Decision time long term rates

The current environment for long term interest rates in Europe is a very peculiar battle ground between countries which are deemed to be mired in vicious cycles of sovereign debt crunch leading to default and countries which are stable and possibly going to suffer from recessionary and deflationary environment.

Germany is a country which could suffer from the latter. Firstly it is expected the economy will slow down in the 4Q leading potentially to economic contraction in early 2012. At the same time as the European and global economy is slowing down fast European countries will be hit most. The fiscal austerity prescribed by Germany and enforced by frantic downgrade avalanche by rating agencies will definitely worsen the situation. The retrenchment of the governments will greatly impair government spending and investment leading to deeper economic retrenchment.

The current German government bonds are locked in a trading range which seeks resolution. The pattern which is forming can be resolved to the downside if and when the German Bund falls below 133. On the other hand if the German Bund is going to rise above 140 then interest rates on long-term German government bonds may begin a new round of declines. This is the upper level of a well-marked uptrend as shown in the chart. Thus any movement above this level shall be highly significant.

Further decline in German rates could be associated with more equity market risk, more sovereign stress in Europe, continued expectation of deflation particularly in Germany and finally but not lastly stronger expectation of Euro-zone disintegration.

The resolution of the trading range in the German Bund can have an extremely strong indicative character for the things to come.
Source : Bloomberg

Store of value or loss of value

Something very amazing is happening with the gold price suddenly. The price of gold the proclaimed store of value corrected from its lofty highs around 2000 earlier this year to below 1600 USD.

The issues discussed can vary dramatically. The negative correlation between USD and gold have been cited; weak demand from India and China; speculative unwinding of gold positions. Whatever the issues may be at the moment the safe haven of gold is no longer so safe. The multi-year fear trade out of paper assets into real assets hit bumpers. One of the most credible issues evaluating gold price may be that the inflation expectations are falling and the interest rates globally follow suit. The new round of interest rate cuts by global central banks appears to have started gradually as the economic growth slows. Europe is expected to be already in recession and other economies are beginning to start the fight against the possible recession. Particularly China and India will stage a fight to revive credit cycle in order to stabilise growth which so important for the long-term prosperity and development of both countries. Falling inflation and falling interest rates could reverse the multi-year trend of negative real interest rates. The negative interest rates have always been a good guide to the direction of gold price.

It is important if the strong monotonous rise in gold price which begun in 2008 is finding some feeble support. If the final support is going to be broken it can be expected that it will spook hosts of investors who have been faithful believer in stronger and continued higher gold prices. The subsequent collapse could be more than anybody would predict.

Source: Bloomberg

Volatility the new normal

The history is a very good guide to the future. Unfortunately it does not replay or repeat itself the same way again and again. This time the equity market is choppy and very volatile. Investors are just thinking about the next catastrophe coming down the way and it obviously have to be Europe. The European financial crises and obviously not the Euro crises is something which occupies the investor mind taking his eyes off many other important issues. Let us concentrate for a moment on the better performing equity markets in the world. US equity markets are showing again a positive return for the years and since the European financial crises broke out in early 2010 the US equity market appreciated by more than 10%. This is not too bad for the current environment and uncertainty.

Now the VIX as an indicator of fear refuses to rise. Does it mean the fear is less or is the market not driven by fear any longer? Between the levels of 20 and 40 the VIX heralded a choppy market which could be either rising, like in the late 90s or falling, like 2001-2003. Any major push beyond 40 was a fear factor which marked an important low in the markets ascent or descent. Following the exhaustion the US equity market generally quieted down falling towards 20 reading. Usually it did not revers in the middle of this range but rather moved toward the lower level around the 20 or even 15 reading. Thus the choppy current markets may last for a while but the short to medium trend could take them higher against most market participants expectations.

The VIX implications are also supporting the December and early January characteristics of the equity markets which tended to be a reliable source of alpha over many years.

Source: Bloomberg

Usually the SPX and VIX move in opposite directions, especially on a big down day. On days when the S&P lost more than -1.5%, the VIX rose 95% of the time – Whatever the reason, the table on the attached website shows how the futures performed going forward when both the S&P and the VIX declined by a large amount on the same day.

Greece – there is a way out…

On a ridiculously busy results day, I thought it was worth taking a look back at history. It reminded me that a relation of mine had kept a whole lot of cuttings from fashion magazines from the 1920′s to the 1960′s. My knowledge of fashion is negligible but, even I was able to recognise how styles that we think are original today are often just a ‘re-heated’ version of fashion from a previous decade. The point is that if you look back far enough, it is amazing how often history repeats itself. And, it might do again. Greece’s debt balloon and its contagion to Italy and others countries remains the key market risk. All the feathers flying around at the moment regarding Papandreou, and today’s ECB rate cut, are just a distraction from the real issue – Greece’s debt, the cost of it and Italian contagion.

When looking back to the early 1940′s, the US was still reeling from the financial fallout of the Great Depression. US debt was already running at c.120% of GDP and, huge additional borrowing was required by the US Government to fund the ongoing cost of the war. Understandably, investors were increasingly nervous about the US Government’s finances. Bear in mind that 120% was far worse than the US’s current debt to GDP of c.100% for 2011e and 105% for 2012e. What did the US do? The Federal Reserve ‘pegged’ long term Treasury bonds at a ceiling of 2.5%, the 12 month at c.1%, and the 3 month at c.0.4%.

In the longer term, this policy of ‘debt monetisation’ does become inflationary but, in comparison to the chaos in the European Bond / wider markets at the moment, this would be a problem for another day. The reason Greece’s debt to GDP ratio has been rising so aggressively is because of the ‘debt spiral’ given tax revenues are not rising and the economy is shrinking. Because Greece can no longer issue Bonds in the public market, symbolically, the 10 year Greek Government Bond is trading at over 23% i.e. assuming default. Although the suggested haircut of 50% eases the absolute debt amount, aside recent EU support, it does not address the mid to long term concerns regarding the risk / coupon applied to Greek debt. Those Greeks that can get either themselves and / or their money out of the country have been doing so, highlighted by Estate Agents here that estimate Greek nationals have bought c. £250m of prime London property during 2011. While I recognise the EFSF enlargement is an valiant attempt to provide a sufficient financial fund for liquidity and a loss absorbing cushion, it is unlikely to stop the debt market speculation. The only thing we know is that if Greece snowballs into Italy, Spain etc, even an enlarged EFSF will not be enough.

As far as Greece’s debts are concerned, the EU has already started down the path of limiting the interest rate that Greece pays. There is the €100bn from the EU (July 2011), of which c.€60bn has been paid to Greece already, that attracts an interest rate of c.5%. Meanwhile, the IMF is also looking at another package with a ‘limited’ rate of interest for the c.€100bn of existing Greek debt that matures for re-financing between now and mid 2013. But, surely this is just an unnecessarily messy recipe in comparison to imposing a blanket yield on all Greek debts?

If the ECB sets a ‘peg’ for Greek Government Bonds, then Greece has a fighting chance of not needing repeated bailouts and even the current proposed 50% haircut might be reduced. Clearly, if speculators then increase the upward pressure on Italian Government Bond yields, the ECB could then apply the same ‘peg’ to these too. Yes, it would be critical for the EU to still require austerity measures on those countries that enjoy the ‘pegged’ bond rates. Unthinkable? Well, the US applied a ‘peg’ successfully to its bond market at a time of severe financial strain. We have already seen that European Politicians have applied ‘short bans’ on Banks in order to ‘cut the hands off’ the Equity speculators so, why not do the same to the fixed income speculators? Simultaneously, it ‘castrates’ the ratings agencies and sends them a suitable ‘thank you’ given all the brilliant ‘rear view mirror’ foresight they have offered us in the last several years……..

When you consider the extreme fragility of the US finances in the 1940′s, the real measure of success is the unusually low Treasury Bill rates from the early to late 1940′s (please scroll through the email below). Reverting to the ‘fashion’ example at the start of this email, this is a formula that has been applied successfully before. Although clearly the US is a single country (and a more dynamic economy) while Greece is a small part of the EU, European Politicians might well be advised to thumb through their history books once again

Many thanks for a friendly help from a good Friend Alex.

The light at the end of a tunnel?

It is very fashionable to join the camp of the doom and gloom sayers. There is consolation in numbers and nobody
in its same mind would like to argue that the crisis is over. It is so “in” to add to the difficult feeling of demise that at the current moment contrarian thinking would be seen as ludicrous. Positive statements about the economy or
even a view that the global economy may not be in a negative tails spin which will bring it to the abyss of disaster and economic mayhem are viewed as fantasies.

Let me explore those fantasies. Let us think for a moment about the old truth that if everyone thinks the same
nobody thinks. Now everyone thinks mayhem, recession, inflation, imploding Euro, debt crises in Europe, end of the Euro and possibly EU just to mention a few. Anybody can obviously add as many negative statements to his or hers liking.

Now let us see if we can say something positive about the markets. Well……? Any thoughts? Let me concentrate
on two at the moment which can provide some useful fundamental ideas to explore in the coming months. Those initial thoughts are like candle in the wind of the current overwhelming opinion – unacceptable for most people.
First idea could consider a bottoming process for the European banking industry. Did I say that? Bottom for banks? Insane! Not really. Just have a look at the following chart. The European Stoxx 600 Banking Index put a new low in place which – to possibly everyone’s great surprise – is above the low defined in 2009. It appears to be impossible but it is. Despite the most negative news on banking system in Europe in human memory the banks refuse to fall below the lows of 2009. This is a statement on behalf of the investors which did not send the index to new lows. Remarkable!

Source: Bloomberg
The refusal of the index to make new lows has tremendous implications from the technical point of view. Could it
indicate that the worst for banking system is over?
Good price based indicators like the Stoxx 600 Banking Index may not be the best tool as they may contain a lot of
sentiment and noise. What about some fundamental monetary indicators?

The following chart displays the year-on-year growth of monetary M1 indicator as calculated by the ECB. The indicator which is published monthly appears to be putting in a bottom. Few people who would like to continue to support their negative view may just argue that it is only a pause before M1 will continue to fall. However if this is
bottom it shows that it was not as bad as 2008 around the Lehman Brothers demise. Obviously the M1 growth reached some 6% year-on-year growth by the time the market bottomed in Q1 2009. This may indicate that we are still some months away from the final bottom of the market.

Source: Bloomberg
It is often profitable to consider which most investors refuse to think about. The banking system may be fragile
and prone to volatile setbacks. But the important question is, did we see an important low in the banking sector which offered value to daring investors? Most commentator’s reply to this question would be no, I would dare to think yes.

The land of milk and honey

GERMANY.
Is obviously at the epicenter of the great Greek tragedy which shows the grat struggle between the normal people, here read the average investor and the Gods, here read the so much dreaded ominous market forces. Despite all the turmoil and the seemingly difficult situation which may remind somebody of a Gordian knot which cannot be untied unless by a bold stroke. Nobody can see this bold stroke coming thus we remain under the impression that whatever happens at the moment in Europe is outright bad and will finally lead to a disaster unraveling European integration process which lasted decades and destroying the dream of the single Euro currency.

Among all the rubble and dust it is a rough diamond in the dust can be easily overlooked.
Germany is a big global exporter which survived dramatic changes over the last 20 years since its unification. Those changes made the German economy one of the most efficient in the world. Those efficiency gains allowed German companies to prosper through all those perils of the global economic roller-coaster ride. Last two year following the economic down turn in 2008/09 showed how an efficient economy can stomach those fast relentless changes and create jobs while still continuing on the path of efficiency gains and export competitiveness.

Now it appears that the current European debt and economic turmoil could create the second stage of the German sage offering even more glory for German companies. The economic disaster inEuropecould prove to be a bounty forGermanycompanies and German economy. Two major issues are adding to the positive picture: interest rates and Euro.

The first chart shows that the long term interest rates are at generational lows. Not only the German government can borrow at such a low interest rates but obviously the German companies and the German consumer can profit greatly from such a low interest rate environment. In the world where quality and yield are sought after German companies stand to gain.

Source: Bloomberg
At the same time the European currency begins to weaken which for a country relying on exports the benefits are plenty and easily visible. In the world which is going to slow down but not come to a standstill an efficient exporter with depreciating currency would be a300 pounds gorilla to reckon with. It is the seldom combination of low rates, weakening currency and efficiency gains which makes German manufacturing and German economy stand to gain tremendously from any continued Euro weakness.

Source: Bloomberg

As the Euro chart clearly shows at the current level above 1.35 Euro tends to be at the stronger end of its theoretical trading range. The white line shows simply the long-term average since 1975 and it is around 1.17 EUR/USD. At those levels politicians and media may cry foul but it is definitely going to be beneficial for German companies and economy.

DAX contra bear

The bull market which started in 1982 in German equities stalled since 2000. It tried again in the cyclical bull market of 2003 till 2007 to surpass the highs defined in early 2000. In vain. Only now investors slowly recognise that the market may be caught in a multi-year secular bear market as seen throughout the 70s and early 80’s. The so far well behaved nature of the market development as shown by the attached chart may be pointing to a new low coming soon around the support line. This would suggest a support between 4500 and 4700 on the DAX.

Source: Bloomberg
This could be still unnerving investors and more capitulation could be coming soon particularly as the September month is generally viewed as the weakest month for stocks historically. A monthly close below 4500 for the DAX may have a more profound negative implications for the market which than could see the retest of the 2009 lows.

There are obviously numerous fundamental reasons to believe that  the fear of recession and the fall of the stock market are a kind of self-fulfilling prophecy. The investors are getting what they fear but not what they wish for. Thus stay tuned to the market and it will tell you what the next steps in this bear market development are.

The next chart shows the extent of the current secular bear market in German equities.

Source: Bloomberg

It shows the relationship between the DAX Index and the Gold price since 1970. It is not currency adjusted. It can be clearly seen the bottom formed between 1980
and 1982. Subsequently the bull market in equities took hold just to accelerate frantically and vertically into the year 2000 where it peaked. Since 2000 the relation reversed most of its advance and is now much closer to the lows seen in early 1980s. It can be expected that once the relationship between equities and gold stabilises in the next years the equities may begin to form a bottom which will result in a new multi-year secular bull market. The cyclical bull markets in equities between 2003 and 2007 as well as 2009 and 2011 where a mere stabilisation in the downtrend. Equity investors will still need a lot of passions before the equities will bottom.

Gold infatuation

I take this opportunity to again restart my blog on market thoughts and impressions. It appears that gold become not only the most favoured investment in the times or despair but also that it may become soon the next asset class where some people will make a fortune but most will lose their investments.
When gold dipped below 300 USD it was the time when equities were the topic of the day and the blue sky scenarios were handed around in magazines and newspapers. Now the world has changed and the end of the equity culture is the topic. Defaults and despair are the leading highlights of the investment day. Only gold shines and as more investors look for shelter they turn the attention to the everlasting infatuation with gold.

It has been the best investment of the last decade and it is being hailed as the investment of the future. However as any seasoned investor can recall manias and bubbles are dictated by absence of common sense and the believe of the majority in an irrefutable story. This story is gold. For the moment.

Source: Bloomberg

Just a brief look at the attached chart clearly shows that there is a well defined two stages in the development of the gold price. First stage begun with the bottoming process in 2000/2001. The bottoming process was followed by a gradual price appreciation which lasted 5 years into the late 2005. Around the end of 2005 the price of gold moved above the well defined trading band when it moved above 540 to 575 USD price range. Subsequent years did see the gold price retest the upper bounds of the rising channel from the first stage of price appreciation. The channel which was formed in late 2005 early 2006 continues till this day with marked highs being set in 2006 and 2008. The current price action shows a marked retest the upper band of the channel at the 1800 USD level. The important question arises if the gold started the final incline to the ultimate highs or if it is going to be contained by the rising upper band of the current price channel.

Every next channel is steeper if the gold enters the bubble phase. The green line indicates that it may be in the initial stages of the final exponential rise. However this can only be confirmed if gold price moves decisively above 1800 USD in the coming days. The other positive confirmation may come from the retest of the rising third trend line (GREEN in the chart) around 1650 to 1700 USD level. If the retest confirms the strength of the gold price than investors may conclude that we are indeed moving in the third and potentially last stage of the gold price expansion which could see the gold price rise to …..??? There are numerous price targets which can be obtained raging from 2500 USD to 3500 USD. When a mania and bubble begins the upside target appears to be anyone’s guess depending on the strength of the mania.

The current media coverage play to the tune of final stage. Gold should become the new monetary system. Currencies should be backed by gold. Gold is the only investment in town which can shelter against any risk. Those vies are good heralds of the things to come especially bubbles.

Do not say in the future you did not spot the bubble in making.

German bull

This is what I would call outperformance. Lasting outperformance. The German stock market was one or possibly the highlight of investments in Europe. Since 2005 it has been and continues to be a tremendous outperformer.

DAX Index vs. EuroSTOXX 50 Total Return Index

Source: Bloomberg

The economic strength is clearly visible in the outperformance of the equity market. Please be aware that this is the relative performance of the DAX Index as compared to the EuroStoxx50 Total Return. Away from some interim wobbles there was no real weakness in this relation.

Obviously the latest tremendous outperformance is attributable rather to the weakness of the periphery. Italian and Spain which play a great role in the European equity markets are the clear losers of the current financial turmoil.

The German economic machinery carries on pumping and creating value for investors and ordinary people of Germany. The clear question is can it last and continue? The strength of the outperformance could weaken as investors begin to realise that there is some value away from the German growth. This could be similar to the period in the second and third quarter of 2010.

Europe will need to do a lot of repairing and other European countries will need a lot of restructuring of the economic and corporate fundamentals to match the raging economic bull in Germany. Thus stay with the strength and watch it continue.

Interest rates rising

The initial letters of the title IRR would suggest that there is a real assumption investors could profit from current interest rates. The following chart indicates that interest rates in Germany may be rising at the moment and this could continue for a while. Rising interest rates, especially at the long end, is generally a good indicator of improving economic and financial conditions. Remember we are generally still worried about the economy and so far the level of interest rates did support this view ideally.

Source: Bloomberg

Look at the attached chart the head and shoulder reversal formation could be pointing to interest rates well above most people expectations. A level around 2.4% on the 5 year German government bond could be expected.

This obviously would disturb all the investors who committed ever increasing volumes of assets into government bonds particularly in core Europe as the peripheral Europe experienced tremendous financial upheaval.

Fundamentally equity markets did recover a lot of ground from the precipitous fall since early 2008. Looking at the attached charts a normalisation in the 5 year German interest rates would mean that we should see levels closer to the 3%. It will be very surprising to any investor that at the top of Lehman crises the interest rates were still around 4%. This has been viewed as rather normal.

German 5y government interest rates at 4% would cause some turmoil but as the strength of overall global economy adds up and the QE is viewed increasingly as the curse not a blessing we might see interest rates gradually moving back to those normalised levels. Just think what it means to all the investors who bought government bonds! Thus the IRR of this trade could become extremely negative.