When the Swiss National Bank (SNB) intervened in the both the US Dollar / Swissie pair and the Euro / Swissie pair we called it a watershed event that the markets had ignored. Last week we began to hear the rhetoric that we cautioned against.

New Zealand Q1 GDP printed at -2.7% vs. -2.3% estimate Q/Q and Y/Y -1.0% vs. -0.7% estimate. This was the worst GDP print in 15 years which has not been lost on the politicians. The Finance Minister stated the strong New Zealand Dollar was acting like a “handbrake” on the economy. It is this type of rhetoric that usually precedes currency intervention. As we noted, the thinking is, “If the Swiss can do it, why not us?” Furthermore, we remind readers that the Prime Minister of New Zealand is the former head of Global Foreign Exchange trading at Merrill Lynch.

In Japan deflation is the symptom and the prescription is the same as New Zealand and Switzerland. Japanese April CPI was reported at -1.1% at both the headline and core levels. The simple way to combat deflation is to weaken the currency.

The foreign exchange markets can now be divided into those countries that have an incentive to weaken their currency and those countries that either already have weakened or lack the ability. This pits the Eurozone and the US Dollar against the Yen, Swiss Franc and New Zealand dollar.

The US Dollar has already experienced significant weakness over the last several years and quantitative easing has raised the fear of inflation. It is unlikely that the US government would step in to weaken the dollar. Moreover, the global political backlash would be too great.

The Eurozone and the ECB find themselves in a precarious situation. Because of the disparate economic interests in the Eurozone it would be extremely difficult for the ECB to intervene to weaken the Euro. Moreover the ECB has been slow to respond to the global economic meltdown.

Last week the ECB began its campaign to pump liquidity into the financial system by extending 1 year loans at 1% to financial institutions. This is the first and closest form of quantitative easing that the ECB has embarked upon.

The net result is the Euro remains vulnerable to competitive currency devaluations. We remain long EURUSD with a short term bias and an initial target of 1.42. In Euro ETF (FXE) terms this translates into $142 initial target.

Disclosure: Long FXE

Tags: currency, devaluation, FX

As macro traders it behooves us to examine the stellar 2 year note auction. The bid to cover was 3.19 and indirect bidders took 68.6% of the auction!! Anyone who thinks foreign central banks have stopped buying US debt should look to this auction for clarity.

2 Year US Note Future – Sep 09 – 60 Minute Chart

Prior to the auction the 2 year was strong and accelerated after the announcement. Now let’s go out a few years on the curve because Wednesday the Treasury auctioned 5 year notes.

5 Year US Note Future – Sep 09 – 60 Minute Chart

Interestingly the 5 year note did not participate in the bond market euphoria on Tuesday. The likely explanation is risk aversion ahead of Wednesday’s auction. However, the muted action in the 5 year leaves the yield curve distorted in the short term. If today’s auction is at least in line with prior auctions the 5 year will have to play catch up. We intend to play this potential slingshot through the iShares 3-7 Year Treasury ETF (IEI). This ETF has an average maturity of 4.86 years and is designed to track the 5 year note.

30 Year T-Bond Future – Sep 09 – 60 Minute Chart

We purchased the iShares 20+ Year Treasury ETF (TLT) on the strong 2 year auction. The 2 year note is the maturity of choice for investors to hide from inflation. The strength in this maturity suggests that investors no longer are concerned about inflation. Since the long end of the curve involves maturity risk this sector tends to be more volatile and is the reason we chose to purchase TLT.

Additionally, since the mid-month inflation “scare” the break even inflation rate (BEI) has declined below 2%. As a component of bond yields, falling inflation means lower yields and higher prices.

Disclosure: I am long TLT, IEI and call options on IEI

Tags: BONDS, treasury bonds

The Euro is weaker vs. the dollar despite a positive German IFO number. For the third month in a row German IFO indicated that business was improving and the economy may have bottomed. Similar to sentiment in the US, the German business outlook indicated future strength. Since the ECB’s mandate is to keep prices stable ahead of economic growth, market participants expected the ECB to be the first to raise rates. However, ECB member Nowotny threw cold water on that perception.

Nowotny’s assertion that rates would remain unchanged until 2010 resulted in the Euro weakening vs. the dollar. The market is adjusting to the new reality that the dollar may be a better relative investment. This statement by Nowotny makes the FOMC statement even more important. Investors will obsess over the wording to determine if the Fed will be the first to tighten.

This is precisely the change in perception that we anticipated last week and was the catalyst for our purchase of US dollars via the PowerShares Dollar Bull ETF (UUP). The market appears to be catching up to our line of thinking and we anticipate adding to this position on strength.

Disclosure: long UUP

Simply put, we found the industrial production report to be terribly bearish for the US economy. Ten months ago the Federal Reserve began expanding the monetary base and as we have written this should lead to an uptick in industrial production within six months.

In April, we were relived at the stabilization in the IP number. The “less bad” print gave hope that the economy may be bottoming. However, the decline in Industrial Production in May was rather disappointing. In fact, it suggests that the monetary policy of the Federal Reserve is still not working. While the Empire State Index showed optimism for the next 6 months, actual factory usage suggests continued weakness.

Capacity Utilization fell to 68.3 in May, a new record low. If the economy were staging a recovery we would expect capacity utilization to begin to increase. This data leaves us very concerned that the economy could suffer the dreaded “double dip” recession.

Disclosures: none

Tags: industrial production

In the aftermath of the employment report one could almost hear the investment community asking the same question. What will the investment landscape look like if the Fed, Treasury and Administration succeed at turning the economy around?

The answer is unknowable, but the market suggests a few bets have changed. The most striking example of the reversal of thinking can be seen in the US Dollar trading before, during and after the report.

US Dollar Index - 5 Minute Chart

The initial reaction was an immediate sell-off in the dollar and a concomitant rally in US equity futures. For the last several weeks, the predominant and profitable line of thinking has been, “When you see green shoots, sell the dollar and buy equities.” However, that all changed on at 8:40am Friday morning.

In last Tuesday’s Surf Report, our headline was “It’s Alive,” a reference to Frankenstein and the Triple R rally. It appears that last Friday market participants finally got around to reading our Tuesday report!

So what will the investment landscape look like if the monetary and fiscal stimuli actually work? The first stop on our tour of the new outlook will be dollar-land. If the economy is recovering, then the need to print more money has ended. In fact, the Fed may actually be able to cease quantitative easing altogether. The implication is that those who have been fearful of a falling dollar due to oversupply are wrong. We are included in this group.

An economic recovery means that the Fed will begin to decrease the money supply. Recent Fed rhetoric has foreshadowed such an action. Many of the governors have become increasingly concerned with the Fed’s independence and are actively seeking an exit strategy.

A contraction in the money supply is precisely what Chairman Bernanke has been concerned about. His entire academic and professional career has been devoted to avoiding the mistakes made during the Great Depression. In particular, Chairman Bernanke has concluded that the Depression was exacerbated by the Fed’s inaction on a declining supply of money. The Fed Governors who are looking for an exit strategy will have a tough fight on their hands, as they should.

Now is not the time to talk about exit strategies and a contraction of the money supply. Sure, there are green shoots, but a farmer does not remove the fertilizer once the sprouts have sprung. There will be a time and place for such discussions, but now we must tend to the sprouts.

Attending to the sprouts may mean the rapid expansion of the money supply is over and that is enough to get the dollar moving higher. It is also enough for us to tighten our stops in our weak dollar trade, especially gold and silver.

The dollar also received a boost from the market belief that the Fed may actually raise rates. At one point on Friday the Fed Funds Futures implied there was 60% chance the Fed would raise rates by November! Once again an unlikely and detrimental scenario and once again we need to remind ourselves that we are trading the market not our opinions.

So where does that leave us? Let us summarize: the probability that the Fed will slow the rate of expansion in the money supply means the dollar may strengthen, coupled with higher rates (both actual and perceived) should attract capital to the United States. Our answer to the question “What if they succeed?”

Buy American!

Disclosure: I am long GDX, SLV, FXE and many US Equities.

Tags: Fed

As WTI Crude oil for July delivery passed $65 a barrel last week there was talk that high oil prices could derail the recovery. We share this view with one qualifier; oil prices above $50 take significant political risk off the table.

Most of the Gulf States have based their previous budgets on oil above $50 a barrel. When oil dipped below this level, many countries, including Iran were forced to cut expenditures. The fastest way to derail economic recovery would be to have political and social unrest in Iran.

Our neighbor to the south, Mexico, has also been labeled a dangerous state with the potential for rapid collapse. The Mexican government has been fighting a losing battle with drug cartels. The government relies on oil sales to fund over 30% of the budget. In what was probably the greatest trade by a country in 2008, Mexico hedged its oil output at $70 a barrel through Goldman Sachs. This allowed the government to continue to fund the war against the drug dealers. As oil approaches that level again, we would advise President Calderon to pay a visit to his friendly bankers at Goldman Sachs. And since the US government is so keen on intervention, we should encourage this meeting in the name of national security. Despite the light sarcasm of our suggestion, social unrest is a serious threat and is a direct result of not enough money.

Additionally, oil at the higher end of the range ($75) makes exploration and alternative energy a profitable venture. Certainly, higher gas prices will crimp consumer spending and is why we see oil above $75 a barrel as detrimental to the economic recovery. There is a delicate balance between stability and recovery.

Disclosure: I am long UGA.

Tags: OIL

This week the Supplemental Budget Appropriations Bill goes to committee to reconcile the differences between the House and Senate. While most eyes will be focused on the political horse trading that will surely be a part of the process, we will be focused on Title XIII of the bill.

Title XIII, Section 66 is titled, Approval to Sell a Limited Amount of the Fund’s Gold. This section appears on page 105 of a 110 page document and is the authority the IMF has been waiting for since the G20 meeting in April. We noted then as now that these gold sales should have no impact on the gold market for several reasons.

The amount of gold for the proposed sale is 12.97 million ounces (403.3 metric tons). This gold was acquired after the second amendment to the Fund’s Articles of Agreement in April 1978. The Crockett Commission was formed to advise the IMF on the sale of this gold. The recommendation was to sell the gold in a manner that would not disrupt the gold market. It has come to be understood that any sales by the IMF would be subject to the Central Bank Gold Agreement (CBGA), which the IMF is not a signatory.

The CBGA limits gold sales by central banks to 400 tons per year. If the IMF were to sell all the gold in one year it would “crowd out” the other central banks. This is an extraordinarily unlikely scenario.

Hypothetically, if the IMF decided to snub its nose at the CBGA and dump its gold on the market, there still would be virtually no impact. The London Bullion Market is where virtually all central bank and official gold trading takes place. In April, the London Bullion Market transferred an average of 20.5 million ounces of gold everyday. So even if Mr. Strauss-Kahn was feeling a bit irreverent, he could accomplish the sale of 12.97 million ounces in one day.

We see the more likely scenario developing in which China purchases the gold directly from the IMF. Since there is a limit on yearly gold sales it would take a long term forward contract to be executed. We do not think it is purely coincidence that Treasury Secy. Geitner is in China during the same week the Congress is set to give approval to IMF gold sales.

Finally, a sale to China may upset India and several of the Gulf States as they all have expressed interest in purchasing the gold. If this occurs, nothing could be more bullish for the price of gold. Any protest would show just how motivated these governments are to purchase gold. Once the sale is complete, regardless of the buyer or buyers, the gold would then be transferred from weak hands to strong.

Disclosure: I am long GDX and GLD options.

Tags: GOLD, IMF

It is not often that we get a stark example of the power of market sentiment, but the reaction to the Chicago PMI report was just such an instance.

The report not only showed overall economic weakness, it also indicated the employment situation continued to deteriorate and new orders continued to fall. Not a pretty economic picture and not a good preview of the ISM manufacturing index due to be released Monday morning. Yet, it appears that month end window dressing and hope for green shoots fueled the bulls.

An alternate, and more grounded, explanation is that the Chicago PMI is a narrow measure of economic activity. Additionally, the ISM index rose in April and showed an increase in new orders.

The new orders index for April was 47.2, just shy of the 48.8 level that indicates economic expansion. As well, the backlog diffusion index showed improvement. The combination of these developments could result in a positive, or “less bad”, ISM index. With the bullish market sentiment any green shoot is met with buying.

Disclosures: None

Tags: ISM

If have been you watching popular media you might have been left with the impression that the bond market was taken to the woodshed last week on fears that the US would lose its AAA credit rating. In reality investors fled government debt when a reverse auction produced a bid to cover of 6.17 while at the same time the Treasury announced $101 billion in supply for this week. To add insult to injury, Bill Gross turned, uncharacteristically, into a bully.

The markets took seriously Mr. Gross’ assessment that the bond market rout was due to investors fearing the US will lose its AAA rating. However, loss of its AAA is remote in the near term and in fact, may be a potential buying opportunity.

Viewed in the context of the most recent FOMC minutes and jobless claims, this is exactly the type of event the Fed was referencing when they discussed increased quantitative easing. Higher rates and rising continuing claims are not the data that makes a central banker sleep well.

If you need hard data to make for a restful night, take a look at the following chart.
bond yield spike

This chart depicts the log change in the 10 year bond yield over the last year. The log change is similar to percentage change in that it provides a mechanism for comparing the severity of changes at different price levels. The best way to think of this chart is like the equalizer on your boom-box circa 1984; the bigger the spike, the more significant the noise.

The chart makes the markets voice clear. The move in bond yields on Thursday barely registered a blip on the “equalizer.” The two events that stand out are the Lehman Brothers bankruptcy and the initial announcement of quantitative easing. The market has spoken, and the result is a big yawn. Despite the media hype, the market clearly does not believe the US will lose its AAA rating.

Beyond the fancy mathematical manipulations and spiffy charts is common sense. A downgrade of US sovereign debt would be a de facto downgrade of ALL sovereign debt, since ALL sovereign debt is priced relative to US bonds. Therefore any downgrade would be ceremonial at best.

Disclosures: none

Tags: BONDS, treasury bonds, us debt

the beginning of May, the gasoline futures market has been in backwardation. Backwardation is the term used to describe when near month futures contracts trade above far month contracts. The implication for the gasoline market is that near month demand is stronger than supply, a bullish signal for gasoline. In fact, since the beginning of May, the July RBOB futures contract is up 18%.

RBOB – July 2009 vs. August 2009

This chart depicts the change from contango to backwardation in the gasoline market. The backwardation began on May 7 and has recently begun to widen.

RBOB – July 2009 vs. July 2010

Furthermore the longer end of the gasoline futures curve is beginning to trend toward backwardation. Each of these developments is bullish for gasoline as it suggests the demand for gas is above supply in the short term.

We are playing the bullish gasoline theme via the United States Gasoline Fund (UGA). This is from the same fund family that manages the United States Oil fund (USO). We have written about the losses being realized in USO as a result of the contango. By virtue of the fact that gasoline is in backwardation, UGA does not suffer from the drawbacks of negative roll yield. In fact the fund benefits from the roll into cheaper contracts.

Gasoline stocks are near the low end of the average range.

This is likely the result of the contango in the crude oil markets. As more crude has been diverted to storage to take advantage of the super-contango, fewer barrels are heading to refineries.

The most recent data from the Energy Information Administration (EIA) supports this view. Refinery inputs have dropped below the 4 week moving average, and despite climbing in April, they did not reach the highs seen last November. The natural result of declining refinery inputs is declining gasoline production.

The EIA reports that reformulated gasoline production is tracking below the pace of 2008. With the summer driving season fast approaching the net impact is higher gasoline prices.

Disclosure: I am long UGA.

Tags: backwardation, contango, Gasoline, OIL