An update on the repeat theme of 2010 in 2012: A bearish view

In the article of 2012 is going to repeat 2010 dated Sep 14 2012, I set out the repeat theme for risks in the rest of the year.

Nearly two months on, the repeat theme has played out nicely with Hang Seng rising from there to the peak by around 10%. For those who made money out of this rise, it should be the time to re-evaluate whether or not it is still justified to hold on with the risks.

The election in the US yesterday was clear a bad sign with Democrats claiming the President and Senate while the Republicans got the lower house. This unchanged setting basically tells us that NO way we will have a full resolution in fiscal cliff on time.  The best case is muddling through with some sorts of half year extension in tax cut.

I am turning bearish here with the fact that uncertainties in the market are growing. Today we have the national congress in China, but my real concern is still in Europe. 

After the US presidential election on the 6^th, the National Congress in China on the 8^{th (}Today), the market will face the Eurozone finance ministers meeting on the 12^th and the Catalonian parliamentary election in Spain on the 25^th.

The Greek Prime Minister Antonis Samaras said that his government would run out of cash on the 16^th of this month if the Eurozone finance ministers couldn’t make the decision to release another tranche of aid during their meeting. The case for Greece has always been a game of brinkmanship and it may actually turn out to be fine. However, the market will need to deal with another European country further down the road. Catalonia, the autonomous community of Spain which has been trying to gain independence, will have the regional parliamentary election. The victory of any anti-Spain party would cast doubt on the fourth largest economy of the Eurozone. 

The updated chart from the repeat theme on Hang Seng hinting a peak in November looks scary too, doesn't it?

Source: Reuters, click to enlarge 

Now, having sold out all Hong Kong stocks , I would go long 2-month ATM call (costs around 2.2%)  and sell 2-month future on Hang Seng Index. The long ATM call is basically a "down side protection" to my bearishness here. And my break-even point would be any 2.2% drop in the index.

The real risks to this short-biased view is that new Chinese leaders after today, namely Xi and Li, somehow feel the the urge to do something to boost the economy. 

But the upside is that if there is no stimulus after the 18th National Congress, what the market has been expecting, building into the price in the past 2 months seems groundless and reversal is due to come.

When will the music stop?

Under QE3, it will take 44 months to create the same liquidity as QE1 did and 15 months as QE2...

What about the impact on asset prices? Pick the number you like....

Source: The Federal Reserve, click to enlarge 

2012 is going to repeat 2010

After the ECB and the Fed both rolled out their own bazooka, all bears, myself included, should have surrendered.

Without digging into details too much, the rest of 2012 is going to be a repeat of 2010 - a policy-induced bull market. Here are quite a few self - explanatory charts:

Source: Reuters, click to enlarge 

Source: Reuters, click to enlarge 

Source: Reuters, click to enlarge 

Let's enjoy the rally while it lasts. If 2012 turns out to repeat 2010, then 2013 is going to be a repeat of 2011, if not 2008...

I will illustrate further here the headwinds facing the market next year both in the US and Europe as we head toward the end of this rally.

The ECB’s bazooka/ Gold rising on misunderstood fundamentals

Basically all assets were buoyed by the ECB’s bazooka, a plan to load up unlimited amount of troubled country’s debt, since last Thursday. I have to admit that my assessment regarding “no open-ended commitment from the ECB” (See rationale here) was wrong and hence I missed the rally in the past few days.

With the one-sided rising asset prices in the past few days, I spot some upward movements in certain assets were unjustified, and gold (silver as well) is one of the assets that rose on a misunderstood fundamental.

The ECB’s bazooka, a.k.a. Outright Monetary Transactions (OMT), is a plan to remove certain “tail risks of  Euro breakup” with the details listed below:

1.          Purchases of sovereign bonds maturing in 1 – 3 years in the secondary market

2.          No quantitative limits are set on OMT

3.          No subordination of private investors

4.          Full Sterilization

5.          Conditionality of OMT is attached to EFSF/ESM program

Indeed, OMT is enough to build a firewall to safeguard the too-big-to-fails (Spain and Italy) as long as those countries comply with austerity measures (Of course, austerity will mean a recession for them). OMT, in my opinion, has several implications to the market:

l   Removing a Lehman-like re-denomination risks in Europe in the intermediate term (until a blowup of the ECB)

l   Increasing recessionary risks for countries under OMT, just like the Greece and Portugal which carried out austerity measures under the current Trioka plans

l   The total liquidity in the euro system will stay unchanged given the full sterilization structure

I think the Operation Twist (OT) by the Fed which was firstly launched in Sep 2011 and then extended in Jun 2012 was a good example in explaining the term “sterilization” and its impact on asset prices.

As I covered here few months ago, sterilization is hardly supportive to commodity prices (incl. precious metals).  This is also the reason why gold peaked at US$ 1,900 last September and trended down to recent low at US$ 1520 in Q2 2012 despite the crisis in Europe kept worsening.

If OMT really means less crisis, no money printing and higher chance of recession in Europe, I don’t see the reason why the “safe-haven”, “money-printing-sensitive” gold could rise as much as, if not more than,  equities, Euro or others assets that benefit from the removal of tail risks in Europe.

While some investors are arguing gold will rise as the Fed will carry out QE 3 on 13^th Sep FOMC meeting to match what the ECB did last Thursday, I am holding my breath to see what will happen otherwise.

I am particularly interested in the movement of gold in Euro (XAUEUR) if QE 3 doesn’t become reality this week. A dramatic fall for this pair is likely to happen: 

Source: Reuters, click to enlarge 

If central banks only get a BB gun while the market expects a bazooka…

The article was firstly published on September4, 2012 on the Marketwise column of China Daily.

Since mid-June, risk assets across the board have been buoyant for various reasons. One of the most dominant reasons is that central banks globally started hinting for another round of accommodative momentary policies in the face of poor economic readings and worsening debt woes in Europe.

Mario Draghi, the president of the European Central Bank (ECB) has made a strong statement in an investment conference in London on 26^th July, 2012 pledging to do whatever it takes to save the Euro. Mr. Draghi further announced that the ECB is considering some non-standard monetary policies after the Governing Council Meeting on 2^nd August, 2012.

After Mr. Draghi’s speeches in the past two months, it is widely believed that the ECB would set a target yield range for short-dated Spanish and Italian government bonds and enforce this target yield range by purchasing enormous amount of these bonds in the secondary market. However, given the plan’s structure and timing, I remain skeptical as to whether or not this grand plan will come into being on time while the market is expecting it in a matter of weeks.

Firstly, if a target yield range is set, it literally means that the ECB will enter into an open-ended commitment to buy unlimited amounts of Spanish and Italian government bonds whenever the interest rate rises above the target range. Nonetheless, an open-ended commitment has been a taboo for the ECB since such a commitment would give rise to debt monetization and mutualization among member states in the currency bloc according to their stakes in the ECB.

Source: Reuters, click to enlarge

Unlike the Federal Reserve in the US which only serves one single federal government. The ECB is held accountable to the 17 fiscally independent member states which are not supposed to share liability with each other. While the Eurozone is still at an early stage toward fiscal union, it is hard to believe that Eurozone leaders would agree on re-distributing liability from debtor states like Spain and Italy to creditor states like Finland and Germany in an unfair manner at this point in time.

Secondly, I would argue that if the ECB and other policy makers have the sense of urgency to take this bold step when the capital market in Europe seems like it is returning to normality after Draghi’s speeches in the past two months. The Euro has rebounded from a multi-year low of $1.20 to the recent high close to $1.26 while the two-year Spanish yield dropped to below 4% from nearly 7% just a month ago (See chart). These market movements demonstrate not only improving signs of the debt crisis in Europe but also a high expectation of investors regarding upcoming policy responses.

Draghi’s speeches have indeed succeeded in kicking the can down the road and calming the jittery market. If buying more time is ultimately what policy makers in Europe want to achieve, this goal is considered done. I expect the ECB meeting on 6^th September, 2012 is more likely to surprise to the downside, especially when investors have such a high expectation on it.

If the market is expecting a bazooka while the ECB can only provide a BB gun, disappointment among investors will be a sufficient reason to sink risk assets.

Three magic tricks by the Fed in the past four years

The article was firstly published on May 23, 2012 on the Marketwise column of China Daily.

The Federal Reserve carried out three major unconventional monetary policies since late 2008, namely the two rounds of Quantitative Easing (QE1 and QE2) and Operation Twist (OT).

Instead of marking the Fed’s official announcement as the starting date of stimulating the national economy, I looked at the Fed’s asset size (i.e. reserve balance) to define the real start of the easing. For QE1, the Fed started the easing process when it bought billions of assets since September 2008, way before the official announcement in November 2008 and the program’s expansion in March 2009.

For QE2, Ben Bernanke, the Fed chairman, hinted at another round of easing in August 2010 at a conference in Jackson Hole (that was when the market expectation of QE2 materialized) and announced it officially in October 2010. For both QE1 and QE2, we saw a soaring reserve balance of the Fed (more liquidity provided to the market) during the term of QE.

For OT, which the Fed announced and launched it in September 2011, the overall reserve balance stayed flat as the Fed sterilized the additional purchases of long-term Treasuries at the expense of short-term bills and notes.

The first two QEs are different from OT in nature and hence had a different impact on asset prices. For QE1 and QE2, the Fed did throw billions of dollars to the market to inflate its own balance sheet and loaded up with securities. The overall capital injected to the market by the Fed can be observed by the increase in the reserve balance during the term of the two QEs. As a result, all risk assets including commodity and equity were buoyant with the increased liquidity. The effect on assets can be said as “too much money chasing too few goods.”

However, OT hasn’t expanded the Fed’s balance sheet as a result. Since OT is meant to increase the Fed’s holding in long-term Treasuries at the expense of the short-term ones, the overall liquidity in the market remained unchanged. With the extra purchases of long-term Treasuries, the Fed managed to keep long-term interest rates ultra-low.

Since the aggregate liquidity in the market has not increased, the impact of OT on asset prices is not because of “too much money chasing too few goods.” Instead, the magic trick that the Fed did in the past six months was to keep the risk-free rate, which is widely used to discount future cash flow in all equity valuation models, very low and in turn lifted the equity prices.

Source: Reuters, click to enlarge

The Achilles’ heel of QE1 and QE2 was the effect of “too much money chasing too few goods”, which drove up not only equity prices but also commodity prices. The side effect of rising commodity prices passed through the supply chain of all businesses and caused margin compression for corporates, which at the end dragged down the equity valuations and prices. However, since OT doesn’t cause an increase in market liquidity, it has NO effect on commodity prices. This is the reason why we saw a strong equity rally (i.e. MSCI World Index) but a sideways commodity market (i.e. CRB index) in the past six months.

As OT will come to an end in June, I will go through the possible effects on the market next time.

Investors warned to stay off circuit

The article was firstly published on April 18, 2012 on the Marketwise column of China Daily.

I warned in this column in early March that the equity rally had run out of steam, and argued in late March that the spike in Treasury yield was rather short-term and wouldn’t trigger another equity rally. I continue to be skeptical about the buoyant sentiment in the market given the overstated growth expectation in the US and the worsening economic outlook in Europe.

The tumbling market across major risk assets that was mainly triggered by the worse-than-expected employment readings in the US in early April has been in line with my expectation. I am not particularly worried about a down market caused by economic disappointments going forward as the downside from the current level should be manageable. However, the eyesore remains in the European peripheries.

As I pointed out in early March, the way we saw the rally during the first quarter is that equities had been playing catch-up and pricing in the improved market sentiment with a month of delay after the first long-term refinancing operations (LTRO), a funding facility by European Central Bank (ECB) that lent out billions of euros for three years to European banks and removed the tail risk of a sudden collapse in the banking sector in December last year.

The LTRO did improve the short-term liquidity problem but the long-term imbalances and insolvency remain very much unchanged. Investors should be well aware that it is about when, but not if, the debt woes in Europe would come back and haunt the market again.

In fact, sovereign bond investors seem to agree that the expiration date for this honeymoon period created by the LTRO won’t be farther than three years from now when banks return the borrowed money to the ECB. The Spanish bond market indicated this short-termism in the market with the 2-year yield dropping significantly to its lowest level since late 2010 after the LTRO and decoupled from the 10-year yield which stayed at an elevated level throughout the period.

Source: Reuters

Before the Greek debt restructuring that reduced the debt value by more than half, investors thought large-scale write-downs on European sovereign debt was impossible as the ECB was held hostage with its massive holdings of debt issued by those Eurozone nations.

This thought was of course proven wrong at the end as the Greek debt held by the ECB was exempted from haircut, but this kind of misperception did help slow the pace of the crisis during the second half of last year.

However, after the nasty Greek debt restructuring in which private investors got squeezed harshly and subordinated to the ECB without any prior agreement nor notice, it becomes absolutely clear to everyone that large-scale write-down on European sovereign debts would happen.

Investors are all once bitten, twice shy, especially when the bad experience falls within the short memory of the investment world. It is almost certain that the return of debt crisis, if any, would come really fast and way more severe. While the rising Spanish yields lately may hint of the return of the debt crisis, investors, especially those with less risk tolerance, may want to shy away from risk assets before everyone does.

Treasury bears, don’t growl too early

The article was firstly published on March 22, 2012 on China Daily.

In the past two weeks, the US Treasury market has experienced one of the most serious selloffs in the last 12 months. As investors dump their Treasury bonds, the Treasury yields, which go inversely with prices, have soared substantially with the 10-year benchmark yield rising more than 30 basis points from slightly above 2 percent to nearly 2.4 percent in less than 10 days. The selloff started after the Federal Reserve released its statement last Tuesday as Fed Chairman Ben Bernanke refused to give any hints on the possibility of further bond buying. The expected decrease in demands for Treasuries from the Federal Reserve has weighed on the Treasury prices and been widely taken as a sell signal by the Treasury market.

There is a mainstream thought in the market following this broad-based sharp rise in Treasury yields, which suggests the decade-long bull run in Treasury market has come to an end and trillions worth of money outflow from the Treasury market will soon trigger another rally in equity. However, neither these views convince me.

I would argue that the downward pressure on Treasury yields is rather long term and structural. Like many US economic watchers pointed out, the labour force participation rate (the ratio between labour force and population) in the US has been dropping from its peak in April 2000 at 67.3 percent to the latest reading at 63.9 percent in February 2012. The continuously dropping participation rate suggests not only the fact that a lot of American workers lost their jobs in the past decade but also a phenomenon whereby millions of baby boomers started to retire.

For an economy with aging population and decreasing productivity, the benchmark interest rates, like Treasury yields in the US, staying ultra-low is nothing new in modern economic history. In fact, if Japan is any guide for the US, the Treasury yields at today’s levels are never too low to sustain. The 10-year yields on Japanese government bonds had firstly dipped below 2 percent in August 1997 and almost stayed below this important threshold since then in the past 15 years. Until recently, the Japanese 10-year yield is still lingering around 1 percent.

In addition, it is also not favorable to the US government if Treasury yields, which are laterally their borrowing costs, are really going up in the coming years. Since the crisis in 2008 hit the US financial sector badly, the US government pumped trillions of dollars into the system and most of this money was financed through issuance of short to medium-term Treasuries.

As time goes by, most of this debt will turn mature in the coming three years, implying that the US government will need to re-finance the debt in the spot market at prevailing interest rates. According to Reuters’ data, 48 percent of the total outstanding government-related debt will become due by the end of 2014. A rising interest rate would basically mean a higher re-financing cost and worsening indebtedness for the US government. We have every reason to believe from an economic and political point of view that interest rates in the US would remain low in the coming three years.

Although I do expect to see Treasury yields to further normalize after a panic 2011 on the back of European debt crisis and rise to more reasonable levels (i.e. 2.5 percent-3 percent for 10-year Treasuries), the recent selloff is hardly taken as a long-term turning point in the Treasury market, needless to say as a signal for another equity rally ahead. My advice to those Treasury bears would be: don’t growl too early.

How far can the equity market catch-up play go?

The article was firstly published on March 7, 2012 on China Daily. 

At the end of 2011, expert opinion on equity markets prospects was so one-sided and bearish with the fear of a disorderly default in Greece, European banks’ insolvency problem and the possible collapse of the Euro system amid the refinancing peak in March and April of 2012. Despite all this one-sided bearishness, the Hang Seng Index, like most of its peers globally, finished the first month of 2012 with more than 10 percent gains and kept up the momentum in February.

The reason we saw the best start to the year since 1991 for Hang Seng Index is that the bearish consensus back then had largely overstated the equity market risks. One way to measure the perceived risk level is to look at the risk premium that equity investors require to gain in excess of US Treasuries. If the risk premium (the spreads between Hang Seng Index’s earnings yield and 10-year Treasury yield) widens, it indicates equity investors demand a higher safety margin to hold equities instead of the risk-free US Treasuries. For the last quarter in 2011, the risk premium mostly remained at an elevated level at above 8 percent, indicating equity investors were very pessimistic. With the one-sided pessimism in the market that already priced in a lot of bad news, the lack of fresh bad news together with various central banks easing policies around the world has buoyed the market by a meaningful margin in a short period of time.

I didn’t anticipate the extent of the current rally in risk assets, but it was well expected that the one-sided bearishness in the equity market could not sustain as other risk proxies, like the volatility index, indicated that the market’s risk level was actually going down instead of up back in December 2011. The volatility index (VIX for S&P 500, VHSI for Hang Seng Index, etc) that measures the implied volatility in the option market of respective equity index is often called “fear gauge” with its sensitivity and inverse correlation with the equity market. Since implied volatility is an important variable in option pricing, the volatility index would normally see a spike amid panic market when investors are rushing to buy protection and bid up the price of put options.

For the first 11 months in 2011, the implied volatility (VHSI) has been closely tracking the Hang Seng Index’s risk premium as both of them are regarded as good proxies for indicating the perceived risk level in the market. However, these two lines decoupled since December, especially after the announcement of the first long-term refinancing operations (LTRO), a funding facility by European Central Bank that lent out nearly 500 billion euro to European banks. The decoupling of the two lines basically reflected the option market was pricing in a lower market risk ahead but the equity market was still reluctant to accept the fact that there was any market improvement.

After two strong months for equities, it is obvious that the option market got the better of the equity market when it hinted a rally back in December with the drop in implied volatility. Indeed, the way we see the recent rally in the past two months is that equities have been playing catch-up and pricing in the improved market sentiment after around a month of delay compared to the option market.

As we reach the end of this quarter, the question for both institutional and individual investors is that how far this catch-up play in equity market can possibly go. With the second LTRO that lent out another 529.5 billion euro, it is hard to imagine what sort of good news to expect moving forward.

In addition, the volatility Index (the VIX Index) demonstrates a strong mean-reverting pattern, which seems set for a rebound as it approaches low end of the range. If history repeats itself with the volatility index leading the equity market, a widening equity risk premium and therefore a weak equity market are expected in the coming months.

Although it is unwise to bet against an up market as it can always stay irrational longer than anyone can stay solvent, adding more risk positions to the portfolio at this point in time seems equally reckless.