I never thought I would ever say this but I was thinking the other day how I long for the days of Alan Greenspan as Fed Chairman. Don’t get me wrong, I think that his arrogance and wrong- headed thinking rank right up there with the worst of the Fed Chairman. The Maestro’s long diatribes ranged from the appropriateness of adjustable rate mortgages, to the shape of the oil futures curve. One thing that he did however was couch the Fed intentions to always shelter the capital markets under a cover of obfuscation. Our most recent Fed Chairs feel no compulsion to “fake it”, their role is to micro-manage the capital markets and no one should be under any misconceptions otherwise. In fact, the latest Maestro is particularly adamant that the suppression of rates has not necessarily created anything that she can’t handle. Our response to that is: “We Will See”. We were describing the state of markets the other day to someone using the accident victim as an analogy. The capital markets/global economy in 2008/2009 experienced a self-inflicted crash, followed by a near death experience. The expanded role of Central Banks was initially to save the patient. However, their ever expanded duties included administering morphine, gassing up the new car and pulling it around front for the quasi-healthy patient to take another joy ride. The problem is that how many near death experiences can one person have, and no one car crash looks like another. As we have discussed, one would expect a certain amount of Central Bank hubris, given that markets have recovered in such a sharp and unexpected fashion ( who would expect that sub-prime loans are exploding and that AAA CLO’s containing the crummiest of credits are exploding as well). However, markets have a way of acting in very non-linear ways and the belief that macro-prudential market regulation will do the trick ignores the speed at which dislocations can occur. Fade Chairman Yellens woman’s intuition: BUY STUFF
Category: base metals
Leave it to a French attorney to supply us with the latest addition to the list of non-words we currently must endure. In her words before the upcoming IMF meeting, Christine Lagarde commented on the job killing low-flation that exists in the Eurozone. Fed Governor Bullard must have been envious that he did not think of it first when he remarked today that inflation rate in the U.S. will be managed from below (???) and that Fed policy will be highly responsive to any signs of falling inflation. We comment on these remarks because the level of certainty and respect that is currently being afforded these monetary mandarins is bordering on crazy. As we await the ECB’s decision to extend their own non-traditional monetary policies, in addition to rumblings out of Japan that they will extend their monetary carpet bombing even further, we have run across a study by the BOE that throws water on the entire concept of the money multiplier. The authors of said report maintain that traditional concepts of money creation are essentially relics of the past and that the monetary base can only be altered by Central Bank policy, particularly the non-traditional variety. If you like curve fitting studies, then you will really love this one as it looks at the most recent actions by Central Banks and their effects on lending and money creation. The conclusion is that there is no such thing as “money printing” and that Central Banks, through their various non-traditonal zero rate bound policies have the ultimate ability to affect the amount of “money” in the system. The study pays lip service to increased bank regulation and attitudes toward risk, but my point in discussing this study is that we are currently on the brink of giving Central Bankers complete carte blanche, even when it comes to dismissing tried and true concepts of money and banking. The risk, as we have discussed, is that with power comes hubris and a Central Bank mindset that believes markets, economies and attitudes toward risk can be effectively managed using some intricate (unknown to us) algorithm. It is our belief that this complacent and unjustifiable faith in Central Bankers represents an inflection point, just as the complete lack of belief in monetary efficacy represented a tipping point during the Volcker era.These inflection points are critical as they, in our opinion, represent secular divergences between paper and non-paper assets. Buy Stuff Sell Paper
We are routinely amazed at the multiples assigned to the current crop of publicly traded “story” stocks. While this type of price action is not new, we saw it in the late 90’s, it does highlight the degree to which Central Banks have pushed capital markets to the brink of credulity. While we do not profess to understand one tenth of what is occurring in the social media sphere, we have seen this movie before (2001) and it does not end well. We bring up this modern day pixie dust because it is a prime example of how certain sectors of the equity markets always possess the ability to capture investor imagination. This is a nice way of saying that investors always seem to latch unto a good story, particularly if it is backed up not necessarily by fundamentals, but by a good enough narrative and a rising stock price. Compare and contrast this with the resource/commodity sectors. These sectors involve products which for the most part are dull and highly prone to swings in both supply and demand. The one thing they are not prone to however is technological obsolescence. While it is true that high prices can lead to thrifting and the potential for substitution, zinc is not going to replaced by two guys working out of their dorm room. Investors in the resource/commodity sector tend to invest only when both the macro and micro tailwinds are at their back. The problem with their story is there is no sexy story to tell. The only story that can be told is high prices eventually cure high prices and low prices eventually cure low prices. While it will not make for the most interesting cocktail banter, prospective investors in these sectors that can successfully manage around the cyclicality should be amply rewarded.
Take an Exit Row Seat
The talk in the Capital Markets, post taper, seems to be heavily tainted with certainty. This certainty involves a gradual glide path of rates, growth, employment, and inflation. However, as we all know, real life often intrudes on plans and projections. We have often spoken about the Fed and their attempts to influence investor expectations, particularly at the long end of the yield curve. However, it would seem that this latest round of Fed action appears to take this sentiment manipulation to a new level. While the Fed purports to have begun cutting their bond purchases by a meagre $10Bln per month, they explicitly reserve the right to move the goalposts as to when they may or may not cease altogether (employment or 2% inflation non exclusive). If the U.S. Economy is getting better, by their own admission, then why must the Fed go to such great lengths to show markets that they” have their backs”. Is the Fed so concerned that this recovery is so fragile that even a 150 basis point back up in rates would completely derail the progress that has been made? Perhaps the Fed is more concerned with the markets level of certainty than they are with the efficacy of current policy. Evidence of this market certainty is shown in the total breakdown in the correlations between gold and the Fed’s balance sheet, post QE3. Prior to QE3 the correlation between gold and the Fed’s balance sheet was +.95%, and post QE3 that correlation had shifted 180 degrees to a -.94%. Thus if you take gold as a proxy for market uncertainty, QE3 only substantiated the markets belief that the Fed’s balance sheet would provide an seemingly endless backstop. In fact, a Fund manager commented recently on Bloomberg News that “Gold was probably one of the easiest shorts of all time”. When market dislocation and uncertainty are dismissed to this extent, it is time to start positioning one’s self by the proverbial exit door. Buy Stuff, Sell Paper.
Name Your Price
The recent article in the FT regarding a potential change in benchmark cobalt pricing, made me think back to a conversation I had with a MF Global broker back in the late 90’s. The broker relayed the story to me of a conversation he had with a very large fund manager, whereby the manager called to inquire about the “tick size” in the Lead Futures contract. After relaying this information to the manager, said manager promptly sold short the equivalent of 10% of the world’s current lead production. The article in the FT, which discusses a potential shift in cobalt benchmark pricing from a MB based price system to a LME based price, made me think of this story because we feel it is a inherent mistake to simply assume that exchange pricing is always superior to physical transactional pricing. ETF activity, cash and carry trades, as well as the explosion in HFT has left exchange pricing often divorced from the real underlying market fundamentals. While we do agree that a benchmark price based on a loose canvassing of market participants is fraught with problems, we feel that an exchange price involving the aforementioned exchange driven activity is just as problematic. Given today’s technology, it would seem that market participants could devise some kind of pricing system which utilizes anonymous input pricing backed up with some verifiable volume metric.
We all should be happy to know that we now can become familiar, and concurrently sick to death of, a new Fed related term: Forward Guidance. A recent Fed sponsored study showed that there might be some potential benefit to tapering current bond purchases while extending the end date of said purchases to coincide with a new lower target unemployment figure ( possibly 5.5%). This change in targeting coincides with shifting targets across a number of other Central Banks, particularly the ECB where lower than expected recent inflation figures have prompted some officials to, once again, suggest the possibility of imposing negative nominal rates of interest. While this entire Central Bank lab experiment might have started out with un-conventional methods, designed to meet somewhat specific goals, we are now faced with un-coventional methods designed to meet goals that seem to be shifting by the week. One might think that such a scattershot approach would elicit a broad sense of concern across all capital markets, however concern seems to be in short supply as of late. The question we now must ask as proactive investors is: Where does the liquidity flow, now that Financial Assets of all stripes have been sufficiently bid up? The problem with un-conventional and untested methods should be self evident, but when these methods involve massive inflows of liquidity into global asset markets, one has to wonder what the secondary beneficiaries of this massive influx of liquidity might be. The recent Economist cover should provide some clues ( it is generally the perfect contra-indicator) as it is titled: The Perils of Falling Inflation. Buy Stuff.
Treasury and The Fed: BFF’s ?
The recent announcement that the Treasury would be issuing floating rate notes in an effort to feed the appetite for those investors not satisfied by the TIPS markets makes us wonder about whether the Fed and the Treasury are still on speaking terms. We are sure that the Treasury appreciates the Fed’s help, and by help we mean taking down 70% of all new issuance. But the issuance of floaters, juxtaposed with a Central Bank that aspires to create inflation, would seem to represent a situation where the two parties are at cross purposes. While it is true that the issuance is small ($10-15 Bln), and that interest rate movements are not necessarily correlated only with inflation, the fact that the Treasury would structure part of its issuance in direct opposition to what the Fed is trying to explicitly accomplish seems odd. The fact that all Central Banks( for the most part) are currently inflation wannabes, as evidenced by the ECB rate cut today and comments by Mario Draghi, might give potential buyers of said notes cause for concern. If Central Banks do indeed get their way, floating rate notes will most likely provide some protection from the collateral damage of higher inflation, but a better bet would be a position in hard assets. Continue to sell paper and buy stuff.
From Alan Greenspan’s new book: ” It is easy to contemplate price acceleration, with today’s Federal Reserve balances unchanged, ranging from 3 percent per annum to double digits over the next five to ten years.”
The always progressive CFTC has come forward with a new effort to initiate position limits in a number of “key” commodity futures markets. This new rule, if enacted, would limit position sizes in a number of markets like: Crude, Wheat, PGM’s, Copper and others. Driven by pressure from end users, these rules will ostensibly diminish any upward price pressure on prices (forget the fact that large players can short as well). We wonder why the CFTC is not more concerned with the HFT activity in these markets , but that is a whole different discussion for another day. We also have to wonder if end users have fully thought out the possible implications of rules that might force players into alternative vehicles, namely the physical markets. It is not difficult to imagine an environment in which several large players choose to express their particular views on a specific commodity via the physical markets, as opposed to the futures markets. In a market with tight supply, no limits on physical holdings, and no real ease of entry and exit, end users could be looking at a significant amount of available supply held in much stickier hands than before.
Be Careful What You Wish For
Back in February, the CEO of UC Rusal expressed his desire to see financial players play a diminished role in the aluminum market. He stated that “capital flows driven by index investors and hedge funds in particular, have distorted the supply/demand equilibrium, sending the wrong signal for players in the market”. The recent LME proposal to eliminate some of the load out delays that exist at accepted LME warehouses has him singing quite a different tune however. Mr. Deripaska recently penned a letter to said LME ,regarding the proposal, which stands in sharp contrast to his earlier stance. In this letter, Mr. Deripaska states that the LME proposal is an unprecedented intervention and one that Rusal strongly objects to”. We suspect that Mr. Deripaska’s earlier statements were made in an effort to see some rationalization in production come to the aluminum market. However, the reality is that the structural, persistent contango (aided by LME rules) has led to a sustained high levels of premiums for Rusal and others. We also suspect that any changes to the LME delivery rules will most likely result in a flood of metal released unto the market eliminating most of the premiums that exist today. Any changes to the existing LME rules has to be looked at as a long term positive for the market. However, the self serving attitudes exhibited by Alcoa and Rusal in response to these changes, have the potential to inflict long term damage on the reputation of the marketplace itself.
Can you hear me now?
A recent mining conference in South Africa was quite instructive as to the level of communication, or non-communication, between those in the mining world and those in the political realm. A study was presented to the conference by an independent survey company which laid out some disturbing comments from major mining executives as it relates to their future involvement in South Africa. One of the comments that struck out from this survey was that some executives thought ” Both South Africa and Zimbabwe are driving social experiments not driven by logic and economy but by ideology. In the absence of reason, primary industries become the cash cows to fund the unfundable.” This conference is taking place against the backdrop of new wage talks among both platinum and gold miners in which both are asking for high double digit rate increases in the context of falling precious metal prices. However, the comments from the government were most telling. The Deputy President proceeded to inform the conference that “the mining industry, supported by discriminatory legislation, has developed methods of making super-profits by relying on the super-exploitation of unskilled workers”. The most confusing comments from government however were made by the Finance minister Pravin Gordhan who stated that “South Africa is not going to become competitive by all of us sitting on our laurels”. I am not sure what laurels he is speaking of, when the industry has a workforce that is 25% less productive than it was 10 years ago and a cost structure that is hampered by excessive power costs rendering at least 60% of most platinum companies unprofitable at current price levels.