Reflation's Gravity

“Gravity is a contributing factor in nearly 73 percent of all accidents involving falling objects.”
-Dave Barry

The top 2 stories on Bloomberg this morning have the following headlines: 1. “Dollar rises most in two months against Yen as Bernanke signals exit plan” and 2. “Bernanke says Fed will be ready to tighten policy when economy improves.”…
 
Now let’s understand where these headlines are coming from. This is what Bernanke said last night at the Board of Governors conference in Washington:

“My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period”…“At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.”


Then, this is what Larry Summers said at a Bloomberg Forum:
 
“He made it very clear that our commitment is to a strong dollar based on strong fundamentals…”
 
So, no matter where you go this morning, there the change in rhetoric is. The long awaited shift in US monetary policy is in motion. No, these are not explicitly hawkish comments on rates. But, on the margin, this is an important shift from only dovish and ignoring a Burning Buck, to at least recognizing gravity. Maybe $1049/oz Gold or a Russian Stock market +111% YTD focuses the mind. ZERO percent interest rates in America is NOT a perpetual policy. This is progress.
 
Or is it progress? For a lot of investors, the answer to that questions has multiple durations and perspectives. My answer is Australian. Raising rates to levels in line with at least those of the BOE (0.5%) and ECB (1%) is the only option for America, unless we’d like to become the world’s funding currency.
 
Until most recently, the Japanese Yen has been that carry trading currency. After hitting a 9 month high versus the US Dollar earlier this week, the Yen is getting pounded this morning, trading down a full percentage point. Yes, in FX trading, that’s a lot!
 
We are short Japanese Equities via the EWJ etf. From an immediate term TRADE perspective, a weakening Yen doesn’t help drive continued alpha points in that short position. But being short of US Dollar denominated REFLATION positions does. I am short Oil’s curve, via the USO. I am long China via the CAF closed end fund. China doesn’t like Burning Bucks. China’s stock market voted yes on US rate hikes last night, closing up +4.8% - it’s largest move in 5-weeks.
 
I have been looking for two fundamental factors to drive a Bombed Out Buck here in Q4:
 
1.      
A Q4 sequential acceleration in reported inflation (Reflation’s Rotation from the lows of reported y/y Deflation)

2.      A Q4 signalling from the US Federal Reserve that we no longer have Great Depression like growth and the need for “emergency” rates of ZERO percent

 
The only two things that matter to US Federal Reserve policy SHOULD be growth and inflation. Understanding that this is the most politicized US Federal Reserves in modern history, however, reminds me that SHOULD doesn’t equal and objective will to obey the laws of gravity. That said, however marginally less dovish these comments from Bernanke and Summers are, this is progress.
 
The US Dollar was down -0.66%, yesterday at $76.03. That was another higher-low for 2009.
 
The SP500 was up +0.75% yesterday at 1065. That was another lower-high for 2009.
 
Lower-highs and higher-lows are what they are in my macro models. In the immediate term, they are not bullish for everything priced in what were Burning Bucks. We currently have everyone from The Politico to Glen Beck chirping bearish on the US Dollar. That consensus gravity, and the perpetual ring tones from the manic media over at CNBC, make being short the US Dollar at higher-YTD-lows a position I am no longer willing to take.
 
I respect that bottoms are processes, not points. I respect that being early with my macro calls can equate to my being wrong. I respect gravity.
 
My immediate term downside support levels for the SP500 are 1050 and 1044. A breakdown through the 1044 line, combined with a US Dollar Index breaking out above the $76.92 line, will be very bearish in the immediate term for everything REFLATION. Risk managers beware.
 
Best of luck out there today,
KM


LONG ETFS
 
EWT – iShares Taiwan
With the introduction of “Panda Diplomacy” Taiwan has found itself growing closer to mainland China. Although the politics remain awkward, the business opportunities are massive and the private sector, now almost fully emerged from state dominance, has rushed to both service “the client” and to make capital investments there.  With an export industry base heavily weighted towards technology and communications equipment, Taiwanese companies are in the right place at the right time to catch the wave of increased consumer spending spurred by Beijing’s massive stimulus package.

EWG – iShares Germany Chancellor Angela Merkel won reelection with her pro-business coalition partners the Free Democrats. We expect to see continued leadership from her team with a focus on economic growth, including tax cuts. We believe that Germany’s powerful manufacturing capacity remains a primary structural advantage; with fundamentals improving in a low CPI/interest rate environment, we expect slow but steady economic improvement from Europe’s largest economy.

CAF – Morgan Stanley China Fund
A closed-end fund providing exposure to the Shanghai A share market, we use CAF tactically to ride the more volatile domestic equity market instead of the shares listed in Hong Kong. To date the Chinese have shown leadership and a proactive response to the global recession, and now their number one priority is to offset contracting external demand with domestic growth. Although this process will inevitably come at a steep cost, we still see this as the best catalyst for economic growth globally and are long going into the celebration of the 60th Anniversary of the People’s Republic.

GLD – SPDR Gold We bought back our long standing bullish position on gold on a down day on 9/14 with the threat of US centric stagflation heightening.   

XLV – SPDR Healthcare We’re finally getting the correction we’ve been calling for in Healthcare. We like defensible growth with an M&A tailwind. Our Healthcare sector head Tom Tobin remains bullish on fading the “public plan” at a price.

CYB – WisdomTree Dreyfus Chinese Yuan The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global trade.

TIP – iShares TIPS The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield. We believe that future inflation expectations are currently mispriced and that TIPS are a efficient way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

 
SHORT ETFS

USO – US OIL Fund We shorted oil on 9/30. The three Fed Heads put rate hike rhetoric right on the table. If the Buck stops Burning, Reflation stops working.

EWJ – iShares Japan While a sweeping victory for the Democratic Party of Japan has ended over 50 years of rule by the LDP bringing some hope to voters; the new leadership  appears, if anything, to have a less developed recovery plan than their predecessors. We view Japan as something of a Ponzi Economy -with a population maintaining very high savings rate whose nest eggs allow the government to borrow at ultra low interest levels in order to execute stimulus programs designed to encourage people to save less. This cycle of internal public debt accumulation (now hovering at close to 200% of GDP) is anchored to a vicious demographic curve that leaves the Japanese economy in the long-term position of a man treading water with a bowling ball in his hands.

SHY – iShares 1-3 Year Treasury Bonds
 If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yields are going to continue to make higher-highs and higher lows until consensus gets realistic.