Commodities and Correlations

Conclusion: Given the historical inverse correlations, a strengthening U.S. dollar is likely to continue deflating key commodity prices, which is positive, on the margin, for the U.S. economy. 


One the more bullish factors in our global macro models as of late is the strength in the U.S. dollar.  In the short term, this is viewed as a flight to safety as global asset allocators get increasingly concerned about the outlook of the euro and the global economy and naturally reallocate funds into U.S. dollar-denominated assets.  In both the short term and long term, a strong U.S. dollar has one key positive benefit, which is a Deflation of the Inflation.


As we’ve consistently highlighted over the course of the past three years, the key driver of many global asset prices has been and will continue be the direction of the U.S. dollar versus other major currencies.  In the chart below, we’ve charted the U.S. Dollar Index versus WTI oil and copper going back three years.  In fact, according to our analysis the correlation between the U.S. dollar index and both copper and oil going back three years is -0.77 and -0.68, respectively.


Commodities and Correlations - 1


The immediate term impact of Deflating the Inflation is at the gas pump in the United States.  As of last week’s retail pricing across the United States, gasoline was priced at $3.51 per gallon and diesel was priced at $3.79 per gallon.  On year-over-year basis, as of last week, the price in gasoline is up +29.9% and the price of diesel is up +28.3%.  On a year-over-year basis, this is obviously not great news, but gas prices are also now at their lowest level since March 2011 and prices have been declining for the last four weeks, so, on the margin, we are seeing some alleviation of the energy consumption tax.


Commodities and Correlations - 2


In the short term, gasoline demand has been proven to be inelastic, so when prices change demand does not change meaningfully.  Therefore, it is likely that these gas savings potentially get funneled back into other areas of consumer spending. 


As a frame of reference for the potential impact to the economy of changing energy prices, according to the Energy Information Administration in 2009 the United States consumed roughly 19.2 MM barrels of oil per day (2/3rds in transportation alone).  This equates to just over 7 billion barrels of oil per year.  Thus, a $10 deflation of the price of oil on an annualized basis leads to $70 billion that can be reallocated within the economy.  In aggregate terms this decrease in the price of oil has a potential positive impact of ~+0.6% on GDP growth.


As an interesting aside, the only two major commodities that have shown a positive correlation to the U.S. dollar over the last three years are natural gas and lumber with +0.49 and +0.62, respectively.  On natural gas, this is somewhat understandable as natural gas, due to transportation costs, is a localized market that is priced based on local supply and demand dynamics.  The lumber point is more interesting and seems to at least tangentially suggest what we’ve often theorized, which is that a strong dollar will lead to a willingness by foreign investors to purchase excess U.S. real estate assets (and thus buoy the price of housing materials).


As it relates to correlations, another key risk point we wanted to highlight is globally increasing correlations between markets and asset classes.  This is occurring in fixed income markets versus equities (at a 40-year high in Europe according to reports), in components of the emerging markets versus the emerging markets index, and between subsectors in the U.S. market.  To the last point, we’ve highlighted in the chart below this strengthening correlation in the U.S. of the SP500 versus its key sectors.  This outcome of increased correlation is, obviously, increased directional risk, but also increased performance risk, as Alpha becomes increasingly difficult to come by.


Commodities and Correlations - 3


Daryl G. Jones

Director of Research

No Rush: SP500 Levels, Refreshed

POSITION: Short Consumer Staples (XLP)


So far, I’m at least a day early going back to 0% US Equity exposure. Being early is also called being wrong.


After the August-September my team has had, I’m not willing to put on the crash-helmet-risk for the sake of another immediate-term TRADE breakout in the SP500.


That doesn’t mean that we aren’t seeing a breakout above my TRADE line of 1182 by the way. It just means I’m not willing to get sucked into another month-end markup.


When I moved the Hedgeye Portfolio back to net short on August 30th (first time I’d done that since June 23rd), it was because my immediate-term TRADE range had run out of price range and the end of the month had run out of time. Time and Price is what I do. There’s still room here.


Today, provided that 1182 holds, there’s still immediate-term TRADE upside to 1203. So, I wait and watch. Both the intermediate-term TREND and long-term TAIL (1266) for US Equities remain broken.


I’m in no rush to get net short, yet.



Keith R. McCullough
Chief Executive Officer


No Rush: SP500 Levels, Refreshed - SPX

German Pain by the Charts

Positions: We currently have no European positions (including FX) in the Hedgeye Virtual Portfolio

We’ve taken our chips off the table in Europe in the last weeks, including EUR-USD, a good call given the downside in country indices (despite the recent bounce over the last few days) and uncertainty on the go-forward policy to address the region’s sovereign debt and banking contagion risks.


Below we refreshed some key charts we’ve had our eye over the last months that have helped us predict Germany’s economic slowdown and stock market crash.


The DAX is down -23% over the last two months. We think the +8.3% squeeze in the  DAX over the last three days has a high probability of being short lived, and therefore there exists heightened downside risk from here. The key catalyst the market is anticipating is a passage vote from Germany on the EFSF on Thursday.  The problem is that while this hurtle is significant in and of itself, the larger picture shows that any attempts to contain contagion risks will require additional hurdles, themselves much larger, which would need to include some form of a larger EFSF, bank recapitalization programs, and enhanced ECB debt buying programs. Further the question remains just how big the kitchen sink must be to contain the issue, and if it can be contained at all without default.   


In the charts below we’ve highlighted our levels on the DAX, and include German sentiment charts and Services and Manufacturing PMI figures which began turning down around February of this year and have helped us to navigate Germany’s slowdown.


As we’ve stated before in our research, no country is immune to Europe’s growth slowdown, which has been augmented by sovereign debt imbalances across the periphery and the significant web of European banking exposures to one another, and in particular to the PIIGS. The domino effect—of countries leaving the Eurozone and the EUR collapsing—is one that Eurocrats remain intensely aware of; this point alone suggests their behavior will likely include attaching near-term band-aids in an attempt to “fix” far deeper, and structural problems. Here we're calling out that Europe's strongest player is down and out-- this bodes very poorly for the region's go-forward economic outlook.


We expect investors to buy the rumors and sell the news going into the critical decisions that Eurocrats will discuss in the coming weeks and months—that is to say that even given a positive outcome to the most near-term catalyst of Germany’s vote on the EFSF this Thursday there’s a long road ahead (which we think weighs to the downside) in the European project to stabilize the region.


Matthew Hedrick

Senior Analyst


German Pain by the Charts - 1. dax


German Pain by the Charts - 1. ifo


German Pain by the Charts - 1. gfk


German Pain by the Charts - 1. pmi


Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.

The fine line between bad luck and rogue trades


No change to September revenue forecast of HK$20-22BN.



Despite investor fears of a slowdown, Macau had another outstanding week and remains on pace to hit the midpoint of our previous HK$20-22 billion estimate for the full month of September.  Average daily table revenue of HK$689 million this past week was almost exactly in-line with the prior week and slightly above the month to date average of HK$686 million.  Our full month projection assumes a slowdown in the last 4 days of the month which is typical heading into Golden Week.


Golden Week, from Oct 1st thru Oct 9th, should be the busiest period of the year.  We are hearing that hotel rooms are fully booked and that the Junkets and Promoters are geared up for a record holiday.  


In terms of market share, as expected, Wynn continues to recover from low hold experienced earlier in the month and MPEL’s share moderated from record highs.  However, MPEL is trending well ahead of trend and remains on track for a blockbuster quarter.  Galaxy looks like it hit a homerun on the luck side this past week as its MTD share went from 16.3% last week all the way up to 19.1%.




Last week, ARCO was down 15% underperforming the S&P 500 by 850bps.  The underperformance was not surprising given the MACRO environment, especially for the commodity centric countries.  Yesterday, the macro team suggested that last week moves in Latin American financial and capital markets are signaling a very bearish outlook for the regional economy.


As measured by our recent meeting with management and consensus estimates moving up by 2.8% last week, the fundamentals for ARCO remain strong 3Q11.  The following is taken from the Hedgeye Macro team Latin America Risk Monitor.    




Latin American equity markets got completely tagged last week, closing down -7.2% wk/wk on a median basis. The cap-weighted MSCI EM Latin America Index (Brazil, Chile, Colombia, Mexico, and Peru) actually closed down -13.6% wk/wk as the Flight to Liquidity trade continues to roil emerging market assets worldwide. This was confirmed in the FX market as well, with the region’s currencies depreciating nearly a full four percent wk/wk vs. the USD on a median basis.


Latin American sovereign debt markets sang a similar tune, with yields generally backing up across the curve throughout the region. Brazil’s 2yr sovereign debt yields posted a noteworthy negative divergence on expectations of more dovish monetary policy, as indicated by the -20bps wk/wk decline in the country’s 1yr on-shore interest rate swap. From a credit quality perspective, Latin American 5yr CDS widened fairly dramatically wk/wk, with Brazil, Chile, Colombia, Mexico, and Peru all posting percentage gains north of +30%. With the exception of Chile – the region’s highest rated sovereign credit – 5yr CDS quotes for these countries have nearly doubled in the YTD.




Brazil: The key developments out of Brazil in the past week largely centered on the real’s plunge vs. the USD (down -15.3%

over the past two months, making it the 2nd-worst performing currency in the world over that time period). The declines were met with central bank action, as the bank stepped into the market to mitigate declines by auctioning currency swap contracts (112,290 in total with maturities between Nov and Jan). This effort, which is equivalent to selling dollars in the futures market, reverses a 28-month-old trend of implementing policy designed to limit real appreciation. With renewed speculation of a Greek default swirling about the financial media, Brazilian policymakers were quick to act in support of their currency.


The real, which declined -32.3% in the five months through Dec 31, 2008, is a major source of worry for Brazilian officials – which explains the hard line stance of defense provided by the central bank (per monetary policy director Aldo Mendes’ recent commentary). Aside from exacerbating the external debt burdens of the sovereign and Brazilian corporations alike, the real’s rapid depreciation also threatens to continue undermining Brazilian capital markets and make the cost of financing business ventures prohibitive for Brazilian corporations. For example, the cost of short-term trade financing for Brazilian investment grade companies has more than doubled this month (1yr credit line export contracts now cost 2.85% vs. 1.35% 1mo ago) and is fueling speculation that the central bank will have to step in to support this market as they did back in ’08.


All told, the real’s global underperformance vs. the USD of late is largely a function of a series of Big Government Intervention designed to limit real appreciation – inconveniently at the top of the global economic cycle. The cumulative effect of the measures, which included a tax on foreign currency derivatives transactions, caused foreign wagers for real appreciation (vs. the USD) to fall -85% from July’s record high of $25.6 billion in futures and dollar spread contracts. Now, Brazil is backpedaling as its currency suffers the most as a result of these capital controls:


“We established regulatory measures exactly for that, to add and take away. The IOF is one of those; we introduced it, then we can take it away when it’s no longer needed. We are always looking at all the possibilities, but there is no decision.”

-Finance Minister Guido Mantega (9/23)


Mexico: The Mexican peso, which just snapped its longest losing streak on record last Friday is in a similar boat as Brazil – though largely for a different reason (Indefinitely Dovish monetary policy as opposed to Big Government Intervention). The peso, which is down over -14% vs. the USD over the past two months is facilitating foreign liquidation across Mexican financial markets, headlined by the -13.2% loss for peso-denominated sovereign debt in the month-to-date (vs. +2.5% for U.S. Treasuries and an -8.2% average across all emerging markets). Central bank governor Augustin Carstens believes that peso weakness is “transitory” and expects it to “resume its upward trend” along with other Latin American currencies.


Clearly Carstens is modeling in a near-term inflection point in the global economic cycle – an outcome not being priced into any of the macro markets we monitor globally. This view is likely to leave the Mexican central bank on the sidelines for now as it relates to meaningfully supporting the peso in the FX market – potentially paving the way for further declines. As interest rates continue to back up and increase the cost of capital for Mexican corporations and consumers, we expect growth south of the border to continue slowing – just as we called out in early 2Q when we first went negative on the Mexican economy and its stock and currency markets.


Colombia: The key callout out of Colombia last week is undoubtedly the government’s decision to scrap a $240 million bond issue for the rest of year, citing “global financial turmoil”. The key takeaway here is that if the Colombian government is finding it hard to raise debt capital, we don’t think many Colombian corporations are able to do so either. Growth tends to slow when capital markets dry up.


Elsewhere in the Colombian economy, Finance Minister Juan Carlos Echeverry, who put his own job on the line if the Colombian unemployment rate doesn’t improve to single digits by year end (11.3% currently), did reiterate his forecast for Colombia to grow 5% next year. We interpret this as they’ll be quick to quick to fire the stimulus gun to help achieve this goal should Colombian economic data start to come in negative on the margin. He is also keen on maintaining national confidence so that financial intermediation can continue to support growth. This may prove to be a tall order, given the global economic backdrop.


Argentina: Continuing with the theme of capital flight, which is currently on pace for the largest yearly amount on record, new data does indeed confirm that Argentina is likely to run out of money to defend its currency, the peso, in 2012. Based on a law that FX reserves are not allowed to fall below the monetary base (put in place for this exact reason – to protect against capital flight), we can now see that Argentina has only a $3.4 billion buffer before FX reserves hit this dreaded level. To complicate matters, President Cristina Fernandez’s 2012 budget includes a $5.7 billion provision of FX reserves for international debt service. Moreover, Argentina’s inability to access international debt capital markets (especially in times of global stress) all but guarantees this payment is made – perhaps alongside other FX reserve-financed social spending in the event of an economic downturn (which we’d argue is already happening given that Argentina systematically underreports inflation by 10-15% – artificially boosting GDP growth on a real-adjusted basis).


Argentina’s FX reserves, which have declined by -5.8% YTD to $49.1 billion, are largely a function of trade revenue from agricultural commodities (over 50% of exports per Bloomberg). With our call for Deflating the Inflation to continue, over the intermediate term, we think the market will continue to price in a peso devaluation at some point over the next year to get reserves to a comfortable level when compared to the monetary base. This is what the FX market has been sniffing out and is largely the reason why the blue-chip exchange rate (a market that intensifies during bouts of capital flight) is trading at a -10.4% discount to the spot market rate (vs. the USD). The capital flight ahead of a perceived currency devaluation has pushed up yields on Argentine peso-denominated bonds due in 2033 +361bps YTD to 10.51% vs. an increase of “only” +283bps on Argentine dollar bonds. All told, we are bearish on the Argentine peso (and Argentinean assets in general from a USD perspective) until the FX reserve issue is adequately addressed – a resolution we don’t see taking place anytime soon.


Darius Dale














Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.43%
  • SHORT SIGNALS 78.34%