Notes From Underground

The last seven weeks has brought out the bond bears in the forms of Bill Gross, Jeff Gundlach and also well-known stock picker and financial wizard, Warren Buffett. While Gundlach and Gross were very bearish on the European sovereign debt markets, the Omaha denizen opined on how stocks may be rich but bonds offer a terrible risk/reward return. Large bond investors are nervous that they have possibly bought an overvalued asset and may experience sizable losses on a quarter-to-quarter to basis. The problem for pensions, insurance companies and those saddled with a defined payout obligation, the FED and other central banks have broken the bond market as a value barometer so it is very difficult to match assets with potential liabilities.

As Bill Gross widely proclaimed last week, German bunds are “The SHORT OF A LIFETIME.” Gundlach also called the German debt a great short as the Draghi Purchase Plan had brought the German BUND to a mind-boggling 7 basis points. This low yield was the debt instrument of a AAA-sovereign buyer with at least 1% inflation and maybe 3% GDP growth, indeed the short of a lifetime. By following the FED‘s playbook, ECB President Draghi became the “rotten egg” for he waited until the Fed and BOJ had already succeeded in pushing global rates to ridiculously low levels.

(As I was writing, while speaking at the Sohn Investment Conference, Gundlach said he believes the Fed will probably not raise interest rates this year, partly due to a lack of wage inflation.)

Now, if global investors follow the opinions of Gross, Gundlach and Buffett the ECB is going to be met with large amounts of debt to purchase. The ECB is buying an advertised 60 billion euros of assets a month until September 2016. The problem is that investors and hedgers will utilize the buying power of the ECB to place credit risk onto the balance sheet of the central bank in order to partake in the short of a lifetime. Mario Draghi is suffering under the potential load of global risk transfer. Yes, the BUNDS and other sovereign debt instruments will rally on ECB purchases but once the ECB is removed the selling begins anew. Traders can short any instrument in an effort to make money or merely hedge risk. Mario Draghi is in a difficult bind in trying to figure out how to allocate the 60 billion euros a month.

Compounding the problem for Draghi is that unlike the FED that merely had to buy U.S. assets, the ECB has to buy on a prorated basis, according to the ECB’s capital key of each nations’ contributions to the ECB balance sheet. In an important bow to this problem, the interest rates on several European sovereign debt instruments retraced to January 22 and 23, the time at which Mario Draghi announced the proposed ECB Quantitative Ease program.

For those trading the European 10-year paper–bunds, French OATS and Italian BTP futures–those levels are roughly at the close of that day: BUND, 155.43; OAT, 153.55 with a low of that day of 151.98; and the BTP low of 135.07 with a close of 137.19. (All charts are EQUALIZED ACTIVE DAILY CONTINUATIONS on CQG.)

The retracement of the entire January 22 move means that the pressure is building on President Draghi to act to thwart the will of traders. I Wonder when Mario Draghi will publicly blast “speculators” for challenging the desires of the ECB and European monetary policy? I wonder if Citadel and Pimco have room at the table for another well informed consultant. As the question gets asked in the cult film Putney Swope, “HOW MANY SYLLABLES MARIO?” as the life was leaving his body.

***Today’s market action across a cacophony of assets is very interesting. As U.S. Treasuries and European sovereigns sold off the equities across the world joined the parade. Even as risk off was the theme the U.S. dollar failed to rally. Even as European DEBT was supposedly sold because of the “Greek Crisis” the euro continued on its recent rally mode. Even a upward move in U.S. yields failed to provide any strength to the DOLLAR, even against the commodity and emerging market currencies.

The initial problems with the dollar began with the release of the U.S. Trade Balance at 7:30 a.m. CST as the trade deficit ballooned to $51.4 billion, far above the projected $40 billion. The initial action was a selloff in the DOLLAR and a rally in the BONDS and short-term interest rates as analysts opined that the STRONG DOLLAR was hampering U.S. exports and thus economic growth. IT IS BELIEVED THAT SLOWING EXPORTS DUE TO THE STRONG DOLLAR WILL PROVIDE A REASON FOR THE FED TO REMAIN ON HOLD FOR LONGER, but the BOND rally failed and all interest rates sold off and the rise in U.S. YIELDS IN DEFIANCE OF POSSIBLE FED INACTION could not provide strength to the DOLLAR.

This will be important for the UNEMPLOYMENT NUMBER ON FRIDAY for if the payroll data is stronger than consensus and the DOLLAR CAANOT RALLY IT WILL BE AN IMPORTANT BAROMETER OF A CHANGE IN INVESTOR SENTIMENT. THE SAME VIEW WILL BE PROVIDED FOR THE GOLD. A strong JOBS number that does not result in a selloff of this week’s GOLD RALLY will be a sign that sentiment is shifting.

It has been discussed that this weeks $25.00 rally in the GOLD has been a result of rumors about China undertaking a QE Program of its own in an effort to stimulate its economy. The rumor arose from the Chinese authorities hinting that the PBOC might undertake buying some of the DEBT of credit-stressed municipalities. In my opinion, the PBOC may buy some distressed municipal debt in an effort to unclog the credit pipes but it will not be a FED-, BOJ- or ECB-type QE program. The Chinese will be leery of heading down a theoretical experiment for nobody has ever exited from a QE program so there is far too much uncertainty in exiting QE for the Chinese authorities to risk their credibility.

Adding to the strength of the argument against Chinese QE is an article by Henny Sender in the Financial Times, titled, “China Share In Global Indices Set to Rise.” The first paragraph states: “Come June, the IMF will probably decide to include the Chinese renminbi in its SPECIAL DRAWING RIGHTS (SDR).” Further the author quotes Michael Cembalest of JP Morgan Asset Management, who says, “More importantly, the renminbi is also growing in stature as an investable currency. Today, central banks and sovereign wealth funds have invested between RMB 300bn and RMB 400bn in renminbi-denominated assets.” The article also notes that the BOJ and PBOC are discussing investing in each other’s bonds.

Ms. Sender closes the article with the following: “The growing legitimacy of the renminbi also comes at a time when the rest of the world is searching for a credible alternative to the dollar as the only real reserve currency.”

The Chinese will not want the unstable nature of theoretical monetary policy undermining its hard earned credibility. As Vito Correleone said, “Women and children can afford to be careless, men cannot.” The world’s established capitalists can afford to experiment while rising powers must be more concerned about protecting its image in the realm of global investment. Gold is not rising because of Chinese QE. Why? I don’t know but will watch for any clue after the JOBS REPORT.

Tags: Bill Gross, Bunds, China, ECB, Equities, French oats, Gold, Italian BTPs, Jeffrey Gundlach, Mario Draghi, QE, U.S. Dollar, U.S. Treasuries, Warren Buffett

This entry was posted on May 5, 2015 at 3:53 pm and is filed under BoJ, Central Banks, Currency, Debt Market, ECB, Europe, Fed, Gold. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.