QE reversal = Ursa Minor

Author Cam Hui

Posted: 1 July 2013

Since 2008, I have seen various analysts criticizing the Fed, ECB and other central banks for their efforts at quantitative easing and other forms of unconventional monetary policy. These policies have been criticized as less than effective. One such analyst is Stephen Roach, formerly of Morgan Stanley:

While the Fed’s first round of quantitative easing helped to end the financial-market turmoil that occurred in the depths of the recent crisis, two subsequent rounds – including the current, open-ended QE3 – have done little to alleviate the lingering pressure on over-extended American consumers. Indeed, household-sector debt is still in excess of 110% of disposable personal income and the personal saving rate remains below 3%, averages that compare unfavorably with the 75% and 7.9% norms that prevailed, respectively, in the final three decades of the twentieth century.

Now that the Fed is hinting that it is thinking of taking its foot off the accelerator, we are now seeing the reversal of some of the effects of QE – and it’s sent the markets into convulsions. The intention of all these unconventional policies was to bring down interest rates and push the market into taking more risk. As a result, asset prices have soared and risk premiums have shrunk. Just look at this chart from Zero Hedge:

Now that the Fed is hinting that it is thinking about unwinding these programs, which Fed officials have quick to distinguish between taking the foot off the gas (tapering) and stepping on the brakes (tightening), risk premiums have begun to rise and asset prices have fallen. This chart from Gwyn Davies show that, despite Fed officials communications policy, the market has de facto tightened in spite of Federal Reserve actions:

Consider the effects of this reversal:

  • Treasury bond yields have spiked. The Fed’s began with lowering short-term rates, progressed to buying Treasuries further out on the yield curve and finally added agencies to its purchases. Now that the Fed has signaled that it is considering winding down its QE program, Treasury yields have spiked.
  • It has caused carnage in the Eurodollar market. If you hold down short rates and then tell the world that you expect to hold short rates at zero or near zero for a long, long time, it is an invitation to Mr. Market to put on a carry trade – and it did, with leverage. The signal of reversal is causing these carry trades to unwind, the most obvious of which is the “get cheap funding and buy Eurodollar deposits” trade. See Vince Foster’s Minyanville articleBernanke’s Misfired Shot Heard ‘Round the World.
  • Other carry trades like the currency carry trade are being unwound in a disorderly manner.
  • The Fed’s implicit encouragement for the market to take risk pushed funds into junk and emerging market bonds. We have seen how investors reached for yield in the last few years, some of that money made its way into lower quality credits like junk bonds and emerging market bonds. In particular, the emerging market bond market has sold off in a frenzy. In addition, it has caused stress in a number of EM currencies as the market has begun to re-calibrate risk premiums.
  • The market’s reach for yield likely played a role in China’s latest shadow banking bubble and recent liquidity squeeze. Michael Pettisexplained the carry trade this way:

Over the last two years, and especially in 2013, mainland corporations with offshore affiliates had been borrowing money abroad, faking trade invoices to import the money disguised as export revenues, and profitably relending it as Chinese yuan. As China receives more dollars from exports and foreign investment than it spends on imports and Chinese investment abroad, the People’s Bank of China, the central bank, is forced to buy those excess dollars to maintain the value of the yuan. It does this by borrowing yuan in the domestic markets. But because its borrowing cost is greater than the return it receives when it invests those dollars in low-earning U.S. Treasury bonds, the central bank loses money as its reserves expand. Large companies bringing money into the mainland also force the central bank to expand the domestic money supply when it purchases the inflows, expanding the amount of credit in the system.

In May, however, the authorities began clamping down on the fake trade invoices, causing export revenues to decline. Foreign currency inflows into China dried up, as did the liquidity that had accommodated rapid credit growth. The combination of rapidly rising credit and slower growth in the money supply created enormous liquidity strains within the banking system. This is probably what caused last week’s liquidity crunch and this week’s market convulsions.

When Pettis wrote that Chinese companies imported foreign money and engaged in the practice of “profitably relending it as Chinese yuan”, he is referring to injections into China’s shadow banking system, which is really their subprime market. In a separate note, Izabella Kamanska of FT Alphaville also documented analysis from Deutsche’s Bilal Hafeez indicating that the tight USD-CNY relationship was ripe for a carry trade.

  • Tapering talk has devastated the TIPS market. As the market has contemplated the reversal of QE, inflationary expectations have plummeted and so have the price of TIPS. 
  • QE first buoyed commodity prices and now we are seeing the reversal of that trade. Gold and other hard commodities benefited from low and negative real interest rates. Now that we are seeing real interest rates rise (and inflationary expectations fall), commodity prices are getting hammered.
  • Tapering talk has also implicitly hurt Europe. The ECB has been able to stabilize the eurozone with Draghi’s “whatever it takes” remark and the unveiling of its OMT program, which has not been activated yet. Yield spreads of peripheral countries’ bonds against Bunds have narrowed because of the ECB’s threat of action, along with the flood of global liquidity. Now that the flood of global liquidity is starting to recede, the ECB may actually have to resort to OMT, which would cause another round of euro-angst and more risk premium re-calibration.

I’ve probably forgotten or missed out on some other side effects of the various rounds of Fed QE, but you get the idea. Many of these bets were leveraged bets as they were designed to help banks profit and repair their balance sheets, e.g. the Eurodollar carry trade. When these trades unwind, the effects will not a blip, but a tsunami.

All these macro effects are suggesting that we are at the start of a risk re-pricing process that will take months to complete. It will not be friendly to asset prices at all.

Earnings headwinds
In the US, stock prices are starting to face headwinds from a deteriorating earnings outlook. Ed Yardeni documented that while Street earnings estimates continue to rise, forward sales estimates are falling. How long can this divergence continue? Can margins continue to rise?

One way of boosting earnings per share while the sales outlook is punk is to buy back shares. If you reduce the denominator (shares outstanding), earnings can rise (everything else being equal). Bloomberg reported that the level of share buybacks are so high that corporate quality is deteriorating [emphasis added]:

“The trend of improving credit quality has slowed as profits are slowing,” Ben Garber, an economist at Moody’s Analytics in New York, said in a telephone interview. “As the recovery matures, companies are liable to get more aggressive in taking on share buybacks and dividends.”

Rather than using cash to pay down debt, companies in the S+P 500 Index are attempting to boost their share prices by buying back almost $700 billion of stock this year, approaching the 2007 record of $731 billion, said Rob Leiphart, an analyst at equity researcher Birinyi Associates in Westport, Connecticut.

Borrowers controlled by buyout firms are on pace to raise more than $72.7 billion this year through dividends financed by bank loans, surpassing last year’s record of $48.8 billion, according to S+P Capital IQ Leveraged Commentary & Data.

After cutting expenses as much as they could to improve profitability, companies “will need to see further revenue growth to boost earnings from here,” Anthony Valeri, a market strategist in San Diego with LPL Financial Corp., which oversees $350 billion, said in a telephone interview.

The good news: Ursa Minor
All these factors add up to bad news for the stock market. The good news is that any pullback is likely to be relatively minor and the possibility of a market crash is remote. The Fed has made it clear that it continues to be “data sensitive” and will adjust policy as necessary.

Translation: The Bernanke Put still lives.

Relief rally: Mind the gap(s)
My inner investor has already pulled back to a position of defensiveness. My inner trader, on the other hand, is watching the relief rally for an entry point on the short side. I am indebted to Tim Knight for his idea of watching the charts of HYG, JNK and MUB to watch for rallies up to fill the downside gaps. The theory is that stocks often see trading gaps filled after a price reversal, just as we are seeing now. After that, the down trend would continue. Tim Knight put it more colorfully than I ever could:

There are three ETFs I am watching very closely for gap closes. My motivation is twofold: first, I want to short the everloving bejesus out of them once the gaps are filled, and second, it’s going to be my signal to go balls-out shorting the equities in general.

As I write these words, the gaps in HYG, JNK and MUB have been filled. However, my inner trader is not ready to short “the everloving bejesus” out of this market yet. He is more inclined to pivot from a pure US-centric view to a more global macro view of the world and he is watching how the gaps in the ETFs of some of the aforementioned sectors that were affected by the Fed’s QE actions are resolving themselves.

Consider TLT, the long Treasury ETF, which has not rallied sufficiently to fill the (tinted) gap:

DBV, which is the ETF representing the currency carry trade, has seen its gap filled.

The emerging market ETFs have had their gaps either filled or mostly filled. Here is the chart for EM bonds (EMB):

Here is EM equities (EEM):

Here is China (FXI), which has been a focus of the markets in the past couple of weeks:

Commodity ETFs, however, aren’t performing that well and they continue to be in a downtrend without rallying to fill their gaps. Here is DBC, as a representative of the entire commodity complex. DBC violated a key support level and continues to weaken. It has seen no rally attempt to fill in its gap.

Gold (GLD) is one of the ugliest charts of all. Note, however, how it rallied back in April and May to fill in the gap (shown in green) but it continues to weaken and has shown two gaps (in yellow) that have yet to been filled in a relief rally.

The currencies of commodity-linked economies are behaving badly. Here is the Aussie Dollar:

Here is the Canadian Dollar, which is continue to decline with an unfilled gap:

What about Europe? The chart of FEZ representing eurozone equities below shows that while we have seen a minor relief rally, eurozone equities have not rallied up to fill its gap.

Here’s the score. Sectors with filled gaps: 3; unfilled gaps: 2. My inner trader’s conclusion is that the relief rally isn’t quite finished yet. We are likely to see several weeks of volatility before the process is complete before the longer term fundamentals of the recalibration of risk premiums pushes asset prices lower.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. 
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned. 


Twist Extension Doesn’t Impress Commodities

Author Larry Berman

Posted: 25 June 2012 re-posted from etfcm

The fed did extend twist and commodity prices were not impressed. The TSX has some material headwinds when it comes to the 30% weight in the energy sector given the clear slowing global economic picture. Major support for WTI in the $75 could be tested in the next few months, but it should hold as the global economy is not falling off a cliff.

Gold will be hit and miss for the next few months with QE3 being dangled by the Fed. Look for the sector to do well on disappointing economic numbers and weaken if numbers are a bit stronger. The banks will bounce around with the US financials and the fate of the global banking risks, but do face some earnings headwinds too.


Bad news is bad news, good news is…

Author Cam Hui

Posted: 09 Apr 2012

It’s always good to have a long weekend once in a while as it gives me time to think and reflect, rather than to react in a knee-jerk fashion to news. So what to make of the shocker of a NFP release last Friday?

Upon further consideration, it sounds bad as the stock market is caught by the dilemma where bad news is bad news and good news may be bad news.

Why was employment rising so quickly?
Ben Bernanke’s speech to National Association for Business Economics Annual Conference provides some clues. He said that:

[T]he better jobs numbers seem somewhat out of sync with the overall pace of economic expansion. What explains this apparent discrepancy and what implications does it have for the future course of the labor market and the economy?

The apparent discrepancy is due to Okun’s Law [emphasis added]:

Okun noted that, because of ongoing increases in the size of the labor force and in the level of productivity, real GDP growth close to the rate of growth of its potential is normally required just to hold the unemployment rate steady. To reduce the unemployment rate, therefore, the economy must grow at a pace above its potential. More specifically, according to currently accepted versions of Okun’s law, to achieve a 1 percentage point decline in the unemployment rate in the course of a year, real GDP must grow approximately 2 percentage points faster than the rate of growth of potential GDP over that period. So, for illustration, if the potential rate of GDP growth is 2 percent, Okun’s law says that GDP must grow at about a 4 percent rate for one year to achieve a 1 percentage point reduction in the rate of unemployment.

Why are we seeing unemployment falling so quickly when GDP is growing so slowly? Chairman Bernanke explains:

[A]n examination of recent deviations from Okun’s law suggests that the recent decline in the unemployment rate may reflect, at least in part, a reversal of the unusually large layoffs that occurred during late 2008 and over 2009. To the extent that this reversal has been completed, further significant improvements in the unemployment rate will likely require a more-rapid expansion of production and demand from consumers and businesses, a process that can be supported by continued accommodative policies.

Stalling employment gains would provide fuel for policy doves (like Bernanke) within the FOMC for further rounds of QE. As I wrote before (see How easy is this Fed?), the Fed is unlikely to have the political capital to engage in quantitative easing in the 2H as it is an election year. So will the data deteriorate fast enough to warrant QE? They are unlikely to act at the April meeting on a single month’s data, especially when there is a 90% chance that the actual number lies between 20K and 220K. Doves will focus on the falling employment number, while hawks will focus on the falling UNemployment number. What if the next month’s NFP came in around 150K? Will that be enough? I doubt it.

I agree with Tim Duy when he summarized his reaction to last Friday’s NFP release as [emphasis added]:

A disappointing jobs report for those who expected the US economy was about to rocket forward, but one consistent with the slow and steady trend into which the US economy appears to have settled. And no reason to change the basic outlook for monetary policy – the Fed is on hold until the data breaks cleanly one direction or the other.

The markets sold off last week when the FOMC minutes revealed that, while QE3 remained on the table, further rounds of QE are unlikely unless the economic data significantly deteriorates. For now, bad news (on employment) is bad news, unless it’s really, really bad.

Improving employment = Profit recession
What if last Friday’s number was a statistical blip and employment continues to improve? Chairman Bernanke explains:

[A]nother interpretation of the recent improvement is that it represents a catch-up from outsized job losses during and just after the recession. In 2008 and 2009, the decline in payrolls and the associated jump in unemployment were extraordinary…In other words, employers reduced their workforces at an unusually rapid rate near the business cycle trough–perhaps because they feared an even more severe contraction to come or, with credit availability sharply curtailed, they were trying to conserve available cash.

Now that the economy has improved, businesses need to add workers to catch up. Indeed, we can see that from the graph below which shows a picture of rising labor productivity:

The price of rising employment in “defiance” of Okun’s Law is a profit recession, with sales rising but profits falling as the gain begin accruing to the suppliers of labor rather to the suppliers of capital. Ed Yardeni documented this phenomena as he showed that consensus sales estimates have been rising:

…while earnings estimates growth has been stagnant:

In a way, Yardeni is implicitly endorsing this view of employment catch-up with his analysis of the jobs picture before the NFP release.

This outlook is also consistent with Gallup’s observation of falling unemployment, rising economic confidence and improving consumer spending. In addition, the Conference Board also reported that CEO hiring plans are rising.

As we move into another Earnings Season, the interaction between employment and profits bear watching. Whether the inflection point for earnings to start rolling over happens this quarter or next quarter, I have no idea. I do, however, have a pretty good idea of the trajectory of the US corporate earnings for the rest of the year.

Equity outlook: US likely to roll over, does it all depend on China?
So there you have it. If we get good news on the labor front, it means a profit recession, which is bad for the stock market. If we bad news on employment, the Fed’s hands are tied for the second half of 2012 unless the economy really craters.

Looking ahead to 2013, we have the Bush era tax cuts expiring. With little agreement in Congress ahead of an election year, the US is likely to see rising fiscal drag in 2013. As we enter the second half of 2012, the markets will start to look forward and discount slower American growth, which would be negative for stock prices.

Ben Inker, the head of asset allocation at GMO, essentially voiced the similar concerns over potential margin compression as the effects of fiscal drag become more evident next year:

High profit margins are the biggest impediment to returns in the equity markets. “The big issue is profits are at an all-time high relative to GDP,” Inker said. “We don’t think that is sustainable. We think it’s going to come down.”

The question is, why has that occurred amid a relatively weak global economy? And what could cause it to change?

Inker believes the reversal of government budget deficits will kill margins. Profits have risen as corporations have successfully cut labor costs, but that was a short-term gain, Inker said. Normally, wage reductions and workforce cutbacks leave less money for consumers to spend across the whole economy. That didn’t happen over the last several years because the government stepped in with offsetting stimulus measures, allowing disposable income to remain high despite the fact that labor income has been shrinking.

Hence current profits cannot last for long. Even though he expects modest growth in the global economy, lower unemployment and higher capacity utilization, Inker said that “as a necessary condition of decent growth, we need to see profit margins come down.”

Today, US equities are the market leader based on a belief of an improving consumer (see This bull depends on the US consumer), Europe is starting to go sideways on concerns over Spain, Portugal, etc., and China is not showing strength.

My Asset Inflation-Deflation Trend Model moved to a neutral reading early last week (see Time to take some risk off the table), which is the likely correct tactical response for now as the markets aren’t in any imminent danger of tanking dramatically. Looking forward, however, the 12-month outlook for the US are faltering. There are a number of China bulls starting to come out of the woodwork (see example here), but I can see no technical turnaround in Chinese related markets for the moment.

Under these circumstances, the bulls only hope are dependent on a revival of Chinese growth in the 2H, which is a risky bet on timing. While my inner trader isn’t outright bearish, my inner investor tells me that selling in May is starting to sound good right now.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Today on Berman’s Call: Earnings Season Does Not Have High Expectations

Author Larry Berman

Posted: 9 Apr 2012 reposted from etfcm

Investors are about to turn their attention back to Q1 earnings, which are the weakest in several quarters. The trend in the past few months have been towards more downgrades of 12-month forward earnings than increases. If we backed out technology, earnings growth for the quarter would be negative for the index overall on a Q/Q basis with the biggest weakness in telecom, materials, energy, and health care. This suggests the TSX will also see a rather poor quarterly earnings period given the much higher energy and materials exposure, although most of these Canadian stocks have corrected already, they have not in the US.

The one area we just cannot seem to reconcile well is the retail stocks. XRT is the ETF representing an equal weight index of US retailers. The chart show that US retail stocks are 30% above their 2007 peaks, which is hard to reconcile compared to the unemployment picture and massive debt hangover and housing stress. So with expectations on the low side, that could mean some surprises, but the fact that stocks have been relatively strong heading into the earnings season, the good news is probably already factored in. Expect volatility to pick up significantly in the coming months with uncertainty levels so high and debt concerns brewing again in Europe.


The Only Strong Commodity Sectors at Present are in Energy

Author Larry Berman

Posted: 12 Mar 2012 reposted from etfcm

There appears to be a base pattern developing in the broad DJP commodity indices, but the steeper contango seen in many commodities is taking a toll on the buy and hold commodity investor. The only sectors that look strong at this point are in the energy sector (except natural gas), which has become so cheap by historical standards it is actually compelling.

Natural gas equities as measured by FCG is still not as cheap as one would expect given the price of the underlying. ECA, the pure natural gas play is developing a major base pattern and looks compelling to accumulate on weakness. We do however expect significant disappointment during the next earnings period on the gassy energy stocks.

Copper looks to be struggling and industry leader FCX is clearly showing very poor behaviour after it failed breakout over its 200-day average. Agricultural stocks within MOO, also look to be undergoing more corrective price action that probably has 5-10% downside before it is attractive.

Bernanke is Clear on Triggers for QE3, and We Aren’t Close to Them

Author Larry Berman

Posted: 1 Mar 2012 reposted from etfcm

Yesterday was the first notable higher volume distribution day since December. All the news wires and headlines this morning are blaming Bernanke’s lack of talk about QE3. He has been pretty clear what the triggers are for QE3 and we are not close to any of them. In fact, the thought that they would launch another QE with operation twist still playing out is staggering. There are many very smart people on Wall Street—we find it hard to believe they are that naïve. Nevertheless, these things move markets and are part of trying to navigate the markets.

Outside of some surprise at the reaction, specifically in the 50 handle drop in gold in about a nanosecond as Ron Paul was giving Big Ben a thorough lashing (if this was 1012 and not 2012, it might have been a public bloodletting). Ron Paul has just joined Newt in the unelectable category of candidates who are out of touch with reality. Without the Fed, we would be in the 1930s. Right now we are only in 1999 in Japan. 1352 remains important near-term support; the trading trend is higher until that breaks.

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