My Diary 403 --- The Last Wanted Macro Mix; The Bond Markets Int

My Diary 403 --- The Last Wanted Macro Mix; The Bond Markets Interpretation; The Thin Trading Volumes; The Walk –Talk and Oil Bets

June 9, 2008

On behalf of my family, I want to thank for many friend’s encouraging words regarding my mom’s cancer disease and liver operation. After doing the modern radiological checks, including CT, MR and PET-CT as well as a series of pre-operation bio-chemical exams, we and the doctor team have decided to take the risks and go for operation in this Thursday…God bless Mom and all the virtuous people…

The biggest story over the week is the sharp 0.5% rise in unemployment rate. Although this is only one month data, it is very rare for this kind of move to occur and it has not happened in 22 years. In particular, it is part of a rising trend since unemployment troughed at 4.4% in March 2007. Adding to the ugly employment numbers, the average price of regular gas crept up to $4 a gallon for the first time, according to AAA. The market sold off big at the Friday close, with the Dow drops almost 400 points and S&P 500 violates all sorts of technical signals to the downside. Monday should be interesting and I believe that the uneasy Wall Street will eye on oil and retail data. Elsewhere, oil prices skyrocketed, as 1MWTI price surged an unprecedented $16.5/bbl in two days—to close at an all-time high of over $138/bbl. Reacted to that, globally equities moved down 1.9% this week, dropping 2.9% in US (the 2ND largest decline ytd), 1.9% in EU, and 1.5% in UK. Meanwhile, Nikkei rose 1% prior to oil’s climb. UST rallied, as 2yr and 10yr yields sank 27bp and 15bp, respectively, on balance this week, after 20bp gains last week. Accordingly, USD weakened 1.2% vs. EUR (1.5779) and 1% vs. YEN (104.83).

What we had over the week are the central banks on inflation fight + MS call on a $20/bbl rise in oil + conspiracy theories and Iran + margin calls and short covering…all give us the perfect storm. From the magnitude of equity markets’ reaction to US macro data and oil price move, we now know that a deep US recession is not priced in after Bear Stearns bail-out and the BTE macro data before the past week. I still hold my view that growth is the single largest risk factor to the equities and the rising oil prices is the key concern. The World Bank forecast in January that US economic growth will probably fall below 1%if oil stays at about $140/bbl…

The Last Wanted Macro Mix
To the equity investors, the scariest story on Friday was that US labour market is deteriorating, as NFPR have shrunk every month this year (-49K in May) and US jobless rate increased to 5.5% from 5% in April. In general, the market fears that the longer that job creation stagnates, the greater the risk of a significant consumer retrenchment. Historically, the last couple of periods where we had big unemployment jumps of this size within a rising unemployment environment was 1980 (during the Volker credit crunch when unemployment ultimately reached nearly 11%), and then before that in 1975 when unemployment reached 9%. The silver line for equity is that the Fed is unlikely to tighten policy while the labour market struggles.

In other reports, data showed the rising food and fuel prices pushed up the cost of living and the housing slump showed no sign of abating. Thus, we have no reason to be optimistic on US consumers. According to a BBG survey, Michigan index for June may decline to 59.5, the lowest since 1980, from 59.8. The rising cost of oil also probably caused the trade deficit to widen to $59.9 billion in April from $58.2 billion in March, according to Commerce Dept. survey. But, people are still expecting US retail rose in May (+0.5%) as Americans started spending tax rebate checks (~ US$57bn) and record gas prices inflated service-station receipts…Still, I think, the improvement may be short-lived as tighter credit, plummeting property values and a weakening labour market signal consumers will retrench.

Another louder voices come from central banks, as Bernanke at Harvard said while rising public expectations for inflation are a “significant concern'', there's little sign of the pressures that drove price increases above 10% in the 1970s. Echoed to the Fed Chief’s talk, I was somewhat surprised at how hawkish ECB on the price front. I think the ECB is now staying with heightened alertness on price stability with a number of council members wanted to raise rates. Remember, the EU area 2008 inflation projection is 3.2% - 3.6% and 2009 is 1.8%-3%. The market is priced in greater than 50% chance of a 25bp hike in July……Headaches to Central Bankers with the last wanted macro mix --- deteriorating job market + rising energy and food prices.

The Bond Markets Interpretation
In sync with sharp move of equity market, the decline in 2yr and 10yr yields were the biggest drop since the week ending 29Feb2008, when Fed Chairman Bernanke signalled it was prepared to cut interest rates again. Futures market showed a 64% chance the Fed will increase FFTR by 25bp by December, compared with 78% odds a week ago. In comparison, ECB kept its main refinancing rate at a six-year high of 4 percent, where it has been since last June. The interest-rate differential now is moving in favour of the EUR and against USD. The 2yr UST yielded 2.38%, or 2.25% less than the comparable-maturity German bund. The gap was the widest since 1993, making USD denominated assets less attractive.

The bond market seemed to be too optimistic on the reacceleration of growth scenario, and now have swung to the bearish side. The first scenario was the market consensus. According to the median figure in a May 9 BBG survey, US economy likely will expand by 1.7% in 3Q08……this forecast seems to have a big question mark hanging on, as corporate credit markets have their own interpretations. In the US, CDS on benchmark indexes rose to an almost two-month high as the U.S. unemployment rate increased by the most in 22 years and oil prices soared above $139 a barrel. According to BBG, CDX NA IG (125 companies in US and Canada) rose 8bp to 116.5bp, while in EU, the iTraxx XO (50 HY names) rose 21bp to 482bp, according to JPMorgan. The LCDX index (US leveraged loan) declined 0.4% to 98.85, according to Goldman Sachs.

Moreover, Standard & Poor's lowered credit ratings for Morgan Stanley, Merrill Lynch and Lehman, saying they may have to book more write-downs on devalued assets. The rating agency also took negative ratings actions on the bond insurance businesses of CIFG, SCA and FGIC as the companies struggle to address potential losses on securities they guaranteed…Would these suggest more bad news to come?...

The Thin Trading Volumes
On last Friday, both China and Hong Kong markets registered very light volume, ahead of NFPR data and long weekend. In A- share market, SHCOMP finished down on 4th consecutive day and dropped 3% over the week with very light volume (16 month low). Meanwhile, HK equity volume was HK$58.6bn (the 2nd lowest YTD, 50day mavg =80bn). In addition, the two New IPOs --- Pau Sheng (3813HK) & Central China Property (832HK) dropped 10.1% and 5.5%, respectively……That was definitely a very bad IPO debut day.

Regional flow wise, according to EPFR Global, Asian fund outflows continued with YTD total net outflows from Asian funds have been US$5.3bn vs. US$818mn outflows for global equity funds as Asian markets have underperformed 8.45% YTD.  In addition, redemption breadth widens as 67% of Asia-dedicated regional and country funds tracked by EPFR recorded outflows last week, compared with 42% on average between April and May. Valuations side MSCI CN ended 15.8X 08EPE vs. 23.3% 08EPSG, MSCI HK at 16.9X 08PE vs. -2.4% 08EPSG vs. MSCI AxJ at 14.3X 08EPE vs. 10.7% 08EPSG. Hong Kong H-shares traded at 15.2X 08PE vs. 23.9% 08EPSG.

Macro front, several key economic data points for May will be released over the next two weeks, including PPI (11/Jun), CPI (12/Jun), retail sales (13/Jun), IP (16/Jun) and FAI (17/Jun).  The eye-catching figures will be CPI and retail sales. The overall market is expecting China CPI to slow significantly to around 7.5%yoy in May from 8.5% in April, mostly due to food prices drop. The deceleration of CPI has been viewed as positive to Chinese investable universe as PBOC is under pressure to relax credit policy and there could have power tariff hikes coming soon. However, PBOC announced on June 7, that RRR will be raised by 100bps, to 17.5%, effective on June 15 (50bps) and June 25 (50bps), respectively. Such a move is more like an enhancement policy to prevent potential rebounce of inflation, if the government decides to raise energy prices in the near future, and to suck up the liquidity released by +RMB480bn PBOC bills maturing in June…..Liquidity control is the top agenda to PBOC….but A share has another reason to fill up the gap caused by Stamp duty Tax Cut….

The Walk –Talk and Oil Bets
An interesting comment I read from internet recently is that, in terms of raising interest rates, The ECB walks the walk, and the Fed talks the talk. In reality, USD weakened last week as ECB President Trichet said policy makers are in a state of “heightened alertness'' over inflation. His remarks pushed USD down from a 4WK high, touched after Bernanke said the central bank is “attentive'' to the implications of the weakened currency. USD fell the most against EUR in two months to 1.5778 this week, from 1.5554 on May 30 and to 104.93YEN, from 105.52.

To recap, Bernanke said that USD weakness exacerbates US inflation expectations and that both the Fed and the US Treasury are watching FX closely…joint intervention??? …It is important to note that these comments were in a prepared speech and just after a US official visit to the Gulf. Additionally, Bernanke’s comments also talked about the excessive commodity market speculation as the market thinking is that significant Fed rate cuts have led to an equally significant USD downdraft, which in turn has added to commodity market speculation, inflating inflation expectations in the process. I do not buy the strong USD story as this time, export is one of the few sources of growth contributor to US…a stronger USD is the last thing they need…..However, speculators have different view. Futures traders in CFTC have increased their bet on a decline in the EUR with net shorts at 14,454 on June 3, compared with 3,390 a week ago.

There is a real connection between the price of dollar and the price of oil. Crude oil increased to a record $139.12/bbl on Friday as demand grew for a hedge against a weakened dollar. The price of a barrel of oil was up $16 in the last two days, to $138.54, a violent 13% move. So what happened? Nasty speculators, tight fundamentals, or Israel bombing Iran…I think, given the Fed is "on hold" and is unlikely to lower rates in the current environment, the next move is ECB to lower rates in response to a weakening environment, and that served to push USDEUR higher.

The problem is today’s commodity market is not that simple, given its mix of investors and speculators… Looking at recent CFTC data, commercials( including large oil corps, commodity funds and ETFs) were long 827mn bbls of oil vs. average 350mn bbls in the early part of the decade…the question is has supply increased over 100%? I believe NOT… Adding to the flavour of oil market is that there are limits to how much exposure speculators can buy, but there are no position limits for commercials who are hedging. Unfortunately, large commercials are not hedged, such as long-only commodity index funds and ETFs. They simply buy baskets of commodities at whatever the price is, speculating on the rise in the price of the overall commodity market. For speculators, they are making the rest of stories, to short the market….now you see the problem is, whenever the short got squeeze, one have to cover its short as quickly as possible  due to the position limits…and you simply have to do it at whatever price and the spiral goes on….

Good night, my dear friends!