Notes From Underground: The Second Quarter Begins (the Resurrection of Volatility)

On March 26, me and Rick Santelli Rick Santelli discussed a few key issues on CNBC (the video is posted below).  The final week of the first quarter saw the continuation of increased volatility as the market tried to sort through myriad issues. The influence of budget deficits, peace talks with North Korea, trade issues in the U.S. all creating a sense of uncertainty as global investors are forced to calibrate present positions in regards to regards to potential risk. Chinese growth is meeting expectations even as the XI regime is determined to clamp down on increased debt. The copper market tested the 200-day moving average early in the week but managed to close above it at week’s (even as the metal had a weak quarter).

(Click on the image to watch me and Rick discuss global trade.)

An interesting development is the recent strength of the Chinese yuan against the dollar. Are the Chinese attempting to preempt Trump’s tariffs by allowing the yuan to appreciate and deflate the argument of yuan weakness as a tool to manage its buoyant trade sector? There is NO QUESTION that the Mnuchin/Ross/Navarro team is keyed in on currency valuations and seem very prepared to counter major trade imbalances by using the dollar to pressure other nations to adhere to U.S. demands about correcting imbalances. The weakness in the DOLLAR has been the most perplexing trade of the last six months as both FED rate hikes and Trump-promoted fiscal stimulus package have failed to boost the greenback.

[An aside, on Sunday the Chinese announced tariffs on a minimal amount of U.S. products almost in an effort to stand-up to the Trump tariffs. Tellingly, there is no tariffs on U.S. grains so the tit-for-tat is just letting the U.S. know that it will not stand by idly. But this is not even a shot across the bow. It is surprising that the Chinese did not target SOYABEANS, especially after Thursday’s strong rally following the USDA crop report.]

But the YUAN is not the only emerging market currency showing strength. The Mexican peso closed out the first quarter by putting in a very  positive technical picture despite political problems and a presidential election in July that threatens to bring a leftist populist into power. The peso is benefiting from an overnight interest rate of 7.5% which has been steadily increased to combat rising inflation. The MEXICAN rate is now higher than the Brazilian rate of 6.5% making Mexico a destination for hot money flows. The Mexican peso is also CHEAP versus the Chinese yuan, which is important for Mexico given its significance in NAFTA. Cheap Mexican labor costs coupled with a historically weak currency makes Mexico an attractive alternative to Asian economies in the global supply chain.

In 1994, the Mexican peso was 3.10 to the dollar as NAFTA went into effect on January 1. The point I regularly make at Notes From Underground: On the day NAFTA began, the Chinese DEVALUED its currency by 50%, taking the yuan to 8.7 from 5.8. This was no coincidence because the Chinese understood the significance of NAFTA for the global economy. Cheap labor coupled with Canadian raw materials and energy with the dynamic U.S. market was a powerful force to confront. The immediate impact was the Mexican financial crisis of 1994-95 followed by the Asian crisis of 1997-98 as the issues of EXCESS CAPACITY created massive problems for over-leveraged global production. Going forward, the question will be: Is the Mexican peso weak enough to resurrect massive foreign direct investment in order to ensure access to the NAFTA regional powerhouse?  One of my favorite indicators is, of course, Kansas Southern Railroad (KSU) for it provides the cheapest form of transportation of goods between Mexico and the U.S.

When there was great fear of Trump negating all of NAFTA I recommended KSU at $91.50. The stock is now trading at $109.80 but is volatile as it reacts to every Trump tweet on the trade agreement. If the NAFTA discussions result in a new and improved deal I believe that Berkshire will be a willing buyer as it is the missing jewel in the Warren Buffett railroad oligopoly. If there is one thing Buffett desires it is a moat around his financial castle. I am not touting the PESO or KSU. As usual, I advise you to do your work to determine if you can find a risk/reward profile that fits your needs and abilities. But that PESO chart is interesting.

***While the U.S. yield curve continues flattening, the European 2/10 curves continue steepening, which is in contradiction to the ECB’s ongoing QE efforts. The ECB continues purchasing 30 billion euros a month, which means that the bank is buying more of the short-dated sovereign paper. The U.S. curve is 47 basis points, while the main European curves are: 113bp in Germany; 124bp in France; and 219bp in Italy. I’m not sure what this means at this point, but it is important to watch. If there were fears of a global recession all curves should be flattening. This is just another indicator we need to be watching, especially as the European stock markets finished the first quarter down on the year, much weaker than the U.S. indices.

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8 Responses to “Notes From Underground: The Second Quarter Begins (the Resurrection of Volatility)”

  1. john cioffi Says:

    Wonderful insights as always….quick question. Did you mean to say “ Trump railroad oligopoly” Or Buffett…….. ….. ? Thanks as always for your generous sharing. john

    Sent from Mail for Windows 10

  2. Stefan Jovanovich Says:

    Yra is being generous again. The Oregano of Omaha’s railroad is the price taker; the UP is the price giver in terms of the western Class 1 railroads.
    Regarding short rates, I wish our host could persuade Mr. Santeilli to interview Eugene Fama again and this time let the Professor speak for a few minutes before doing a Liesman. As Fama has explained, as long as the Federal Reserve continues to pay interest of excess reserves, its “quantitative easing” and other operations can only have effects on the term structure. And, even those are changes that are more presumed than proven. Whether buys long (QE) or buys intermediate (the 2s,5s,7s on the present calendar), it is selling the near-money maturities by crediting the sellers’ bank accounts and having those balances added to the sum of excess reserves.
    Fama’s thought experiment requires an answer: How many Trillion $ of long maturities would the Fed have sell in order to get the proper shape of the yield curve that those of us raised in the free money era consider “normal”? The string that the Fed is pushing on with its “rate increases” is now tied directly to its own finger.
    Discount rates are now driven by the FX market. In that sense our host and his friend are on the money; what the President tweets has an enormous influence of how willing people are to take delivery of greenbacks next week, next month and next year.

    • Stefan Jovanovich Says:

      Fat thumb. The Fed is pulling, not pushing; but the string is still making a loop back on itself.

    • Chicken Says:

      Interest on excess reserves is outright offshore entity corporate welfare (at the expense of taxpayers, for that wealth is diverted from becoming property of US Treasury?), I don’t comprehend how paying banks not to lend is stimulative (QE)?

  3. Chicken Says:

    Wonder how “China is Buying Tons of Gold” they feel now with the Yuan ripping higher.

    Looks to me as if markets needed an convenient excuse for what was up until recently the long anticipated correction.

    Perfect timing BTW, for the FED to expedite their bag of tricks in the interest of forcing waves of defaults and bankruptcies.

    Rinse and Repeat

  4. kevinwaspi Says:

    Wait for it…….. “I’m SO SHOCKED!”
    They said, Soy-a-beans!

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