GOLDMAN SACHS: THE TREASURY BULL RUN IS OVER

By Min Zeng

• Goldman’s Garzarelli says yields will rise as the U.S. economy picks up speed in the second half
• Garzarelli expects Treasurys to post 5% losses in the second half
• Garzarelli recommends short positions on five-year notes

This week’s heavy selloff in U.S. Treasurys has prompted Goldman Sachs, one of the biggest Treasury bond dealers, to declare that the months-long bull run is dead.

“We think the rally is over,” Francesco Garzarelli, chief interest-rate strategist in London at Goldman Sachs Group Inc., said in an email interview with Dow Jones Newswires on Thursday. Goldman has long held to the view that Treasury prices would fall over the course of this year.

This past week, the Treasury market has sold off in each trading session. The benchmark 10-year note’s yield, which moves inversely to its price, has surged more than 30 basis points to 3.151% Thursday from a six-month low of 2.842% on Monday.

The main triggers for the end to a rally that started in early April were associated with events that reduced the risk of default by Greece, including the crucial passage of necessary austerity measures by the country’s parliament. This prompted investors to rotate out of safe-haven Treasurys and into stocks.

Some stronger U.S. data, such as Thursday’s business outlook index for the Chicago region, added to these trends by boosting the view that the U.S. economy could pick up speed in the coming months, after a soft patch in the first half.

Garzarelli said Treasury yields will rise as he expects the economic numbers to improve in the third and fourth quarters, while U.S. inflation excluding food and energy–a measure closely watched by the Federal Reserve that has been ticking up in recent months–will hold to its higher levels.

Garzarelli said Goldman Sachs expects the U.S. economy to grow at an annualized rate of 2% in the second quarter and accelerate to 3.25% in both the third and fourth quarters of 2011.

In a monthly report, Garzarelli predicted the total returns on U.S Treasurys at negative-5% for the second half, while German bunds–another safe-haven asset–would post a loss of 3%.

Even as Treasurys rallied and yields fell in prior months, Goldman stuck to its forecast for the U.S. 10-year yield to rise to 3.75% by the end of the year while other major dealers reduced their end-2011 yield projections.

Garzarelli recommended clients short the five-year Treasury note in expectation that it will decline in price. That note has been one of the best performing maturities in the Treasury market in recent weeks.

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QE2: Was it Worth It and Will There be a QE3?

by DailyFX

On June 30, 2011, the Federal Reserve’s second round of Treasury bond buying, informally known as quantitative easing, or QE2 ended. With a QE3 program unlikely to occur, this marks the completion of an eight-month window in which the Federal Reserve purchased $600 billion worth of assets in an attempt to add liquidity to the market, and thus, stimulate the U.S. economy.

After two rounds of bond buying, public confidence in the future of the economy has weakened and the effectiveness of QE2 is being questioned. Meanwhile, as pessimism continues to grow among Americans over concerns of a double dip, if not continuation of the recession into perhaps a depression, many are left to wonder if the Fed has any monetary tools remaining to spark the economy, after devaluing the U.S. Dollar so drastically. So, the question arises: was quantitative easing worth it?

In November 2010, the Fed announced the need to commence a second round of bond-buying to lower long term interest rates to boost the economy. With $600 billion stated to be purchased, the primary goals of QE2 were: decrease the unemployment rate; and ensure that the inflation rate remains close to 2.0 percent. Eight months later, although QE2 contributed to a rebound in the equities market, on a nominal basis, and boosted inflationary pressures slightly, the long-term outlook for the U.S. economy remains bleak as the Federal Reserve still faces low price pressures and a stubbornly high unemployment rate.

Some have argued that the United States has benefited from a weaker U.S. dollar, with many countries, including China, noting that they are being affected by Dollar weakness, seeing a decline in competitiveness; a weaker dollar makes U.S. goods more attractive to foreign investors. In fact, since late August, when Federal Reserve Chairman Ben Bernanke announced the possibility of a second round of monetary easing, the U.S. Dollar has been down against every other major currency, falling the most against the Swiss Franc (-20.93%), the Australian Dollar ( -17.67%) and the New Zealand Dollar (-16.33%).

While most signals pointing to an unsuccessful implementation of the $600 billion bond purchases, there are indications that QE2 met several of its objectives. The Fed maintained low interest rates on Treasuries. Commodities and equities were well supported by the program. All the major indexes enjoyed formidable gains dating from the fourth quarter of 2010 to the second quarter of 2011.

At its most recent conference on June 22, 2011, the Fed announced that its bond-buying program will not continue. However, the Fed expects to maintain its interest rate at 0.25 percent for “an extended period,” which Chairman Bernanke has noted would be for atleast two or three more meetings.

So, what are the implications from a trading perspective?

Prepared by Jamie Saettele, CMT

2 yr Treasury yields ended the quarter down about 16% (from .5481 to .4616) from when the Fed announced the bond purchasing program in late August of 2010. Just last week the yield on 2 yr Treasuries was down 40% (at .3290). However, in February, 2 yr yields were up over 50% from the time of the bond purchasing announcement. As such, hailing the Fed’s actions as the reason for the decline in 2 yr yields is dubious.

If the Fed’s program exerted so much control over short term credit, then why didn’t yields consistently decline throughout the period of bond purchases? The bottom line is that 2 yr yields have been under pressure since April (which is when the Yen crosses topped…not a coincidence) but the sharp turn from last week’s low gives scope a double bottom with the October low. If 2 yr yields continue higher, then look to the USDJPY as a way of expressing your opinion (next chart). By the way, 10 yr and 30 yr treasury yields increased roughly 16% and 20% on a net basis. In general, longer dated maturities are less affected by Fed policy and more indicative of inflation expectations.

Prepared by Jamie Saettele, CMT

The relationship between the USDJPY and 2 year Treasury-JGB differential is clear. If the interest rate differential has found a low (triple bottom), then the USDJPY is most likely headed higher as well.

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The Dollar Speaks While Gold, Silver, Oil, & the S&P 500 Listen

by J.W. Jones

Investors and traders alike were watching the action unfold across the pond earlier this week. It was seemingly a foregone conclusion that Greece would get the bailout they desired in order to prevent a potentially catastrophic default. The Greek default situation increased volatility in financial markets around the world. In addition to the Greek dilemma, the end of the 2nd quarter and the customary window dressing by institutional money managers only heightened the volatile situation.

For the past week or so I have been sitting in cash, watching the price action and waiting for setups that have defined risk and solid rewards. With the heightened volatility I did not want to get involved because a trade in the wrong direction would wreak havoc with my portfolio. As this week evolved, the validity of those concerns was unquestionable.

Commodity investors have faced some tough price action recently as gold, silver, and oil have traded significantly lower quickly. Now that we have witnessed some heavy selling pressure set in particularly in the silver and oil markets investors want to know where price is heading in the short term.

U.S. Dollar Index

For the past several months I have been monitoring the U.S. Dollar Index futures in order to gauge the price action in commodities and the S&P 500. The Dollar is currently trading at a key support level and the price action in coming days will be telling. While I do not trade solely on analysis pertaining to the Dollar, I do look for setups where an underlying is dramatically impacted by its price movements.

When the planets align, I will take a trade with a directional bias that is supported by the price action in both the underlying that I’m trading and the U.S. Dollar’s price action as well. At this point in time, the U.S. Dollar Index is trading right at a key support level marked by the 20 & 50 period moving averages as well a recent low. The daily chart of the Powershares U.S. Dollar Index Bullish Fund $UUP is shown below:

UUP Daily Chart

Gold & Silver

The recent bounce higher in the U.S. Dollar has been a factor in pushing gold, silver, oil, & the S&P 500 lower. Silver and oil were impacted in the harshest manner, but all four asset classes were negatively impacted. Precious metals tend to weaken during the summer and then pick back up in the fall. However, the selloff in silver the past few months has been breathtaking. For precious metals bulls who entered silver late in the rally the only outcomes were dismal. Late comers to the silver bull market were either stopped out or are currently experiencing significant pain.

While I remain a longer term bull as it relates to precious metals, in the short term I expect lower prices to continue. A major factor in my analysis stems from a longer term standpoint; the U.S. Dollar has likely put in an intermediate to long term low. There are a variety of reasons as to why, but suffice it say that from a market cycle standpoint the Dollar has likely achieved a major low and a reflex rally is likely.

Issues in the Eurozone are far from over and as time passes I expect the impact of fiscal issues rising in countries like Ireland, Portugal, and Spain to have a major impact on U.S. Dollar prices. If the sovereign fiscal issues in Europe result in a default or even a more mild technical default, the impact will likely be bullish for the U.S. Dollar.

The daily chart of the SPDR Gold TR ETF $GLD and the Ishares Silver Trust $SLV shown below illustrate the key areas which may be tested before the bull market in precious metals continues:

GLD Daily Chart

SLV Daily Chart

I am of the opinion that if precious metals investors are patient an outstanding buying opportunity will present itself in both gold and silver in weeks ahead. Looking at the daily chart of the two shiny metals and identifying key levels that make sense to acquire positions is important in the trade planning process.

I like to have a trading plan in place should my expectations unfold because it removes emotion from my trading. Planning a trade and trading a plan are extremely helpful when investing in volatile markets like silver and gold. In the longer term, I continue to believe that gold and silver will shine, but in the short term more price weakness may be ahead.

Crude Oil

I am a long term gold and silver bull, but the single asset class that I am the most bullish about is energy. Oil prices in the long term have only one direction to go – HIGHER. I realize that a slowdown in the economy will put downward pressure on oil prices, but as the world’s demand for oil increases and the supply level plateaus or decreases oil prices will be forced higher. If the Dollar does rally as I expect, oil prices would likely be negatively impacted and a buying opportunity would be forged.

The daily chart of the United States Oil Fund ETF $USO is shown below with my future price expectations and current key price levels illustrated:

Oil Daily Chart

S&P 500

The S&P 500 is in a very tricky spot for traders. Right now price action is testing the underbelly of a major descending trendline on the daily chart shown below:

SPX Daily Chart

However, if we take a look at a weekly chart note the massive head and shoulders formation that many traders have totally missed. A rally to the S&P 500 1,340 price level would complete the pattern. While head and shoulders patterns have failed several times in recent history, this is a major head and shoulders pattern on the weekly chart which holds more credence than shorter time frames such as the hourly or even the daily charts. The weekly chart of SPX illustrates the head and shoulders pattern.

SPX Weekly Chart

In the short run I think the S&P 500 can work higher, but if I’m right about higher prices for the U.S. Dollar in the future I expect to see much lower prices in the S&P 500 in the intermediate term, particularly if the weekly head and shoulders pattern plays out. If the S&P 500 struggles to breakout above key resistance levels, I will be of the opinion that the bear may have stopped hibernating and an impending recession may be thrust upon us in short order. There are signs pointing in that direction, but right now it remains too early to call.

Conclusion

In closing, my analysis reveals that the U.S. Dollar is poised to push higher, particularly if current support holds. If the Dollar can push above key resistance levels overhead, I expect the resulting price action in gold, silver, oil, & the S&P 500 to be dismal for the bulls.

I will be watching the Dollar closely looking for clues about price action. If I’m wrong and the Dollar breaks to new lows I would expect a massive rally in precious metals, energy, and domestic equities. With the recent price action that we have seen in the U.S. Dollar, I find it much more likely that the U.S. Dollar extends higher in coming weeks. As usual, time will tell.

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THE GREAT “COLLAPSE” IN U.S. TREASURY BONDS

by Cullen Roche

The “surge” in yields this week has many pointing to the end of QE2 as the beginning of the awakening of the bond vigilantes or even the beginning of the collapse of the mythical “bond bubble”. But I went to find this “surge” in yields or “collapse” in the bond market and I had to pull out the trusty magnifying glass again. As you can see below, Treasury yields are surging so much that you have to magnify the move by 10X just to see it on a long-term chart.

More hilarious is the fact that yields aren’t surging due to some bond vigilantes or fears that we are Greece as some fret over the debt ceiling. Yields are surging at the same time equities surge, the risk on trade re-emerges and investors realize that the end of QE2 doesn’t mean the end of the world (most hyperinflationists still have no idea why this is even hilarious).

Just one week ago I said this was no time to panic about Greece, debt ceilings or even the macro picture (yet):

“Personally, I don’t think we need to panic just yet. The China slow-down is far from overshooting to the downside and the Europeans simply can’t afford to let the situation spiral out of control. There is too much to lose. The European politicians have invested too much time and money into this Euro project to allow it to just crumble now. China is a much bigger question mark. Their economy is a black box of central planning and irrational government intervention. One thing is certain – inflation almost always resolves itself in the form of recession.

The question now is how deep will the Chinese economy slide and how much will it hurt US corporations? I think buy and hold investors are silly to wait around and find out. In the meantime, I think the markets look more attractive than they did in May when I said we should all be hedging risk and/or selling.

…So, while I was bearish a few weeks ago I have moved towards a more bullish posture now. So, just to be clear, I am not long-term bullish, but I am short-term bullish.”

Investors were overreacting to all the bad news and becoming excessively negative. This week’s very tiny move in yields is not a sign of the end of days. It’s just a sign that too many big ____ swingin’ bond traders got caught flat footed. So put that magnifying glass away and wipe off your forehead. This is as much a non-event as the end of QE2.

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Predictable Surprises

by Chris Pavese

The way we see it is quite simple. With every investor and every company in the world seeking exposure to China and betting on continued and unabated Chinese growth, what happens if they are wrong? Is it at least worth having some insurance in the portfolio to hedge against the risk of being wrong? If nothing else, we recognize that we are sometimes (often) wrong! GMO’s James Montier recently shared the following thoughts with investors:

“Thinking about fundamental risk also reduces the “black swan” element of investing. Nassim Taleb defines a black swan as a highly improbable event with three principle characteristics: 1) it is unpredictable; 2) it has a massive impact; and 3) ex post explanations are concocted that make the event appear less random and more predictable than it was.

“It should be noted that some black swans are a matter of perspective. Rather than genuine black swans, most financial implosions are the result of “predictable surprises” . . . Like black swans, predictable surprises have three characteristics: 1) at least some people are aware of the problem; 2) the problem gets worse over time; and 3) eventually the problem explodes into a crisis, much to the shock of most.

“The nature of predictable surprises is that while uncertainty surrounds the details of the impending disaster, there is little uncertainty that a large disaster awaits.”

China’s debt-fueled speculative bubble is likely to be yet another victim in a long list of predictable surprises. As we discussed in a Cautionary Fable last year, forecasting the timing of such trend changes is always a challenging (and frustrating) exercise. But just because the timing is questionable doesn’t mean the risks should be ignored. More often than not, investors are rightly focused on the odds that circumstances turn negative. But every so often, it is much more important to consider the consequences of these low probability events. With so many believers in today’s Chinese growth miracle and China’s path to world dominance so obviously clear, risks to the downside are not immaterial, yet insurance to hedge against such a risk is almost free.

Consider that China's local government debt load has increased by 36 times in nominal terms and five times relative to GDP since 1997. In just the last three years, total liabilities of local governments have mushroomed from 17% to 27% of GDP based upon the State Council's Audit Report. With more than 80% of those borrowings going to infrastructure, it's difficult to imagine that the return on investment for each additional project has not declined. Aggravating this debt load, about one quarter of it is promised with land sale revenue, making today's real estate bubble even more detrimental to the command economy. Defaults are already happening, even with economic growth rates hovering near 10%. According to Reuters, China's regulators plan to shift 2-3 TRILLION yuan off local government balance sheets - a massive bailout that is multiples of TARP relative to China's GDP. With monetary conditions in China now tighter than the 2007-2008 peak and a global economy much more fragile today, we wonder how fast this number will increase once slowing credit actually stalls economic growth. Consider that in 1999, after borrowing and binging through the 80s and 90s, the NPL ratio of the Big 4 Banks was a massive 39% or roughly 20% of China's GDP from 1988 to 1993. For China, this was a huge sum of money, equivalent to 25% of foreign reserves at the time. Contrast that with the banks current "reported" NPLs near 1% . . . and consider that Fitch reports bad loans could rise to 15% to 30% of assets.

Consequently, we think a small investment today can serve as an effective hedge on a much larger portfolio, in case the global economy’s locomotive hits a speed bump along the way. That being said, we are much more comfortable taking larger positions when we can say with confidence, “This is going to happen.” I’m not sure I can say that with confidence about a yuan devaluation, but I can say that the odds are currently much higher than what Mr. Market is offering today. Aussie housing is one of those "near certainties," with or without a Chinese hard landing. And it appears that the risk in the Australian property market has elevated sharply over the past year. Part of this may be attributable to the slow-down in China. Part of it may be attributable to the Australian banks’ reliance on European financing. Or it may simply be bursting under its own weight, with a little help from the RBA and higher rates. Whatever the cause, the evidence is right in front of anyone who cares to look.

Gold Coast beachfront values have plunged by as much as 50 percent since the peak of the boom in 2008, states The Australian Newspaper Online. We are beginning to see signs of the “blame game” emerging even as we are very early into the expected decline in property prices – check out the collapse of Ray White Broadbeach. Despite claims of a “housing shortage” which is typical of just about every housing bubble, Real Estate Institute of WA president Alan Bourke said that there were now thousands more properties on the market than needed to meet demand. Meanwhile, real estate agents are cutting their sales commissions to compete for fewer buyers – some below one percent. Major banks have warned that loan arrears have increased, real estate data shows house prices in affluent suburbs have fallen more than the overall market and new loans have dropped sharply. High-income earners are also experiencing mortgage problems but nobody is talking about it – they are financially overstretched and quietly making lifestyle changes, deleveraging and selling investments to reduce loans and other debt, and avoiding unwanted public attention they would have if they had to foreclose on their mortgage.

Coming back to China, the 1880s – 1890s boom provides an interesting parallel. In 1890, more than half of Australia’s exports went to Britain, with wool making up the majority. This concentration of exports was a critical vulnerability then, as it is now. Today, Australia’s exports are again dominated by commodities (iron ore) and its future is almost entirely tied to its largest customer, China. That said, the magnitude of the housing boom in the 1880s is dwarfed by what we’ve seen in the past two decades – where prices have more than doubled in real terms versus a gain of a third the first time around.

Then, the withdrawal of foreign capital served as a catalyst for recession, credit crunch and price declines. Today, Australian banks find themselves in an eerily similar position – almost entirely reliant on foreign funding (chart below from RBA), which Moody’s recently cited as they downgraded the major banks. “With the domestic economy increasingly biased to the commodity sector, terms of trade that are exceptionally favorable by historical standards, and high asset prices, there is a potential for confidence shocks to impact the bank’s access to funding.” We believe slowing Chinese demand will be a catalyst for an abrupt reversal in Australia’s terms of trade, likely followed by a collapsing currency, vanishing foreign capital and significant stress on the banking system. Aussie bank CDS look very cheap relative to global peers. The sovereign looks even cheaper when one considers the potential cost of a bank bail-out.

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Swiss Franc and the possibility of huge mortgage defaults in Central Europe

by the trader

It was really easy getting that mortgage in Hungary, and the best of all, denominated in Swiss Francs, so the interest rate was low. Such a great plan, if it wasn’t for that currency risk. Ordinary people don’t think in such terms, and definitely did not hedge that exposure. With the ever increasing strength in the Swiss Franc, people with mortgages in Swiss Francs are starting to feel the currency effect big time. Since such a big proportion of the mortgages are taken out in non domestic currencies, people are squeezed. Could the Swiss Franc increase the debt repayments of the mortgages, and ultimately cause huge defaults in these countries? Exotic Currency risk by retail…..Courtesey Stratfor;

Historically low interest rates on loans in Swiss francs have led consumers in major Central European countries such as Poland, Slovakia, Hungary and the Czech Republic to acquire substantial loans, particularly mortgages, in francs. Currently, 53 percent of outstanding mortgages in Poland and about 60 percent of those in Hungary are denominated in francs.

The franc’s perceived stability amid growing eurozone troubles has strengthened it considerably in comparison to the euro and Central European currencies. This is not only worrisome to the consumers in the countries with significant franc-denominated debt, who now struggle to service their increasing debt load, but also for financial institutions that hold significant assets in Central Europe, such as that of Austria.

While new homeowners in Poland and Hungary have shied away from franc-denominated loans since the franc’s strengthening in the wake of the beginnings of the eurozone sovereign debt crisis in early 2010, the franc has traditionally been considered a stable currency with low associated interest rates and therefore a good alternative to the euro. The majority of Polish and Hungarian mortgage purchasers before 2008 took out their loans in francs at a time when, due to the economic dynamism of the emerging Polish and Hungarian economies, the zloty and forint were relatively strong in relation to the Swiss franc. The franc traded for 160 forints before the crisis; it currently trades for 224, a 40 percent increase. Similarly, the franc traded for 2.1 zlotys in July 2008 before jumping 57 percent to currently trade at 3.3. Moreover, the fluctuation in the zloty or forint value of the Swiss-denominated loan proportionally increases the debt repayment value. The compulsory nature of making a mortgage payment (the failure to pay one’s mortgage will eventually result in losing one’s home) means that debtors are unlikely to default despite the increase in monthly mortgage payment value. However, debtors are also likely to drastically cut all other spending when faced with the risk of default, thus undercutting domestic consumption — a major driver of the Polish economy in particular.

The situation is not necessarily as alarming as some reports from Poland and Hungary claim. Central European governments have begun implementing stabilization measures to reduce the risk to mortgage owners. The Hungarian parliament approved a legislative package June 10 that included fixing the exchange rate on franc-denominated mortgage repayments at 180 forints. Hungary is also considering implementing a program that would buy back a defaulting property and take in its owners as tenants. Poland has thus far taken a passive role on the issue but has declared itself willing to intervene should mortgage defaults become imminent. Moreover, Switzerland itself has an incentive to devalue its currency, mainly to ensure that its large export sector remains competitive. To a certain extent, the Swiss government can mitigate the rise of the franc by purchasing foreign currency, particularly euros, driving down the demand for francs. The problem is that Switzerland has already been undertaking such an effort since the start of the eurozone crisis and yet the franc has still appreciated considerably.

However, a major economic event in the eurozone — such as a Greek default, Spanish banking problems, or the brewing political crises in Italy and Spain — could cause the franc to skyrocket in relation to both the euro and currencies such as the zloty and the forint. Such an increase could be so large that even the Hungarian and Polish governments would be unable to avoid massive domestic defaults on mortgages and Switzerland would be powerless to offset its strengthening currency. Homeowners with mortgages denominated in Swiss francs would find themselves unable to repay the value of the appreciated loan in their domestic currency and would be forced to default.

This certainly would not bode well for Europe, especially Austria. The 2008 financial crisis started in Europe when the collapse of Lehman Brothers triggered a massive capital flight away from Central Europe, and a mortgage crisis in Hungary or Poland could potentially replicate these triggers, leading to contagion across the Continent. Austria, particularly susceptible to contagion emanating from Central Europe, could act as the gateway for the crisis into the eurozone. The Austrian financial sector would have to incur these losses, potentially forcing Vienna to bail out its banks, focusing the markets and investors on Austria itself.

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