Price Action

In Don Coxe's latest and typically excellent letter, "All Clear?", he highlights the opportunity in precious metals mining companies: "If there were one over-arching theme at the BMO Global Metals & Mining Conference, it was that the gold miners are upset and even embarrassed that their shares have so dramatically underperformed bullion...  "On the one hand, they were delighted in 2011 when it was reported that since Nixon closed the gold window, a bar of bullion had delivered higher investment returns than the S&P 500 for forty years-- with dividends reinvested. But some gold mining CEOs find it an insult that what they mine is more respected than their companies' shares...  "In our view, we have entered the most favourable era for gold prices in our lifetime, and the share prices of the great mining companies will eventually outperform bullion prices." As Don Coxe makes clear, governments are running deficits "beyond the forecasts of all but the hardiest goldbugs five years ago; central banks are printing money and creating liquidity beyond the forecasts of all but the most paranoid goldbugs a year ago." The choice for the saver is essentially binary: hold money in ever-depreciating paper, or in a tangible vehicle that has the potential to rise dramatically as expressed in paper money terms.

Short term, the bulls will probably remain in control. 

For the third day in a row (equal most for the year), stocks fell, led by the broad high-beta sectors (as one would expect) with energy (suffering as WTI lost almost 2%), materials, industrials, and financials all down notably (with the majors dominating weakness in the financials - though still up significantly post-JPM-divi). Futures and cash volumes picked up from yesterday - nearing their average year-to-date but average trade size fell further equaling the lowest year-to-date. With the China news (and then Europe), it was AUD and JPY that dominated price action as JPY strengthened and AUD weakened leaving the USD tracking the EUR and ending very modestly higher on the day. Commodities faced another day of torment with Silver underperforming. Gold outperformed but was down on the day still as from mid-afternoon, the commodity complex crept higher as the USD stabilized.  Broadly speaking risk assets (CONTEXT) led the equity market lower into lunch and then stabilized this afternoon - holding stocks off from further deterioration. An up-day for HYG (the high-yield bond ETF) - seemingly on the back of HY-HYG arbitrage more than asset rotation - and the craziness in the vol complex (VXX vs TVIX) somewhat supported SPY on the day but we note that ES (the S&P 500 e-mini futures contract) was unable to break above its VWAP meaningfully the entire day. Treasuries sold off from early in the US day session but only very marginally as 30Y remains -4bps on the week while the rest of the curve is unch to 1bps lower in yield only.

As the rumor (and denial) of the potential release of the SPR washed out Crude and Brent prices last week, only to recover within 24 hours, we wonder if this was all the bang for the buck that these kind of pre-announcements will get. With the majority of crude reserves based in the US and product reserves based in Europe and spare capacity falling as OPEC picks up production even as Iran backs off, Morgan Stanley notes that the maximum stocks drawdown of the SPR in month 1 could average 14.4mmb/d (10.4mmb/d  of crude and 4.0mmb/d of products) which is enough to mitigate flows passing through the Strait of Hormuz (according to the IEA). However with only 90 days of cover at these rates, it is hardly the 'solution' to even the briefest of geopolitical disruptions. This perhaps explains the price action of previous SPR announcements, which varies by crude benchmark, but holds prices lower for a maximum of two weeks. Most notably, the greatest price drops on the SPR announcement tend to occur in the first 2-3 days at which point the term structure starts to increase once again. Louisiana Light tends to be hit the most followed by Brent and then WTI but the rebound is just as aggressive and we wonder if last week's rumor was merely a strawman to see just what impact was possible (we dropped 2-3% or so) and recovered rapidly compared to the 4-5% drop in June during the Arab Spring release (which was the largest release in the last 20 years).

Without a doubt, retail has fallen in love with corporate bonds.  Fund flows were originally into mutual funds, and have shifted more and more into the ETF’s.  The ETF’s are gaining a greater institutional following as well – their daily trading volumes cannot be ignored, and for the high yield space, many hedgers believe it mimics their portfolio far better than the CDS indices. The investment grade market looks extremely dangerous right now as the rationale for investing in corporate bonds – spreads are cheap – and the investment vehicles – yield based products. With corporate bonds spreads (investment grade and high yield) already reflecting a lot of the move in equities, it will be critical to see how well they can withstand the pressure from the treasury markets.

UPDATE: The UK outlook change has had little reaction so far: TSY yield down 1-2bps, gold/silver bounced up a little, and a small drop in GBP.

While most of the talk will be about the drop in precious metals today, the sell-off in Treasuries is of a much larger relative magnitude and yet equities broadly ignored this re-risking 'signal'. At almost 2.5 standard deviations, today's 10Y rate jump (closing it above the 200DMA for the first time in eight months) trumps the 1.3 standard deviation drop in Gold prices - taking prices back to mid-January levels. According to our data (h/t JL) for only the 14th time in the last five years (and not seen for 16 months) Treasury yields rose significantly and stocks fell as the broad gains in yesterday's financials (on the JPM rip) were held on to at the ETF level but not for Morgan Stanley, Goldman Sachs, or Citigroup (who gave all the knee-jerk reaction back). Tech led the way as AAPL surged once again (though faltered a few times intraday) having now completed back-to-back unfilled gap-up-openings. Credit and equity were generally in sync until mid afternoon when the up-in-quality rotation took over and stocks and high-yield sold off (notably HYG - the high-yield bond ETF underperformed all day long) while investment grade credit rallied to multi-month tights. VIX bounced higher (notably more than the S&P would have implied) recovering to Monday's closing levels and back above 15%. The Treasury sell-off was 'balanced' in terms of risk-on/-off by the strength in the USD (and modest weakness in FX carry pairs as JPY's weakness was largely in sync with the rest of the majors - hinting its was a USD story). Oil and Copper both lost ground (as did Silver - the most on the day) though they tracked more in line with USD strength than the PMs.

While WTI hovers around $105.5 (slightly underperforming USD strength), Brent has notably outperformed with the Brent-WTI spread now edging towards $20 (from under $15 two weeks ago). Given the increasing tension, we thought it useful to get a grasp of just what an oil-supply shock means. BNP points out that in all but one of the historical oil price shocks of the last 40 years, equities have notably underperformed oil (understandably) but the higher the oil price rise, the higher the chance of negative absolute returns for stocks. We also note that oil prices tend to rise in anticipation of the crisis and then explode (so arguing that we are discounting an event is proved moot) and the impact (in lost supply) from closing the Straits of Hormuz is an order of magnitude larger than the next five largest events. Regionally, positioning favors the middle-eastern oil producers obviously with Asian EM nations set to suffer dramatically worse than DMs.

It would appear, given the actions and rhetoric of the last week or so, that global central bank printing presses have been switched to 'pause' mode and allowed to cool as implicit inflation 'energy' rears its economic-growth-dragging head around the world (as the bears told us earlier). Whether this leads to a slow grind higher or a tactical correction is the question Morgan Stanley considers in a recent note and their answer is that bullish sentiment, 'under-appreciated' risks, and 'tranquil' markets justify a cautious asset allocation. The focus has switched much more to growth, likely why we have not seen a greater deterioration post-printing yet, but this leaves the market much more sensitive to data surprises (as the backstop of QE has been removed for now). Simply put, we tend to agree with MS' view (given our previous discussions of the volatility surface) that as event and growth risks linger, and with valuations no longer cheap in most cases, expectations of a continued grind higher without a tactical correction are overly confident.

The ever-so-popular high-yield bond ETF, HYG, is suffering its biggest 3-day drop since Thanksgiving as higher beta assets are underperforming and the up-in-quality and up-in-capital-structure trade gathers pace post LTRO 2. Even with last week's ex-divi date, we note that this loss of the last 2-3 days wipes out the yield that was 'reached for' of the last 2-3 months. It seems all too easy to buy high-yield bonds when they are on the rise but underlying that ETF is a portfolio of 'junk' assets - some better and some worse obviously - that are increasingly being driven top-down by the fast-money action in this newfound ETF's liquidity (as dealer inventories dwindle). This leaves them prone to just-as-fast exits as the secondary high yield bond market remains 'illiquid' away from benchmark size and ETF-bound assets providing little underlying 'pricing' evidence of market value. This is the largest underperformance of the high-yield market relative to the equity market since the recent rally began.

Just like the first time around, the net gain from the LTRO when taking into account rolling off instruments, will be lower than the Gross amount. How much? According to SocGen, the final number by which the ECB's deposit account will increase will be about €210 billion less than the overhead number. From SocGen's Lauren Rosborough: "The LTRO outcome: €529.53bio was allocated to 800 institutions (compared with €489.19bio allocated to 523 institutions in Dec). The net increase, according to our economists, is €311bio (adjusted for yesterday’s MRO reduction, 3m LTRO allotment this morning, and the roll-off of the 3m and 6m LTROs tomorrow). The allocation was above our and at the upper end of the market range of expectations. After a brief and limited positive risk move (AUD/USD spiked to 1.0857), currencies are broadly unchanged and the EUR/USD is lower, possibly reflecting positioning unwinds. The LTRO outcome opens the way for further positive risk moves (high-beta, non-Japan Asia, lower DXY) but recent price action suggests to us that the rally is fatigued." Net: this means that following settlement, European banks will park not €500 billion but up to €810 billion with the ECB, on which they will collect 25 bps (while paying 1%, aka inverse carry as described here first). It also means that in three years Europe's bank will have to not only pay the ECB €1 trillion in case (assuming there is no perpetual rollover of the LTRO, which there will be), but also delever by another €2.5 billion, for net asset drop of €3.5 trillion. Good luck building up shareholder equity by the same amount to offset unchanging liabilities.

The “Placebo Effect” is fascinating. In a typical drug testing trial, one group of patients will receive the actual drug being tested, and a “control” group will be given an “inert” medicine (or “sugar pill”) that shouldn’t do anything for the patient, but the patient doesn’t know that. So much of what I find wrong about “economics” is that it masquerades as far more of a science than it actually is. It doesn’t have theories that can be “tested” in a real world, where 2 similar situations are treated differently to see which “treatment” works better. Each economy and each situation is so different that it is IMPOSSIBLE to determine why policies failed or what should have been done differently. It is possible to come up with reasonable ideas and theories of what could have been done or should have been done, but they are only theories. The systems are so complex that finding situations with similar starting conditions with similarly motivated entities involved is simply impossible to find. The fact that so much of our policy seems to be based on research into what should have been done in the Great Depression and what has been seen in Japan is frankly scary. There is no way to “know” how the Great Depression would have turned out with a different set of policies. We can make conjectures, but that is all they are – conjectures. The LTRO was designed to support the market, the market is up, so the LTRO must be working. That at least is the logic many investors are applying. They see the improvement in sovereign debt yields, the avalanche of “positive” (if unfounded) headlines, and the relentless march higher of the stock market. So the plan is working? Not so fast.

As the Greek PSI deal rears its ugly head on our screens once again with Merkel, Schaeuble, and Papademos all pulling from one angle or another (and Dallara disquietingly silent in his uselessness), BNP created a simple flowchart of the various steps and probabilities of participation rates, retroactive embedded CACs, CDS triggers, and actual debt reduction that may (or may not) occur in the next week or two. The price action in Greek CDS and Bonds strongly suggest the CDS will trigger (as we have been vehemently explaining for weeks/months now) but there is a long way between here and there.

The better tone in risk markets is largely being driven by encouraging economic data from the US and Europe, which as a result saw Bunds trade in negative territory. Of note, ECB’s Liikanen has said that inflation is not a particular concern in Europe, adding that the ECB has never said that there is an interest rate floor. On the other hand, Gilts are being supported by comments from BoE’s Fisher, as well as less than impressive GDP report. Nevertheless, EUR/USD took out touted barrier at the 1.3400 level earlier in the session, while USD/JPY is trading in close proximity to an intraday option expiry at 80.60.

I am staggered at how easily the concepts of Democracy and the Rule of Law – two of the pillars of the modern world – have been brushed aside in the interests of political expediency. This is not just a eurozone phenomenon but of course the removal of elected governments and the instalment of "insider" technocrats who simply serve the interests of the elite has become a specialisation in Europe. Many will think this kind of development is not a big deal and is instead may be what is needed. Personally I am absolutely certain that the kind of totalitarianism being pushed on us by our leaders will – if allowed to persist and fester – end with consequences which are way beyond anything the printing presses of our central banks could ever hope to contain. Communism failed badly. Why then are we arguably trying to resurrect a version of it, particularly in Europe? Are the banks so powerful that we are all beholden to them and the biggest nonsense of all – that defaults should never happen (unless said defaults are trivial or largely meaningless)?...– So, in terms of markets, be warned. My personal recommendation is to sit in Gold and non-financial high quality corporate credit and blue-chip big cap non-financial global equities. Bond and Currency markets are now so rigged by policy makers that I have no meaningful insights to offer, other than my bubble fears...The end of the bubble will be sign posted by either monetary anarchy creating major real economy inflation or by a deflationary credit collapse (if they run out of pumping "mandates"). The end game is incredibly binary in my view, but in between it is pretty much a random walk. Either way, "bonds are toast" in any secular timeframe (due either to huge inflationary pressures, or due to a deflationary credit collapse), which in turn means that asset bubbles in risky assets will get crushed on a secular basis.

Sprott strategist John Embry has never been a fan of the existing financial system. Today, he makes that once again quite clear in this interview with Egon von Grayerz' Matterhorn Asset Management in which he says: "I think that the current financial system, as we know it, will be totally destroyed, probably sooner rather than later. The next system will require gold backing to have any legitimacy. This has happened many times in history." Needless to say, he proceeds to explain why a monetary system based on gold, one in which one, gasp, lives according to one's means, is better. Logically, he also explains why the status quo, whose insolvent welfare world has nearly a third of a quadrillion in the form of unfunded future liabilities, will never let this happen. Much more inside.