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.

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.

Here Comes Trumpflation… But Not the Way You Think

The consensus view on Wall Street is that PEOTUS is about to bring $1 trillion in stimulus to the United States – this spending is expected to increase the prices of things, aka inflation; aka Trumpflation. Trumpflation is expected to be benign, gently lifting prices like an old man from a warm bath. But what if its not? What if there was something else lurking that could bring a more sinister type of inflation – the type that eats into profit margins and reduces consumer spending power?

BK is here to tell you that there is something more sinister and it steaming toward the US on a Ultra Large Container Vessel (ULCV).

Factory gate inflation (PPI) is soaring in China – the most recent reading released overnight suggests that the cost of producing in China has climbed by 5.5% on a year over year basis. This is the fastest rise since 2011 and the fourth straight month of increases. If it wasn’t clear already, the era of cheap Chinese production is over.

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As you can see from the chart above, Chinese PPI is closely tied to US CPI. This means that the price of things we buy in the US is going up. It also means that companies with supply chains that stretch to China will have to raise prices…if they can.

For some US companies raising prices is unlikely to be a problem, but for others, low priced imported goods are the business model. Let’s take the two most obvious examples, Wal-Mart and Apple. Apple manufactures the iPhone in China via Foxconn – since the cost of doing business in China is rising Foxconn is likely to raise its prices to Apple. Thanks to the cult-like status of the iPhone and the potential for subsidies from mobile phone carriers, the price increase could go unnoticed. But low cost retailers like Wal-Mart face an entirely different challenge. The Wal-Mart business model is to sell low priced goods sourced from China. Promotions like “roll-backs” and price matching are integral to the perception that Wal-Mart is the place to get a deal. Customers are programmed to think that Wal-Mart will always have low prices. But what if that is no longer a valid belief? Wal-Mart (and many of the “dollar stores”) will either need to absorb the prices increases, thus reducing margins, or pass the increase on to customers breaking its implied contract with its patrons. There is no alternative.

On a broader perspective, more expensive imports means that the bond market is probably mispricing the risk of higher inflation. The 5 Year Breakeven inflation rate is pricing about 2% inflation, roughly the same expectation that has prevailed since 2009.

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But if the cost of imports are increasing at the fastest pace since 2011 and that increase is expected to be sustained, then the bond market is wrong about 2% inflation. As is typical, BK is early on this view. There are others talking about it, but not enough for it to have an immediate impact on securities prices today. That being said, rising inflation (the bad kind) is one of BK’s themes for 2017.

Twas the Night of Fast Money

Twas the day before the night before Christmas, when all through Wall Street
Not a creature was stirring, not even Preet;

The stocks were hung at the highs of the year,
In hopes that St. Stimulus soon would be there;

The Millenials were nestled all smug in their beds;
While visions of sharing danced in their heads;

And Dan in his ‘kerchief, and BK in his Bear Suit,
Were still looking for a bull thesis they could shoot,

When out on the Street there arose such a clatter,
Traders sprang from their screens to see what was the matter.

Away to the pits they flew like a flash,
And put on a tail hedge, preparing for a crash.

The sun on the breast of a perky little show,
Gave a lustre to the midtown to objects below,

When what to their wondering eyes did appear,
But a miniature sleigh and eight tiny rein-deer,

With a smart little driver quick and lively she be,
They knew in a moment he must be MLee.

More rapid than eagles her coursers they came,
And she whistled, and shouted, and called them by name:

“Now, Guy! now, Tim! now Seaburg and Karen!
On, Grasso! on, Pete! on, BK and Dan!

At the top of the hour! I’m talking to you all!
Let’s keep it lively and fun so ratings don’t fall!

So out to the NASDAQ the coursers they flew
With the sleigh full of trades, and Melissa Lee too—

And then, in a twinkling, upon the roof
The prancing and pawing of each little hoof.

As the clock was making the 5pm round,
Down the chimney the FM gang came with a bound.

Tim was dressed all in suede, from his head to his foot,
And BK’s Bear Suit was tarnished with ashes and soot;

A bundle of value Karen flung on her back,
And Guy looked like a trader from the way-back.

Dave Seaburg’s eyes—how they twinkled! his stock picks, how cherry!
While Pete’s picks were like roses, his options how merry!

Dan’s droll little mouth was drawn up like a bow,
And the options on his blotter were in the green as we now;

Steve Grasso held the stump of a pipe tight in his teeth,
While the profits, they circled his head like a wreath;

They had a broad audience that made other shows jelly
Which made them shake and laugh, like a bowl full of jelly.

They were bright and funny, right jolly old elfs,
And people laughed when they saw them, in spite of themselves;

A wink of M Lee’s eye and a twist of her head
Let them all know she was the one to dread;

She spoke not a word, but went straight to her work,
And turned around and called Guy a jerk,

And laying a finger aside of her nose,
And giving a nod, up the chimney they rose;

She sprang to the sleigh, to her team gave a whistle,
And away they all flew like the down of a thistle.

But I heard them exclaim, as they drove out of sight—

“Happy Christmas to all, and to all a Fast Money night!

China – Airpocalypse Now

Gray Swan Alert

BK was struck by this story from the FT today –> China’s ‘airpocalypse’ hits half a billion people – not because of the brilliant title and not because the financial markets are slowing down into year end – but because man-made pollution is so bad that it shuts schools and airports and has the potential to be an economic shock.

The proximate cause of the ‘airpocalypse’ is coal fired steel and electricity plants that have been running at full tilt due to the government stimulus plan. As well, during the winter the general population turns on their heat in a ‘crazy’ attempt to stay warm.

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Think about this air pollution as having the same economic effect as a major snow storm or a very cold winter in the US – plenty of companies blame poor earnings on weather events – now imagine these weather events being a permanent fixture. The long run solution is for China to require factories to clean up emissions like US factories are required. Of course this takes time and money. Moreover, this will add cost that will accelerate the rate of factory gate inflation.

In the short term the solution is to simply shut the factories down so that the general public can breathe. This solution would be an economic shock at the exact time that China needs GDP growth to prevent a massive deleveraging similar to what the US experienced in 2008. To be clear, BK is not calling for a 2008 style meltdown in China…yet…just that a highly leveraged economy that experiences slow growth is very vulnerable.

Is the Bond Bull Dead-Dead?

For 30 years US stocks have enjoyed the balmy trade winds of falling interest rates. In fact, T.I.N.A (There is no alternative) and the “Hunt for Yield” are not just kitschy constructs of the post-GFC markets – they have been operating in the background for three decades. This behind the scenes dynamic could be changing as many of the driving forces are in flux. Low wages from Asia (think Foxconn) are quickly becoming an historic anomaly adding to global inflationary pressures; inflows into China have reversed resulting in Chinese selling of US bonds; and the promise of a yuuuuge fiscal stimulus in the US are all contributing to the demise of the 30 year bond bull market.

While the bond bull market may be mostly-dead, but it’s not dead-dead.

The interest rate on the 10 year US Treasury note has yet to breach the 30 year down-trend line, which means there is still time to bellow air into the aging bovine.

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Many have asked – via the Twitter machine – whether BK is still long TLT (the position he initiated before the FOMC meeting). The answer is yes. BK is long of the 20+ Year US Treasury ETF (TLT) as a way to trade an extended market that is approaching a major technical level – this is not to say BK is a raging bond bull. The truth is, BK doesn’t really know about the long term prospects interest rates. To BK’s mind the arguments for and against rising rates have equal merit – therefore he is obliged to fade the exuberance for a short term move.

While BK awaits the outcome of this short-term trade he will continue to try and answer THE question for 2017 – is the bond bull dead-dead?

Could a FED Induced Short Squeeze in Bonds be Good for Stocks?

The bond short squeeze meme is picking up steam. The Credit Writedowns blog has picked up the theme and has an excellent post on the extreme positioning in the bond market.

With everyone piled into a short position on safe assets, all we need is one crisis trigger to create the mother of all short-covering rallies back into safe assets, not just in the US but globally.

This extreme positioning coupled with a weak retail sales report gives the power to the FED to initiate the squeeze. Based on Commitment of Traders data (and anecdotal evidence), everyone and his brother’s uncle’s cousin’s dentist is short of bonds…expect BK 😉

This chart from Citi (via Jamie McGeever at Reuters) shows that the aggregate short position in the bond market is 5 standard deviations from the mean! BK is not a statistician…but even he can understand this is extreme!!

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Given that positioning is the fuel for a short squeeze – a more dovish FED could be the catalyst. But would that be “bad” for stocks?

Not necessarily.

The rise in US interest rates has been relentless, prompting many to wonder how far is too far before it hurts the economic recovery. In fact,the so-called New Bond King – Jeff Gundlach – has declared a 3% yield on the 10 year bond would be detrimental to the US economy…and by extension US stocks. This fear has gripped most of the market coverage today (at least from what BK has read/watched), therefore any drop in yields could be met with relief. Imagine a scenario where the FED is willing to run a “high pressure” economy AND there is a promise of tax cuts with fiscal stimulus. Then add relief that rising interest rates will not be a headwind and you just might get a stock market rally based on short squeeze in the bond market.

Why is BK Long TLT?

Over the last fortnight, BK has harped on the “China is importing inflation” theme. He has suggested that buying gold (GLD) and Inflation Protected Bonds (TIP) was the prudent move in this environment. But last night on the television program Fast Money, BK argued that now was the time to BUY TLT – how can BK think that inflation is picking up AND that interest rates are going lower?

Answer: A combination of timing and extreme positioning.

BK is not the first to discover that inflation may be the story of 2017 – plenty of pundits and investment bank strategists have opined that Trumponomics combined with rising factory prices in China could lead to rising prices for US consumers. In fact, BK would suggest that much of the “bond market bloodbath” has been investors re-positioning portfolios in preparation of higher interest rates. The evidence of this shift can be seen in the futures market for both Eurodollars (the interest rate kind) and 30 Year US Treasuries.

In the Eurodollar market (short term interest rates) leveraged funds have the largest short position (green line) in the last 10 years.

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The short position in 30 year US Treasuries is not as extreme as Eurodollars, but it has been steadily increasing since the US election.

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The takeaway from the futures markets is that leveraged funds are all betting on higher rates…so who is left to sell?

On the timing front, the FOMC meeting offers the perfect trigger for bond prices to head higher. Despite BK’s longer term concern over China importing inflation, the economic data released today gives the FED cover to be more dovish at this week’s meeting.

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Import prices dropped the most in 9 months, suggesting in the short term inflationary pressures have yet to hit the supply chain. This sets up a situation where funds are positioned for disappointment.

IBKHO the market is mispricing how hawkish the FED will be and herein lies the opportunity. If “everyone” is short and is expecting the FED signal multiple rate hikes next year, then all the FED needs to do is disappoint the market and voila… a short covering rally in TLT.