Value of Perfect Information

1. The International Monetary Fund could offer Italy between EUR400 billion and EUR600 billion in financial support to give Italian Prime Minister Mario Monti a window of 12 to 18 months to enact reforms sufficient to restore waning market confidence in Italy’s ability to repay its debt, Turin daily La Stampa reported Sunday, citing IMF sources.

2. German Chancellor Angela Merkel and French President Nicolas Sarkozy are planning more drastic means – including a quick new Stability Pact – to fight the euro zone sovereign debt crisis…..Euro-zone countries are weighing a new plan to accelerate the integration of their fiscal policies, people familiar with the matter said, as Europe’s leaders race to convince investors they can resolve the region’s debt crisis and keep the currency area from fracturing

3. The European Financial Stability Facility may insure bonds of troubled countries with guarantees of between 20 percent and 30 percent of each issue to be determined in light of market circumstances. The proposal to attach guarantees of up to 30 percent of future EFSF bond issuances’ worth may create a threefold expansion of the 440 billion-euro ($583 billion) fund.

Runner-up! Black Friday retail sales up 7%

Update 7:30 p.m. EST.

The good news continues…

The biggest bond dealers in the U.S. say the Federal Reserve is poised to start a new round of stimulus, injecting more money into the economy by purchasing mortgage securities instead of Treasuries. Fed Chairman Ben S. Bernanke and his fellow policy makers, who bought $2.3 trillion of Treasury and mortgage-related bonds between 2008 and June, will start another program next quarter, 16 of the 21 primary dealers of U.S. government securities that trade with the central bank said in a Bloomberg News survey last week. The Fed may buy about $545 billion in home-loan debt, based on the median of the 10 firms that provided estimates.

Follow Euro trading here:

http://www.sgxniftydowfutureslive.com/index_files/DOWFUTURES.htm

http://www.forex-markets.com/quotes.htm

http://www.kitco.com/ Scroll to bottom for exchange rate.

http://www.xe.com/

To see how FTSE will open go here:

http://www.igindex.co.uk/

or here:

http://www.financialspreads.com/public/

This is a multi-part series that looks at the derivatives market to help understand the systemic risk these products represent to the global economy. Unfortunately this problem was never resolved after the 2008 financial crisis. One day it will have to be addressed.

Wikipedia defines a derivative as:

“A financial instrument (or, more simply, an agreement between two parties) that has a value, based on the expected future price movements of the asset to which it is linked, called the underlying asset.”

The most basic of derivatives would be the equity option such as a call. Using the definition above, the derivative, the call option, is an agreement between the buyer and seller of the option, whose value is based on the future price of the underlying asset in this case, equity. A 300 call option on AAPL is an agreement between a buyer and a seller and the value of the option is based on the price of the underlying asset, AAPL stock.

Although scary in name, such as an Interest Rate Derivative, the product itself is relatively straightforward as will be discussed in future posts. Derivatives are used for various reasons from speculation, increased leverage to arbitrage, but primarily as a hedge against risk. They serve an important role in the world of finance but like anything moderation is key.

Derivatives can be broken down into two categories:

• Over The Counter (OTC)

• Exchange-Traded

OTC is where we will focus as this represents the greatest risk to the global economy. In the 2008 financial crisis, derivatives took center stage and became part of everyone’s vocabulary. Unfortunately though, the 2008 financial crisis did very little to resolve inherent risks to the financial system. As you will see the size of this market is truly beyond comprehension.

Global GDP in 2008 was roughly $58 trillion USD.
The notional value of OTC derivatives is 12 times greater at $684 trillion USD

Interest Rate Derivatives are by far the largest of the OTC derivatives market

Imagine an unregulated product that is 12 times greater than the GDP of the world.  Does that make any sense? Anyone who thinks we have moved past the problems of the 2008 financial meltdown is kidding themselves.  This is a serious problem that must be understood, especially in a financial world where central banks have a heavy hand and whose actions often produce different results than intended.

In future posts we will discuss various derivative products in depth and the risk of each to the global economy.

Remember back in 2008 each Sunday night seemed to be a new class on the latest financial product that failed. Guess what? They are still out there and the risk in many cases is even greater. So as we watch a market chop up anyone trying to price in reality, time is better served for longer term and or macro traders to study and be prepared for those falling shoes still being levitated by the Fed, FASB and Treasury.

Over the next few days I’ll discuss various derivatives. Derivatives are important financial products but like anything in moderation. Derivatives have outgrown their intended use and as a result represent major systemic risk to the global economy that still have yet to be addressed.

Below is an example of an interest rate derivative product. In its most basic definition, all this product does is convert a floating rate to a fixed rate and vice versa.

GM needs capital and wants to sell debt to GEICO. They offer to sell $100 million in debt to GEICO for five years at an adjustable rate of 6 month Libor plus 200 bp (2%). GEICO loves the deal but wants a fixed rate. The interest rate derivative is the product that allows this deal to get done.

Inflation is a function of supply and demand. If supply is greater than demand, prices fall. If demand is greater than supply prices rise. Pretty basic right? You could also argue though that the thought of rising prices increases demand which then in reality causes higher prices.

Two years after the US downturn, there still lacks true demand. From high unemployment to damaged balance sheets, the American consumer is less willing to spend on discretionary items. One of the goals of quantitative easing is to increase inflation expectations. In a deflationary environment where prices fall, why buy today what will be cheaper tomorrow. In an inflationary environment where prices rise, why not buy today what will be more expensive tomorrow.

So if you can increase inflation expectations you can basically pull demand forward. This increase in demand in theory causes more production and thus more jobs further increasing demand. In theory, if you can pull demand forward enough, you can jumpstart the economy.

The ability to control inflation is difficult though. As prices rise, consumers need more money to maintain their standard of living and thus demand higher wages. Higher wages increase costs which further add to inflation. Once an employer raises wages though, it’s almost impossible for them to lower those wages.

During congressional hearings on February 9, Paul Ryan asks Bernanke about this balancing act of creating enough inflation to stimulate growth but not so much that prices grow out of control. In a free, democratic, market driven economy it is truly amazing that one man controls monetary policy and yet the implications of that policy are very far reaching.

Equally disturbing are the responses from Bernanke (at 5:25 in the video)

“Overall inflation including food and energy is still very low…”

“There is no indication in our financial markets that in the United States there is an expectation of inflation…”

These comments are disturbing for reports of inflation are rampant. Bernanke discounts inflation and uses the five year Treasury TIPS spread at 2.10% as proof that inflation expectations are in line with Fed policy. He is aware of the inflation that is here and that which is coming but publicly he cannot state that as he is trying to increase expectations. The man who said subprime was contained though is now entrusted to adjust monetary policy at that precise moment that inflation grows beyond control.

From a macro standpoint it is my belief that all this rising inflation will do is choke off demand and push the US back into recession. One has to wonder if the strength in durable goods and CAT earnings are driven partly from farmers reinvesting profits from rising prices, the same prices that will slowly stifle the US economy.

The Fed has officially lost control of the yield curve. First it was the ten year and beyond but now the shorter end of the curve is being assaulted. Just imagine if the Fed said they would be pumping $125 billion into equities each month for six months. Would you ever expect equities to sell off? That is exactly what the bond market has been doing.

The implications of higher yields cannot be understated nor should they be ignored. Bernanke is going to need to do something soon and try and stop the exodus. Today’s three year auction was not a positive sign with a very low indirect bid leaving primary dealers to buy over 60% of the auction. The Fed cannot come out and say QE failed. They either have to cause a sell off in equities (and hope people rush to the “safety” of treasuries) or have to say the economy is improving so much, QE2 can be stopped. The past few days we have heard from three Fed members (two of which are voting members) that they won’t support QE3 but will the bond market wait until June when QE2 ends? Time is becoming of the essence.

Below are two charts of treasury yields from June 1, 2010 through February 8, 2011.

The first chart is of various maturities over time. Yields actually dropped from the August Jackson Hole rumor of QE until the Nov. 2 official announcement. Then rates, primarily the long end really began to move up. Most recently the one and two year maturities have begun to move rather significantly.

The second chart is the yield curve over time.  It is now approaching a record in terms of steepness.  In a normal credit cycle this would be advantageous for the banking sector but no credit is being formed.  Instead the rise for example in ten year treasury yields is having a very negative impact on housing prices, while the five year will put added pressure on commercial real estate that needs to be rolled in 2011.

In a prior post, I commented on the move in treasury yields since QE was first mentioned by the Fed in August of 2010. The very short end of the curve has not budged but as you begin moving beyond one year and especially five years to ten years yields have moved substantially higher.

In the equity markets there is talk of the Bernanke put. If any market should welcome this free option play it should be the bond market. After all, the Fed has communicated regularly their goal of low rates for an extended period and the launch of QE to specifically keep rates low. The Fed has said to the bond market we will put a floor under your security. For some reason though the bond market has decided to take their ball and play elsewhere. QE1 did manage to keep yields low when RMBS was being purchased.

There are a number of possible explanations for this move higher in yields.

• The Fed has encouraged yield chasing and with commodities rising 30% in a matter of months or equities up 25% in five months, why invest in a ten year bond yielding 3%? It would take you ten years just to match a three month return on a long rice trade.
• The economy is improving so quickly that bond investors are demanding higher rates as the Fed will be forced to raise rates sooner than currently forecasted. The problem with this argument is once QE2 was hinted at, rates began moving. Perhaps the bond market was so confident in the success of QE2 and its ability to stimulate economic growth that bond yields responded immediately. The results of QE1 combined with trillions in Federal stimulus did little to improve economic growth so why would QE2 be any different?
• Inflation is a concern and nominal yields are moving accordingly. If you look at the TIPS market though (TIPS are inflation adjusted or real yields) inflation does not look to be much of a concern. The Fed’s target for inflation is 1-2% annually so inflation is a concern beyond ten years but not much at just 36 basis points above the upper target.

5 Year Inflation – 1.50% in August 2010, now forecasted at 1.98%
10 Year Inflation – 1.86% in August 2010, now forecasted at 2.36%
30 Year Inflation – 2.18% in August 2010, now forecasted at 2.55%

• The bond market is beginning to truly question the sustainability of US fiscal policy in the face of growing debt as a percent of GDP. The question I would raise is why now? Why not a few years ago? The reality of investing in US treasuries is you are relying on additional debt to pay back your existing debt. The greater fool theory is the key to this market unfortunately.

The reality behind this move in yields is probably a combination of all of the above. I was surprised in looking at the TIPS data to see how low inflation expectations truly are. I think the inflation or deflation argument comes down to one simple truth. Does QE choke off the remaining final demand in the economy before velocity explodes the money supply? My vote is the former. The bond market is sending a signal and one that needs to be watched as it will have direct implications on future monetary and fiscal policy. Let’s hope it finally forces some discipline at the Fed and DC.

Should you worry about inflation?

Many investors don’t care about what is happening to long term interest rates as seen on today’s TYX chart (30 year bond yields).

But … should you worry about long term yields?

The answer is yes, and the reason is that it has a correlation relative to the level of inflation.

Up until now, consumers haven’t really been concerned about inflation.  This attitude is probably similar to people and diseases … most people don’t worry about getting cancer until after they get it.

For those who look at a long term monthly chart of the 30 year yields, they know that we are at the very cusp of ending a 15 year down trend, with the possibility of beginning a new multi-year up trend.

We won’t show that monthly chart today because we post it every day on our Advanced subscriber site.  However, we will post the current weekly chart of the 30 year yields.

As you can see on today’s weekly chart, something very significant happened last Friday.

The 30 year yields jumped up and above the June 2009 to February 2011 resistance line.  This is implying that Bernanke and the Fed have lost control over keeping rates interest rates low.   In reality, they probably don’t mind because this could be construed as an opportunity to inflate away current debt levels.

In any case, the direction of the current trending should be of concern to consumers and it should be the basis for a change in their long term personal strategies.

Some mixed messages come out of this week’s CFTC Commitment of Traders Report. Below are six charts with my best estimate of what the data is telling us. The three key takeaways are

• Commercial traders appear positioned for further bond weakness

• Commercial traders are reducing net short positions implying copper weakness

• Retail traders are positioned for further USD weakness, implying USD strength

Bonds

Looking purely at the relationship to 30 year yield and the SPX, this chart implies that further bond weakness (lower price higher yield) would be a positive for the SPX. This cannot be taken purely at face value though. There are many implications to a weakening bond market beyond this chart. Still, the data below would imply continued equity strength.

Bonds – Commercial Net

Commercial positions continue to move towards a more net long in the face of 30 year weakness.  At face value this chart would imply further bond weakness to come.  It’s important to note though that commercial positions are approaching a 52 week high.

USD – Commercial Net

This is a tough one to read.  The commercial trader position is net long and matches that of the prior 52 week high.  It is very possible their net long position grows but considering this position relative to the prior 52 weeks, it is quite possible they begin getting more short which would imply USD strength.  The USD has bounced off key support which would further argue for a reversal to a more short commercial net position.

USD – Commercial VS Retail Net

This next chart is that of the non reporting positions versus commercial positions.  Non reporting (retail) are relatively short versus prior times in the year so there is fuel for a short squeeze in the USD.  Hard to make any definitive call though.

Copper – Commercial Net

This is a rather interesting chart.  Copper caught a nice bid the past week yet the commercial traders are not buying it (literally).  They appear to be getting more net long (this  chart is inverted for comparison sake) which would imply pending copper weakness.

Copper – SPX VS Commercial

Nothing too definitive can be drawn here other than a word of caution for the SPX as commercial positions appear to becoming more net long (chart is inverted for comparison sake).

Due to the Thanksgiving holiday the CFTC report came out today, versus Friday. Three charts I wanted to show that support the theory that this market is finally beginning to rollover relate to copper, crude and 30 year treasuries. Historically Copper and Crude have correlated very well with SPX. Looking at the commercial accounts in the CFTC weekly report for each commodity is yet another way of gauging a change in direction.

Chart 1 – Commercial Net Positions in Copper VS SPX: The past two weeks have seen a reversal in the net position after hitting a 2010 high and indicate a SPX reversal.

Chart 2 – Commercial Net Positions Crude (NYMEX) VS SPX: Similar to copper, net positions have reversed after matching 2010 highs and look to be rolling over.

Chart 3 – 30 Year Treasury Price (inverted) VS SPX: With yields coming back, the 30 year looks to be catching a bid once again.  Based on this comparison fair value on SPX would be about 1025 today.