Air Pockets Ahead

From Nic Lenoir of ICAP

The chairman would like for you to return to your seats and fasten your seatbelts. If I have not given many updates in the past few days it's because the fundamentals are known, the Fed's game plan is known, and now we just need to front-run the fed and watch everything as we know it falls apart.

Over 40 million Americans on food stamps, a bankrupt banking system, bankrupt sovereign governments in many cases, a broken world economic model where the consumers borrow and the producers don't consume, and in my eyes you can add a broken political system in most Western democracies, peak oil, and food supply shortages... all counterbalanced by the stacks of Benjamins thrown at the world by helicopter Ben. It's like hiding in the basement when a meteorite the size of the moon is about to crash on earth. 

My friend Julian Brigden recently pointed out the interesting example of the Nasdaq in 1999. Back then terrorized by Y2K the Fed engorged the financial system with tons of cash which led to a 100% rally in the Nasdaq from the fall of 1999 until March 2000. Of course the market went as quickly as it came. Will we see a repeat? Maybe... Maybe not. For that we have to wait the next couple weeks to see if when the cash starts to actually flow in we do get a ramp up, or whether the discontent and distrust are so great that markets protest against loose policies. Fundamentals are a lot worse than in 1999 for one, and most of the cash printed goes into precious metals or abroad because most realize the future or safety don't lie within our borders and banking system, at least not without some serious changes as to how things function and after the market is allowed to clear at prices that will truly attract investors for the right reason (read: right reason does not equal front-running the Fed for a quick buck). The backlash from international observers was quite expected as a lot of emerging countries are being choked by inflation as USD liquidity flood their markets. More interesting is some of the backlash domestically, from established independent economists to Kevin Warsh at the Fed who basically said that skyrocketing commodities and a weak USD would be a sign of failure of current policy path. That's about as much disagreement as one could expect from someone in his position and that's why I feel those words carry a lot of weight.

Precious metals took everyone by surprise interrupting their parabolic ascent yesterday following the announcement of higher margins for Silver future. Some claim it is a way to rig the market. I respectfully disagree. While having no faith in the government as I know economic releases and markets are heavily manipulated by its actions, given recent volatility it makes perfect sense to increase margins. After all margins are a function of the VAR (hence volatility) and liquidity in the market. When liquidity deteriorates and price swings grow in size the exchange needs to make sure everyone can cover their losses to avoid serious systemic risk. If the Fed keeps buying bonds and there is a status quo in terms of the way the world economy operates, precious metals remain well supported fundamentals and this violent pullback does not threaten the overall trend one bit. Watch 1,384/1,385 in gold as support, as a break there would mean more weakness short-term as a H&S is triggered and in such choppy markets it would most likely be followed by some liquidations of weak longs, but other than that the fundamentals behind the trend remain intact. If anything people should be more worried if LCH and other clearing houses start asking bigger haircuts on bonds, as this is a lot more significant since it puts pressure on bond prices which are not fundamentally sound.

Being long German Fixed Income seems to be the only other thing that makes sense fundamentally as people spread it against short PIIGS and Germany inspires confidence to investors by its austerity. However given the swings you have to actively trade in and out of your positions to manage avoiding the flushes that will happen in tandem with those in US bonds for which supply and demand are in such size versus the risk appetite of non-government participants that chainsaw price action is likely to be the norm. With a holiday tomorrow, 30Y auction today, and Fed buybacks on Friday we have a perfect set up for choppy markets and so far today has not disappointed in that respect. As we said after the Fed announcement: welcome to markets where VIX and other vol measures collapse yet prices have daily 2%/3% swings constantly. This is what happens when markets experience tides of liquidity and disturbed fundamentals, until the swings get so big that all assets collapse as nobody can withstand the volatility anymore. It would have been the advantage of letting asset markets find the real price at which they are supposed to clear, that way they could have relied on solid footing. We are dealing with a lack of confidence in the financial system's solvency, a lack of confidence in our currencies, and a lack of confidence politicians are anywhere close to add something good to the mix.

For now I think that as long as there bond market does not collapse around the auction today being long into the close today to front-run Friday's POMO makes good sense (too much sense? be nimble as everybody might be thinking the same and you will need to jump ship quickly so you better be sharp at observing fractal nature of price swings!). There are a lot of local opportunities but they require small positions and active management given the environment. We will know a lot more on trends we can rely on when the cash starts flowing in on Friday and subsequently and we can gauge whether the Fed's wallet can muscle around public distrust. Until then trade like your TT is your first Nintendo in 1988!

Good luck trading,



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