Shadow Capitalism

First of all, just a notification: our Trades tab page has been updated with new trades, closed/stopped-out positions, and updated PnL’s.

Now to the post…

The pre-crisis status quo in regards to US-China economic relations involved the United States exporting USDs to China via consumption for Chinese exports. China recycled these USDs into Tsys, which fueled further consumption and increasing imbalances. With the crisis at hand, however, China is now forced to choose between continuining its bid for quickly-debasing UST’s or rethinking its investment strategy.

With its announcement of a record trade deficit for March, China seems to be posturing for reallocating its surpluses away from US exposure. Falling exports surely impacted China’s trade balance but the bigger issue is China’s new appetite for commodities, importing hoards of them from places like Australia. This is confirmed by the fact that China’s Bills exposure has declined more than 67% in just one year! It is evident China is not rolling its Bills held and instead is bidding for commodities (its imports are up over 60% YoY).

The reallocation away from US short-term debt into hard assets is clearly an inflation hedge play. Commodities (particularly copper) have surged, as have risk assets as a whole, while Tsy rates have been spiking and are in fact approaching breakout.

The US Treasury needs a bid for Bills to keep interest expense at reasonable levels or it will go the way of Greece. Record deficit spending and debt issuance, coupled with spiking CDS and a lack of Bills rolling from China, means the Tsy is incentivized for a risk asset selloff to spur demand into liquid safe havens, in which the USD/Bills still hold the crown, on a relative basis.

Without a surge in organic Bills demand, the USA will have a funding crisis and very bad inflation. This is not only bearish for the US, but for the entire world, because of the USD’s role as the international reserve currency, the US’s political and militaristic positions, and the massive foreign holdings of USD and UST’s. More Fed demand via QE also would spike rates, as 10yr yields went up 25% in just the first (and thus far only) iteration of QE, in less than a year.

As per trading, the key will be the AUD. It seems to be topping and a 200DMA break signals a great short opportunity and more importantly signals an end to the China-fueled commodities imports demand (at least temporarily). Given the game theory behind the US Tsy’s relations with the rest of the world, we also believe this would signal a risk asset sell-off for capital reallocation into Tsys, at the front end of the curve. The deleveraging and fundamentals on the real economy support this, but timing is key. An AUD/USD breakdown should signal a breakdown in risk assets across the board, and commodities indeed are already topping and beginning new downtrends (energy is the weakest sector in equity at the moment). We will be shorting in size the S&P and the AUD/USD on a 200DMA breakdown. A breakout through 0.935 invalidates this thesis and would lead to us stalking a long position (if there is sufficient follow-through to define it as a breakout), but would also presumably lead to plunging Tsys (yields are already on the verge of breakout, especially in the 10 and 30yr arena). Considering the inverted swap spreads anywhre from 7yr to 30yr bases and the unique position America is in politically and economically, we believe short-term deflation risk and an “engineered” reallocation from risk assets into Bills is the more likely scenario.

Below are charts showing the AUD’s overvaluation, courtesy of Citi.

Those of you who follow my twitter know I have been repeatedly talking about some of my fx trades, specifically long USD/NOK (the 200DMA breakout was a beauty), USD/JPY, USD/HUF (ht Aaron Murphy), USD/CAD; short EUR/USD, GBP/USD, AUD/USD. These have been working terrifically, as the USD has been revived because of pervasive sovereign credit risk abroad with no marginal excess dollar liquidity to overcome demand (QE is all but over).

Some quick notes about those trades:

I like the NOK and HUF as shorts against the USD because they’re great vehicles to target CEE risk (in my opinion, the next shoe to drop in Europe after the PIIGS). As per NOK, Nordics have huge eastern Europe exposure and I expect their status as the regional “safe havens” to be called into question as the CEE debacle heats up again. I’ve been (vocally) short EUR/USD since Thanksgiving, but I have been taking lots of profits in recent weeks– not because I believe that fears are overblown or that Greece/EU/any entity out there is structurally sound, but because of the risk of sudden Fed intervention (liquidity swaplines to essentially the entire globe in 2008 + to Italy in 1974 set the relevant precedents), causing a short squeeze I simply don’t want to risk being a part of. Nevertheless, I’ll continue selling short EUR/USD on strength, and agree that the probability of complete euro dissolution is higher than many people expect. For now, however, I’m keeping it to speculative sizes, but the bear flag that broke down is looking like a great short opportunity.

GBP/USD is another long-term short for me, although I also took a lot of profits in the 1.48-1.49 level. A fresh break of support may trigger a sizable bearish bet against pound sterling again from me. USD/JPY is a long-term buy that I’ve expressed support for several times. Big moves in this pair in the past few days. JGBs finally may get the crisis everyone’s been waiting for and the yen may be headed for big inflation. USD/CAD is just for a trade at this point. Fundamentals just aren’t there yet to bet big against Canada (if/when property bubbles burst, then it’s a different story) and this is just a technical trade. Similar situation with Aussie Dollar, though I consider that one very overvalued and correlated with risk assets as a whole. AUD/USD has gone nowhere for months now, this is looking like it’s topping and will be a helluva short. Some words on the Aussie Dollar from fellow ShadowCap contributor Qasim Khan:

While there is an array of opinions regarding the effects of the health care overhaul (master prognosticator Jim Cramer calling for a double-dip because of the bill), the truth is the effects of the bill are about as clear as the Greece bailout resolution (are they or aren’t they). Instead, I find it far more useful to spend my time analyzing something far more understandable: AUD/USD.

Perceived relative economic superiority and hawkish interest rate policy by the Reserve Bank of Australia have fueled a cogent AUD/USD rally over the past year. While the USD has enjoyed a significant rally against European currencies since November/December, the AUD and JPY have lagged, trading in pattern ranges. And while there are continued rumors of further rate increases by the RBA, the 50% appreciation from last year’s lows would indicate that the aggressive policy response has been priced in in its entirety, rather than individual interest rate hikes. Despite record outflows from money market funds, equity volumes reveal a complete lack of conviction in risky assets that have enjoyed a ride up. Nearly every trader I’ve spoken with, regardless of how bullish or bearish they have been in the past, has treated the most recent leg of the rally with skepticism. I doubt it would take much to break the weak rally and with the extreme degree of uncertainty (Greece, health care, US-Israel-Iran-China foreign relations, Ali Farokhmanesh, etc.) there is no lack of stimuli for the reversal, sentencing an end to the carry-trade fueled attractiveness of currencies like the AUD.

The miraculous health care victory for Obama potentially presents some concerns for the USD in the longer time frame (a topic to be discussed in greater detail), but that is another issue altogether and likely won’t provide enough of an impetus to fuel a push through formation resistance in the near future. The USD looks poised for another leg up with the DXY rallying off its 50dma. It would not be surprising to see the AUD/USD rally here from .91 levels; DXY is at a previous resistance near 81 and may require another attempt before it breaks upward. However, doing so would open up the possibility of a textbook head-and-shoulders reversal on the 30d AUD/USD chart. Either way, there appears to be significant downside to the AUD/USD at this time.

As per equities, energy is the sector I’ve been suggesting shorts in and it remains that way. Oil contango trade from late 2008-early 2009 can’t be rolled over at these normalized spreads and crude is probably topping– taking out $85/bbl would render my opinion wrong. Lots of weak issues in energy showing up to me as great shorts, eg CHK HK DVN (as well as ETFs OIH and USO). Commodities in general seem toppish, not just oil. Look for FCX and X to be big shorts again soon.

S&P is right back to its crash breakdown level just under 1200. Stalking general market to short, but just stalking for now. Technicals not allowing big bets yet, though the distribution days are piling up. Energy is the only safe short in equity imo right now.

Long USD is the trade I have on in most size. Flatteners, esp in 3s5s and 2s30s arena, looking good. Crude looking like a good short, while stalking HY, copper, and S&P on short side. When general market rolls over (commodities will probably lead the wave down), financials and REITs may crash down to more realistic valuations. But patience is a virtue for short sellers in this Fed-directed market. Wait for the patterns to allow it– eg energy stocks right now.

China’s no longer (at least at the moment) recycling USDs into Tsys. Bills are yielding nothing and the current yield curve environment make the Treasury’s funding situation appear very bleak now that Fed-originating demand is out of the picture. A thesis I have been pushing for months (and one recently picked up by Zero Hedge) is that the Treasury needs a new massive bid for notes and bonds or it will face a spike in interest rates that will kill any sort of recovery, particularly with the Obama Dems in power and continuing their spending binge (disclaimer: we’re just as critical– if not more– of Bush’s GOP administration). Without a second iteration of QE (which the bond market responded to with a huge steepener trade, calling Bernanke’s bluff without even a second attempt), there needs to be big reallocation away from risk assets and yield. The USD has began its reversal rally and the carry trade is off and unwinding. The stars seem to be aligning for the next wave down in equity, but as I keep saying, patience is key. Commodities, however, are rolling over and are ready to be shorted. Keep shorting the EUR and energy stocks on their 50DMA and 200DMA retraces and buying USD on 50DMA bounces.

Good luck trading.

As some of you may know, I’m a junior math major at the University of Michigan. I am a member of the student-run Maize & Blue Fund, which is comprised of BBA and MBA analysts who pitch stocks and trade endowed capital upon the theses. As a member of the Economics & Strategy group, I recently pitched an underweight energy recommendation (that did pass). Pretty basic summary given that it’s just the .ppt, but for those of you short energy or oil (or long, for that matter), this may be of some interest to you.

Enjoy.

Been very busy lately but will be back soon with regular posts. Just a quick update here on my thoughts on the market. Posting quickly on my phone in a car so no charts and just going off the top of my head. Forgive the stream of consciousness ranting.

Aussie dollar is beginning to look tired and after another rate hike, the hidden fragility in the Australian financial system (particularly its housing/real estate industry) may be increasingly exposed soon. At least at these levels, I like the AUD as a short against some other currencies. I’m short AUD/USD and I like EUR/AUD for an intermediate term play.

EUR & GBP have been getting pounded lately on (very legitimate) fiscal concerns from PIIGS & UK, respectively. The euro remains a good long term short in my opinion (though oversold bounces can be very volatile) as the Greece situation is still not wholly resolved, the Italy, Portugal, & Spain crises barely priced in, and the Eastern European cataclysm all but forgotten about. I’m short EUR/USD and holding. Also short GBP/USD but have taken some profits off the table– may add back in later. Gold priced in EUR & GBP making new all-time highs almost by the day.

Japan is still weak and 2010-2011 might be the beginning of the plunge in JGBs people have been predicting since the Nikkei crash in the late 80s. Private & financial sector debt crises tend to be BULLISH for the associated nation’s sov bonds, contrary to popular conception, so long as the nation’s fiscal state is relatively healthy. It’s the common safe haven play. But now with a global credit crunch, tanking export revs, increasing protectionism, and an aging workforce, crisis is back on the table at no-growth Japan. And this time the sovereign sector is levered up (as a consequence of Keynesian policy in response to the Nikkei crash and corresponding financial crisis). This is bearish for JGBs, as well as the yen, particularly as a safe haven. Yen carry trade should resume until rising costs of capital and inflationary pressures cause rising rates, which will lead to a positive feedback inflationary crisis, imo. I’m long USD/JPY and consider it a steal of an intermediate- to long-term play below 90.

The Nordics have massive CEE exposure, and the funding currencies vs the euro & domestic currencies only further complicate the issue. Bearish on Norwegian Krone, especially at these levels. I’m long USD/NOK and will add in size on a 200DMA breakout. Terrific historical moving average confluence.

Equities look tired and I’ve unhedged my short book (which meanwhile has decreased in size as I take profits/cut losses to raise cash into this mkt bounce that I actually called to the day in my last post). Expecting further USD strength from here and tomorrow’s jobs report may catalyze the beginning next wave down, like in late Jan I believe, but I’m not positioned for the NFP one way or another. USD edging higher ahead of report as I type this, conensus is -50k NFP. Mutual fund cash levels at historic postwar lows seen only at 1973, 2000, & 2007 market highs, so expecting resumption of equity decline from here. Carry trade unwinds are to be watched for, as well. More importantly, QE ends this month (Tsy portion ended in Oct 2009, MBS portion in Mar 2010), while TALF’s non-CMBS ABS-secured lending expires on the 31st. This is a significant liquidity drain that should be substantially bearish for equities & risk assets, while bullish for USD and the short end of the curve. Random note: lots of big-name hedgies been reporting stakes in Citi common equity in 13Fs, including Soros. Take that for what it’s worth. Unsure of any note/pref/CDS/short exposure so may be an arb or hedge play. Would love reader’s thoughts. Also, I’ve recently been recommending a DV01-neutral 3s5s flattener in the intermediate term for risk asset decline, though I’m bullish steepener longer term.

Tishman Speyer’s foreclosure on its ill-fated Stuyvesant Town/Peter Cooper Village property will hit CMBS prices next month. Expect the real estate double dip to blatantly manifest before summer arrives. Insurers like HIG & quasi-financials like GE have large CRE exposure. Expecting surprise writedowns in Q2-Q4 2010 in those firms. BBVA recently had a 96% (+/- 2%… My mind’s drawing a blank on the exact figure) drop in earnings YoY in its Jan earnings report, partly due to American CRE.

China bubbles in property & equity are running out of steam and may be unwinding as we speak. HSBC out with poor earnings, substantially due to Chinese investment losses. Copper (bubbled up via China) appears to be analogous now to oil in summer 08. Big declines could be in store for /HG.

Speaking of oil, the contango trade has now matured and the tankers full of crude in the Pacific can’t be rolled over with contango spreads normalized and significantly lower than cost of carry. This is huge supply that should drive down crude prices significantly. Bullish for USD, bearish for commodity currencies like CAD & AUD. Also support for my short AUD/USD thesis.

Net-short riskies, like USD, like Tsy flattener (esp 3s5s) in short/intermediate term, bearish on /HG /CL, bearish AUD GBP EUR NOK. Also probably will enter long SPY/short IWM short-beta trade soon. Stay posted.

And soapbox time: enough with the EUR shorts/Greek CDS scapegoating! Those long RMBS during the bubble weren’t probed! Shorts & CDS players don’t cause weakness, they expose it and profit off of it. As if Greece & the Eurozone don’t have enormous structural problems!

The anti-shorts remind me of how insecure high school girls often complain of bullies/antagonists causing low self-esteem in them. As Katt Williams best put it, “it’s SELF esteem– esteem of your goddamn SELF”. No one lowers your self-esteem but you! Self esteem goes down because of 1. insecurity or 2. exposed flaws/faults/weaknesses. Either way, the underlying problem is with YOU. Not the people exposing it. And the quicker it’s exposed, the quicker it’s acknowledged, and the quicker the self-denial delusions make way for positive self-improvement that raises self-esteem!

Same thing with those short EUR (me included) and long various sov CDS. The underlying problem is Greece’s/Eurozone’s. All euro shorts/sov CDS longs do is EXPOSE that weakness. Which forces acknowledgment, catalyzing change & reform, permitting malinvestment purging, sowing the seeds for ORGANIC & SUSTAINABLE growth. Jim Chanos was right. Or are you going to try to tell me the shorts killed Enron & not their SPVs and accounting fraud?

/end rant. Regular posting (and updated trades & PnL’s) resuming soon.

PS I’m soliciting names for my hedgie… Send all submissions to naufalsanaullah@gmail.com. Winner gets $5000. Winner announced July-Aug sometime.