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.
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.
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.
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.
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 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.
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.