Mexico Builds a Currency Wall…and Pays for It!

Late on Tuesday February 21, 2017, the Mexican central bank (Banxico) announced a $20b currency swap arrangement designed to stop the Peso from collapsing.  The first swap auction will occur on March 6, 2017 and will have a similar effect as Banxico selling US Dollar futures up to 12 months out.  The immediate impact was a 2% spike in the USDMXN rate.
The reason Banxico chose the swap, as opposed to direct intervention, is because the swap is a leveraged agreement which means it won’t deplete FX reserves at the same pace as direct intervention. Technically these swap agreements are not a claim on Mexican FX reserves BUT in reality Banxico is not going to default on the swap as long as they have FX reserves.

This type of levered quasi-government backed arrangement can work for a long time, until it suddenly doesn’t. The breaking point comes when Banxico’s short dollar position becomes so large that counter-parties issue a margin call. Mexico is a LONG way from having this happen, but this is how the movie ends.

In the short to medium term, this move should prove to be successful in halting the decline of the Peso. The unknown is the long run impact. For BK’s part, he will be waiting for the trade to turn against Banxico before committing sizable capital to a Peso trade.

Passive Investors are Nihilists Man

Passive investors don’t care about President Trump. This is the only conclusion that BK can draw after watching the US equity market shrug off a disturbing, albeit entertaining press conference yesterday. BK was confounded by how “the market” could still think that President Trump will get any of his agenda off the ground with the chaos surrounding him – but then he realized passive investors are nihilists man, they believe in nothing.

The relentless charge higher in US equity indexes makes a lot more sense when you realize all the money pouring into passive index funds doesn’t care about valuation, tax reform, protectionism, Obama Care or anything else. As long as the money keeps flowing into index funds the stock market can chug higher. The risk, of course, is that the price becomes more and more detached from reality. It’s only a matter of time before somebody declares that index investing has created a permanently high plateau.

Eventually this will all end – probably when the great migration from active to passive investing is complete. The trick for the active investor is to step off the nihilist ride just before you get a bowling ball to the groin.

What If the Yuan Strengthens?

What If the Yuan Strengthens?

Everyone and his brother and his brother’s cousin’s hairdresser – are expecting the Chinese currency to weaken. But what if it doesn’t? There are three reason’s why it is in China’s best interest to have a strong currency:

1.) Capital Flows
2.) Inflation
3.) Trump

The outflow of capital has been well documented and with FX Reserves below $3 trillion China is perilously close to a currency crisis. The IMF estimates that a country of China’s size needs approximately $2 trillion in reserves to operate the economy. This means the cushion for China is less than $1 trillion – this may seem like a lot, but with $100b month outflows it would take less than 10 months for China to reach a crisis. In short, China needs a strong currency to stem capital flows.

With inflation picking up China may indeed get a strong currency. The most recent reading on both CPI and PPI show inflation at 5 year highs.

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To stem the tide of rising prices, China may need to raise interest rates – which could result in a strong Yuan. Moreover, a strong Yuan would help keep import prices down and in turn could reduce inflation.

Finally, with the approval of Steve Mnuchin as Treasury Secretary, the door is wide open for Trump to declare China a currency manipulator. The claim would be that China has been artificially keeping its currency weak. Of course, the opposite it true, but alternative facts are in vogue. If China strengthened its currency then there would no basis for a Trump attack.

What would this mean for asset prices? Gold would likely be the biggest beneficiary as a weak dollar would be the order of the day. Equities and commodities would also benefit. But there is a dark side to a stringer Yuan. China is in the middle of a credit bubble – if rates increase then the entire bubble could pop.

Are Stocks Heading Towards a Blow-Off Top?

Is the Stock Market Heading Toward a Blow-off top and If So What Does That Look Like?

The good news is, we have a tool to measure extreme market moves; the bad news is because the future is dependent upon unknown decisions made today it is unknowable. However, we can observe fear and greed, and we can define when those distinctly human emotions reach extremes. There is a plethora (yes, a plethora) of research on financial market bubbles, but for BK’s purposes he likes research that is objective, can be replicated and can be tested. Those who want a deep dive should read the work of both Jeremy Grantham and Cliff Asness, both have done groundbreaking work.

In the simplest terms, the extremes of fear and greed can be observed when markets stray far from equilibrium. We can define equilibrium as the trend and the extremes as a 2 standard deviation move from the trend. Armed with these definitions we can look back at bull markets and look for similar patterns of human behavior.

If the research and BK’s thesis are valid then what we should observe is that major stock market tops occur when the price reaches an extreme (defined as 2 standard deviations from the trend). Let’s go to the charts.

BK used the Dow Jones Industrial Average because of its long history. The following charts are of every major bull market since 1921 overlaid with a regression channel. The middle line of the regression channel is the trend and the upper and lower lines mark a 2 standard deviation from the trend.

1921-1929
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1932-1937

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1942-1946
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1949-1966

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1983-1987
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1987-2000
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2002-2007
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What do every single one of these bull markets have in common? They all ended with a blow-off top that resulted in the price breaching 2 standard deviations from the trend.

What does the DJIA look like today?

2009 – 2017
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Based on this single indicator one might conclude that the DJIA would need to breach 21k before we could define this move as a blow-off top. To repeat what BK wrote earlier – the future is unknowable – but if the DJIA breaches 21k AND we see a deteriorating economic landscape then the conditions would replicate every other blow-off top.

Oil Price Spikes to Nowhere

Oil is the big mover today after the IEA said that OPEC is strictly complying with the production cut agreement. BK’s comment: No Sh!t. Saudi Arabia is in the long process of launching and marketing the Saudi Aramco IPO that is expected to trade in 2018. During this process it is in Saudi Arabia’s best interest to keep the front month oil contract relatively high.

This short term chart shows today’s price move.

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But when we zoom out to a weekly chart it is easy to see that oil has really gone nowhere since breaking above $50. This actually suits the Saudis just fine.

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If the price of oil rises too much then the US producers will flood the market with supply and make it more difficult for Saudi Arabia to keep the price elevated. The trick is to keep the front month elevated while keeping the back months depressed so that US producers cannot hedge future production. So far this game has worked, but in the IEA report that caused the price spike, it was also noted that in the second half of 2017 supply is expected to increase without a commensurate increase in demand.

Bottom Line: oil remains range bound, but when it breaks it will have global implications.

Will the Anniversary of the Oil Bottom Kill the Market Rally?

A year ago Saturday marks the bottom in oil – this means the base effect of low oil prices will begin to recede from inflation/reflation indicators. The broader US equity market has climbed on the back of the materials, industrials and various infrastructure plays – this is the so-called reflation trade. While this equity rally occurred the bond market was pricing in higher inflation. Interestingly, the 5 year break-even inflation rate was indicating almost no YoY growth in November 2016, since then inflation expectations have soared.

The following chart shows the YoY % change in 5 year inflation expectations and the YoY% change in WTI Crude Oil Prices. As you can see there is a very close relationship.

This means that the direction of the price of oil is probably more important than any other single factor when trying to determine if the reflation trade will continue. On February 11, 2016 crude oil hit the lowest price since the financial crisis.

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This means that moving forward the effect of low oil prices will be muted and likely result in falling inflation expectations. In turn, this could make the bonds bears decidedly bullish. BK is long of TLT.

Today’s Bitcoin Crash

What you need to know:

Why it Happened

  • 2 off the 3 Big Three Chinese exchanges (OKCoin and Huobi) have halted withdrawals for a month, so far BTCC has not but BK would expect soon
  • This means money can’t move out of China via bitcoin
  • The capital flight trade was a big driver of bitcoin speculation

What BK is hearing from the insiders:

  • this move is less about capital flight and more about preventing yet another asset bubble
  • if China wanted to “kill” bitcoin they would just close the exchanges
  • But most of the bitcoin mining is done in China by pseudo-state sponsored enterprises
  • this is about stopping a speculative bubble
  • so far Chinese speculators have hoarded garlic, chili peppers and copper

If Oil Breaks $50 The Investing Game Could Change

The predominant theme in the markets is the “reflation” trade. For those who have been living in a Scientology compound since November 2016, the reflation narrative goes something like this -> the global economy was improving before the election; Trumponomics (infrastructure spending and tax cuts) will be supportive of a strong economy; asset prices will move higher as the US economy grows at 4%+. BUT…if oil breaks $50, the reflation narrative could fail.

BK has argued that due to the Saudi Aramco IPO, Saudi Arabia has a vested interest in keeping the price of oil high enough to support a strong valuation, but not too high as cause another US shale led supply response. So far the line in the sand appears to be ~$50.

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The Saudi Plan to keep oil prices elevated has worked but is now threatened by market forces. First, the days supply of oil in the US is at a level not seen since the oil bust of the 1980’s (yep, JR Ewing style).

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Second, speculators have not been this long of oil futures since 2006 (green line in the chart below).

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The way the supply/demand fundamentals line up, coupled with market positioning means that if $50 cannot hold then we could see a non-trivial decline in oil. In turn, this would blow a whole in the reflation narrative.

US Dollar is the New VIX… and There is a Problem

US Dollar is the New VIX… and There is a Problem

The VIX Index is broken. It no longer provides an accurate measure of the amount of leverage in the financial system. This poses a problem because central bankers, regulators, policy makers and economic forecasters all use the VIX as a the central measure of leverage. In short here is how the dollar becomes new risk index ->

  • The US dollar is used as the base currency in international lending.
  • In order to operate long supply chains (i.e. iPhones made in China and shipped to US) working capital is needed.
  • This working capital is financed by the banks and denominated in US dollars.
  • Since manufacturers (like Foxconn) finance in US dollars but pay salaries in local currency (Yuan), when the dollar rises profit margins decrease.
  • The declining profit margins cause the banks to lend less.
  • This creates a forced deleveraging that is NOT captured by a rising VIX.
  • Therefore the higher the dollar rises, the greater the probability of a forced deleveraging similar to 2008

Since the US election, investors have not had to worry about a stronger dollar causing a forced deleveraging. In fact, the US Dollar Index peaked at 103.21 on the first trading day of 2017 and has subsequently fallen -2.6%. But while the dollar fell something curious happened with bond yields…they climbed and broke the nearly perfect correlation they had with the US Dollar.

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There are plenty of guesses as to why this divergence has occurred – Chinese selling of Treasuries to defend the Yuan is the most compelling guess to BK.

But the bigger questions is this –> Why is this a Problem?

In fact, BK has stated that a lower/stable dollar and gently rising bond yields were the key to further equity market gains. The problem occurs when this divergence becomes wide enough to attract international investors. Just like when one travels abroad and hopes for a weak foreign currency to “get a deal” international investors play the same game. In particular, with the Bank of Japan pegging yields at historic lows the interest rate differentials between the two countries eventually will cause money to flow into the US Dollar.

The risk is that this divergence adds pressure to a violent snap back rally in the US Dollar – especially if the economic data continues to improve. Investors may initially misinterpret the rising dollar as a positive signal, but lurking beneath the surface is a deleveraging monster.

Bitcoin Go Boom

They say the best disinfectant is sunlight and the PBoC just opened the shades on bitcoin. According to multiple news reports, the PBoC will conduct ongoing examinations of bitcoin exchanges – this has caused the price of bitcoin to crash another 10%. Interestingly, despite bitcoin’s low volatility in 2016, a 10% drop is not unusual in the history of this emerging currency. Furthermore, increased oversight should be welcomed by those (like BK) who view bitcoin as the first of many digital assets in the fin-tech investing category.

The Chinese exchanges matter because that is where the majority of the trading takes place. Bitcoin trades more dollar volume on a daily basis than the Gold ETF (GLD) and 95%+ of that volume is traded in China. So yeah, China is kinda important to bitcoin and by extension the PBoC is very important to bitcoin.

Presumably the PBoC action is a response to speculation that bitcoin has been used as a tool for capital flight from China and I suspect they will find evidence of that activity. But it should be put into perspective – the total value of all the bitcoin in existence is $12.9 billion, last year official currency outflow from China was $320 billion – so any capital flight that was taking place via bitcoin was/is tiny. Of course, it had an impact on the price of bitcoin, but it’s not where the majority of capital flight is occurring. In fact, there are currently 16 million bitcoin in circulation and the population of Shanghai is 24 million – if every person in Shanghai wanted to buy just one bitcoin (current value of $800) they could not. The point being, if the PBoC finds that capital flight occurred it will be small and good cleansing of the system. What’s more, because institutional investors are becoming more interested in bitcoin, the price drop could move bitcoin from weak hands to strong hands.

The news has resulted many to panic sell and proclaim that “Chinese bitcoin exchanges are being raided.” This is exactly the type investor depression that BK likes to be on the other side. In fact, it was just last week that BK wrote these words when bitcoin was trading at $1100,

This extreme move coupled with one of the key drivers breaking suggests the ride might be over…for now. In the long run, BK is quite bullish on bitcoin, but in the near term he must wait until investor depression sets in before he can think about adding new positions.

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It appears the market for bitcoin is approaching another inflection point and the time may have arrived to add new positions.

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Moreover, there are other drivers of the price that investors have yet to recognize. BK is looking at you Mexico! Bitcoin has proved to be extremely useful as alternative currency – it’s been 40 years since the last fiat currency regime failure – after the Bretton Woods Agreement failed, investors had gold. This time we have bitcoin.