December 12, 2008

Unusual Markets & Price Imbalances

US stocks closed up for the day and showed relatively modest gains for the week except for the Dow which ended the week a tad lower (-0.07%). S&P500 (0.42%) and more so NASDAQ (2.08%) moved higher since last Friday. While US stock markets had a comparatively calm trading week, we've noticed some interesting developments in other markets. We have witnessed yet a few more records, "never heard-of's" and rather unusual situations in various markets.

US Bond Markets
The yield on 3 month Treasury Bills turned briefly negative this week, the first time this occurred since 1940. It highlights the amount of fear that is still in the market. One must ask why anyone would want to essentially pay for the "privilege" of owning US short term bonds; if anything, you should be receiving something in return for lending your money to the government. Then again, if you're still concerned that your money isn't safe at banks and your mattress isn't big enough to hoard all your cash, T-Bills seem to be the investor's choice these days. 3 month T-Bills closed today with a yield of 0.01%, plenty negative in real-terms after accounting for inflation. As long as short term yields on US government bonds are effectively negative, we must assume the market is pricing in further bleak economic news and concerns about a prolonged recession. And the demand for the relative safest short term assets was exceptionally high this week driving up bond prices and hence turning the yield effectively to zero. Similar to previous comments made on short terms trades in Japanese Yen, here too the flight to relative safety is costing investors a significant premium and essentially eroding the value of these assets over time. This can therefore only be seen as an unusual short term condition which should reverse itself in time, even if all other things remain the same i.e. assuming global economic conditions will be as bad as expected, but not worse...

US Gasoline prices fell further this week to an average price of $1.67 today - source: After reaching a four year low at just above $40 last Friday, Crude oil staged a small retracement ending the week above $46. Some analysts have predicted a further decline to $25 per barrel but at the same time there are now traders looking at a larger retracement if not a trend reversal. As the saying goes, something's got to give. A major commodity such as oil doesn't just fall 70% (in a few months) without some serious repercussions from price imbalances.

In his article in the Financial Times today, Javier Blas noted that volatility levels in oil futures were as high as last seen during the first Gulf War. He suggested that the same traders who helped push the "oil price yo-yo" up to almost $150 and then down to nearly $40 might now drive prices up again in the hope to achieve similarly spectacular gains again. One factor confirming this view is the volume of outstanding call option contracts. He notes that for call options priced at $80 and expiring in March 2009 the volume has gone up six fold - source:

Then again, we also recall that some analysts had predicted an oil price approaching $25 in the near future. Echoing a similar point of view this week, the Worldbank's chief economist concluded that a) the global economy will be facing the worst recession since the Great Depression and b) that the end of the commodity boom was in sight. He predicted that that US oil demand would continue to drop next year putting further downward pressure on prices.

These opposing viewpoints suggest that significant movements in either direction are possible and one could consider an options trade. However, that is now slightly more sophisticated territory and should not be undertaken unless you have some experience in trading options. The possible trades would be Long Straddles and/or Long Strangles with the effect of paying higher option premiums but getting a payout when prices move in either direction. For more on oil research and background info, check out the financial times online:

On Currencies
Currency markets were active again this week. On the back of worsening trade figures, the US$ caved in against most major currencies. In October, the US trade deficit increased to $57bn. Considering the expected contraction in global demand combined with a recent increase in the US$ against most major currencies, it is no surprise that US exports would have an uphill battle.

On the other side of the trade, the Japanese Yen was again one of the big winners this week. It strengthened to a level of 88.22 Yen per US$ during Asian markets before retracing back to the 90/91 level today. This has been the strongest Yen, conversely the weakest US$ rate against Yen since April 1995, when the Japanese currency traded briefly below 80. I can think of no fundamental reason (other than fear of a prolonged global recession) why Yen would be so strong against other currencies. But with respect to the US$, the Japanese are still accounting for a big chunk of the US trade deficit and no specific reversal in that trend is on the horizon for now. The US$ is trading near long term historic lows against the Yen and it helps to get a historic perspective. In 1985, the US$ vs. Yen rate was still above 260, but as a result of the massive export strength of Japanese goods, this currency had a phenomenal long-term rally (email us if you like copy of the long-term chart).

Among the major currencies, the other significant winner was clearly the Euro this week. At the end of the European trading session, the Euro came near 0.9000 against the British Pound, the highest level since the inception of the Euro. The UK and London as the financial center of Europe have been (and presumably will be) suffering from the current financial crisis more than most other countries in Europe . The drop in the value of the Pound against the Japanese Yen and increasingly so against the Euro further reflect the risk of relatively worse consequences felt in the UK as compared with Continental Europe. A few weeks back, Wolfgang M√ľnchau (FT 18-November-08) made the case for the UK to enter the European Monetary Union and abandoning the Pound in favor of the Euro It may be early stages still, however, with the ongoing crisis and a further decline in value of the British Pound, one could argue that an integration of the Pound within the Euro may help in mastering the crisis.

The Euro also gained further against the US$ ending the week at 1.3350. In technical terms, we are now showing about a 30% retracement from the highs earlier this summer. In terms of the major long-term trend of the Euro, we are currently in the middle of a several decade long upward moving long-term channel which suggests that the massive long-term upward trend of the European currencies continues to hold. In the medium term, we could see swings of 10-20 percent in either direction. However, the major long term trend is still sloping upwards in favor of the Euro (email us if you like a copy of our technical chart). This feeds into the underlying fundamental situation of this currency pair as well. Although this is not a strict mathematical exercise, try this: The US budget deficit + (negative) US trade balance + further printing of money (to combat the now officially declared US recession) = dilution in the value of the US$. Maybe somewhat simplistic, but in the long-run, these basic fundamentals will prevail.

The Precious Metal (Gold)
Gold markets also witnessed one of the aforementioned "never heard-of's" recently. Referencing a blogpost at: for the first time in reported history, the cash price (aka spot price) of gold traded higher than the futures prices this month. This is truly exceptional since Gold, more so than any other commodity, shows higher futures prices than spot prices, the furthest futures month typically trading at the highest price. This is the typical scenario called a Contango market and it's based on the fact that the futures price equals the spot price plus a premium based on the return you would receive from a risk-free asset e.g. a Treasury Bill; this premium can also be regarded as the cost of carry (traditionally gold has been kept safe in bank vaults since it is too heave to "carry" - against a fee of course).

The onset of "Backwardation" (i.e. futures prices trading lower than the spot market), as the article initially suggests, led some traders and analysts to conclude that a massive gold rally was imminent. One possible explanation would be that greatly increased demand for Gold (driven by fear of a prolonged global crisis) would cause short term supply problems. This would drive immediate cash prices up, while longer term physical supply shortages would balance out.

Although this is sounds reasonable, Dennis Gartman was quoted as saying that "funding rates are so low, with the overnight fed funds rate as effectively near zero as it can get, that there are strange distortions taking place in gold lending operations." This would indeed explain that near term futures prices are trading at or near spot values since the effective negative yield on short term T-Bills reflects a strange but nevertheless plausible negative cost of carry in the Gold futures markets. Effectively, you would be paid to buy forward futures versus spot gold.

A third possible explanation which has been overlooked here goes like this: It would be possible, albeit rare, that Gold futures prices trade lower than the spot price, as it can happen in other commodities futures. Such a scenario would give rise to the possibility of a continued deflationary period and further downward pressure on all commodities, including Gold. We shall see which scenario will play out in a few months. For reference, here are the closing prices for Gold as of today: Spot Gold: $820.30, Dec-08: $818.90, Jan-09: $819.40, Feb-09: $820.50, Apr-09: $822.00, Jun-09: $823.60, Aug-09: $825.20

Central Bank Action
Central Banks around the world have been easing interest rates significantly in the last few months. This week, the Bank of Canada cut interest rates to 1.5%, their lowest level in 50 years. This 0.75% cut is the largest since September 11, 2001. In Europe, the Swiss central bank cut its interest rate to a four-year low of 0.5%. In Asia, South Korea's central bank lowered their benchmark rate from 4% to 3%, its biggest interest rate cut ever. All of these rate cuts obviously indicate heightened concern by the major industrialized nations that a prolonged recession may be on the horizon.

Rates for major currencies are:

On a final note, we have begun a survey on what investors consider to be the strongest currency in 2009. This survey is more of a fun exercise and highly unscientific but just to get a sort of feel for what traders believe could happen next year. When you have a spare moment, please cast your vote here at:

Good luck and good trading

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