White Ants

This note was originally published at 8am on December 13, 2012 for Hedgeye subscribers.

“Socialism would make our society comparable to that of the white ant.”

-Winston Churchill


After the market close last night I was excited to crack open the biggest brick in my reading pile – The Last Lion: Defender of The Realm (1940-1965). This puppy is 1182 pages long; could take awhile – so prepare for plenty from the Old Man on 10 Downing St.


Comparing Britain’s rise and fall from global economic (and currency) power of the early 20th century is very appropriate when considering what the United States of America is doing under Bush/Obama in the 21st. Churchill has always resonated with me, not because I am like him, but because he wasn’t liked by the burgeoning British #PoliticalClass.


“Churchill had a natural sympathy for simple people because he himself took a simple view of what was required… That was no doubt why the man-in-the-street loved him and the intellectuals did not… For that reason, Churchill had “dislike and contempt”, of a kind that transcended politics.” (Preamble, page 6)


Back to the Global Macro Grind


Reading the preamble to Churchill after watching the gong show that became Ben Bernanke’s rock-star presser yesterday may very well have done the unthinkable to me last night – it made me think.


How conflicted, constrained, and compromised are we in America at this point to even consider some of the un-qualified spew that comes out of an un-elected and un-accountable professor who is literally making it up at this point on the fly?


Educating yourself to contextualize this moment in economic history is one thing – having common sense is entirely another. Bernanke admitted yesterday that his entire policy framework is based on forecasts that you should have no confidence in.


Finally, I think global markets actually took his word for it on that.


To review Bernanke’s 2012 experimentations (actually he called them “innovations” yesterday, and smirked):


1.   January 25th, 2012 – right when Global Growth was accelerating (I was as bullish as anyone in the world on the prospects for US and Global Consumption growth on JAN24), he arbitrarily decided to move his 0% interest rate Policy To Inflate out to 2014 from 2013. Stocks and Commodities ripped for the next month, then topped.


2.   September 13th, 2012 – after whispering sweet bailout promises to whoever got the memo (other than me) from Jackson Hole, Bernanke pushes his 0% interest rate Policy To Inflate out to 2015 and beyond. Stocks and Commodities continued to rip for another day, then topped.


3.   December 12th, 2012 – whoever was front-running the Fed’s latest “innovation” (knowing he’d move to “targeting” an unemployment rate that you may not see until 2017-2020) didn’t even stick around for the full press conference. Stocks and Commodities topped, intraday!


After perpetuating all-time highs in Housing, Education, Oil, Gold, and Food prices (2006-2012), he pushed out 0% rates 3x in 10 months, from 2013 to 2017 and beyond. Each time, the market rallied less (for less time) on less volume. Atta boy Ben!


And people wonder why the commodity/stock market casino of front-running whatever Bernanke makes up next doesn’t reflect the underlying fundamentals of A) the economy and/or B) corporate revenue/earnings growth? Wonder no more. His explanation of what he is doing and why yesterday was so scary that even Gold wouldn’t keep going up.


And boom! Gold and Silver fall another -1.2% to 2.4%, respectively, this morning. To me at least, it’s like watching White Ants marching over their own expectations cliff. If you’re really long this stuff (say, for example, you own 21% of the Gold ETF), what, precisely, is your next catalyst? 2050?


As Churchill said, “Never, ever, give up!” And I won’t in contextualizing the moment markets are in within the lessons of history learned. Gold has been up (year-over-year) for 12 consecutive years. One might assume that the market has sufficiently discounted:

  1. Japan cutting to zero (and now setting the Yen on fire)
  2. USA cutting to zero (and then re-defining zero)
  3. Europe readying itself to create the fiscal/debt union to accomplish Japanese/American Style Zero

Zero. Think about what zero means. If the risk-free rate is zero, going forward it’s going to be increasingly difficult to beat zero.


I think most people who run money get that. And if you’re being honest with yourself (all you have to do is look at the balances in your equity market accounts versus where they were in December 2007 to get the point), you’d be happy to get back to zero (break-even). Like the Nikkei post its real-estate/asset 1980s price bubble, the SP500 keeps making lower long-term highs.


As I’ve written multiple times since stocks bottomed at higher-lows in November, there will be a great economic opportunity born out of food and energy price deflation if we allow Bernanke’s Bubbles (Commodities) to pop.


Deflating The Inflation Expectations out there will definitely take time – but at this point you don’t even have to have faith. You don’t have to believe the Keynesian intellectuals who are failing all-over themselves anymore either.


Just be a simpleton, like me. Think mean reversion, gravity, and White Ants.


Our immediate-term Risk Ranges for Gold, Oil (Brent), Copper, US Dollar, EUR/USD, UST 10yr Yield, Shanghai Composite, and the SP500 are now $1684-1719, $105.43-109.65, $3.61-3.71, $1.29-1.31, 1.66-1.72%, 2035-2095, and 1419-1432, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


White Ants - Chart of the Day


White Ants - Virtual Portfolio

Consumer Staples and Utilities – Birds of a Feather?

Last week, during our initiation on the Consumer Staples sector, we suggested that some investors have been involved in the sector in an effort to chase yield, given that lack of yield in other investment vehicles.  In this note, we expand our original analysis of the XLP to include the Utility sector (XLU), another sector whose constituents enjoy stable and consistent cash flows and pay out a significant portion of those cash flows to investors in the form of dividends.  As one would suspect, the XLU has seen some of the same anomalous behavior relative to history that we pointed out
regarding the XLP.  In fact, the recent correlation of the price of the XLU and the 10 year yield is higher (r2 = 0.5485) that that of XLP versus the 10 year (r2=0.4836).  Both sectors correlation to the yield of the 10 year is a relatively new phenomenon (since 2009) and represents a break with historical trends.


Consumer Staples and Utilities – Birds of a Feather? - XLP vs. 10 year


Consumer Staples and Utilities – Birds of a Feather? - XLU vs. 10 year


Unsurprisingly, the difference between the yield of the XLU and the yield of the XLP has been remarkably consistent since the beginning of 2009, with an average of 1.42% (the XLU has the greater yield) with a standard deviation of 0.22% - very stable.  The yield spreads of each sector versus the yield of the 10 year are stable in relationship to each other as well – this makes sense intuitively as investors wouldn’t likely see a need to shift between the XLP and the XLU, but rather to simply look at the yield of each index in relation to the yield of the 10 year.


Consumer Staples and Utilities – Birds of a Feather? - Yield Spread XLU v. XLP


Consumer Staples and Utilities – Birds of a Feather? - Relative Yield Spreads


With regard to the price of each index, we were hoping for some predictive ability in terms of price movements, but were disappointed.  Peaks and troughs for the two sectors occurred simultaneously or with inconsistent leadership by sector.  Intuitively, the XLU, with the higher yield, should have been more sensitive to changes in the 10 year – this turned out not to be the case.


What was the case (again, unsurprisingly), was that the price movements for the two sectors were highly correlated (r2 =0.9259), lending significant support to our view that both sectors have seen significant inflows as investors search for yield in a yield-less world.  At the same time, we have seen the multiple of the consumer staples sector creep upward.  We believe that this increases the risk for fundamental investors in the staples sector, to the extent that fund flows are being dictated by circumstances unrelated to business fundamentals - it would not surprise us at all that at a point when investors should start to see improvement in the underlying business as the broader economy recovers, money flows out of the sector as rates creep upward.  This will likely be in addition to any sector allocation strategies that might favor more recovery-oriented sectors.


Consumer Staples and Utilities – Birds of a Feather? - XLP and XLU price


In summary, our analysis shows that the XLU does indeed display the same anomalies with respect to investors chasing yield the past several years as does the XLP, and this phenomenon increases the risk for fundamental investors in both sectors.


Robert  Campagnino

Managing Director






Today we covered our short position in Core Labs (CLB) at $108.69 a share at 3:27 PM EDT in our Real-Time Alerts. We originally shorted Core Labs on December 19 at $108.87 a share at 3:41 PM EDT. We believe the stock is oversold at the moment so we covered on red, booking a modest gain. We remain bearish on the TREND duration for CLB.



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Takeaway: Japan’s fiscal POLICY outlook augurs bearishly for the yen over the intermediate term.



  • Between now and the JAN 22nd BOJ meeting and from then until the APR ’13 replacements of the BOJ governorship and two deputy-governorships, Japan’s fiscal POLICY outlook will take center stage in our TREND/TAIL call for a demonstrably weaker yen.
  • Ahead of the APR 1st fiscal new year, Abe and Aso will craft a “large-scale” supplementary budget for the FY12 year (likely > ¥10 trillion), as well as a FY13 federal budget. Regarding the latter, the previously-imposed ¥71 trillion spending cap for FY13 was recently disregarded by the LDP, suggesting Abe is poised to take public expenditures to new heights. In short, we think Japan’s pending fiscal and monetary POLICY mix risks igniting a backup in JGB yields that could threaten Japan’s fiscal sustainability, potentially triggering a European-style sovereign debt crisis.
  • Regarding the yen specifically, sell-side consensus and Japanese exporters do not yet agree with our call for sustained yen weakness over the intermediate-to-long term. Sell-side consensus expects the currency to strengthen to ¥83 per USD by the end of 1Q13 and Japan’s large manufacturers expect it to average ¥78.73 per USD in the fiscal half year through the end of MAR ’13 (up from the current average of ¥81 in the fiscal-half-year-to-date).
  • To the extent the latter party joins the “party” we could see another meaningful leg down in the yen over the next few months, as commercial traders remain positioned long of the JPY to the tune of two standard deviations relative to the trailing 52-week average.


While we were away, Japan’s parliament approved Shinzo Abe as the nation’s seventh prime minster throughout the past six years, returning him to a post he abandoned in 2007. Coming in hot, Abe was quick to name Taro Aso as his minister of finance – Japan’s sixth finance chief throughout the past three years. With political turnover like that, it’s no wonder Japan is struggling mightily to get its fiscal house in order.


Aso, a former prime minster in his own right in the 12 months through SEP ’09, will also serve as deputy prime minster and financial services minister in Abe’s cabinet. This give the LDP a strong 1-2 spending punch atop Japanese leadership, as both Abe and Aso are champions of Keynesian-style, countercyclically-expansionary fiscal POLICY.


During his brief stint as prime minster, Aso introduced three extra budgets worth about ¥20 TRILLION, abandoned a pledge to balance the budget by March 2012 and distributed a ¥12,000 per-person cash handout. A supporter of the “by any means necessary” fiscal POLICY that has plagued the Japanese sovereign balance sheet for much of the past ~20 years, Aso has developed a reputation for signing off on seemingly wasteful stimulus initiatives (such as authorizing ¥12.4 BILLION in 2009 for the cleanup of fishing gear).


It should be noted that Abe, Aso and their underlings will be hard at work on crafting a “large scale” supplementary budget for the FY12 year (ending in MAR ’13), as well as a FY13 budget that takes Japanese public expenditures to new heights. The party has already abandoned the previously-imposed ¥71 trillion spending cap for the upcoming fiscal year (starting in APR ’13); following through with that pledge would grow Japan’s primary public expenditures by roughly +4% YoY in nominal terms.


Importantly, doing that in a time of economic calamity as Japan currently is in (second recession in the last two years; third in the last four) would likely impose a greater reliance on sovereign debt issuance to fund public expenditures. We consider it crucial that Japan is poised to surpass the 50% mark with regards to the sovereign’s bond dependency ratio in the upcoming fiscal year – i.e. over half of public expenditures will be funded via debt issuance, as opposed to more traditional revenue sources such as tax and fee collection.




Indeed, historical trends for the growth of sovereign debt service and total tax & fee revenue suggest long-term holders of JGB’s should be very leery of the Abe/Aso duo. Extrapolating CAGRs from the previous five years suggests Japan’s sovereign debt service is poised to completely consume all traditional revenues in 15 years – i.e. the “point of no return” or the sovereign “endgame”, so to speak. There are a myriad of reasons why 15 years is a really aggressive assumption (i.e. the point of intersection is likely much further into the future), but it is a fun theoretical exercise nonetheless.




What is not theoretical is the fact that both Japan’s sovereign debt service (currently 24.3% of total public expenditures) and interest expense (currently 44.7% of total debt service) continue to grow in nominal terms – despite the sovereign’s weighted average cost of capital plunging to new lows in recent years (1-1.2% by our estimates, down from 2% ten years ago and 5.8% twenty years ago).




To the extent Abe makes good on his promise for +3% nominal GROWTH and +2% consumer price INFLATION or if his POLICY mix induces a stagflationary concoction of said “monetary math” (i.e. +1% GROWTH and +4% INFLATION), a demonstrable backup across the JGB yield curve could make the aforementioned theoretical exercise a lot closer to reality than what we think is currently implied by a sovereign CDS quote of 81bps. It should be duly noted that the trailing 10-year averages for Japan’s nominal GDP growth and CPI are -0.7% and -0.2%, respectively.




This is why we continue to express caution regarding Japan’s pending monetary and fiscal POLICY mix – specifically in that a backup in JGB yields could threaten Japan’s fiscal sustainability, potentially triggering a European-style sovereign debt crisis. Fear not, however. Our interpretation of market chatter suggests Abe fundamentally believes Japan can avert a meaningful jump in bond yields a long as the central bank is committed to unlimited financing of the sovereign; per the latest data (3Q12), BOJ holdings of JGBs increased to the highest on record (¥104.9 TRILLION or 11.1% of all sovereign debt).


To the extent investors start to anticipate anything meaningfully in the direction of a 1930’s-style debt monetization scheme over the long-term TAIL, it could be “look out below” with respect to the market PRICE of the Japanese yen and the market PRICE(s) of Japanese sovereign debt. We wouldn’t want to be holding the bag on Japanese equities in that scenario, which is exactly why we continue to anticipate reflation in the months ahead, but refuse to endorse the trade explicitly.


On the monetary POLICY front, the latest developments suggest that the LDP will consider revising the BOJ’s mandate if the board fails to double its INFLATION target at the JAN ’13 meeting. Abe also suggested that he plans to nominate a BOJ governor that favors the policies of his party and explicitly stated that it was vital for Japan to resist the strengthening of the yen which he sees as a likely result of other countries weakening their currencies.


Be careful what you wish for Misters Abe and Aso; you just might receive it. On that note, the JPY has fallen for six consecutive weeks vs. the USD as is now at multi-year lows of ~¥85.61 per USD. In the spirit of keeping score, Japan’s currency has plunged -9.4% vs. the USD since we outlined our TREND-duration bearish thesis on 9/27; that compares to regional median gain of +0.2%.




From a sentiment perspective, sell-side consensus and Japanese exporters do not yet agree with our call for sustained yen weakness over the intermediate-to-long term. Sell-side consensus expects the currency to strengthen to ¥83 per USD by the end of 1Q13 and Japan’s large manufacturers expect it to average ¥78.73 per USD in the fiscal half year through the end of MAR ’13 (up from the current average of ¥81 in the fiscal-half-year-to-date). To the extent the latter party joins the “party” we could see another meaningful leg down in the yen over the next few months, as commercial traders remain positioned long of the JPY to the tune of two standard deviations relative to the trailing 52-week average.




Lastly, to review the POLICY and PRICE catalysts embedded in our bearish thesis on the Japanese yen, we view each one of the following risks as probable over the next 12-18 months:


  • A +2-3% joint Diet-BOJ INFLATION target (JAN ’13?);
  • A meaningful expansion of public expenditures and “large scale” stimulus package (1Q13?);
  • A VAT hike delay (2H13?);
  • The LDP wins a  majority in the Upper House pending elections (JUL or AUG?);
  • An erosion of BOJ independence, with the BOJ governorship and two deputy governorships eventually assumed by LDP puppets (1H13?);
  • Experimental monetary POLICY – particularly a foreign asset purchase program (1H13?); and
  • The UST 2Y-JGB 2Y yield spread widens in any meaningful way (2013?).


Stay tuned; if the market is telling us anything, it’s that this train is just getting started.


Darius Dale

Senior Analyst

Destroying The Yen

The Bank of Japan recently decided it would prefer to follow in the footsteps of the United States and the Federal Reserve. Japan's policy of debauching its currency, the yen, is part of a plan to stop its strength. As you can see in the chart below, the yen has fallen considerably over the last three months and recently hit a 27-month low against the US dollar. Japan thinks that more stimulus spending, currency printing and bailouts are the surefire way to fix the Japanese economy; if the US economy is anything to go by, that type of plan is but nothing but wishful thinking.


Destroying The Yen - YEN

Goodbye Gold

The great commodity super-cycle is in the process of turning and driving commodity prices down with it. As the American economy moves from "Growth Slowing" to "Growth Stabilizing," the artificial commodity bubble  brought on by the policies of the Federal Reserve is now popping. Plenty of investors, from hedge funds to individuals, are long gold and it's beginning to really hurt. Gold snapped our long-term TAIL risk line of $1671 last week, which means the price is likely to continue falling until catching some kind of support. Gold is down nearly $100 over the last month alone and CFTC gold net long contracts are down -13% week-over-week as investors flee. This is what happens when you let Ben Bernanke take control of the wheel.


Goodbye Gold - annotategold

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