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Damned Lies

“I am not well qualified to criticize the theory of rational expectations and the efficient market hypothesis because as a market participant I considered them so unrealistic that I never bothered to study them.”

-George Soros

 

Just as Keith has his pile of reading, I also have mine.  The quote above from George Soros was in a speech he gave to the Institute for New Economic Thinking Annual Plenary Conference.  The quote itself was buried somewhat deep in Soros’ comments, but it jumped off the page at me.  To me it is somewhat akin, and I hate to use another hockey analogy, to Wayne Gretzky being told he couldn’t score 90+ goals in a NHL season (which is more than one goal per game) after he did it.

 

Soros, of course, is in a similar situation in the realm of investing.   He has absolutely crushed it in terms of outperforming the market over long periods of time.  His performance has been so staggering, in fact, that his net worth today is estimated north of $22 billion.  Now I haven’t always admired Soros’ political positions, but it is very difficult not to admire his investment track record. 

 

More importantly, I’ve always admired his desire and interest in attempting to explain his investment process.  Much of what Soros has written about his investment process revolves around reflexivity.  He loosely based this way of interpreting the markets on a theory by philosopher Karl Popper that suggests that the individual’s interpretation of reality never quite correspond with reality itself.  

 

According to Soros, in financial markets this is taken one step further in that individuals with a flawed sense of reality actually take action based on this flawed interpretation of the future.  In turn, these collective actions often influence future events, or more likely, as Soros said, create a “divergence between the participants’ view of reality and the actual state of affairs and a divergence between the participants’ expectations and the actual outcome.”

 

From my seat, the pin action in Europe over the past 18-months highlights Soros’ idea that collectively market participants really have no idea what the ultimate outcome in Europe will be to resolve the intrinsic issues associate with the Maastricht Treaty. Specifically, I’m referring to the issue that a European monetary union cannot exist sustainably without a strong political union or fiscal solidarity.

 

This morning the first of two key Spanish debt auctions occurred for the week.  The reflexive response from the equity markets is that the auction was a success, as European equities are up across the board with beleaguered French banks leading the way.  According to reports we are receiving from some of our contacts on the ground in Europe, the Spaniards sold 3.2 billion euros of 12 – 18 month bills versus a maximum target of 3.0 billion euros at a total bid-to-cover of 3.19.  On the negative side, the bills sold yielded 2.6% on the 12-year versus 1.4% prior and 3.1% on the 18-year versus 1.7% prior.  So, yes the auction was “successful”, albeit at usury type rates.

 

It’s quite possible that the Spanish debt auction this Thursday is just as “successful”.  Although as always, I would recommend watching not necessarily what the government officials say, but what they actually do.  In that vein, this week European officials are headed to Washington, DC with hat in hand to ask for more money from the International Monetary Fund.  The IMF meetings occur from April 20 – 22nd.  Interestingly, the Europeans may meet at least one surprising fiscal hawk in the way of U.S. Treasury Secretary who has already ruled out additional contributions to the IMF based on the belief that the IMF already has “substantial financial resources.”

 

Meanwhile as the loose monetary policies in Europe appear likely to be extended in perpetuity, inflation readings came in stickier, even if marginally, across the board this morning.  Eurozone March CPI came in at +1.3% month-over-month and +2.7% on year-over-year basis, both ahead of expectations.  The acceleration in U.K. inflation was even more noteworthy coming in at +3.5% versus estimates of +3.4%.

 

The scary thing with inflation is that, just like George Soros’ returns, it also compounds.  So, at this rate of inflation, in 10 years someone in the U.K. who makes $50,000 now will have to make $70,000 to have the same purchasing power.  Thus we have the hidden tax of inflation. 

 

Switching gears briefly, I wanted to touch on U.S. politics.  Yesterday the Senate blocked the so-called Buffett Tax, which would have implemented a mandatory tax of 30% on anyone earning over $1 million in income.  The legislation was blocked basically on party lines.  In terms of true tax reform, the Buffett tax is basically meaningless and is clearly not much more than a political stunt, although perhaps an adroit one by the Obama camp as according to a recent Gallup poll 6 in 10 eligible voters supported passage of the bill. 

 

The Democrats are only going to continue to focus on this class warfare type issue heading into the Presidential elections this fall.  In fact, yesterday I received a blast email from Stephanie Cutter, the Deputy Campaign Manager for Obama which invited me to compare my tax rate to Romney’s.  Ultimately, this “war on the rich” is and will continue to backfire on Obama in one key way: political donations.  So far, corporate executives across almost every industry have been giving less money to Obama and the Democrats this election cycle.  (We will have a note on this up today.)

 

For those looking for some interesting and enlightening reading this morning, the IMF releases the world economic outlook and fiscal monitor at 9am and ECB President Draghi is delivering an intro speech at the 6thECB Statistics conference.   Thinking about an annual ECB statistics conference reminds of Mark Twain’s famous quote (who he purportedly borrowed from former U.K. Prime Minister Benjamin Disraeli):

 

"There are three kinds of lies: lies, damned lies, and statistics."

 

Indeed.

 

The immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, Japanese Yen (vs USD), Euro/USD, and the SP500 are now $1, $117.67-121.61, $79.27-79.67, $80.03-82.34, $1.30-1.32, and 1, respectively.

 

Keep your head up and stick on the ice,

 

Daryl G. Jones

Director of Research

 

Damned Lies - Chart of the Day

 

Damned Lies - Virtual Portfolio


Dollar Debauchery

This note was originally published at 8am on April 03, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“The current international currency system is the product of the past.”

-Chinese President Hu Jintao, January 2011

 

If Ben S. Bernanke thinks that he can continue to debauch the US Dollar and the rest of the world is going to say nothing this time, that will be different.

 

In James Rickards chapter titled “Prewar” of Currency Wars, he uses the aforementioned Chinese quote. It’s a year old now, but the East versus West policy waters are starting to boil. Since Commodity Inflation Slows Global Growth, many sharp minds are figuring this out.

 

Whether it’s the Reinhart & Rogoff Op-ed for Bloomberg this morning that tells the Fed to “stop moving the goal posts”, or it’s China’s Central Bank Governor Zhou telling the Fed it has a “responsibility to consider the global effects” of devaluing the world’s reserve currency, the battle lines are being drawn. Bernanke’s War is on.

 

Back to the Global Macro Grind

 

It’s really easy for US centric stock market investors to not see what’s going on across the rest of the world right now. It requires a repeatable and globally interconnected Macro process to absorb all of the world’s real-time data. Few on the Old Wall have one. Even fewer Washington “economists” and “strategists” even know what that means.

 

Got un-awareness? In Currency Wars, Rickards hammers my point home in telling his story about a war games exercise he took part in that was sponsored by the Department of Defense: “I noticed the absence of representatives with any actual capital markets experience… we needed people who, in the immortal words of John Gutfreund, were “ready to bite the ass off of a bear”…” (page 9)

 

To be clear, I’d much rather dance with a bear than bite one.

 

Altogether though this is a very serious point that needs to be crystal clear in the minds of any American Patriot who regards the credibility of his or her currency as something worth fighting for. Cheering on a market that moves like it did yesterday (Down Dollar = Up Oil and Energy stocks) is effectively asking for $5 bucks at the pump come Memorial Day weekend.

 

Taking a step back to Bernanke’s Dollar Debauchery Decision of 2012 (January 25th when, despite running 3% US GDP growth in Q4, he pushed the 0% rate of return on American Savings accounts to 2014), here are the 60-day correlations to the US Dollar Index:

  1. SP500 = -0.47
  2. EuroStoxx600 = -0.70
  3. MSCI EM Index = -0.72
  4. CRB Commodities Index = -0.47
  5. CRB Raw Industrials Index = -0.74
  6. CRB Food Index = -0.41

In other words, no matter what you think about correlation versus causality (I think the relationship between a country’s monetary policy and currency valuation is very causal), these are highly correlated moves.

 

Now, Bernanke or his banker buddy at the NY Fed, Bill Dudley (who also takes car service to work), might tell you to go eat an iPad or stick some natural gas in your tank – and like it. But the rest of the world doesn’t get paid that way.

 

The people who get paid are the few of us who have figured out that this Policy To Inflate is something to be long, until that very moment when it becomes obvious to everyone else that commodity inflation is slowing growth, again.

 

Again!

 

If Inflation from these food and energy price levels doesn’t slow growth – then why:

  1. Didn’t yesterday’s no-volume rally in US Stocks equate to higher bond yields? Treasury yields are down -3bps day/day
  2. Didn’t the rest of the world’s Equity markets open with a boom this morning? Italy chasing Spain lower now
  3. Didn’t Commodities continue to rock to the upside? Most of them are down this morning because the US Dollar isn’t

A: because world markets know (just as well as Bernanke should) that the US Dollar is being held, artificially, like a ball under-water.

 

How much longer can he hold the ball under water? How close does he have it to his face? What happens when that thing rips out of the water (like it has multiple times since he took over at the Fed), and deflates every asset price he’s trying to inflate?

 

I fear, my friends, that gravity is going to catch up with us when the least amount of us are positioned for it. Whether I am right on this or Reinhart, Rogoff, and the Chinese are doesn’t matter – it’s the when that will determine Bernanke’s legacy.

 

My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, and the SP500 are now $1666-1689, $121.94-126.12, $78.62-79.21, and 1406-1422, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Dollar Debauchery - Chart of the Day

 

Dollar Debauchery - Virtual Portfolio


THE HEDGEYE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP – April 17, 2012


As we look at today’s set up for the S&P 500, the range is 34 points or -1.50% downside to 1349 and 0.98% upside to 1383. 

                                            

SECTOR AND GLOBAL PERFORMANCE

 

THE HEDGEYE DAILY OUTLOOK - 1

 

THE HEDGEYE DAILY OUTLOOK - 2

 

THE HEDGEYE DAILY OUTLOOK - 3

 

EQUITY SENTIMENT:

  • ADVANCE/DECLINE LINE: on 4/16 NYSE 411
    • Up from the prior day’s trading of -1577
  • VOLUME: on 4/16 NYSE 735.51
    • Decrease versus prior day’s trading of -4.60%
  • VIX:  as of 4/16 was at 19.55
    • Unchanged  versus most recent day’s trading
    • Year-to-date decrease of -16.45%
  • SPX PUT/CALL RATIO: as of 04/16 closed at 2.15
    • Increase from the day prior at 1.98 

CREDIT/ECONOMIC MARKET LOOK:

  • TED SPREAD: as of this morning 39
  • 3-MONTH T-BILL YIELD: as of this morning 0.08%
  • 10-Year: as of this morning 2.01
    • Up from prior day’s trading of 1.98
  • YIELD CURVE: as of this morning 1.73
    • Increase from prior day’s trading at 1.71 

MACRO DATA POINTS (Bloomberg Estimates):

  • 7am: ECB President Mario Draghi delivers introductory speech at the Sixth ECB Statistics Conference
  • 8:30am: Housing Starts, March, est. up 1% M/m to 705k (prior 698k)
  • 8:30am: Building Permits, March, est. 710k (prior revised 715k)
  • 9am: Bank of Canada interest rates
  • 9:15am: Industrial Production, March, est. 0.3% (prior 0.0%)
  • 9:15am: Capacity Util., March, est. 78.5% (prior revised 78.4%)
  • 11:30am: Treasury selling $30b 4-week bills 

GOVERNMENT:

  • IMF, World Bank holds first day of annual spring meetings
  • IMF releases World Economic Outlook and Fiscal Monitor, 9am
  • CFTC Dodd-Frank rules for swap dealers take effect
  • Deadline for EPA to release rules for air pollution from oil, gas drilling, primarily affecting fracking
  • Secretary of State Hillary Clinton attends U.S.-Brazil Global Partnership dialogue in Brasilia
  • Arizona primary for Gabrielle Giffords’s Congressional seat
  • House, Senate in session:
    • House Transportation subcommittee holds hearing on GSA waste of taxpayers’ money, 8:30am
    • Senate Banking Committee holds hearing on Export-Import Bank reauthorization, 10am
    • House Ways and Means Committee holds hearing on tax incentives for retirement accounts, 10am
    • House Energy subcommittee marks up Gasoline Regulation Act and Strategic Energy Production Act
    • House Oversight subcommittee holds hearing on the Securities and Exchange Commission and cost-benefit analysis, 10am
    • Senate Homeland Security Committee subcommittee holds hearing on Contingency Contracting Reform Act of 2012, 10:30am   

WHAT TO WATCH:

  • Goldman Sachs releases 1Q results; watch trading, investing rev.
  • Spain pledged to take “decisive” action against Argentina within days, after Argentinian President seized YPF, the oil company majority-owned by Repsol
  • Home starts may have increased 1.0% to a 705k annual rate in March, economists est., as housing demand stabilized
  • RIM said to be in talks to hire financial adviser to help weigh strategic options
  • Toshiba agrees to buy IBM’s point-of-sale terminal business for $850m
  • Japan said it will provide $60b to IMF’s effort to expand its resources
  • Audi said poised to purchase motorcycle-maker Ducati for $1.1b
  • Citigroup hosts annual meeting
  • Zynga plans to step up pace of acquisitions in search for new ‘FarmVille’
  • Rio Tinto 1Q mined copper output misses analyst ests.
  • Fiat, Renault and Peugeot Citroen lead European car sales to 14-year low as economy stalls
  • Zayo/AboveNet go-shop ends today 

EARNINGS:

    • Comerica (CMA) 6:40 a.m., $0.56
    • US Bancorp (USB) 6:45 a.m., $0.64
    • Omnicom Group (OMC) 7 a.m., $0.69
    • State Street (STT) 7:06 a.m., $0.87
    • Northern Trust (NTRS) 7:14 a.m., $0.65
    • TD Ameritrade Holding (AMTD) 7:30 a.m., $0.26
    • Coca-Cola (KO) 7:30 a.m., $0.87
    • Johnson & Johnson (JNJ) 7:45 a.m., $1.36
    • Forest Laboratories (FRX) 8 a.m., $0.70
    • Goldman Sachs (GS) 8 a.m., $3.55
    • WW Grainger (GWW) 8 a.m., $2.52
    • McMoRan Exploration Co (MMR) 8 a.m., $(0.12)
    • USG (USG) 8:29 a.m., $(0.42)
    • Cree (CREE) 4 p.m., $0.21
    • Stryker (SYK) 4 p.m., $0.99
    • CSX (CSX) 4:01 p.m., $0.38
    • Seagate Technology (STX) 4:01 p.m., $2.12
    • International Business Machines (IBM) 4:03 p.m., $2.66
    • Intel (INTC) 4:05 p.m., $0.51
    • Intuitive Surgical (ISRG) 4:05 p.m., $3.12
    • Yahoo! (YHOO) 4:05 p.m., $0.18
    • United Rentals (URI) 4:15 p.m., $0.05
    • Webster Financial (WBS) 4:15 p.m., $0.40
    • Cathay General Bancorp (CATY) 4:30 p.m., $0.30
    • Fulton Financial (FULT) 4:30 p.m., $0.19
    • East West Bancorp (EWBC) 4:45 p.m., $0.43
    • Linear Technology (LLTC) 5 p.m., $0.42
    • Packaging of America (PKG) 5 p.m., $0.40 

COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)


COPPER – we continue to see Bernanke’s Bubbles in commodities popping. On the commodities bounce this morning, Copper is down again and remains in a bearish formation alongside 10yr UST yields < 2.03% at 1.99% last. 

  • Drought Draining Stocks of Oils Amid Record Demand: Commodities
  • Oil Rises to Two-Day High on Spain Debt Auction, Retail Sales
  • March Gold Sales Drop as Stability Returns, Perth Mint Says
  • China May Become Top Corn Importer by 2014, Displacing Japan
  • Soybeans Rise on Signs of Increasing Chinese Demand; Wheat Gains
  • Gold May Gain in London as Euro-Area Debt Crisis Spurs Demand
  • Copper Pares Declines in London, Gains 0.3% to $8,004 a Ton
  • Shanghai Futures Exchange Announces Silver Contract Draft Plan
  • Rubber in Tokyo Drops as Slower Growth in China Weakens Demand
  • Rio Tinto First-Quarter Iron Ore Output Misses Estimates
  • U.K. Reliance on Norwegian Gas Boosts Volatility: Energy Markets
  • Ghana Signs $1 Billion Loan With China for Natural Gas Project
  • Freeport Takeover Talk Intensifies With Low Valuation: Real M&A
  • Drought Pushes Edible Oils Demand Higher
  • Soybean Imports by China Seen Topping USDA Estimate on Crush
  • LME Studying Including Chinese Yuan for Settlement, Clearing
  • Palm Oil May Advance as Rainfall in Malaysia Disrupts Harvests 

THE HEDGEYE DAILY OUTLOOK - 4

 

 

CURRENCIES

 

THE HEDGEYE DAILY OUTLOOK - 5

 

 

EUROPEAN MARKETS


SPAIN – you learn the most about bear markets on the bounces – this morning’s in Spanish Equities on no-volume tells you all you need to know as people keep focusing on last year’s game (bond auction yields); it’s now all about the economic gravity of the situation and the IBEX needs to close > 7585 to recapture its 1st line of support. France and Italy don’t look much better.

 

THE HEDGEYE DAILY OUTLOOK - 6

 

 

ASIAN MARKETS


JAPAN – the Nikkei was down for the 9th of the last 10 trading sessions last night, taking its correction from the March YTD top to -7.7%; Asian equities were generally weak with the exception of India who reverted to the broken playbook, cutting rates.

 

THE HEDGEYE DAILY OUTLOOK - 7

 

 

MIDDLE EAST


THE HEDGEYE DAILY OUTLOOK - 8

 

 

 

The Hedgeye Macro Team

 


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 80.28%
  • SHORT SIGNALS 78.51%

President Obama's Reelection Chances Slip This Week -- Hedgeye Election Indicator

 

President Obama's Reelection Chances Slip This Week -- Hedgeye Election Indicator  - Screen Shot 2012 04 17 at 5.10.07 AM

 

 

For the third straight week, President Obama's chances to win reelection declined, according to the Hedgeye Election Indicator (HEI). If the Presidential election were held today, President Obama's chances of winning reelection now stand at 60.5%, down from 61% a week ago and down from a high of 62.3% in late March, according to the HEI.

 

 

President Obama's Reelection Chances Slip This Week -- Hedgeye Election Indicator  - HEI

 


Hedgeye developed the HEI to understand the relationship between key market and economic data and the US Presidential Election. After rigorous back testing, Hedgeye has determined that there are a short list of real time market-based indicators, that move ahead of President Obama’s position in conventional polls or other measures of sentiment. One of those measures, the overall performance of US equities, declined, and that move in the market translated into lower odds of President Obama winning in November, according to the HEI.

 

Based on our analysis, market prices will adjust in real-time ahead of economic conditions, which will ultimately shape voters’ perception of the Obama Presidency, the Republican candidates and influence the probability of an Obama reelection.  The model assumes that the Presidential election would be held today against any Republican candidate. Our model is indifferent toward who the Republican candidate is as the sentiment for Obama and for any Republican opponent is imputed in the market prices that determine the HEI. The HEI is based on a scale of 0 – 200, with 100 equating to a 50% probability that President Obama would win or lose if the election were held today.

 

Hedgeye releases the HEI every Tuesday at 7 a.m. ET, all the way until election day Tuesday November 6.


Athletic Specialty Footwear: Strength Confirmed

Robust 11% growth in March footwear sales within the athletic specialty channel confirm the anecdote from the FINL 4Q12 call citing March comps up 10% and reaffirms the bifurcation in performance across athletic footwear channels of distribution. 

 

Throughout the month of March, weekly sales growth in industry athletic footwear sales averaged +MSD with ASPs +LSD. In reality, it seems sales were up closer to ~8% with ASP expansion in line with the weekly average. More importantly however, is that the athletic specialty channel continues to outperform the industry average (+11.3% vs. +7.8% in March) as well as the Department store and Shoe chain channels with both unit volume and ASP expansion supporting growth +7% and +4% respectively.

 

The athletic specialty channel has continued to support increased pricing with ASPs +4% to +6% over the past 3 months. On a call with FINL management Friday morning, the team was optimistic regarding sustainable price increases suggesting customers continued to show no resistance to increases provided the product showed newness and innovation (FINL ASPs were +3% in 4Q12). Similarly, Foot Locker reported customer response to additional price increases as “favorable” through February on the 4Q11 conference call with 2012 comp guidance predicated on both unit volume and continued ASP expansion.

 

Although we saw a slight deceleration in sales growth in Running and Casual Athletic sales within the athletic specialty channel, sales growth remained up HSD with Basketball (30% of Athletic Specialty FW) improving sequentially. Additionally, should the performance spread across the 3 athletic footwear channels remain pronounced, last week’s industry sales growth of 22% driven by a 21% increase in unit volume suggests the Athletic Specialty channel started April Exceptionally strong. Although we expect weekly sales to slow meaningfully and potentially go negative starting next week due to the Easter tail wind shifting to a head wind (See our note "Athletic Apparel & FW: Easter Headwind Nearing") Athletic Specialty channel sales should remain +LSD.

 

While near term top line strength is necessary to offset planned capital spending in 1Q13 to support even a 30% decrease in earnings as guided on the Q4 call, we think the FINL risk/reward is favorable for investors with a duration of 1 year or greater.

 

Matt Darula

Analyst

 

Athletic Specialty Footwear: Strength Confirmed - FW brand and channel growth

 

Athletic Specialty Footwear: Strength Confirmed - FW Marketshare growth

 

Athletic Specialty Footwear: Strength Confirmed - FW growth by cat

 

Athletic Specialty Footwear: Strength Confirmed - 2 yr chart


Flagging Asymmetric Risk in the Chinese Yuan and Dim Sum Bond Market

Conclusion: Given the asymmetry of both the pricing setup and fundamental outlook, secular yuan weakness and a bearish re-pricing of the Dim Sum bond market are two long-term TAIL risks we are flagging to you at the current juncture.

 

The most topical news out of Asia this morning came with the PBOC’s decision to widen the yuan’s trading band (vs. the USD) to up to 1% from its daily reference rate (from 0.5% prior). In theory, this should increase the volatility of the yuan, especially given the central bank’s desire to “promote price discovery” by enhancing the “two-way flexibility” of the currency. The PBOC did, however, state that they will keep the yuan “basically stable at an adaptive and equilibrium level” – denoting no change from their 2012 policy outlook statement or their actions (the yuan is down only -14bps vs. the USD since the start of the year).

 

We strongly caution against joining in the consensus hoopla which is still largely stuck on the secular yuan appreciation story. In fact, we are of the view that the China’s currency will likely weaken over the intermediate term as declining trade flows and a dramatically-subdued inflation environment gives the PBOC cover to pursue easing policy in the form of currency devaluation – a method of monetary easing that doesn’t necessarily undermine the State Council’s oft-restated goal of quashing speculation in China’s domestic property market. For a more in-depth look at each of those trends, please refer to our APR 10 piece titled, “China Is Boring”.

 

Jumping back to the consensus yuan appreciation story, the China Securities and Regulatory Commission’s decision to meaningfully expand its Qualified Foreign Intuitional Investor (QFII) and Renminbi QFII quotas ($80B from $30B; CNY50B from CNY20B) and a rebound in the country’s FX reserves in 1Q12 (+3.9% QoQ after posting their first quarterly decline in 4Q11 since 2Q98) are each contributing to a consensus view that China will continue to allow the yuan to appreciate as it seeks a greater international role for its currency amid unrelenting political pressure.

 

Flagging Asymmetric Risk in the Chinese Yuan and Dim Sum Bond Market - 1

 

Per Bloomberg consensus forecasts, the yuan is likely to gain an additional +2.7% vs. the USD through year-end and an additional +4.3% in 2013. Looking to the premium/discount spread for offshore (Hong Kong) vs. onshore (Shanghai) rates, the buy-side is also bullish on the yuan in aggregate – assigning a +12bps premium to obtain yuan in Hong Kong, though down from +58bps in JAN. Because international investors are generally limited to obtaining offshore yuan for exposure to China’s currency, the premium/discount they apply to the onshore rate can be a colorful tool in determining how [collectively] bullish/bearish the buy-side is on the yuan at the present moment.

 

Lately, however, a noteworthy divergence has emerged in the relationship between the yuan’s present outlook with its future outlook. 1yr non-deliverable forwards (settled in USD) for both the CNY (onshore) and CNH (offshore) USD crosses are trading at a -0.6% and -1.2% discount, respectively, to their present rates – signaling that investors are increasingly hedging for yuan weakness, rather than strength, over the NTM.

 

Flagging Asymmetric Risk in the Chinese Yuan and Dim Sum Bond Market - 2

 

The present-day bullishness on the yuan and recent yuan strength (Asia’s best-performing currency vs. the USD and EUR over the LTM) have been a boon the Dim Sum bond market, which are denominated in yuan and traded in Hong Kong (named after the territory’s famous cuisine, which also happens to be this ex-offensive lineman’s favorite food). Per Bank of America Merrill Lynch’s index(s), Dim Sum bonds have returned a record +3.4% in 1Q12, with average yields on corporate bonds falling -63bps YTD to 4.89%. Mean reversion has also been supportive here; Dim Sum bonds fell -3.9% in 2011 according to a Bank of China Ltd. index amid record new supply ($23.7B in ’11; on pace for $33.8B in ‘12), waning demand (yuan deposits in Hong Kong peaked in NOV), and increased scrutiny regarding their creditworthiness (only 37% of Chinese company issues are rated in the BofA index; Moody’s raised “red flags” on all 61 companies it examined in a JUL ’11 report).

 

Flagging Asymmetric Risk in the Chinese Yuan and Dim Sum Bond Market - 3

 

Flagging Asymmetric Risk in the Chinese Yuan and Dim Sum Bond Market - 4

 

Despite those headwinds, a consensus desire to seek exposure to China’s currency appreciation story by any means necessary has contributed to a fair amount of price dislocation in China’s corporate bond market, with top-rated onshore issuers paying an average of 4.81% on their bonds vs. 2.54% for investment-grade Dim Sum issuers. To the extent that the secular, one-sided yuan appreciation story is peaking/has peaked, we would expect to see some degree of arbitrage here over the long-term (i.e. the yuan appreciation premium inherent in Dim Sum bonds is unwound) – especially if the Chinese yuan actually starts to exhibit the two-way flexibility the PBOC claims it seeks.

 

While we can’t know for sure at the current juncture, who’s to say the Chinese yuan isn’t dramatically overvalued, especially given that capital account flows (while minimal) have been as one-sided [inbounding] as China’s trade flows have been over the last decade or so? What if during the process of China’s liberalization of its capital account its large stock of domestic savings begins to flow offshore in search of higher risk-adjusted real rates of return? Currently, China’s domestic savers’ options for investment are rather limited and unattractive: property market speculation (policy headwinds there); domestic equities (Shanghai Composite Index was down -14.3% in 2010 and another -21.7% in 2011); and savings accounts (negative real interest rates locked up at systemically risky banks). If capital outflows ever sustainably exceed China’s trade and investment income – which are likely both headed lower over the long-term as the country rebalances towards increased consumption (lower net exports) – a secular bear thesis for the Chinese yuan wouldn’t be that difficult to justify.

 

Flagging Asymmetric Risk in the Chinese Yuan and Dim Sum Bond Market - 5

 

At the bare minimum, we think those are questions and scenario analyses that neither the buy-side nor sell-side has begun to explore en masse, and given the asymmetry of both the pricing setup and fundamental outlook, secular yuan weakness and a bearish re-pricing of the Dim Sum bond market are two long-term TAIL risks we are flagging to you at the current juncture.

 

Darius Dale

Senior Analyst


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