t Shadow Capitalism
a topic of mainstream monetary policy deliberation (and
MARKET COMMENTARY BY NAUFAL SANAULLAH
Wednesday, November 3, 2010
Bad is bad and good is good again.
Amid all of the fireworks, the FOMC ends up announcing
$600b in asset purchases and $200-300b of MBS proceeds
reinvestment. Belly of the curve is favored, with 5-7yr tenors
getting the most love, while only 4% representing demand in
the 17-30yr sector. The headline number is well under the
trillions being considered and below the $1t+ or so that, in
my opinion, has been discounted in the market since late
summer.
But what is the most relevant new factor in play, now that
Fed day has come and gone? In my opinion, this second
iteration of QE will be no more effective (as per the criteria of
the FOMC’s dual mandate) than the first instance. QE I was
instituted at the height of the financial crisis and successfully
ended the emergency liquidity situation in the banking sector
by extending banks enough liquidity to return to normalized
capital ratios and repair asset-liability mismatches. However,
fixing the acute banking system concerns did little to help on
the real economy level, as unemployment has remained
elevated, near-term deflation and growth risk high, and long-
term inflation risk high and rising. October 2008’s
introduction of the interest rate on reserves, both excess and
required, has created a liquidity trap within excess reserves.
Unemployment cannot tick down until production and
industrial activity picks up, which requires consumption to
pick back up, which will not happen as long as consumers are
deleveraging. Consumer credit is still declining, showing that
household balance sheets have a long way to go before
they’re fixed and that QE liquidity was unsuccessful in
reaching household balance sheets and thus has not been
able to repair household asset-liability mismatches. More QE
will bring more of the same: more printing, more storing in
reserves, more liquidity not reaching households.
Since QE I was only a success as far as the banking system is
concerned and today’s concerns are about the real economy,
markets won’t respond bullishly to anything but bullish news
now. More bearish news doesn’t mean more QE—at that
point, more QE wouldn’t matter, because it would mean QE is
not working. I contend that we are returning to an intuitive
trading environment once again, where good news receives
bullish responses and bad news is discounted in by selloffs.
Unless and until the interest rate on excess reserves becomes
justifiably, given that it has no nominal zero-bound and is
perfect for dealing with trapped liquidity via Taylor rule), this
paradigm will stand. If and when the IOER enters consensus
debate, we may (and probably will) return to a bad-is-good
and good-is-bad market, where the worse data gets, the
more (successful/effective) liquidity the Fed is willing to
throw at the market.
And given my pessimistic outlook on the efficacy of the Fed’s
monetary policy, at least as long as IOER is greater than zero,
I expect risk to correct. The $600b figure is well below
estimates as well, which doesn’t hurt the bear case, neither
does the fact that longer-term Tsys weren’t targeted and thus
long-term yields (whose decline is one of the most effective
tools in promoting growth and inflation) won’t be depressed.
The Fed did, however, eliminate its 35% per-issue SOMA
limit, and with its small but healthy amount of QE announced
today, could be setting up for an essentially indefinite length
of asset purchases, in an ad hoc manner not ceasing until the
status quo changes to a more positive one. I am bearish risk
in the near-term but am getting bullish commodities and
other inflation plays in the longer-term, as inflation is surging
in EM and this now possibly implicit perpetual, “until-
needed” easing (and its slightly younger, still-in-the-womb
sibling across the pond from the BoE) brings inflation much
closer to the developed nations.
In news flow, besides QE, UK and US services PMI both beat
by respectable margins, while US ADP employment and
factory orders both grew at above expected rates. On the
political front, the GOP takes the House, as expected, and
takes a big chunk of the Senate, leaving only 51 seats still held
by Dems. The gridlock in Washington, as I’ve been stating,
eliminates fiscal stimulus potential, which merely means it
will be transferred to the obligation of Bernanke & co., as
monetary policy overcompensates. In Europe, Portugal
opposition party DSP saw its austerity budget proposal get
last-minute acceptance, but the bond market responded far
from in kind, with the 3m yield going to 1.82% vs 1.60 prior
after its auction. Elsewhere, Turkish CPI grew 8.6% vs 8.0%
consensus in October, with food prices jumping to 17.1% YoY
last month and PPI rising 9.92% YoY. Food and input prices
have been on a tear around the world, with food CPI running
above 8% YoY in China and Wholesale Prices rising 17% in
India (as pointed in a recent TMM piece). There has been a
divergence in core and ex-food & energy CPI in the US and
developed markets as well, and soybeans and corn prices
both saw 15% gains last month in their futures markets. The
race to debase is on and fully running and (especially serially)
hiking rates will go from being a bullish signal of growth and
recovery to a bearish signal of unsuccessfully attempting to
curb runaway inflation, at rates choking off any remaining
growth in these markets. The RBA’s decision to hike in
November instead of waiting until next month, despite the
weak CPI print a few days ago, as well as China’s huge GDP
and copper demand data, underscore this current
phenomenon.
Equity ended the day up 40bps after selling off ahead of the
FOMC release and reversing sharply upwards after the 2:15
PM EST announcement. The S&P is right up near resistance
around 1200-1220, and I think downside risk is the greater
risk by far at this level and given current circumstances and
internals. After staying out of shorting the S&P for several
weeks (and long for 110 points from 1040), I went short the
S&P and other US equities into close, looking for a reversal to
begin by the end of this week.
EURUSD breaks into the 1.41 handle on the QE news but is
paring its gains since hitting mid-October highs. If this can
break into the 1.42 handle, I’d consider getting long, but
given my perspective on the sustainability of today’s QE
trade, I am expecting a reversal beginning by the end of this
week. Portuguese spreads are widening and peripheral bonds
and CDS spreads have not declined much even as the euro
has surged on the back of tightening liquidity and easing
expectations from the Fed. The German export recovery is
also another significant bearish catalyst going forward, as
prevailing exchange rates will send the “recovery” reversing
in a blink of an eye. I’ll short on some weakness and get
sizably short if 1.37 is broken down.
I’m staying short EURNZD still, however, as the pro-risk (or,
more accurately, inverse-vol—except in the case of USD-
driven risk correction) proxy of bearish euro sentiment. And
with milk/corn ratio (see chart below, courtesy of Bloomberg)
at 15 month lows (and frustrated farmers looking to diminish
livestock herd sizes in response to surging feed costs, causing
milk supply to decline), NZD looks bullish as its main export
looks ready for major sector rotation gains and its central
bank continues its hike cycle. EURNZD remains in its range
between 1.74 and 1.88, selling off from its 200d and range
channel resistance, netting my portfolio another 140 pips on
today’s selloff.
AUDUSD up another big fig on the back of the surprise rate
hike and QE of course. With the rest of the world busy
debasing and easing and printing, I suspect that the RBA
doesn’t know what it is in for as far as hot money inflows and
eventually very tough-to-fight input inflation and
unsustainable and quickly-reversing asset price inflation,
particularly in housing. With a prevailing 475bps cash rate,
bank margins are now non-existent and the massive
contagion risk between the five large Aussie banks holding
ridiculously large exposure to Australia’s housing sector (and
by consequence, mining sector) while maintaining 2007-
reminiscent 25% Texas ratios. Eventually balance sheet issues
will start popping up at the banks, which are currently
running tripling profits, and those issues will spread like
wildfire throughout the Australian economy. Commonwealth
already hiked mortgage rates 45bps in reaction to the RBA’s
25bps cash rate hike. This can’t end well. Still, for now,
there’s no fighting the uptrend and as long as its chart
remains strong, I will go back to buy-the-dip mode in AUD
and copper/Shanghai. The recent plunge in AUDNZD
continued today, and this may be a bad sign as the now-175-
in-positive-carry is still seeing offered supply, even in the face
of carry trades running rampant elsewhere on the back of the
FOMC. This is also bullish for our NZD-bull position in the
EURNZD short trade. AUDUSD’s breakout today may hold, in
which case I’d be buying on dips, but given the measured
move target from August’s consolidation is 0.99, how
AUDUSD reacts around overhead resistance will be key to
watch. Below 0.965, its 55d, and/or its channel support
trendline, it looks like a terrific short.
Bonds sold off on the lack of QE allocation for the longer-end
of the curve, confirming my suspicions. The 30yr yield surged
20bps to 4.06%, as 10s30s widened 10bps to 145bps and 30yr
prices ticked down to low 130 handle on volume significantly
above open interest. I expect this trend to continue, as input
and food/energy prices rise, causing back-end spreads
(representing long-term inflation risk—and currently highly
correlated to sovereign CDS and precious metals prices) to
widen as long yields tick up and the belly sees yield
depression from marginal Fed demand. A breakdown below
129 should really get the ball rolling in my long bond short
and back-end curve steepener.
A significant implication of the rise in long yields that I have
been predicting and am now seeing manifest is in the rates
differential between US and Japanese bond yields. With
Japanese yields the lowest of all in the world, and going
nowhere fast thanks to a surging currency and the worst-
performing equity market since March 2009 lows, the
nominal yield on USTs is determining the entire spread
function of US-Japan rates differentials, which is why USDJPY
has been so highly correlated to yield spreads. With long
bond yields spiking and looking to being a strong wave up,
this is bullish USDJPY and sets up for a reversal in the cross,
which leads up to the JGB crisis I expect in 2011-2012. Back
this past summer, I got very bearish USDJPY and was one of
the first to call for inevitable (and unsuccessful) BoJ
intervention. Now, after Toyota Motors has revised its
USDJPY forecast from 90 to 80 (cutting billions in expected
revenue in the process), and while UST yields have started
rising in the back-end, I think the time to buy USDJPY in size
has arrived. I remain long from average price 80.75 in size.
Great move in F today, breaking out of a great seven month
base on greater than 2x average daily volume, surging over
5%. It announced bullish earnings just a few days ago on the
th
26 of October, and looks very bullish going forward. This is
the type of equity chart I love being long. As long as the 14.50
level holds, this one should be headed for much higher, with
technicals targeting an over 30% rally from current levels, and
possibly challenging the $20 level sometime next year.
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DISCLAIMER: Nothing contained anywhere in this commentary, including

analysis and trade ideas, constitutes or should be construed as investing or
financial advice, suggestion, or recommendation. Please consult a financial
professional and do due diligence before engaging in any purchase or sale of
securities.

OPEN TRADES

Long /ZN | 125’15 | stop 124’20 | +1’14

Short APOL | 51.90 | stop 54.00 | +25.88%
Short STRA | 160.00 | stop 165.00 | +15.59%
Long TBT | 32.65 | stop 31.80 | +6.16%
Short /ZB | 133’24 | stop 135’15 | +3’00
Short BAC | 13.32 | stop 13.75 | +13.51%
Short BLK | 179.89 | stop 182.20 | +7.91%
Short GE | 16.73 | stop 17.50 | +4.00%
Long AMZN | 159.10 | stop 152.00 | +5.89%
Long VECO | 39.00 | stop 36.30 | +8.79%
Long YHOO | 15.65 | stop 15.35 | +3.32%
Long /ZC | 559.10 | stop 511.25 | +4.14%
Long TWX | 31.25 | stop 30.80 | +2.62%
Long USD/JPY | 80.75 | stop 79.85 | +35 pips
Long ACAS | 6.67 | stop 6.25 | +7.95%
Long MSFT | 25.20 | stop 24.85 | +7.26%
Long F | 14.25 | stop 13.85 | +6.53%
Short MON | 58.75 | stop 60.50 | -1.36%
Short EUR/NZD | 1.8370 | stop 1.8650 | +370 pips
Short GBP/NZD | 2.0885 | stop 2.1900 | +360 pips
Long LUV | 13.34 | stop 13.00 | +5.77%
Long CAD/JPY | 79.60 | stop 78.55 | +100 pips
Short PWER | 10.58 | stop 11.40 | +5.95%

CLOSED TRADES

Long AGU | 80.00 | sell 85.73 | +7.16%

Long MEE | 35.35 | sell 41.30 | +19.15%

NEW TRADES

Long ZSL | 16.66 | stop 16.40

Short BP | 42.40 | stop 44.80
Short /ES | 1195.00 | stop 1212.00