fredag den 30. maj 2008

Fighting Demons

The market right now is on the edge - the real money managers looking to reallocate and the hedge fund managers like myself needing to reassess the standard protocol. Their reasoning? The dramatic increase in interest rates; whether this is driven by drifting inflation expectations or the need to re-establish positive real rates makes for a huge difference in investment outlook.

Forget Bill Gross’ talk on how inflation is measured ( - the 1y Fed expected Fed is going through the roof:

Chart 1: 1 Year Forward Fed rates
Source: Bloomberg and Credit Suisse (1 year forward FED rates based on swap market)

As can be clearly seen the expected FED moves in May alone moved from zero to almost 100 bps over the next meetings. This is was exacerbated by the hawkish Atlanata Fed President Fisher ( ) - who however, never have been at the core of Fed thinking.

The risk is market is getting ahead of themselves here, meanwhile the inflation expectations seems well anchored (which is even more surprising considering the money printing practice of the Fed) @ 2.65% and the tight range of 2.40% to 2.80% since June last year.

Chart 2: Forward break even rates

Source: Bloomberg and Fed - This is US 5 yr by 5yr forward inflation break even (TIPS minus Treau. Fwds)

Conclusion: The move in rates must be the readjustment of real rates, plus positioning of the market. The latter, in my simple farmer’s view being the main driver. There are cyclical reasons why we can be expect this to be the peak of the this rate cycle:

Mean reversion: 10y rates have been trading in nice formation with 4.09/10 now representing the upper border - and an expected reversion back to 3.60/65 being the name of the game.
Cyclical: Summer months generally makes for good bond markets
The incoming data globally, but also in the US is going to reflect the slow which happened in late part of Q1 into Q2 (See last blog comment)
The risk is obvious here - the market continues to price 130 plus Crude into inflation and the worlds finance ministers keeps spending more money fiscally in order to reignite their slowing growth.

The world is asynchronous in the sense that everything seems decoupled and trends are short and reversals nasty in depth and size. This has to do with the overall phenomenon of the uncertainty of the path forward: Where we have been "blessed" with falling inflation , stable growth and inflation through this major credit cycle, we now have almost TOTAL uncertainty:

Will the consumer come back or not; Should ECB cut or raise rates; Are Fed done lowering rates or not: Will BOE hike or lower rates, this makes for an INCREASE in overall financial volatility - the only REAL trend this year.

The most important question right now - remains the US dollar - for me a stronger US dollar is the path of least resistance for a lot of the issues of the world:

It will fight the inflation in the Middle East and Asia.
It will indirectly reinstate the confidence in the US economy and investors, like tourists in the US, we will start to see "bargains" based on cheap US dollar.
Trade flow - the biggest single input to the US economy will be stronger exports (it is already responsible for most of the growth in earnings in the US)
The leading indicators I use (talk about a contradiction in terms) clearly show the game have changed of late:
Chart 3 - Leading EURUSD indicators
Source: Bloomberg and own indicators. DTXDOW = DAX index divided by DOW .US2-10= 2-10 y us rate spread.

Both of the indicators point down.. EUR slowly starting to follow.

The retail sales this morning from Germany, plus the revisions backwards indicate that most of the Q1 surprise performance was clearly in investment, not in consumption. I expect to see a dramatic slow-down in Europe. The recoupling is happening, and if so, the EURUSD should speak loud and clear as an indicator.

Bottom line: A cyclical stronger US dollar has been my main theme all year, but I have been playing one final high in EURO (wrongly), it is now time to step aside, and initiate long US dollar, not based on the uptick in rates(which is more than matched by ECB) but in RECOUPLING and a continued lead in stimulus from the US.

When I make speeches these days I like the analogy between the economy and Alpe Huez stage in Tour De France: The US is on the mountain very close to the peak, though still climbing, but the steepness is far worse than Europe, who is trailing down the mountain and only 1/3 up the mountain, where the steepness starts to hurt, while Asia and Middle East is still on the lead into the mountain having been the muscle men (momentum) sitting at the front of the peleton; the fact remains: They ALL need to climb to the top and down again.....!!!

Enough- Heading off to my summerhouse for the a weekend of 30 degrees celsius - the hottest month in history, it could be the hottest few quarters coming up as the world economy is on the edge, the edge of what remains the question.

Good luck,


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