Tuesday, June 18, 2013

Whither China?

by John Mauldin

All weekend long and this morning as I wake up in Monaco, the number of disparate publications screaming at me about problems in China is just overwhelming. Then I get myself up early to hear a speech by the esteemed British economist Charles Dumas of Lombard Street fame, and I am confronted with even more China. I have been watching China for a long time, expecting a crisis, as I readily admit I simply do not understand a country that has defied so many of the economic laws of gravity for so long. Some kind of return to normal economic paradigms seems almost mandated, but the question has always been when. Have the Chinese discovered some new control mechanism, found some different levers to pull that they should share with the rest of the world, or will we see them revert to something that looks more like whatever it is that passes for "normal" these days? My bet has always been the latter.

That said, I do not expect China to slip silently away. It is here to stay, and it will be bigger and more dynamic in the future, but the transition from an economy driven by investment and massive debt into one more soundly based on domestic consumption will not be easy. Today's Outside the Box will focus on two readings on China that came my way this weekend. The first is from the formidable Lyric Hughes Hale, an expert on Japan and Asia, founder of China Online, who is married to the eminent economist David Hale. I have had the pleasure of meeting with them and find them quite the economic power couple. She gives us a tour of recent work on China. Perhaps, as she asserts, the current Chinese economic model, based on cheap labor and cheap money, has run its course. The challenges that face China are daunting.

Then we turn to a thought-provoking piece of analysis from the Financial Times that underscores Hale's central point. China is grossly inefficient, with severe overcapacity in many industries: "The problem with subsidies everywhere is they tend to support activity not outcomes and they become more of a problem when they're just subsidizing inefficiencies…"

Just a few quotes from some of the other pieces I read in the last 48 hours:

China's shadow banking system is out of control and under mounting stress as borrowers struggle to roll over short-term debts, Fitch Ratings has warned. The agency said the scale of credit was so extreme that the country would find it very hard to grow its way out of the excesses as in past episodes, implying tougher times ahead. "The credit-driven growth model is clearly falling apart. This could feed into a massive over-capacity problem, and potentially into a Japanese-style deflation," said Charlene Chu, the agency's senior director in Beijing." (from Ambrose Evans-Pritchard in the London Telegraph)

And then Stratfor writes:

A cash crunch over the past three weeks has caused rates on loans between banks to spike to the highest levels since mid-2011, drawing attention back to China's financial instability. Rates have since subsided, but conditions exist for them to remain elevated over the next month or beyond. Unlike two years ago, at least one bank has already defaulted on a loan and there are rumors that other defaults have occurred. The emergence of bank defaults poses a serious challenge to the central government's efforts to clamp down on credit growth as part of its broader attempt to reform the country's economy.

And finally, my friend Simon Hunt, who has been deeply involved in China for decades and spends many months each year traveling throughout the country meeting manufacturers, writes:

The credit crisis that we have been warning about has arrived. Debt has reached such peak levels that it can no longer be put under the carpet and rolled over for another day. The economy is having a mini-recovery this month but will weaken again in July.

Not expecting a collapse, Simon does see that serious adjustments are needed and believes they will be enacted:

Nor is there much of a risk that China's credit markets will implode because banks have built up a US$3 trillion war chest which is lodged with the PBOC and because [the] government has assets that can be utilized. The question is how the pain will be shared out throughout the country.

China always has my attention. I believe that Japan is forcing their hand with its own massive quantitative easing. China may have the easiest answer of all the major global trading countries, however. All they have to do is gradually float their currency. As Charles Dumas noted, they have $4 trillion in savings that will look for a home outside of China. A floating currency will weaken the renminbi against major world currencies and help their export businesses. It will also drive US Senators Schumer and Graham nuts, which is a side benefit. A floating currency with no significant QE when the Fed is printing with full abandon will be the strongest argument against the accusation that China is manipulating its currency. Interesting times.

My speech at GAIM will be tomorrow, and then I will take a few days to explore the south of France before heading off to Cyprus. I will speak at a venue that is being arranged on Wednesday in Nicosia, and the event will be open to the public. I will announce the time and place in this weekend's letter. And then it's on to Croatia and a long weekend with David McWilliams and his family on some idyllic little island in the middle of nowhere. Sounds divine. I hope you are enjoying your summer, wherever you may be.

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Watch the Shockwave of an Explosion at Mexico’s Popocatépetl

By Erik Klemetti

Volcanism at Mexico’s Popocatépetl is highly punctuated, especially during its current level of activity where domes of lava grow in the summit crater. These domes occasionally collapse or are destroyed by explosions that can lessen the pressure on the magma beneath to create an even larger explosion. This is akin to popping the top off a shaken bottle of soda — the dissolved bubbles come out of solution rapidly as the pressure is released and you get an explosion of soda.

Today, Popocatépetl had one of those explosions, and thanks to the beautiful weather in Mexico and some nice placement of webcams surrounding the volcano, the explosion was caught on some pretty amazing webcam footage compiled by webcamsdemexico (see above). The video is short, only 30 second long, but after the first few seconds of calm, the explosion occurs, sending a dark grey plume into the atmosphere above the volcano. Now, these explosions come with a lot of force, and you can see after the initial explosion is how the clouds of water vapor around Popocatepetl shudder as the explosion front moves past. Then quickly, the upper flanks of the volcano turn grey from the rapid raining out of ash and volcanic debris (tephra). It is a little surprising how little the clouds actually care that the explosion just occurred at first, but as the explosion continues in this sped up video (UPDATE: the rough estimate made by a commenter was ~40x, so this sequence might have lasted 20 minutes — but it does really show that shockwave clearly), the clouds do begin to show more disruption from the hot ash and volcanic gases being released during the explosion. You can also notice how the plume reaches neutral buoyancy not too far above the volcano (bigger the explosion, the higher it can reach before this happens) as the plume begins to spread laterally (to the right in this video) into that classic shape. My guess is the plume was a few kilometers tall by the time the video ends.

You can see how pulsatory the eruption is as well, with the dark plume churning like steam from a steam engine. This might be due to new magma rising in the conduit, feeding the eruption as it continues. However, even with all this fury, the volcano went back to looking idyllic with only some minor puffs of ash within two hours after the explosion (see below) and only the grey ash on the slopes to show for the seemingly giant explosion. Even as impressive as that explosion seems, these ash and tephra deposits usually are wiped clean out of much of the geologic record by rains as they are only a few centimeters thick near the volcano and millimeters thick further away.

The view from the Altzomoni Tlamacas webcam pointed at Popocatépetl, showing the relatively tranquil state of the volcano less then two hours after a large explosion (see video above). Image: webcam capture / CENAPRED.

Remember, you can check out the activity at Popocatépetl on the CENAPRED webcams, including this view from the Altzomoni Tlamacas. The alert status remains at Yellow Phase 2 as these explosions continue to occur and seismicity rolls on.

Video: webcamsdemexico / YouTube

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Who Profits from Corporate Profits

By: Jesse

Why keep the median wage low, despite rising profits and productivity?

Whom does an increasingly debt-based economy serve?

Who profits from the status quo?

Pictures in an exhibition of elephantine greed.

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U.S. Treasury Bond Bubble Red Alert, QE Taper Talk Puts Bonds at Risk – Where to Hide?

By: Axel_Merk

Induced by “taper talk,” volatility in the bond market has been surging of late. Is there a bond bubble? Is it bursting? And if so, what are investors to do, as complacency might be financially hazardous.

Bond bubble indicator on red alert

Our internal best bubble indicator is triggered when an asset, or asset class, exhibits volatility below its historic norm. That is, money flows into an asset not appreciating the risks that are embraced. Think tech stocks in the late 1990s. Think housing in the run-up to the financial crisis. Or think Treasuries. The long-end of the yield curve (longer dated Treasury securities) is historically a rather volatile place. In recent years, however, it’s been eerily quiet. This isn’t limited to U.S. Treasuries, but both domestic and many international fixed income markets have rewarded investors with yield, but relatively low levels of volatility. In our assessment, we don’t need the Chinese to dump their Treasuries, but merely for historic levels of volatility to return to the Treasury markets for there to be a rude awakening. That’s because bond prices can fall; an investor in a bond fund is subject to interest rate risk, i.e. the risk of bond prices falling as higher interest rates are anticipated. A lot of yield chasers and other “weak hands” may be holding Treasuries that might flee this market should heightened volatility persist.

The recent “taper talk”, i.e. the talk about the Federal Reserve (Fed) reducing its Treasury purchases has provided a first taste of how increased volatility affects bond investors. The Fed has worked hard to contain the long end of the yield curve, amongst others, by communicating to keep rates low for an extended period; by buying Treasuries; by engaging in Operation Twist; and finally, by shifting the Fed’s focus from inflation to unemployment. However, as recent volatility in Japan’s government bonds (JGBs) has shown, it may be harder going forward to smooth talk the markets.
Merk Insights

Shorting bonds

The purest way to express a negative view on bonds may be to short them. However, anyone who has ever done so through an ETF or derivative, likely has learned that one better get the timing right. Shorting bonds can be rather expensive, as one constantly has to pay the interest, in addition to the cost of the instrument or vehicle one chooses. We won’t try to talk short-term traders aware of the associated risks out of shorting bonds, but caution that this is not for the faint of heart; we also think it may not be a wise long-term strategy due to the associated costs. An alternative to shorting bonds might be to sell the dollar, where one can tap into other opportunities at the same time; more on currencies later.

Moving from bonds to equities?

Investors are all too often told they can choose between bonds and equities. More so, with the stratospheric rise in equities of late, anyone not fully invested in equities is likely to have “underperformed”. Independent, however, of whether one thinks that equity prices may go higher, equities are historically more volatile than bonds. As such, when shifting from bonds to equities, one inherently accepts a higher risk profile. To us, this seems like a rotten choice: be stuck with what might be overpriced bonds; or move to equities, where one knows the risks are high. We consider some alternatives.

Flexible bond funds

Not all bond funds are created equal. The typical parameters bond managers choose are duration, a reflection of interest rate risk; and credit risk. Some bond managers have the flexibility to adjust, for example, interest rate risk, by shortening the average duration of bonds held. However, few bond managers go below 2 or 3 years in duration, still exposing investors to what might be significant interest rate risk.

Anyone who has ever taken the time to read the prospectus of a bond fund, might find that some of them read like hedge fund prospectuses. Indeed, some bond funds are known to heavily deploy derivatives to take bets on the yield curve. The downside of this approach is that one basically buys a black box, trusting the manager to do the right thing. Sure enough, there are some that have played this well in the past. Investors should ask themselves, however, whether they truly understand the risks the managers take; that is, the risks investors are facing.

Chasing credit risk

Fearful of interest rate risk, many investors have been chasing credit risk. That is, buying short-term debt of less creditworthy issuers, notably junk bonds. As long as Fed Chair Bernanke is healthy, what can possibly go wrong here? Junk bond yields are near historic lows, as this is not a new idea. More importantly, junk bonds tend to trade more like equities, as they are sensitive to “risk” sentiment in the market just as equities are. As such, enjoy the returns while they last, but don’t count on being “diversified” as junk bonds might tumble just as stocks tumble.

Ultra-short bond funds

Ultra-short bond funds, i.e. bond funds that are committed to the short-end of the yield curve, are back in fashion. It appears 2008 is a distant memory: these funds chase credit, but do so while keeping duration fairly low. As 2008 has shown, however, when the going gets tough, a lot of money can be lost in these markets. There’s this thing about investing in anything other than Treasuries: it’s called risky for a reason, and there’s no free lunch.

International bond funds

It turns out many international bond funds have the same challenges, with some added spice, the currency risk. We’ll talk more about currencies in a bit, but let’s first zoom in on the darling of recent years: a lot of money piled into emerging market (EM) local debt funds. Many EM currencies have historically been tightly managed; as such, the currency risk has been lower than one might first think when thinking of “emerging markets.” Yet, the yields available in the bond markets have been reasonably attractive. And aren’t all the shirts cleaner in developing countries? For a few years now, investors were reaping the benefits of high yields investing in these markets. There are only a few challenges:

  • EM debt markets are small. Yet, a lot of money piled into these markets. As such, in recent weeks, when bond market volatility spiked, many investors ran for the same small door, exacerbating volatility in EM local debt markets.
  • Interest rate risk is as present outside of the U.S. as it is inside the U.S. The typical EM bond fund manager may be likely to choose a bond because of liquidity. In recent years, that’s not been a problem as the volatility in EM bonds was contained. But investors might be faced with a double whammy as investors re-evaluate their “strategic positioning” in the space. “Strategic positioning,” by the way, appears to be a codename for turning a blind eye to certain risks, trying to justify why one has to invest in the same market everyone else appears to be investing in.

Emerging markets have responded to the huge demand by issuing more debt. Clearly, we welcome increased liquidity in these markets. But there’s much more needed than more bond issues to have emerging markets mature; for now, there’s mostly a risk that the added debt causes domestic pain in a bond bear market.

Alternative investments

When bond prices are at risk and piling on equity exposure may not be desirable, alternative investments provide a third way. The challenge with alternatives is that they often depend on well functioning markets: in 2008, many alternative investment strategies broke down as managers were unable to execute when liquidity dried up or regulators, for example, banned the shorting of certain securities. As such, let us highlight features of our home turf, the currency asset class:

Currencies: low correlation; low volatility; potential for alpha

Investors paring down interest rate and credit risk move closer to holding cash. However, cash is no longer risk-free, either, as negative real interest rates erode one’s purchasing power. We believe embracing currency risk may well be what the doctor has ordered, as it spreads the risk of any one currency. Currency risk is introduced, which is definitely risky on a nominal basis compared to holding cash, but investors may want to consider the potential benefits:

Corelation. Currencies historically have low correlation to other asset classes. Compared to U.S. bonds, currencies have a near zero correlation or negative correlation (dependent on index chosen).

Volatility. Unlike their reputation, currencies are less volatile than either bonds or equities. When the euro moves a full cent, say from 1.32 to 1.33 versus the dollar, on a percentage basis, it’s a rather small move, even if it makes the headlines because it affects major economies. Currencies are perceived to be volatile mostly because many speculators employ leverage. We don’t think leverage is necessary to make money in the currency markets.

Alpha. The currency space may be well suited for active management, as non-profit maximizing participants, such as corporate hedgers; central banks or travelers can create market inefficiencies for professional investors to exploit.

Directional vs. Non-directional (“long/short”). We group currency investing into two major camps: directional, as in taking a long-term bullish or bearish position on the greenback. For example, central banks have been diversifying to managed baskets of currencies; an investor can do the same in his or her portfolio. Or non-directional (“long/short”), which is taking a position, for example, on the Australian dollar versus the New Zealand dollar. Such a relative position may or may not be profitable, but the returns generated will almost certainly not be correlated to anything else in an investor’s portfolio.

We believe we are in an environment where investors may be chasing the next perceived move of policy makers. The currency space may be an ideal place to express views on what we call the “mania of policy makers,” potentially leading to excess returns through superior insight and active management. After all, we may not like what our policy makers are up to, but we think they are rather predictable. Differently said, investors take on a great deal of noise expressing policy maker moves in the equity market. To learn more about currencies, please visit www.merkinvestments.com

We are about to publish a white paper providing more in-depth data on this discussion; please make sure you are subscribed to our newsletter to be informed when it becomes available. Also, please join us for a webinar that discusses the currency asset class in more detail: click to join our webinar list; our next Webinar is next Tuesday, June 18.

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What the Bond Market Says About the Likelihood of the Fed Tapering

by Graham Summers

The big question on every investors’ lips today and tomorrow is: “will the Fed announce or hint at tapering QE?”

Over the last two years, one of the biggest tools in the Fed’s arsenal has been verbal intervention: the act of saying something in order to push the market up. Time and again 2011-2012 saw various Fed Presidents appear at key points to push the market higher by promising more action or stimulus.

With that in mind, we have to keep our eyes on the bond markets. The Fed is most closely linked to the Primary Dealers. These are the banks that help the Fed and the Treasury with Treasury Auctions (when the US issues debt). These banks, more than any other financial entities on the planet, have access to the Fed’s insights.

Here’s the list of Primary Dealers:

  1. Bank of America
  2. Barclays Capital Inc.
  3. BNP Paribas Securities Corp.
  4. Cantor Fitzgerald & Co.
  5. Citigroup Global Markets Inc.
  6. Credit Suisse Securities (USA) LLC
  7. Daiwa Securities America Inc.
  8. Deutsche Bank Securities Inc.
  9. Goldman, Sachs & Co.
  10. HSBC Securities (USA) Inc.
  11. J. P. Morgan Securities Inc.
  12. Jefferies & Company Inc.
  13. Mizuho Securities USA Inc.
  14. Morgan Stanley & Co. Incorporated
  15. Nomura Securities International Inc.
  16. RBC Capital Markets
  17. RBS Securities Inc.
  18. UBS Securities LLC.

With that in mind, I suggest keeping a close eye on the bond markets. These will be the “tell” of what the Fed is likely to announce.

The 30 Year bond is trending lower in a clear downward channel. We’re now coming up on support at which point we see a rally. This would likely indicate that the Fed will not suggest tapering or will at least word things very carefully.

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Obama on Bernanke: Thanks for Coming. Now it’s Time to Go!

By tothetick

President Barack Obama stated yesterday that Federal Reserve Chairman Ben Bernanke has stayed in his position “longer than he [Bernanke] wanted”. Some will be probably agreeing with Bernanke (and Obama) more than he might have expected after having said that. Although he should have stopped short of adding (for fear of hurting Helicopter Ben’s feelings?) that he has done an “outstanding job”. If it were that outstanding, he wouldn’t want to go, would he? Love you and leave you? I’ve had a party with you guys and now I have to go? But where?

But Bernanke is a man of resourcefulness. This is the guy that was hailed personality of the year back in 2009 by Time magazine. The article even mentioned that he had ‘saved the US’ from the disaster of the financial crisis. That’s an accolade, isn’t it just! Saved the US!

Bernanke was appointed by George W. Bush to the head of the Federal Reserve in 2006. But, people should have seen it coming all this quantitative easing and the print presses rolling off shiny bright new greenbacks as they fluttered down from the sky like manna from heaven when Bernanke gave his famous speech on November 21st 2002 referring to Milton Friedman and throwing money at the people like pieces of meat to lions in a cage. Bernanke should have known too then that he was going to be ripped to pieces by the gladiators in the ring if he even tried to stop feeding the lions. His statement came true when the financial crisis came along and he was able to put all of that into practice.

Then we shouldn’t forget the fated speech on March 10th 2005 when Bernanke as a newly-appointed member of the Council of Economic Advisers stated that the responsibility of the public deficit was down to a global savings glut more than excess consumption by the USA. Someone else’s problem? Shouldn’t certain people have been worried back then as to what he was going to do?

Unemployment has failed to decrease by the percentage that the Federal Reserve had predicted. The crystal ball must have gone a bit cloudy on that day. The US was supposed to be at 5.2% today with an efficient use of resources in the labor market at such a rate. The unemployment rate for May was at 7.6%. The Federal Reserve now holds assets worth to the tune of $3.41 trillion. They stood at $877 billion in 2007. Thanks to QE stimulus.

President Obama’s words are preparing the people for the fact that Bernanke might be on his way out. His current term expires next year. But who will be putting up his photo as employee of the year or even the month? Where will Bernanke be going? Is he going to be retiring to the Caymen Islands to sun himself on the beach and benefit from his well-earned retirement, or will he be ‘helping’ someone else out in the monetary problems? Who wants to wire ahead and tell them what’s going to happen? But Bernanke is still here till January 31st 2014. Will he get rid of QE4 before then, or will he leave that for the next guy to deal with?

But, the next guy might be a girl. By all accounts, it will be Janet Yellen, the Federal Reserve Vice-Chairman that gets her stint at making the economy run like clockwork as from January.

Janet Yellen

Janet Yellen

Stepping into Bernanke’s shoes will be no easy task. If she gets the appointment, she is going to be saddled with the trillions of assets at the Federal Reserve and a market that gets the jitters every time just the words of QE are mentioned. Some are worried and wary though that Ms. Yellen will be pro-inflation. Will she worry enough when the economy picks up (if and when?) and inflation gets out of control? Will the US have trillions in assets, angry traders and a market that will be ready to rip her to pieces and chew her up when the QE gets withdrawn and to boot unemployment that is above acceptable levels and inflation to boot? Time will tell. Maybe we should be thinking ahead, though.

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FOMC June Policy Meeting Preview

By Aamar Hussain


Wednesday 19 June 2013

19:00 BST: US FOMC rate decision (Jun)

19:00 BST: US Federal Reserve to release summary of economic projections

19:30 BST: Press conference with Fed chairman Ben Bernanke


Since Bernanke’s testimony to congress on 22 May markets have become jittery, and volatility has returned with a vengeance as traders try to price in the Fed’s tapering of its asset purchases.

The uncertainty is engulfing not only the US, but all financial markets, with emerging markets particularly bearing the brunt of the market’s wrath. And news from the US is likely to continue shaping traders’ focus in the weeks ahead.

The truth is that the market does not know what to expect from the Fed on this outing. The minutes from the previous Fed meeting in April showed that there is still a divergence of views on the FOMC. And some policymakers have been making comments that add to the uncertainty.

For example, St. Louis Fed president James Bullard – a hawkish voting member on the FOMC – recently said “labour market conditions have improved since last summer… [but] surprisingly low inflation readings may mean that the [FOMC] can maintain its aggressive programme over a longer time frame.” On the other hand, Bernanke’s now notorious comments at his congressional testimony seem more neutral, saying that the pace of asset purchases depends on incoming economic data.

Analysts at Rabobank point out that economic data has been mixed as of late. “While the economic fundamentals in the US have improved, the recovery is being restrained by a global growth slowdown and domestic fiscal policy uncertainty. As a result, the data are not uniformly good, nor are they uniformly bad,” which, in the context of Bernanke’s comments, may suggest that tapering isn’t imminent.

The IMF has also waded into the tapering debate. In its annual review of the US economy, the organisation urged the Fed to keep its current pace of QE in place until the end of year, exhorting the Fed to “carefully calibrate” the timing of its exit from QE.

And while some traders anticipate the Fed to scale back its programme of quantitative easing before the end of 2013 – the Wall Street Journal’s influential Fed watcher, Jon Hilsenrath, also reminded us in an article that the Fed is unlikely to go cold turkey, switch off the monetary taps and raise rates immediately.

It is important to note that the focus of Hilsenrath’s article was about when the Fed was likely to start lifting interest rates. The market, however, seems to be more concerned about when the Fed will scale back asset purchases – but the two are different.

In the article, Hilsenrath writes “chatter about pulling back the bond program has pushed up a wide range of interest rates and appears to have investors second-guessing the Fed’s broader commitment to keeping rates low. This is exactly what the Fed doesn’t want. Officials see bond buying as added fuel they are providing to a limp economy. Once the economy is strong enough to live without the added fuel, they still expect to keep rates low to ensure the economy keeps moving forward.”

Hilsenrath also believes that Bernanke will be pushing home the point that there will be “considerable” time between ending bond buying and raising rates in his press conference. It is an argument that Societe Generale’s Kit Juckes also supports: “The general expectation is that the Ben Bernanke will calm fears of over-zealous ‘tapering'. Still, the case for beginning the process of letting some air out of the monetary bubble is pretty clear, and surely the Fed will be wary of backing down too easily.”

However, others opine that the Fed will be explicit in its intention to taper QE soon. The FT’s Washington correspondent Robin Harding this week wrote an article suggesting that the Fed is likely to signal tapering is close. “Markets seem reluctant to acknowledge the improvement that is leading the Fed towards a taper of QE3. But they also appear to be assuming, incorrectly, that any taper means the Fed has become less willing to support the economy’s recovery.”

Harding adds “Bernanke is likely to push against both misponceptions, combining an upbeat message on how the strength of the economy will soon justify a taper, with a signal that further tapering depends on further improvement in the economy and in no way brings forward an interest rate rise,” which is similar to the Hilsenrath line.


The Fed’s previous economic forecasts predicted that the US economy would grow by 2.6% in 2013 and 3.2% in 2014 (read the previous projections here). And the Fed also predicts that unemployment will fall from 7.4% in 2013 to 6.9% in 2014. “In every year of the economic recovery the Federal Reserve has overestimated how fast the economy would grow,” writes Hilsenrath, in another article this week.

Nevertheless, Jim Reid, a strategist at Deutsche Bank, says that the key takeaway from Wednesday’s FOMC releases could be how these projections have changed. He says “if and how these forecasts change could send an important signal about the Fed’s near-term intentions,” adding “if the Fed maintains confidence in their economic forecasts, it could signal they think they're on track to begin pulling back on QE later this year.”

Hilsenrath himself argues that “Fed officials have been talking lately as if they still think that a growth pickup could happen, which suggests they won't be making big changes to their forecasts.”

Also important, however, is where the Fed sees inflation. Mansoor Mohi-uddin, a strategist at UBS, noted “that remains the key risk from the FOMC meeting in the week ahead. But as investors have already been cautioned to expect a dovish press conference from Bernanke, we think any downside to the dollar here is already largely priced. Instead, we expect investors will look through attempts to push back rate hike expectations and focus still on when the Fed will slow down its asset purchases.”

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Stock-Market Crashes Through the Ages – Part III – Early 20th Century

By tothetick

The 20th century could be categorized as THE century when communications took off and we started living in each other’s pockets. Lives had been ruined by war, trouble and strife. Wealth had been redistributed beyond belief. There were no longer just a few that were making the profits, but there were growing classes of people that wanted recognition.

They might not have got it until the second half of the 20th century, but the way things unraveled in the first half meant that people were not prepared to sit back and let things go into the hands of the rich landlords and the factory owners.

Rights had been acquired and they were being demanded. Women, workers, whoever they were, everybody wanted a piece of the cake. It wasn’t until the second half of the twentieth century that dabbling and buying shares, thinking you could strike it lucky and make a million, was going to become part and parcel of most people’s lives. Maybe that’s the whole problem. People betting on investments as if that was nothing more than a couple of whippets running round the race track on a Saturday afternoon, bag of chips in one hand and a pint of ale in the other. Flat cap and everything.

The markets don’t act like that. But, we allowed people to think that they could make a quick million bucks by investing what they had hidden under the mattresses for decades. Why did they need to worry anyhow, social security had been invented, we were looking after the destitute and not locking them behind the gates of Victorian workhouses and mental asylums. There was a safety net that had been created in society by the advent of the National Health Services (1948 in the UK) that we pride ourselves for inventing or the retirement schemes that we say will make pensioners’ lives better (Dankeschön, Mr. Bismarck).

As time went on in the 19th century the number of stock-market crashes increased.

That number increased even more in the 20th century. Information was accessible. Telecommunication technology was entering our lives as a daily piece of equipment. I could start to be absent and yet present at the same time. I didn’t have to be literally somewhere physically; I could be there almost in person via the transmission of my voice or an image. It was reserved for the elite at the start, but as the century progressed, it became more and more democratized. Later in the century, it would be possible to be completely present, and yet physically absent and I would be able to do it from the comfort of my own living room. Education was becoming more and more widespread. Newspapers were being read even by those that had not been able to read in the previous century (total circulation was at over 27 million in 1920 and households had papers delivered both in the morning and in the evening). Access to information meant the learning of events almost in real-time.

Stock Markets: Interconnected

Stock Markets: Interconnected

The 20th century saw an explosion in the number of stock market crashes. Here are a few of them. The ones that bit us from behind as we scrambled out of the markets sometimes to be left without a cent. One thing about it all was that the dream of the self-made man, the entrepreneur, the idea of striking it rich had really come into its own in this century! This is just the first half of the 20th century!

1. Panic of 1901

We entered the 20th century with a panic. The turn of the century has always been equated with great change, either good or bad. The Panic of 1901 was due to some extent to the fight for the control of the Northern Pacific Railway.

Stock Market: Edward Henry Harriman

Stock Market: Edward Henry Harriman

  • The Northern Pacific was a transcontinental railway (1864-1970).
  • Edward Henry Harriman who was the Chairman of Union Pacific attempted at all costs to monopolize the railway sector.
  • He attempted to buy stock en masse belonging to Northern Pacific Railway to take control of the company.
  • The NYSE was said to look more like a football field as the panic started and prices began to fall as people started to sell in sheer panic.
  • The market crashed and brought down with it the majority of US railway companies (Burlington and Missouri Pacific, for example).
  • The only one that was left still standing was the Northern Pacific. The run on their shares by Harriman had meant that people were selling all other shares like they were going out of fashion and attempting to buy into Northern Pacific.
  • One company’s loss became another companies gain and Northern Pacific increased by 16.5 points.

The crash spread to other companies. It brought the country into recession and was the first stock-market crash of the 20th century.

2. Panic of 1907

The Panic of 1907, is the Bankers’ Panic. The NYSE dropped by 50%. The reasons? Lack of confidence in the market and retraction of market liquidity by NY banks. The banks had lent out too much money in an attempt to purchase the United Copper Company and this caused loss of confidence and bank runs ensued.

  • The US had no central bank that would act as a lender of last resort at the time. President Andrew Jackson had let the charter of the Second Bank of the United States lapse in 1836. Money supplies fluctuated only in line with agricultural cycles. Money left NY in the autumn to purchase harvests and the only thing that made that money come back was a raise in interest rates.
  • J.P. Morgan shored up the banks and bailed them out; otherwise there might have been an even worse situation.
  • There was an attempt to corner United Copper, by purchasing large quantities of the stock of the company in a bid to be able to manipulate the price of copper afterwards.
  • Shares rose in the beginning from $39 to $52 per share. They reached $60 before they began to collapse.
  • Within just a few days, they ended up at $10.

J.P. Morgan had managed to shore up the banks for a while as they were suffering from lack of liquidity, but he was unable to do so indefinitely. The bankers tried to call a press meeting to persuade the papers that they were controlling everything. Even the city of New York needed $20 million otherwise it would go bankrupt.

Morgan said “if people will keep their money in the banks, everything will be all right”.

The banks were not willing to make loans (short-term) to brokers to carry out daily trading, worried that the stock would fall even more. Prices fell as a consequence on October 24th 1907. The President of the NYSE requested that the stock exchange be closed early to halt more losses. Closing the NYSE would mean even greater loss of confidence. So, J. P. Morgan decided to call the banks to a meeting. He requested $25 million and it was raised in 10 minutes flat! Not bad, really! But, it didn’t stop the free-fall.

  • 1907 caused the highest number of bankruptcies to that date in the US.
  • Production was estimated to have fallen by 11%.
  • Imports were down by 26%.
  • Even immigration dropped. The US was no longer the land of plenty (fall from 1.2 million immigrants to just ¾ of a million in one year).
  • Unemployment rose to over 8%, whereas it had been at under 3%.

3. Wall Street Crash 1929

Probably the most famous stock market crash of the entire history of the economy (apart from the one that we are living right now). The Wall Street Crash is also known as Black Tuesday. Since this date we have used Black days throughout our stock market crashes (Black Monday in 1987, or Black Wednesday in 1992, for example).

Just like in the period that preceded the stock-market crash of 2008, there was a time of wealth, success, making money, sandwiched in between World War I and just before World War II. The roaring twenties. Innovation, dynamism, liberation, freedom.

Motion pictures abounded, the automobile became commonplace, electricity entered the homes of the middle-classes. Culture and lifestyles changed drastically. Everything became possible. Modernity had arrived. It’s strange that the period that preceded the stock market crashes of the 21st century was also a time of great change. We had invented and democratized communications to a point where we could carry it around in our pockets. We had changed the way we accessed information and we had it at our finger tips like no other generation had had before via Internet.

Speculation became the order of the day in 1929. The world investors were on a roll and it wasn’t going to end. Money could be had and it was short-time financial gain that was important. Making money and making it fast. But, even though we might not always apply the same knowledge today, what goes up must come down.

  • On March 25th 1929, it began with a mini-crash. This was only an omen of what was to come.
  • The National City Bank tried to shore up the losses by injecting $25 million into the market, stopping is descent into hell. But, it was all temporary.
  • The USA was showing signs of waning economically. The steel market was on the slippery slope and construction wasn’t anything more than just sluggish. The peak had been reached.
  • There were already 20 million cars on the roads, for example in 1929 in the US. Automakers sold 4.5 million cars in the US market alone in that year before the crash.
  • General Motors had a net profit of $248 million. But, the peak had been reached, 1929 saw a dramatic drop. It was only selling 1/3 of the cars it had been selling prior to the crash on the domestic market. It took ten years to come back to the same level of profit and the number of car sales as in the period before the crash of 1929.
  • Although, it has to be said, even then, it was the shareholders that counted. The shareholders got dividends every single year from GM between 1929 and 1939.

The roaring twenties had roared on from 1920 until 1929. The Dow Jones Industrial Average had been multiplied by ten. Some even said that it was a “permanently high plateau” in September 1929. Very few are able to predict what the market will do, but nobody today, at least, would suggest for a second that we are going to be on a permanent high. That lesson has been heard loud and clear. The Dow jones reached its peak at 38.17 on September 3rd 1929.

The London Stock Exchanged collapsed when a British investor (Clarence Hatry) became the most hated man in the UK when he was jailed for fraud. Hatry was a London insurance clerk that had amassed immense wealth by profiteering during WWI. He was about to merge his companies into a $40-million affair called the United Steel Companies. But, the Stock Exchange Committee discovered that he had been borrowing ($1 million) without anything to back it up.

  • It was on October 24th 1929 that Black Thursday occurred. The NYSE plummeted 11%. Bankers managed to stop the landslide and purchase large quantities of stock well above the market price in blue-chip companies. It halted the free-fall. But, temporarily. The NYSE closed at -6.38 points.
  • The newspapers managed to report the news and Monday 28th became known as Black Monday.
  • Black Monday saw the DJIA spiral out of control. The US market lost 12.8% as trading opened up on the NYSE. It plummeted 38.33 points and closed at 260.64.
  • Black Tuesday, October 29th had 16 million shares being traded. The DJIA fell 30.57 points, to just 23.07. It lost 11.7%. In three days of trading the DJIA had lost over 30%.

What went horribly wrong? Speculation and certainly the belief that things would never end. Brokers were lending 2/3 of the face value of stocks that they were purchasing and that meant that in 1929 there was more money that was on loan than the entire currency in circulation in the USA ($8.5 billion). That smacks of something familiar when we think about the sub-prime crisis. The belief that housing prices could never fall and that we would always be on an upper, lending money left, right and center.

One other thing that we learned is that our worlds were interconnected. Falls in London, Tokyo and New York happened at the speed of light in 1929. What one did the other followed suit with. Only 16% of the US population had money invested in the stock market in 1929, but it was probably those that had the companies that employed the people that worked. The knock-on effect was enormous.

But people like Joseph Schumpeter and Nikolai Kondratieff believed through their economic-cycle theories looking at the way the market reacted that the 1929 crash was just acceleration in the cycle and it enabled moving towards the next one.

Stock Market: Nikolai Kondratieff

Stock Market: Nikolai Kondratieff

Stock Market: Joseph Schumpeter

Stock Market: Joseph Schumpeter

4. Recession 1937

Spring 1937 saw the US economy get back on its feet and the levels of economic activity were similar to pre-1929 ones. Unemployment was still relatively high, but that was nothing compared to the vertiginous heights of 1933 (25%!). In 1937 things went haywire for just over a year causing an economic recession in the US, with a knock-on effect in the rest of the world.

  • Unemployment was at 14.3% in 1937. It increased to 19%.
  • Manufacturing output fell by 37%.
  • Spending decreased and incomes fell by 15%.
  • GDP fell by 11%.

Economists fail to agree on the reasons (nothing surprising) as to the economic recession of 1937. Depends where you stand. If you are a Keynesian, you will believe that federal spending cuts brought about the recession, coupled with increased taxation. If you are a Milton-Friedman man then it’s the money supply and the Federal Reserve’s tightening of it that is the instigator.

The 1937 recession was called the ‘Recession within the Depression’.


Some might say that the benefits of what we have gained over the past century are far better than the relatively few times that we had to wade through the nightmares on Wall Street and the Stock Market crashes that hit us full in the face at times.

Some might say that it was worth it as the market generated the wealth on which we prospered in the 20th century. But, they also resulted in depression, recessions and slumps. Recessions that brought about the rise to power of some of the worst dictators that the world had seen.

Recessions that brought about a fight for greed and a closing in upon ourselves in protectionist fear. But, the 1st half the of the century was nothing compared to the stock market crashes that were waiting in store for us once we would become really industrially connected and inter-connected. When we went global, when we reduced our barriers, when we travelled from point A to point B at supersonic speed, and when one push of a fat finger on a keyboard sent millions across the other side of the planet.

Stock markets were going to run in the second half of the 20th century at supersonic, virtual speed. We would enter the Big-Bang world of deregulation of the financial markets, abolishing fixed commission charges. But, behind the big bang was a black hole…

What reasons do you think could explain the stock-market crashes of the 20th century?

Take a look at the Stock Market Crashes Through the Ages – Part I – 17th and 18th Centuries.

Take a look at the Stock Market Crashes Through the Ages – Part II – 19th Century.

In the next installment, we’ll take a look at the historical stock-market crashes in the 2nd half of the 20th century.

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Biggest Bond Bubble In History Is Turning Into Carnage

by AuthorWolf Richter

“We’ve intentionally blown the biggest government bond bubble in history,” confessed Andy Haldane, Executive Director of Financial Stability at the Bank of England, to Members of Parliament in London last week. The bursting of that bubble was a risk he felt “acutely,” he warned. There have already been “shades of that.” And he saw “a disorderly reversion in the yields of government bonds” as the “biggest risk to global financial stability.”

And “shades of that,” as Haldane put it with classic British humor, namely understatement, are visible everywhere.

Ten-year Treasury notes have been kicked down from their historic pedestal last July when some poor souls, blinded by the Fed’s halo of omnipotence and benevolence, bought them at a minuscule yield of 1.3%. For them, it’s been an ice-cold shower ever since. As Treasuries dropped, yields meandered upward in fits and starts. After a five-week jump from 1.88% in early May, they hit 2.29% on Tuesday last week – they’ve retreated to 2.19% since then. Now investors are wondering out loud what would happen if ten-year Treasury yields were to return to more normal levels of 4% or even 5%, dragging other long-term interest rates with them. They know what would happen: carnage!

Wholesale dumping of Treasuries by exasperated foreigners has already commenced. Private foreigners dumped $30.8 billion in Treasuries in April, an all-time record. Official holders got rid of $23.7 billion in long-term Treasury debt, the highest since November 2008, and $30.1 billion in short-term debt. Sell, sell, sell!

Bond fund redemptions spoke of fear and loathing: in the week ended June 12, investors yanked $14.5 billion out of Treasury bond funds, the second highest ever, beating the prior second-highest-ever outflow of $12.5 billion of the week before. They were inferior only to the October 2008 massacre as chaos descended upon financial markets. $27 billion in two weeks!

In lockstep, average 30-year fixed-rate mortgage rates jumped from 3.59% in early May to 4.15% last week. The mortgage refinancing bubble, by which banks have creamed off billions in fees, is imploding – the index has plunged 36% since early May. But home prices have risen as private-equity funds and investors have gobbled up single-family homes, hoping that they could rent them out [which turned out to be difficult ... here’s my take: Housing Bubble II: But This Time It’s Different]. These inflated prices are now colliding with rising mortgage rates – and with the possibility that hot money might dump empty homes while it still can. Which would make for one heck of an ugly dynamic.

In low quality debt, the carnage has been particularly nasty – though it’s just the beginning. Frantic investors went to chase after yield that the Fed, in its infinite wisdom, had deprived them of elsewhere, and they sank their teeth into junk bonds, and overpaid for them in an epic feeding frenzy, and drove yields down to ridiculous lows, below 5% for some, though these bonds promised a relatively high probability of default and loss of principal to their hapless holders.

The absurd magnitude of the bubble was so glaring that even Fed officials who caused it began to get concerned, in part because financial institutions were loading up on junk. But on May 9, the party stopped, and the gnashing of teeth started. Junk bonds plunged and yields skyrocketed, with the BofA Merrill Lynch High-Yield index jumping from 5.24% to 6.44% by Friday [my take on how much more damage might be in store for them.... The Day The Big Fat Junk-Bond Bubble Blew Up]

Emerging-market debt got slaughtered as well, particularly dollar and euro bonds issued by companies that do their business and earn their profits, if any, in now plunging local currencies that once had been hyped as a sure bet against the dollar. Hype dies quickly. Now these companies face the insurmountable task of having to spend ever more of their weakening local currency to service their debts. There will be defaults. Billions will go up in smoke. In anticipation, these now crappy but previously wondrous bonds have taken a hard beating of almost 8% in five weeks. Emerging-market bond funds were hit by $9 billion in redemptions last week, the third largest ever. And it too is just the beginning.

All because of a single word. To its immense credit, the Fed, with its money-printing and bond-buying binge that is continuing at $85 billion a month, has accomplished a unique feat: shifting the focus of financial markets away from awkward economic and business fundamentals to what the Fed will do next. It worked like a charm for years. But now, what the Fed will do next has been boiled down to a single innocuous-sounding word: “taper.”

The mere possibility that the Fed might “taper” its binge has pricked the most insane credit bubble mankind has ever seen. A “disorderly” implosion could take down some big banks, and as Haldane put it, pose the “biggest risk to global financial stability.” So the Fed is now trying to figure out how to exit from its reckless experiment without taking down any banks; more TBTF bank bailouts would be embarrassing. Investors have taken note. Seatbelts are being fastened, and the clicks can be heard around the world.

While the S&P 500 has continued moving higher, with investor sentiment in America cautiously bullish, over the past month, there has been a huge increase in volatility; and emerging markets have been hit with big losses. Read.... Investor Sentiment Eroding Globally – Is America Next?

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VIX and SPX During the 1994 Interest Rate Hike Cycle

by Bill Luby

With yesterday’s The VIX and the Pre-FOMC + Post-FOMC Trades post in the books, it occurred to me that my reference to the series of interest rate hikes in 1994 probably stretches back before the memory banks of the current generation of investors. So with all the anxiety about Fed tapering and ultimately ending quantitative easing, I thought this might be a good time to review what happened to stocks and volatility when the Fed embarked upon a series of interest rate hikes that took the financial community by surprise.

To set the context, the 1990s started out with a recession that coincided with the first Gulf War and a corresponding sharp rise in oil prices. The Fed had been gradually lowering interest rates from 1989 – 1992 and this helped to create an environment that favored a recovery, but this recovery took some time to gain traction and did not get going until 1991. The stock market fared better than the economy during this period; after a down year in 1990, stocks rallied to post gains in 1991, 1992 and 1993. After a strong January for stocks, 1994 appeared to be on a similar path to success.

It was at this point that Federal Reserve Chairman Alan Greenspan decided to remove the proverbial punch bowl before the party got out of hand and on February 4, 1994, the Fed surprised the markets by announcing a 0.25% increase in the federal funds rate. By the time 1994 was over, the Fed had raised interest rates on six different occasions. As the chart below shows, the first three raises were 0.25% increases in the federal funds rate, but the incremental size of the raises increased to 0.50% and eventually 0.75% later in the year and were supplemented by increases in the federal discount rate, which also grew from 0.50% to 0.75%. By the time 1994 was in the books, the federal funds rate had jumped from 3.00% to 5.50% and the federal discount rate had risen from 3.00% to 4.75%. (The rate hike cycle finally ended on February 1, 1995, when the Fed raised the federal funds rate to 6.00% and the federal discount rate to 5.25%.)

Keep in mind that Alan Greenspan did not believe in signaling the Fed’s intentions in those days; on the contrary, he was a master of obfuscation and his cryptic and often ambiguous language typically kept investors in the dark about his intentions. For this reason, it was difficult for the markets to anticipate the Fed’s next move and investors we not necessarily prepared for subsequent interest rate hikes.

How did the financial markets respond to what amounted to almost a doubling of the federal funds rate and an increase of more than 50% in the federal discount rate? With a lot less volatility than one might imagine. The average closing value of the VIX was 13.93 in 1994, little different than the 13.90 average for the VIX in 2013. While the VIX did spike all the way up to 28.30 on April 4th, the VIX only closed above 20.00 on two days during the entire year! The S&P 500 index ended the year with a small loss (a small gain if dividends were to be included in the calculations), but roared back with gains of 34%, 20%, 31%, 27% and 20% in the subsequent five years.

[source(s): StockCharts.com, Federal Reserve Bank of New York, VIX and More]

The series of rate hikes did dramatically change the yield curve, as the chart below illustrates. The more dramatic moves were at the front end of the terms structure, with the curve essentially flat from two years through thirty years by the end of 1994.

[source(s): Wall Street Journal / SmartMoney]

So while Robin Harding’s Fed Likely to Signal Tapering Move is Close article in the Financial Times yesterday (and his subsequent tweet, “The Fed does not leak anything to any journalist to steer markets - especially during blackout”) may have given investors an opportunity for a dress rehearsal for the ultimate tapering, the historical record from 1994 suggests that tapering fears may be exaggerating how the QE end game will ultimately play out.

See the original article >>

JPMorgan: "Fed Stimulus Inflated Prices Of Financial Assets.... Removal Could Create Tail Event"

by Tyler Durden

Then: Risk-On/Risk-Off. JPMorgan's Marko Kolanovic head of Equity Derivatives Strategy explains:

Over the last 5 years, Treasuries and Equities had strong negative correlation. This was the risk-on / risk-off (RORO regime) in which Treasuries were the most broadly used ‘safe haven’ asset. In the RORO regime, investors would hold treasuries and sell them to buy risky assets (and vice versa) while being reassured that Fed will keep the price of Treasuries supported. While we are still on average in a RORO regime, the bond-equity correlation started significantly weakening due to increased risk of Fed tapering and a bond selloff. The effect of the Fed reducing the stimulus could result in lower bond prices as well as lower prices of stocks, commodities and other risky assets whose prices were inflated by the Fed’s stimulus.

Over the past month, in several instances bonds and stocks moved together as investors re-assessed the probability of early tapering. Figure 1 below shows equity-bond correlation (calculated from high frequency intraday data). Correlation turned positive on May 9, 22, and 31 and most recently over the past few days. May 9th and 31st brought better than expected macro data (jobless claims, consumer confidence and Chicago PMI). Ironically, positive data caused equities and bonds to trade lower on increased probability of tapering (good data were bad for stocks). Similarly, on May 22nd, bonds and stocks sold off as Bernanke indicated the possibility of tapering over the next few meetings.

And Now: the "Fed Regime"

A byproduct of these new bond-equity dynamics is that USD is losing its status as a ‘risk off’ currency. As expectations of more (less) stimulus pushes up (down) treasuries and US stocks (both USD denominated), resulting currency flows are weakening the historical negative USD-Equity correlation. Historically, USD had strong negative correlation to equities (i.e. EUR and EM currencies had a positive correlation to equities). This recent relationship is now undermined as treasuries are losing their appeal as a safety asset. This weakening of EM FX and EUR correlation to the S&P 500 (Figure 2) was also helped by investors putting money in US stocks, while avoiding European and Emerging markets in the last leg of market rally.

Fears of Fed tapering the massive QE program is now changing bond-equity correlation from a RORO regime towards a ‘Fed Model’ regime (coincidentally, the name ‘Fed Model’ was crafted in 90s long before invention of quantitative easing). We do not think equity-rate correlation will fully revert back to the ‘Fed Model’ regime, but the recent spikes in rate-equity correlation are worrying signs. Recent bouts of positive correlation of equities, bonds and commodities, suggest that the Fed’s stimulus inflated prices of a broad range of financial assets, and removal of the stimulus could create a tail event in which prices of all assets could go down. While it is expected that the Fed will try to avoid such a scenario by maintaining an appropriate level of stimulus, in the absence of more robust growth, this may turn out to be a difficult task (akin to driving a car without brakes). On this account, we expect more volatility in H2 as compared to the first part of the year. To reduce risk of a bond and equity tail event, investors could diversify ‘safe haven’ assets away from treasuries and into other assets that are at lower risk in case of tapering. For instance investors could increase allocations to cash or Equity Put options.

Helpful. It also appears that Marko and Tom Lee, who sees nothing but smooth sailing from here until S&P 2,000, don't talk much.

And just so the message of JPM's derivatives group is clear, they look at the unprecedented (and previously documented) surge in NYSE margin debt, which has risen at the fastest pace ever so far in 2013, and analyze the empirical evidence of what happens after such a radid move. The result is below:

Last month, NYSE published April data on aggregate debt balances in stock margin accounts. This measure shows how much funds were borrowed to purchase securities, and it reached all time high of $384bn. Net margin debt (calculated as a difference of debt in margin accounts and all credit balances) also reached a high level of $106bn, and the pace of net margin debt increase YTD ($87bn) was the highest on record. We have been asked whether this increase in leverage is a sign of an impending market selloff. To analyze the relationship between S&P 500 prices and margin debt we look at their historical levels over the last 15 years. Figure 7 shows a strong correlation between S&P 500 and NYSE net margin debit. Positive correlation between the S&P 500 and net margin debt indicates that clients tend to finance a fraction of their equity exposure with margin debt. We also note that peaks in margin debt are usually followed with a sharp market correction. However, this on its own does not imply that high margin debt leads to market correction (given the positive correlation of net margin debt and S&P 500, highs in margin debt coincide with highs in S&P 500).

To test for a causal relationship we looked at the changes in net margin debt against S&P 500 performance 3, 6 and 9 months afterwards. Figure 8 shows that large increases of net margin debt are indeed on average followed by weak equity returns. Note that the YTD increase of margin debt is the highest on record, as indicated by the arrow.

Another test we performed is to look at levels of margin debt normalized by the level of the S&P 500. Dividing margin debt by the level of the S&P 500 may give a more accurate measure of leverage (by remove the bias coming from correlation of S&P 500 and margin debt levels).

Figure 9 shows the ratio of margin debt to S&P 500 (red) as well as ratio of net margin debt to S&P 500 (blue). One can see that these normalized measures of leverage peaked prior to the tech bubble burst, in H2 2007 and H1 2008, and in H1 of 2011 – in all cases ahead of significant market corrections. While these are effectively only three data points and hence do not amount to a reliable statistical sample, we think that the quick increase of net margin debt, and high ratio of margin debt to S&P 500 do point to an increased probability of a market correction and volatility increase in the second half of the year.

But don't worry. The Fed is on top of it. All of it.

See the original article >>

When Correlation Is Causation

by Tyler Durden

It is all too easy to dismiss endless charts showing long-run correlations that have become useless in the current liquidity-fueled boom in stocks and real estate in the US with the "well, correlation is not causation" meme, but in Spain, we suspect, few will argue that the relationship between the surging unemployment rate of the OMT-bound nation and its delinquent loan growth is hard to argue with. With both at record highs (and the latter picking up once again after a temporary haitus of seeming banking delays offered some hope), it appears the southern European nation is going from worse to worst.

but there is one 'thing' that is not correlated...

It's not just Spain though - the entirely fake-looking, relatively linear rise in official Italian bad debts is rising at the fastest rate since Dec 2011...

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Bad Loans Continue to Rise in Spain and Italy

by Marc to Market

Spain and Italy reported today that the share of bad loans have continued to rise. There is nothing to suggest that this is the peak. In fact, further deterioration is likely.

Bad loans at Spanish banks rose to 10.87% in April from 10.47% in March and 8.73% in April 2012. These doubtful credits rose to 167.1 bln euros. Spain's problem stems from the housing market boom. Prices have not bottomed.

S&P, for example, warns that another decline in house prices is needed. No sector has emerged to replace the housing related industries as an engine of growth for the Spanish economy. The contracting economy and high unemployment rates, even if it is mitigated in part by the cash economy.

Spanish banks had raised deposit rates to attract and retain savings. The higher deposit rates squeezed Spanish banks earnings. The central bank has successfully gotten the banks to reduce deposit rates. The yield on 1 year deposits, for example, have almost halved to 1.5% from nearly 3% at the end of last year. The decline in deposit rates led investors to pouring savings into mutual funds. Spanish investors have invested almost 7 bln euros into local mutual funds in the year through May.

Italy also reported its bad loan situation today and it is getting worse. The total amount of non-performing loans at Italian banks rose to a 2-year high in April. They are 22.3% above a year ago, a tad lower than Spain's 24.5% increase.

The country's banking association reported that the gross non-performing loans stood at 133.3 bln euros. Italian banks have made provisions to cover about half of this, leaving net NPLs at about 66.5 bln euros. The central bank has encouraged banks to make more provisions. Net NPLs did decline slightly in the first two months of the year as banks made provisions. However, they rose again in March and April to a new two-year high.

Italy did not have a housing market bubble like Spain. It has been the chronic poor growth and high debt servicing costs that have taken a toll. Although the PMIs suggest that pace of economic contraction may be slowing (in both Italy and Spain), it is likely to be insufficient to stem the rot.

If new loans were growing it would also help stabilize the nonperforming loan ratios. However, this is not the case. The Italian banking association data shows that last month, loans to households and businesses fell by 3.1% (though deposits increased by 7.3% to 1.21 trillion euros).

Five years into the crisis and Europe as still not addressed it banking problems. Yes the European Investment bank can help facilitate new loans to small and medium sized businesses. This bypasses the private sector banks without expediting the resolution of their problems.

European banks issuance of sovereign debt has fallen to the lowest level in a decade. Thus far this year, EU banks have issued 132 bln euros of senior debt compared with 158 bln in the same 2012 period. The ostensible cause is the fear the creditors will be held accountable going forward in a way they have not, for the most part up until now. That is what "bail-in" involves.

Senior debt holders have been typically treated as sacrosanct in the default or restructuring situation. However, new rules may place senior debt holders after depositors. The lower interest rate associated with the senior status seems less attractive. European banks have quadrupled their subordinated debt offerings this year compared to the same period a year ago.

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Hormel warns on profits as soaring hog prices tell

by Agrimoney.com

Shares in Hormel Foods dropped after the group cut its profits hopes, blaming "lower-than-expected results" in its pork operations, pressed by a rally in hog prices to their highest in nearly two years.

The maker of Spam luncheon meat cut to $1.88-1.96 a share, from $1.93-2.03 a share, its forecast for earnings in the year to October.

The downgraded figure opened the potential for only marginal earnings growth from the last financial year, and fell short of the $1.99-a-share result that Wall Street has factored.

The downgrade reflects "lower-than-expected results in our pork operations, higher input costs and softs sales of our retail products in our refrigerated foods segment", Jeffrey Ettinger, the Hormel chairman and chief executive, said.

While Mr Ettinger reassured on Hormel's long-term prospects, saying that the group was "very bullish about our future earnings potential", the profits warning sent its shares down 4.1% to $38.99 in early deals in New York.

The group, which does rear some of its own pigs, is known as one of the most reliable US corporations, having last month paid its 339th consecutive quarterly dividend, extending a record of unbroken payouts stretching back to 1928.

Pork vs hogs

The warning by Hormel follows a sharp rally in prices of hogs, which has prevented pork processors from exploiting a rise of more than $20 per hundredweight in 10 weeks in the meat's wholesale values, the so-called "cutout".

The $100.76 per hundredweight that the cutout averaged last week "is the sixth highest weekly average ever", trailing only those recorded during a strong period in July and August 2011, Paragon Economics and Steiner Consulting said in a report.

However, lean hog prices have proven strong too, with spot Chicago futures rising from a late-March low of 76.80 cents per pound ($76.80 per hundredweight) to more than 102 cents per pound on Friday.

The rise in hog prices has left meat processors swallowing losses despite the strong wholesale pork market, with packer margins on Friday falling to a negative $13.25 per animal.

'Margins remain large'

Commentators have mixed views of the sustainability of the hog price rally, which has been widely attributed to the strength of demand in the US, thanks to the onset of the summer barbecue season, typically traced to the Memorial Day holiday weekend, and to persistent rumours of a pick-up in Chinese imports.

Chinese pork imports have tumbled so far in 2013, thanks to curbs imposed by Beijing on meat from producers using the ractopamine growth stimulant commonly used in America.

However, many observers believe that the takeover of US-based Smithfield Foods by China's Shuanghui International is opening the way to a revival in trade.

In fact, Smithfield was this month due to guarantee ractopamine-free pork from a third processing plant.

Meanwhile, US hog slaughter rates, and therefore pork supplies, have fallen to 2013 lows, as the prospect of lower feed bills, assuming domestic corn and soybean harvests meet expectations, puts the brakes on herd liquidation.

"Forward margins [for producers] remain large," US Commodities said, adding that "this will equate to no liquidation and maybe even expansion".

Peak prices?

Broker Doane Ag, noting that best-traded August lean hog futures peaked a week ago, said that "the uptrend in hog prices stalled and turned just sideways on the short-term chart".

The broker flagged "ideas that holiday featuring has run its course and that the premiums for nearby futures compared to deferred futures is unlikely to be sustained".

US Commodities forecast that "we are nearing a peak in the pork cutout" which should feed through into hog prices, and noting that US Department of Agriculture forecasts imply an uptick in slaughter rates.

However, Paragon Economics and Steiner Consulting said that it was "likely that pork values and hog prices will remain strong for several more weeks.

"The cutout has peaked in early August, on average, over the past five years."

The "key question" was whether prices of pork bellies, the source of bacon, can maintain the rise which has seen them account for 80-90% of the rise in the overall cutout.

"It seems that bacon is everywhere these days, and we are just now entering the prime BLT sandwich season as fresh tomatoes will become available soon."

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Orange juice seen falling as rains improve growing conditions

By Jack Scoville


General Comments: Futures closed a little lower in consolidation trading. Futures have been working generally lower since the USDA crop reports last week as showers have been seen and conditions are said to have improved in almost the entire state. USDA lowered production of Oranges in Florida, but decreased production had been expected. Traders are wrestling with more reports of losses from greening disease on the one side and beneficial rains that have hit the state on the other. Greening disease and what it might mean to production prospects continues to be a primary support item and will be for several years. Temperatures are warm in the state, but there are showers reported somewhere in the state every day now. The Valencia harvest is continuing. Brazil is seeing near to above normal temperatures and mostly dry weather.

Overnight News: Florida weather forecasts call for showers. Temperatures will average near to above normal.

Chart Trends: Trends in FCOJ are mixed to down with objectives of 141.00, 133.00, and 130.00 July. Support is at 145.00, 144.00, and 139.00 July, with resistance at 150.00, 154.00, and 156.00 July.


General Comments: Futures were lower on what appeared to be long liquidation from speculators and perhaps some farm selling. Ideas of better weather in production areas were negative for prices. Traders talk of reduced production potential due to the poor weather seen until recently in the Delta and Southeast and still reported in parts of Texas. Trends are up. Ideas of good weather for US crops are still around. The weather has improved, but it is still too dry in Texas and drier weather is needed for the Delta and Southeast. Scattered showers are forecast for the Delta and Southeast, and wetter and warm weather is expected in Texas. Weather for Cotton appears good in India, Pakistan, and China. It is possible that futures made at least a short term high on Friday.

Overnight News: The Delta and Southeast will see some showers this week. Temperatures will average above normal. Texas will get showers today and tomorrow, then dry weather. Temperatures will average above normal. The USDA spot price is now 84.42 ct/lb. ICE said that certified Cotton stocks are now 0.543 million bales, from 0.539 million yesterday.

Chart Trends: Trends in Cotton are mixed to down with no objectives. Support is at 86.75, 85.60, and 84.75 October, with resistance of 90.10, 90.50, and 91.40 October.


General Comments: Futures were mostly a little lower in quiet trading. Interest has left the market in many ways, as many feel prices are too low to sell short again, but there are few who see any reasons to buy for the longer term. Arabica cash markets remain quiet right now and roasters in the US are showing little interest in buying. There is talk of increasing offers of Robusta from producers as they apparently did not sell when prices were much higher. Most sellers, including Brazil, are quiet and are waiting for futures to move higher. Buyers are interested on cheap differentials. Brazil weather is forecast to show dry conditions, but no cold weather. There are some forecasts for cold weather to develop in Brazil at the end of this week. Current crop development is still good this year in Brazil. Central America crops are seeing good rains now. Colombia is reported to have good conditions.

Overnight News: Certified stocks are little changed today and are about 2.746 million bags. GCA stocks are 5.147 million bags, from 4.867 million last month. The ICO composite price is now 116.04 ct/lb. Brazil should get dry weather except for some showers in the southwest. Temperatures will average near to above normal. Colombia should get scattered showers, and Central America and Mexico should get showers, with some big rains possible in central and southern Mexico and northern Central America. Temperatures should average near to above normal.

Chart Trends: Trends in New York are mixed to down with objectives of 116.00 July. Support is at 121.00, 119.00, and 116.00 July, and resistance is at 125.00, 127.00, and 130.00 July. Trends in London are mixed to down with objectives of 1765 July. Support is at 1700, 1680, and 1650 July, and resistance is at 1750, 1780, and 1810 July. Trends in Sao Paulo are mixed to down with no objectives. Support is at 147.00, 144.00, and 140.00 September, and resistance is at 151.00, 155.00, and 159.00 September.


General Comments: Futures closed higher on what appeared to be follow through short covering from speculators. The market has made a bottom and is now reaching for its targets in the recovery. Everyone talks about the big supplies, but reports of renewed demand interest helped rally the market again yesterday. July was higher as short speculators start to pull out of positions before the contract stops trading at the end of the month. There was no other real news for the market. Traders remain bearish on ideas of big supplies, especially from Brazil. Traders in Brazil expect big production as the weather is good. However, some say that the market has traded on big supplies for a long time now and deserves to rally for at least the short term. Demand is said to be strong from North Africa and the Middle East.

Overnight News: Showers are expected in Brazil, mostly in the south ad southwest. Temperatures should average near to above normal.

Chart Trends: Trends in New York are up with objectives of 1730 October. Support is at 1680, 1665, and 1650 October, and resistance is at 1730, 1760, and 1790 October. Trends in London are up with objectives of 495.00 October. Support is at 477.00, 472.00, and 469.00 October, and resistance is at 487.00, 491.00, and 494.00 October.


General Comments: Futures closed lower on what appeared to be a lot of follow through speculative selling. There was not a lot of news for the market, and price action reflected this. Ideas of weak demand after the recent big rally kept some selling interest around. The weather is good in West Africa, with more moderate temperatures and some rains. The mid crop harvest is moving to completion, and less than expected production along with smaller beans is reported. Malaysia and Indonesia crops appear to be in good condition and weather is called favorable.

Overnight News: Scattered showers are expected in West Africa. Temperatures will average near to above normal. Malaysia and Indonesia should see episodes of isolated showers. Temperatures should average near normal. Brazil will get mostly dry conditions and warm temperatures. ICE certified stocks are lower today at 5.067 million bags. ICE said that 4 delivery noticies were posted today and that total deliveries for the month are 68 contracts.

Chart Trends: Trends in New York are down with no objectives. Support is at 2200, 2165, and 2140 September, with resistance at 2250, 2280, and 2300 September. Trends in London are mixed to down with objectives of 1380 and 1270 September. Support is at 1430, 1360, and 1320 September, with resistance at 1520, 1570, and 1600 September.

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Bonds Versus Stocks - Just Ask Japan

by Lance Roberts

The great "bond bull market" is dead.

Interest rates are rising on expectations of stronger economic growth ahead.

The "great rotation" from bonds to stocks is afoot.

These are all statements I have heard being made over the last month as 10-year interest rates went on a surge from deeply oversold levels to grossly overbought levels during that time span. The question, of course, is whether the stock market continue in its current bull market trajectory in the face of higher interest rates? Today's chart of the day is an overlay of the 10-year treasury rate and the S&P 500.


I have noted several things of importance in the chart above:

  • The vertical dashed lines denote when rising interest rates either led to a correction in asset prices or an economic recession.
  • I have noted major events for a chronological perspective.
  • The secular bull market of the 80-90's was spurred by falling interest rates and inflationary pressures which boosted corporate profitability. With the markets valued at roughly 7x earnings with a near 6% dividend yield the markets were primed for credit expansion fueled stock market boom.
  • I have noted (red circle) the recent "surge" in interest rates for some perspective. While the recent rise has certainly gotten the markets attention as of late; from a historical perspective we are still well within the confines of the current long term downtrend.
  • I have also noted the similarity between the secular bull market in the 60-70's versus 2000 to present. The breakout to "all time" highs is not necessarily an indication of the beginning of new "secular bull market". With valuations currently 19x earnings on an trailing reported basis, earnings growth peaking for the current economic cycle and sub-par economic growth rates; the fundamental backdrop for a continued bull market from current levels is not available.

The "bull case" for the continued run in equities has been built around the continuation of monetary interventions from the Federal Reserve and a near zero-interest rate policy. However, if interest rates begin do begin to rise in earnest the fundamental backdrop changes dramatically:

  • People buy "payments" rather than houses. Therefore, the much vaulted support from the sub-3% contribution from housing to the economy will dissipate rapidly as demand slows and prices fall to find buyers.
  • Mortgage refinancing activity will slow to a stop. (Who refinances to higher mortgage payments)
  • Higher interest rates make speculative home buying much less attractive.
  • Personal consumption expenditures (which make up nearly 70% of GDP) will be negatively impacted as the rising costs of variable rate credit lowers discretionary incomes.
  • Corporate earnings will decline as higher borrowing costs impact profitability.
  • Corporate capital expenditures will slow as higher borrowing costs reduce the attractiveness of returns on new projects.
  • Markets will be negatively impacted as higher leverage costs reduce profitability.
  • Corporate bond issuance will slow sharply as borrowing costs surge.
  • "Junk Bonds" will come under duress as higher interest rates sap funding for troubled companies leading to defaults and bankruptcies.
  • Highly indebted municipalities are likely to be "shut out" of the municipal bond markets to obtain funding leading to defaults (i.e. Detroit)
  • Higher interest rates will blow a massive hole in the CBO's government budget and deficit forecasts.

The list goes on but you get the idea. The impact of substantially higher interest rates are not good for the economy or the financial markets going forward. In the short term consumers, and the financial markets, can withstand small incremental shifts higher in interest rates. There is clear evidence historically to suggest the same. However, sustained higher, and rising, interest rates are another matter entirely.

However, before you get to excited, look back at that red circle in the lower right corner of the chart above. It is important to keep in perspective the recent "surge" in interest rates that has gotten the market's attention as of late. In reality, this is nothing more than a bounce in a very sustained downtrend. Is the bond "bull market" extremely long in the tooth? You bet. Does that mean that interest rates are set to surge higher in the near future? No.

While there is not a tremendous amount of downside left for interest rates to go currently - it also doesn't mean that they are going to substantially rise anytime soon. Weak economic growth, an aging demographic, rising governmental debt burdens and continued deflationary pressures can keep interest rates suppressed for a very long time. Just ask Japan.

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Pessimism Creates Buying-on-the-Dip Opportunity

By Rodney Hobson

Rodney Hobson had felt it was difficult to find opportunities in the UK stock market, but the recent reaction to economic news has allayed his concerns.

Back to Front
Markets have taken fright at the prospect of various governments, most notably in the United States, bringing economic stimulation to an end. This should be a cause for rejoicing and the latest falls in the London stock market present a buying opportunity that I feared might not occur until much later in the year, if at all.
It is a well known phenomenon that the same economic measure can have opposite effects on the stock market at different times. If a government takes measures to help the economy, that can be taken either as a signal that things will start to get better or a warning that the economic situation is worse than we thought.
Similarly when the government tightens up, that can be taken to mean either that things are getting better or that we should all start to batten down the hatches. The problem is that you never know how market sentiment will react to the news.
Hints that the US government will let its economic stimulus program tail off later this year, plus the reluctance of the Bank of England’s monetary policy committee to indulge in more quantitative easing, has caused a sharp fall in the FTSE 100 index. The inability of the European Central Bank to come up with any new ideas on ending recession and severe unemployment on the Continent has made matters worse.
Let us take them one by one. The reaction of markets to developments in the US is, in my view, particularly irrational. The US economy has come out of the financial crisis reasonably well, indeed exceptionally well considering that it all started with the collapse of the US housing market and the stand-off in Washington between Republicans and Democrats rumbles on.
We should be pleased that the Fed feels it is now in a position to let the US economy stand on its own two feet. The sooner that happens, the less difficult and painful it will be to unwind all the support dished out so far. In any case, the Fed is not proposing a sudden lurch from one extreme to another but a gradual tapering of economic stimulus, sensibly weaning the economy off its life support.
Similarly, the sooner the MPC brings quantitative easing to an end in the UK the better. Its reluctance to indulge in more buying of gilts reflects a belief that the economy is improving, albeit slowly. Latest indications of growth in services, manufacturing and construction support this view.
The eurozone is the most problematic area. As a whole, the continuing recession on the Continent is far worse than in the UK (new readers please note, I do not accept the ludicrous notion that a recession is two consecutive quarters of contraction and that one quarter of growth ends recession). While it is worrying that the ECB feels unable to do anything more at this stage to rescue the situation, I take a little comfort from the absence of any rash, knee-jerk measures. At least the ECB has been able to put off panicking for another month.
I believe that the fall in share prices has more to do with the fact that the bull run this year had gone too far and that good value was becoming very difficult to spot. The latest setback is merely an overdue correction waiting for an excuse to happen. I still have part of my ISA entitlement for this year to invest and was despairing of finding an opportunity. Shares have become worth buying again.

Spare Us the Truth
The truth always hurts more than lies. The IMF has declared that the rescue of Greece was more about saving the euro than about saving the Greek economy. Whoever thought it was otherwise?
This speaking of the unthinkable has naturally provoked outrage in Brussels because it comes uncomfortably close to the truth. There are many criticisms that can be launched against the European Union, and I have mentioned quite a few in this column over the years, but you cannot fault the EU on its determination to defend its dreams.
That is one reason why I remain reasonably optimistic that, in the short to medium term, there is little likelihood of the eurozone falling apart with the disruption that would inevitably cause.

Testing Times
News that AstraZeneca (AZN) is shelving a treatment for rheumatoid arthritis following disappointing trial results is a warning of the dangers of investing in pharmaceutical companies. Look at the share price table and you will see little evidence of decent yields in the sector, while price/earnings ratios are generally alarmingly high.
It is true that an ageing population should increase the demand for drugs but there are many hurdles for drugs to overcome before they are accepted and, at the other end of their lives, the most successful ones come under attack from generic copies.
Astra shares had almost reached an all-time high above £33 before falling back this week. The surprise to me is that the reaction was so mild, presumably because projected sales of the drug were less than 1% of forecast sales so the blow is not seen as too heavy.
Even so, I feel that Astra is overvalued. Sales and profits fell last year and are projected to continue on a downward path this year and possibly next. It is more lowly rated than GlaxoSmithKline (GSK), a key component of my portfolio, and rightly so. Glaxo has moved into consumer healthcare as a backstop in case its drug development programme falters. Astra has no such fallback.

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