Trades: Retreat

I've been forced to retreat from two of my short equity trades with hefty losses.

Sell 10% position in EDZ @ $28.22, -25.52%.
Buy to cover 10% short position in SPY @ $114.70, -11.04%.

Ouch!

Two things prompted these trades. First was the technical situation, as the S&P 500 (SPY) confirmed its breakout above resistance of 1,130 today with a huge 2% gain. EEM (MSCI emerging market index etf), the underlying index for EDZ (ultrashort EEM), hit new yearly highs today. Although these indexes look overbought, I just don't feel like taking any more losses on them.

The news today, however, is what really prompted these trades. Although Yahoo! Finance made the early claim that the durable goods report was responsible for the jump in equity prices, I don't believe that at all. the real news today came out of Congress as China Bill Heads for House Vote With Panel Approval. This bill would let companies petition the Commerce Department for import duties on Chinese products. Although the bill took some slight watering down to gain Republican backing, it could go for a vote before the house as early as next week. An "I got tough on China" vote is just what congressmen up for re-election need for their campaign speeches. This bill is clearly the work of Treasury Secretary Tim Geithner, and was set up nicely by President Obama yesterday at a U.N. meeting with the Chinese premier.  

This news shows that the U.S. government has reached the limit of its patience with China regarding trade. Geithner has sold his dollar devaluation scheme to lower unemployment to Congress on the basis of the latter benefit. But the unmistakable consequence of trade tariffs cannot be other than a devaluation of the U.S. dollar. Combined with the possibility of lower foreign competition, it is no surprise that equities are in rally mode. Unfortunately, I feel like I should have been able to anticipate the effect of this, at least on equities.

Long-term Treasuries also sold off today, as a devaluation of the dollar is not good for them either. I will most likely sell my Treasuries on Monday.

Short-term outlook

The Fed has spoken, and nothing is changed. That is, they re-iterated their readiness to buy bonds if further economic weakness manifests. Here is how the markets reacted:

Gold is up. To $1,290, a new record. No surprise here.

The S&P 500 failed to keep its hold on 1,140. Call me cocky, but I'll make the risky call of one-day wonder in regards to yesterday's breakout.

The 30-yr Treasury bond broke through resistance last Thursday, and what a one-day wonder that was. Just look at the chart (courtesy of Yahoo!).

So, basically, we have a situation where I see stagnant economic growth, along with failed equity breakouts.
I expect gold to continue its strength, along with bonds, and for equities to slide to the bottom of the trading range they've been in all year. Until further news makes the economic outlook clearer, it's too early to tell whether the S&P 500 will go any further than technical support levels at 1,040.

Update on Ireland

It seems Ireland is out of the woods for the time being. They were able to sell 4 and eight year bonds today. Details are available on Bloomberg. Although the interest rate on the longer bonds is a hefty 6%+, it must be a relief for them just to sell the bonds. Ireland is now fully funded through the first half of next year. Now that they are, Ireland will most likely be almost entirely off the radar of the U.S. mainstream media. It will be very important to remember that Ireland will be coming back to the markets in nine months, and the situation there will most probably be changed either for better or worse.

Ireland and the Austerity Model

Ireland is the model for austerity in Europe. They have bailed out their banking system, cut government deficits, and are attempting to stop the growth of government debt levels. Now, bailouts are not austerity. Rather, it's how Ireland got into this mess in the first place.

After joining the Eurozone, their economy boomed as Ireland wooed global corporations and governement invested heavily in higher education. Unfortunately, the loose-credit policies of the ECB had side effects, the greatest of which was a housing bubble. This took down Ireland's banks, requiring national guarantees of all deposits. Right from the start, Ireland's policymakers took bold, decisive action, and they continue to do so. This transfer of debt from the banking system to the government pushed debt totals to unsustainable levels. Enter the austerity. The government has cut back spending strongly even in the face of declining GDP. Tax receipts have declined. There is only one question left? Will it work?

Or, will tax receiptsand GDP fall faster than deficits? This would become a debt spiral. Unfortunately, it may not even get there, since even the mere idea of a debt spiral may cause investors to refuse to roll over existing debt as it comes due, or lend for operating expenses.

The Financial Times is reporting that a Barclays report had a sickening effect on the Irish bond market today. After yields on two-year bonds jumped half a point to 3.63%, the ECB took the drastic step of buying bonds on the open market to stop the drop in prices. Prices move inversely to yields, so a jump from 3.13% to 3.63% implies an approximate fall in price of 16%. In the bond market, this is apocalyptic. The risks are clear: the ECB is already bailing out Ireland. It may not be long before a full-fledged crisis erupts. Since Ireland is the poster-child for the benefits of the European austerity program, their failure will put into question the ability of Greece, Portugal, Spain, and possibly even Italy to pay off their debts.

How the CBOE Volatility Index (VIX) can be under 22 boggles my mind. Rosenberg says the pullback in Treasuries is a buying opportunity. I'm inclined to trust him because he's been spot on regarding Treasuries all year, but I need to think more about the implication of a possible Geithner-sponsored dollar devaluation through trade sanctions on China.

Damage Control?

So, I woke up yesterday morning mentally preparing myself to do some painful damage control. Looking at the futures market Sunday night, I saw the long bond had broken through the 50-day moving average (3.87%) sharply up to 3.91%. Since the resistance is broken, possibly ending the downtrend in yields, I thought, "have to sell here." Although I don’t like losing so much profit back to the house, I’m not going to wait and hope bonds go back. Also going to close EDZ, as emerging markets have a good deal of momentum here. I might even close SPY and try to regroup. But today’s action is decisive, so I’ll act now. Better late than never.

So, what’s changed in September? First, the equity markets were oversold, while bonds were due for a pullback. Last week was particularly frustrating for me. A steady stream of good news trickled in on marginally important data points, while on the other hand, Irish, Greek, and Spanish CDS spreads rose sharply. In addition, Japanese data was better than expected, implying reduced pressure for the Bank of Japan to weaken the Yen. I felt like a calm surface hid a strong riptide below the surface.

China
Let’s dig into some of the particular stories of interest recently. First, China. Inflation accelerated in August. The market has read this in a positive light, assuming that inflation means people are spending more and internal consumption is increasing. However, there are a couple of details that make me think differently. First, businesses have been complaining of shrinking margins, which means that inflation is not being driven by final demand, but by input prices. Some of this is rising wages, which is good for consumption. But I’m skeptical that wages are rising as fast as inflation. Second, the price increases are mostly in food. Which may not be a good thing for political stability if people get hungry. My opinion is that inflation will become a major problem soon, requiring the authorities to tighten credit. I base this conclusion on the belief that China’s economic imbalances keep getting shakier and shakier. It seems a strange portent that asset prices are falling while food prices start to take off. This bears close watching.

I also feel compelled to comment on strange logic I have heard regarding China. Some have claimed that China’s selling of Treasuries over the last year has concentrated their holdings among shorter duration bills. Since the duration is shorter, this somehow puts pressure on Treasuries as the Chinese have to explicitly act to roll over expiring bills. First of all, it’s just as easy for China to buy, sell, or roll over any maturity of Treasury bond, so this line of reasoning is just a spurious hiding of the underlying assumption that China is trying to pressure the U.S. Treasury market. However, we can see that this is not China’s intention at all when we look at the value of the Renminbi. If China wanted to pressure the dollar, they would let the Renminbi rise against it. But what has happened? A grand total of 1% appreciation. Compared to the Euro, the Yen, and the Pound, the Renminbi has fallen. The last thing China wants is a weaker U.S. dollar. But this is exactly what they get if they sell Treasuries. And the shorter the duration of the bond, the more cashlike it is. So selling short-term Treasuries is almost exactly like selling dollars, and guaranteed to push up the Rmb against the dollar.

Next, we have Australian real estate lending. The news is out that all the major banks are increasing loan to value amounts. Long term, this will increase the bust. But short-term, it may increase prices.

Basel III is a joke. Banks have eight years to double capital. Other than that, I don’t know the details. But there’s no greater sign than the market flight to risk today.

And just as I write this, I see bond yields have dropped 2 bips to 4.85 from their overnight futures high of 4.91, and the Dow Jones is up 40, down from the high of +85.

Even EEM is right at resistance levels, but no major indices have broken through.

The charts are telling me to grin and bear it, so that’s what I’ll do.