FxCurve

07/0712

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For Private Circulation Only

What a week it has been! Welcome to the new gloom doom edition of FxCurve. I am only half joking. People who rely on hope for investments have hope but the underlying facts are very grim. We are not doom fanatics but this edition can certainly beat any gloom-machine to it. What a week - historic and probably crucial for global economy and Eurozone. Cut the chase these three are very important happenings of this week: ECBs record low interest rates Negative interest rates becoming a reality Shutting down of money market funds by JP Morgan, Goldman Sachs and Blackrock

Bonus four: The real economy still sucks Surprise interest rate cuts by PBoC BOE did a QE LIBOR probes get started

Record low rates ECB pushed to a corner by failing austerity measures and no growth cut the interest rates to 75bps. With this the real interest rates are negative. Rate cut will certainly help the economies but this situation is not that of Central Bankers to solve but needs a political solution. Growth will not come back to Europe unless governments get their act together. Printing money has not led to growth. If you have any doubts, ask Obama. ECB surely has been very reluctant to cut rates for precisely this reason but the falling macro indicators forced its hands. Summary: Will it help? Yes, but very little. Core problem is growth which is Governments domain.

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Negative Interest Rates

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Another creature right out of history and text books comes back to life. Denmark cut its interest rates to -0.20%. Call it the problem of plenty, Denmark took the step to discourage inflows from Europe. Another big contender to follow it is Switzerland which is probably weeks if not months away from do it. Switzerland has been facing this problem of being a safe haven. Swiss took the full blast of Euro sell-off, so much so it decided to peg its currency in Euros at 1.2000. They do it by buying the Euros and selling/hedging them against other currencies (especially dollar and yen). But the problem is: They cant sell / hedge the entire amount bought, and these residual Euros have amounted to colossal Euros 365billion reserves. This bet is now worth 2/3rds of Switzerland GDP! Problem is Euro is a falling asset and may even cease to exist. Swiss have bet in the trade far too much. As Ramalingam Raju would say, they are riding the tiger. They cant get off the Euro-peg tiger without getting mauled. One option they do have is Negative Interest rates and in our opinion this is something they would consider very soon. Summary: Negative Interest rates is here to stay. Dynamics of capital flows will shift dramatically over next few months.

Money Markets The BIG BIG story of past two weeks has been the Euro 100billion Spanish bank bailout and the Italy and Spanish revolt at Eurozone summit which got them major concessions. Well, two weeks later both Italy and Spain are back to square one. The bond yields of Spain and Italy are back to near highs again. Which simply means, they would not be able to service the debts at these rates, so the status quo continues. Take for instance: Spains Debt to GDP ratio is near 1, i.e. for every Euro 100 in GDP there is an Euro 100 in Debt. Therefore every 1% increase in yields / interest rates leads to an amount equal to 1% of GDP! And when things go wrong, interest rates will up in days and weeks, while GDP is not similarly flexible. This simply means at one point in time in future rising Spanish yields can bankrupt Spain. Italy is worse because its Debt to GDP is far above 1. Go figure. BETA hedgefx@gmail.com

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It is in this context that JP Morgan, Goldman Sachs and Blackrock, and few more to come, shutting down or (temporarily) stopping their Euro bond money market funds is a HUGE red flag. Now the simplest but important question is: Who will buy Eurozone bonds now? How many buyers are left? How long will they last? And, how and to whom will Eurozone sell its bonds? If you understand that the simple answer is a rapidly declining numbers of investors, we have a reason why Italy and Spanish yields are shooting up. Simply because sellers outnumber buyers at this point. How long will those buyers last is hard to answer. Summary: This in our opinion is a major development people should watch out for. Effectively these three major corporations say they dont want to hold or buy Eurozone bonds. More people will join them in weeks ahead. More the number of sellers worse the situation for Eurozone, Spain, Italy and Euro. Ps: If Eurozone blows, Switzerland joins it.

And to continue the gloom doom

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The real economy is languishing

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Real economy has been on rapid nosedive across the globe. They are likely to remain until a miracle potion can be invented. Frankly, as of now, we have no idea how or when we will emerge from this slump. Here is a chart to explain all ills at a glance.

h/t Ritholtz.com

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Surprise rate cut from PBoC

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Surprise it was! Such a nasty surprise and a puzzle. The big question is, why cut the rate for second time in matter of weeks? The answers are not very clear nor are its implications. It should be sometime before we see some impact. However, traditionally any surprise rate cut is viewed as a desperate measure in toughest circumstances. And somehow they always tend to come near the market tops. [Nobody desperately cuts rates when everything is going smooth] Cutting the rates twice within span of weeks is a clear sign of Chinese governments desperation of its slowing growth. Chinese PMI (as seen above) has been on consistent decline, with inflation moderating and GDP growth dipping below the much publicized 8%. As of now markets are looking for some more bad numbers out of China and also the anecdotal evidences of growth slowdown is hard to ignore. These are as simple as mounting coal and copper inventories, falling electricity production, empty freighters and dropping property values. Summary: This is a classic sign of desperation and markets will treat it that way until proven wrong. However, we have to remember that growth may benefit from these cuts in about two quarters. Ps: China has a huge problem in NPAs, the real numbers are fudged or refinanced. Increasing / promoting the lending alone may not bring back the growth unless its importing partners growth also perks up. Nevertheless, it is good that China is taking its growth slowdown very seriously. Ps2: The BIG difference between 2010 and 2011 (markets rallied in 2010, while it crashed in 2011) was that in 2010 China was chugging along fine. Its banks lax lending practices led to property bubbles and NPAs but growth was good.

BOEs QE / LIBOR BTW, BoE did a QE this week by increasing its quantum of asset purchases. Markets duly noted it and moved on.

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LIBOR scandal has potential to blow up which could lead to big changes down the line but it will be long time coming. Right now we have no idea how this will end. Probably this will end with some legislation or new authority of some kind.

Indian Markets Coupled or De-coupled Some people expect with India being among the few growth countries, the glut would flow into India. We just dont agree to this at all. If there is any lesson from 2008 stock crash it is this: stock markets are coupled, hard bound iron-chain coupled. For anybody who has traded even on an intraday basis on global markets and Nifty would notice, they move tick-for-tick in sync. To expect India would be Noahs Ark when whole world stock markets are decimated is just absurd. But considering the lack of depth in our markets even an odd billion or two would cause a spike. But is waiting for that odd spike a good risk management, we leave it to you. Summary: World markets are tightly correlated. We dont think Indian markets would decouple or for that matter nor are fundamentals sound enough to merit decouple.

Trading Strategy Currently we are in minority and we like it that way. We have been calling for a top since Nifty hit 5150 levels but we have been wrong on this. But we think this is because of the massive relative outperformance of equities in relation to other risk assets. QE Hopes This rally has been especially fueled by the hopes of QE and liquidity inflows. As we have argued earlier, we do not see any major QE from FED until Eurozone blows up or gets resolved or at least is near resolution. The best example of the fragile nature of QE is the this weeks BoEs QE all sentiment gone in few hours! As stated before US has been a

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deriving the benefit of synthetic QE with strong dollar, lower inflation and yields at record lows. FED couldnt have had it better. Only thing missing in the equation is the jobs. Indian Domestic growth The situation on growth is dire. Government hasnt made any moves that would instill confidence in businesses. We have a small window of about 6 months before the state elections begin to stating impacting policies. If government is unable to make positive improvements and/or Eurozone crises deepens, we will have real problems on hand.

Consider this: the maximum gain even on the best circumstance is probably restricted to 5600-5800 levels, a gain of 6%-10% from current levels. The downsides however are 4800-4500 or even lower, a drop of 10%-15% from current levels. On the high beta names the upsides could be about 20% or a drop of 30% or lower. Does the risk reward sound beneficial under the fundamental / macro economic circumstances? It would be a very sound strategy to build cash levels at these levels and wait for the downside. In our opinions the chances of downsides are much higher than upsides. Technically the current trend remains up but at near extremes in near term. None of the indicators are bearish. Oscillators remain in complex overbought pattern and may remain so for indefinite amount of time. Technically, there is nothing to call a short on this except that the prices are close to the 61% retracement of the entire Feb-May fall. And probably retests of the 5150 support zones and fill the 30-point gap at 5165. There are minor negative divergences but they should be ignored in well channeled trends like this. On the longer-term weekly chart, as long as prices remain below 5400 it remains in downtrend.

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