Introduction
Gold bugs and newsletter loyalists who, like yours truly, had beaten the gold drum for most of the summer with the relentless consistency of the Energizer Bunny, were finally rewarded when spot and December gold surged past the $700 level. Belated vindication is always better than none at all (even if you are as impatient as I am).
More recently, in last week's newsletter I speculated that abnormal standard deviations in the effective Fed funds rate distribution, along with highly over-optimistic misconstruing of every utterance from Bernanke and Bush on the part of the market, portended higher volatility and weakening equities over the next several days; both occurred. I also forecast that general commodities would fall, which (with the glaring exception of oil) they did.
More Fed-watching (sorry--you knew it was coming)
These days I sometimes wonder if I should change the title of the newsletter to “The Federal Reserve Weekly Alpha,” because I have spent so much time engaging in the “guess which way the Fed will go” lottery. It's a particularly dubious lottery when everybody else is doing the exact same thing. However, a few data still beg at least an honorable mention.
On Friday, Bloomberg's John Berry authoritatively wrote, “If Federal Reserve officials cut their 5.25 percent target for the overnight lending rate when they meet on Sept. 18, it will be by only a quarter-percentage point with no promise of more to come.” Berry's “opinion” conspicuously omitted the standard passive voice, restatements of consensus, adverb overload, and uncertain verbs that characterize media coverage of something uncertain (e.g., “Speculation abounds that...,” “Many market participants believe ...,” “Fed-watchers generally agree that Bernanke is likely to ...”)
When large institutions know that the market has misconstrued something the institution said, they often do so by “de-contextualizing” their statement through a trusted media intermediary, which in the case of the Federal Reserve apparently consists of John Berry, as well as the WSJ's Greg Ip. Practically every syllable uttered by the Federal Reserve chairman carries some market weight, so by de-contextualizing an important statement through someone such as Ip or Berry, the Fed can “speak” to the audience that needs to know, without the uninformed media noise and market gyrations that accompany actual Fed statements. The Fed generally does not de-contextualize a statement unless it feels that the market has come to an erroneous verdict about future Fed action.
In that vein, Berry's Friday column was very significant: the Fed felt that the market was counting on a 50 basis-point cut in rates when Bernanke had planned otherwise—so the Dow dropped 250 points. (Of course, there was plenty of additional Friday information, such as terrible employment statistics, that muddied the rate-cut waters somewhat and was probably responsible for some of that carnage itself.)
I generally don't pay much attention to which financial columnist is highest on the information chain for issuing Fed “corrections,” because I think it's more predictive – at least in Bernanke's case – to simply watch the effective Fed funds rate. As the Fed let the effective funds rate settle to 5 percent – clearly signaling to financial cognoscenti that a 25-bp cut was forthcoming – Bernanke was effectively pressured (judging by all available speeches) at Jackson Hole, Wyoming, and in subsequent media coverage that 25 basis points was not enough.
Judging by the effective funds rate since then (5.1 percent averaged Tuesday through Thursday), Bernanke told everyone lobbying him for a bigger rate cut to shove it. Berry's column would have been the capstone on the grave of the bailout caucus, were it not for the bad employment figures that came out later the same day.
Credit Markets
Credit markets were placid by recent standards. Spreads widened slightly at the end of the week, especially among investment-grade credit default swaps (“CDX.NA.IG”). Courtesy of the indispensable Markit.com --
More representative, I think, were emerging-markets credit default swaps, which also saw a widening spread and chipped NAV, but hardly to the extent of the IG CDSs.
Collateralized mortgage-backed securities and asset-backed securities (CMBX, ABX) indices have “stabilized” at very low levels. The credit markets have recovered to some extent, in that they are once again differentiating between different gradients of debt, but while they have recovered significant functionality, they haven't recovered significant losses. The BBB-rated AB securities are a case in point:
Wall Street has also faced exploding borrowing costs of its own. Judging by yield premia, Colombian bonds are now rated as safer investments than bonds for both Bear Stearns and Lehman Brothers, the Street's two biggest champions of CDOs. Wall Street is generally viewed as no safer than a gigantic subprime mortgage. And while the market pricing is probably not “correct” in the long-term sense, there is so much uncertainty – more specifically, lack of trust – in Wall Street institutions at the moment, and no effective means to determine which specific Wall Street firms are “screwed.” Lehman and Bear are thought to be in the most trouble, but there are plenty of question marks surrounding Goldman as well (particularly what percentage of the Fed's August repos are still held by Goldman). There is some anecdotal suspicion that Goldman was bailed out in a way that other firms were not.
Notably absent from much of the finance sector hand-wringing is Credit Suisse, which is significantly undervalued.
Outlook: International equities
As of this writing (Monday, 0100 EST), JPY has surged once again to 113.3 JPY/USD. As longtime readers know, I have been a “Japan bear” with dogged consistency. I have long thought that the extent to which the carry trade will unwind (upside value for the yen) is impossible to discern for all but the most informed investors, so it should be shied away from. Additionally, ever since the carry trade begain blowing out in late July, I have believed that concurrent with a rise in the value of the yen, yen-denominated assets will lose value relative to each other in a recessionary spiral (e.g., the Nikkei) in the face of terrible Japanese financial and demographic fundamentals.
The Nikkei has lost another 2 percent so far today. Even Shanghai and Hong Kong are down about .5 percent (they have previously bulldozed ahead oblivious to substantial losses in non-Chinese equities). I have long thought that this reflected Chinese asset flow from bank accounts, which many suspect pay interest significantly below China's real domestic inflation rate, to Chinese equities. If that flow is slowing down, that means Chinese banks are running out of deposits, and the Chinese equities bubble is about to burst.
Unfortunately, I have forecast about 5 of the last zero pops of the Chinese equities bubble, and I'd like to keep that first number as low as possible. But a prolonged slide in Chinese equities will signify, well, the world's last remaining bull (market) finally losing itself in an already-too-volatile china shop. Watch the Shanghai Stock Exchange (SSE) carefully.
Final Note: Gold
In the time that I have written the last three paragraphs, the Nikkei lost another 50 points (.2 percent). European indices have lost more than two percent across the board. There is too much grim data to ascribe the various pullbacks to any one of them – John Berry “clarifying” the Fed's interest-rate stance**, bad labor numbers which were released well after European markets were closed, bad Japanese data released much more recently, or something else.
**Philadelphia Fed Chairman Plesser gave a similar speech in Hawaii on Saturday morning, in which he, without using any traditional disclaimers that he represented only one man's opinion and not a larger group of Fed governors, stated unambiguously that it was not the Fed's job to reduce market volatility.
Therefore, the markets will have a rough first two or three days of the week. The howl for a cut larger than 25 basis points will grow louder, the howls of pain will reach saturation levels, and the Fed will act. (I am officially and finally predicting a 25bp cut, to 5 percent.) I have more respect for Bernanke than the market does. Unfortunately, the Fed is one of the most politicized central banks in the world, and if enough policymakers start making threats, the Fed will be forced to cave. Bernanke's recent assurances that he will “act as needed” (with Senate Banking Committee Chairman Chris Dodd close at hand) have thus far been purely show.
If Bernanke caves (and there is a significant but indeterminate probability that he will) gold will gain more. If he does not, gold will lose less value than most other assets. Therefore, gold remains a solid bet. Long gold; long cash.
As for the euro and GBP, I am shifting into a more neutral regime. In terms of trade balances, I see little basis for further euro appreciation over the long term. Many central banks that have purchased euros in keeping with the global “de-dollarization” have done so to a significant extent, undermining one bullish pillar of euro appreciation. And in terms of momentum-based buying, the euro stands to stall simply by the nature of its outstanding historical performance.
If Bernanke shows spine at the Sept. 18 FOMC meeting, as he appears to intend to do, the dollar's inexorable decline relative to the euro will halt.
I am generally bullish on the Asian currencies, because their enormous trade surpluses ultimately should self-correct through currency appreciation. To a large extent they already have. To what extent they will continue to appreciate is wholly unclear. I am neutral on the Asian currencies (Korean won, JPY, Taiwanese dollar).
The global slowdown will have its most forceful impact on industrial base commodities, including oil. Oil spiked late last week owing to storm concerns, but it is poised to realign with “Dr. Copper” over the medium term. Short industrial commodities.
Precious metals stand to benefit not only from the significant potential for major central bankers to go wobbly, but also because of the “flight to quality effect” in times of declining confidence in major banking institutions. Long precious metals.
That's all for this week's newsletter. I hope you enjoyed it, and if you want to fire away any feedback (positive or negative), don't hesitate to e-mail me at alex.forshaw@gmail.com.
--Alex Forshaw
Editor in Chief
http://www.bestwaytoinvest.com
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