by the implied guarantees on Italian debt, so there is not a single cent left for bank guarantees.

Instead, the EU’s decision was to have each nationality assist in recapitalization of their own domestic banks, if necessary.  The problem with this is that the European banking system is so bloated as compared to the size of the European economy that this is an impossible task.  BNP Paribas alone has 809b euros in short-term borrowings, while France as a country has only 1.6 trillion euros in outstanding debt!  Even a slight, partial guarantee of bank financing by France would cause an immediate French sovereign downgrade, which would cause this crisis to come to a head very quickly.

Since the ability of the EFSF and/or nationalities to assist bank refinancing is limited at best, European banks will be forced to make up the bulk of the capital shortfall and bond maturities by firesaling assets.  Herein lies yet another problem, in that the majority of European banks’ assets are proprietary bank loans, not publicly-traded stocks and bonds.  Because 80% of private capital in Europe comes from direct bank lending rather than public stock and bond markets, European banks are bloated with private loans.  Disposing of these illiquid, proprietary assets will be an extraordinarily difficult and lengthy process due to the one-off nature of these loans and the fact there are no ready buyers.  While private equity firms and other banks will be willing to absorb some of the more attractive loans at bargain prices, the aggregate buying power of these parties is capped in the low 10s of billions, while the European banks will likely need to offload at least half a trillion.

The recent decision of the EU that banks increase their tier-1 capital ratio to 9% by June 2012, combined with the massive bank refinancing, means that banks will not only be disposing of assets, but that their new lending will be severely constricted.  Without new credit, a massively overvalued currency, and no engine for organic growth, Europe will and has already begun to fall into a deep recession.  As European GDP decreases, their debt and deficit to GDP metrics will get worse and worse, further exacerbating the problem.  And if you think the US will somehow be spared from this, think again.  The following chart from Google Public Data Explorers shows US GDP growth vs. Germany over the past 40 years.

As can be seen, there has never been a period in which either the US or Germany suffered a growth slowdown without the other following suit.  In short, if Europe goes into recession, so does the United States.

Trade Recommendation

While our economic thesis continues to revolve around Europe, our trade recommendation may be somewhat surprising.  We recommend shorting the Australian dollar at a price of 1.035 or better.

As the Australian economy is basically entirely dependent on China, the Australian dollar has become a great proxy of both risk aversion and global economic concerns.  If things go badly in Europe, China will undoubtedly slow as China’s largest trading partner, Europe, enters recession.  Also, because Australia has the highest interest rates in the developed world, traders’ reliance on its “carry,” meaning holding long positions in the AUD while funding it with short positions in low-yielding currencies like the USD, means that traders will sell AUD and buy back USD shorts quickly as risk aversion takes hold.

Posted below is a chart of the spread between the RBA cash interest rate target and the Fed Funds target vs. the price of the AUD.USD currency cross.

As can be seen, the AUD carry rate decreased for the first time since 2009 last week, as the RBA rate was decreased by 25 basis points last Monday.  While this is not a huge decrease, it does mark a symbolic shift away from rising rate spreads to declining rate spreads.  This was the main fundamental driver for the increase in exchange rate over the past 5 years, as more and more traders jumped on the long Australian dollar trade to generate both capital appreciation and interest rate returns.  However, as seen in 2008, this trade can unwind alarmingly quickly, and can produce heavy losses in a hurry as traders buy back their USD shorts.  The last period in which the carry rate was at 425 basis points, between May and November 2010, the Australian dollar traded in a range from 0.81 to 0.98.  With the Australian dollar trading at 1.035 today and Europe quickly entering recession, this seems like a highly attractive risk/reward trade.

Also, the massively bearish sentiment in the euro is another reason to add to Australian dollar shorts rather than euro shorts at this level.  The chart below shows speculative longs in the AUD futures vs AUD price.

As can be seen, the AUD futures longs increased this week to over 26k contracts from a small net short position just 3 weeks ago.  This means that there are 26k contracts worth of prospective sellers of the Australian dollar is things take another turn for the worse.  By contrast, here is the chart for the euro.

As can be seen, while euro shorts have come in somewhat, they remain at a highly elevated position.  While this is one reason the euro is staying stubbornly high, we believe there may be more subversive market factors at play in supporting the euro, including Chinese buying in support of the euro.  However, with respect to the Australian dollar, China has no reason to support the AUD and in fact has a vested interest in its depreciation, as Australia is one of their largest suppliers, so they could theoretically benefit from a weak AUD.  Even though most of Australia’s exports to China are priced in USD anyway, the Chinese government has no reason to support the Australian dollar, and will gladly let it depreciate.

While we remain short the euro, the believe that the short Australian dollar position may be a better candidate for size increase over the coming weeks and months due to its continued support by carry traders.

Crude Oil

WTI crude staged an immense rally during October, rising an incredible 18% during the month, and an incredible 26% from its October 4th trough to the October 24th peak.  However, we believe that the rally is quite overdone at this level, and will most likely fade as renewed concerns about the economy resurface.

The following chart shows the price of crude in orange and the Managed Money net long position in white.

As can be seen, the Managed Money net long position is around where it was before the “Arab Spring” events caused crude to briefly jump into statospheric levels.  Even more interesting is that crude prices are actually above where they were before the Tunisian and Egyptian unrests.  To us, this indicates that current prices are being set by speculators increasing their economic and inflation expectations rather than renewed demand from consumers.

With the Managed Money position as large as it currently is, the potential for long liquidation is high at these levels.  With crude pushing up against the 200 day moving average but not yet able to break through, crude appears to be facing stiff resistance technically as well.

Trade Recommendation

We recommend shorting WTI crude December futures at a price of 94.50 or better.  Conservative traders can use the 95.10 level as a stop-loss, as that level is above recent highs as well as above the 200 day moving average.

This Week’s Managed Money Charts

Precious metals Managed Money looks to be at fairly low levels, but we question whether this will be useful going forward.  Correlations between precious  metals and other risk assets are at all-time highs, and the precious metals ETFs control far more metal than do futures traders at this point.  With retail participation in the precious metals market this high, it seems that silver and gold prices will continue to follow equities either to the up or the down side.  Especially with the perplexing non-reaction by precious metals to the Fed’s  inaction this week, we recommend the sidelines for the moment as this picture becomes clearer.  If and when equities start to fall, gold and silver can be shorted alongside them as a proxy.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Ananthan Thangavel was invited back to discuss his forecast for the top of the gold market during his interview with Fox Business 9/12, and also to discuss other assets he is currently shorting.

10/11/2011 Lakshmi Capital Fox Business News Video

From the video:

“To be honest, we are short pretty much all risk assets.  But probably the best one is the Australian Dollar.  The Australian Dollar is heavily economically linked, due to the fact that almost all of Australia’s exports are going to China.  Anytime China slows down, Australia is going to feel that twice as badly.  If you look at what’s going on in Europe right now, Europe is going into a recession which, in my opinion, is a foregone conclusion.  Once Europe goes into a recession, China will slow down.  If that starts to pierce the Chinese real estate bubble, you could have a major problem.  China buys a ton of copper and other commodities from Australia, with China representing 50% of worldwide copper demand, 50% of worldwide cement demand.  The Australian Dollar could take a real beating.”

“The story here is long US Dollar.  The US Dollar back in August lost its safe haven bid a little bit due to the debt debacle and dysfunctionality of the Government.  But, we expect now that the Fed has essentially stopped printing money it’s going to come with Operation Twist until June 2012.  Every other central bank out there, especially in the developed world, is just flooding the world with liquidity.  As the US Dollar regains it’s safe haven status, we really think that asset is going to outperform all others.”

Posted March 17, 2011

The past few weeks have been rife with horrifying headlines. The limelight has shifted from Egypt to Libya, and now of course to Japan. The geopolitical risk spectrum is huge, and investors are running scared as a result. To highlight the hysteria, let’s dig into the numbers.

Currencies: Australian Dollar, Swiss Franc, and the Japanese Yen

Let’s start with 2 currencies that have nothing to do geographically with the panic-stricken areas, the Australian dollar vs. the Swiss Franc. The following chart shows the Australian dollar vs. the Swiss Franc over the past 2 years.

As can be seen, the Australian dollar has gotten nothing short of annihilated against the Swiss franc over the past few days, falling by an incredible 5.6% over the last 3 days. For those of you not familiar with currencies, this is an absolutely gargantuan move.

The Australian Dollar is typically thought of as a “risk” currency while the Swiss franc is considered a “safe haven” currency. One can see the rough effects of this by witnessing the somewhat similar trajectory of the Australian dollar as the S&P 500.

In our current crisis, the relationship between these 2 currencies is very much a “risk on, risk off” situation in which currency investors are panic-buying the Swiss franc and fleeing anything thought of as risky every time someone from the US or EU nuclear regulatory body opens their mouth. This flight from perceived risk is telling proof of the recent irrationality of currency investors.

The Australian dollar should stabilize and investors are paid to carry the currency and wait while the market calms down

When buying the Australian dollar against the Swiss Franc, investors get paid about 2.67% per year (net of broker fees) because the Australian central bank rate is so much higher than the Swiss rate. Conversely, if selling the Australian dollar against the Swiss franc, investors would have to pay 6% annually to the broker to effect the trade. However, because forex is so leveraged, the effects of this interest rate differential are highly magnified. For example, if selling 100,000 AUD against the CHF, an investor would only have to put up about $2,500 to put on the trade (at 40:1 leverage, a typical ratio for forex), but would have to pay $6,000 annually just to keep the trade on. If buying the AUD against the CHF, the investor would still only have to put up $2,500 to put the trade on, but would actually collect $2,670 per year. As is obvious from the calculations, a rational, non-risk averse investor would be much more amenable to owning the AUD than the CHF, and the steady rise in the exchange rate over the past 2 years reflects this.

As is typical of market panics, investors are selling first and asking questions later. If there is any good news out of Japan whatsover (and admittedly this is a large if), the Australian dollar should stabilize, and even if it meanders around its current exchange rate, investors are being paid to carry the currency and wait while the market calms down.

To view the irrationality of the market even more extremely, let’s consider the US dollar vs. the Japanese Yen.  The following chart shows the last 4 days.

The reasons that most market prognosticators have given for the yen rallying after the earthquake is that the yen always rallies in panics, and that the Japanese will need to repatriate their assets to Japan to pay for the damage. However, upon further review of the yen’s recent trading, repatriation cannot be the reason for yen strength.

On Wednesday, the head of the US Nuclear Regulator Commission, Gregory Jaczko, spoke about the nuclear situation in Japan in dire terms. As a result, the yen gained 4.33% against the dollar almost instantly before giving up much of the gains quickly. A 4.33% move for a currency is a huge one, and for it to happen in a matter of seconds indicates massive panic-buying. After all, if I told you that a country was currently experiencing a nuclear disaster, and that the implications of the event were worsening, would that make you want to own that country’s currency more or less?

The Bank of Japan has repeatedly indicated its willingness to devalue the yen

Buyers of the yen are pure speculators who are anticipating fear. There is no other explanation for the market’s reaction to commentary by the NRC chief. If the situation were to truly spiral out of control in epic proportions, and Tokyo were to become uninhabitable (not saying this is even a possibility, but using it as a hyperbole), would anyone want to own yen when the country itself is collapsing?

Also, the Bank of Japan has repeatedly indicated its willingness to devalue the yen. This is because Japan’s economy is extremely dependent on exports, so if the yen becomes too strong, Japanese exports become unattractive. The BOJ intervened directly in the currency markets back in September when the yen reached 82/dollar. Our feeling is that the BOJ will not stand idly by and watch their currency and economy go up in flames, but will vastly increase current quantitative easing programs and again intervene directly in currency markets to devalue the yen. As they do so, they will step up purchases of Japanese stock ETFs, REITs, and Japanese government bonds, as well as sell yen directly into the currency markets (which they have already done in recent past). This is essentially a version of US quantitative easing on crack. If the situation truly becomes dire, the G7 could even act in concert to intervene and devalue the yen (such an event occurred in 2000 when the G7 acted to support the Euro).

In another sign that repatriation is not the cause of JPY strength, we can look at the price of US treasury bonds. Since Japan is the number 2 largest holder of US treasuries in the world at $885 billion worth (behind China with $1.15 trillion), if the Japanese were in fact repatriating assets, it would stand to reason that we would see heavy selling in treasuries, or at least muted gains given the expected domestic US fear-buying of treasuries. A chart of the USD.JPY and US treasury bond is posted below.

The market is ignoring that the problem itself is in Japan

As can be seen, the dollar has dropped big against the yen since the earthquake while the US treasury has simultaneously rallied. To be clear, this is a typical “fear” response of the market. Risk-off usually means yen and treasury strength. However, in this case if the Japanese were in fact looking to repatriate assets, a very likely target would be their massive holdings of US treasuries, which they could sell and convert to yen if they needed cash. The chart above indicates that, at least so far, this is not the case. The US treasury has experienced almost the exact same strength as the yen has, indicating that the buyers of both are one and the same, panicked investors running to their usual perceived safe havens.

The market is ignoring that the problem itself is in Japan. If Japan truly does suffer an even greater blow to their economy from the nuclear crisis worsening, their ability to pay back their debt (the largest in the industrialized world), will be even further imperiled. Additionally, since the economy is heavily dependent on exports, the higher the yen goes, the less Japanese companies make and the less the Japanese government receives in tax revenues, thereby making a Japanese government default more likely. Therefore, the higher the yen goes only means it will fall all that much harder eventually.

The market’s knee-jerk reaction so far has been to buy yen first and ask questions later, but we believe that, in the long run, the yen must devalue for a myriad of reasons, including that the Japanese themselves would welcome a devaluation with open arms.

Trade Recommendation

Before recommending a trade, we would like to make clear that currency trading is extremely risky due to the volatile nature of geopolitics, and the high degree of leverage involved. That being said, currencies can offer some of the best risk/reward characteristics for trades, and we believe the current situation lends itself.

We would recommend purchasing the Australian dollar against both the Swiss franc and the Japanese yen, as well as purchasing the US dollar against the Japanese yen. This trade could be highly volatile in the near term due to the Japanese nuclear situation, but as things calm down over the coming weeks and months, we believe this will be a profitable trade.

In times of fear, speculation and panic reign supreme, but with them come enormous opportunity for the calm, long-term minded investor. Stay tuned for part 2 of this series discussing the Japanese situation’s effect on US stocks.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.