Friday, December 4, 2009

Why today's action is significant

From a macro perspective, here are charts of the three most important movers today.




To begin with, yields on Dec. '10 eurodollar futures rose 17 bps, as their price fell by an equal amount. That means the market raised its expectation of where the Fed funds rate will be at the end of next year by that much. Alternatively, you could say that the market accelerated its expected timetable for Fed tightening to begin. Either way, it means that the market interpreted the jobs data as evidence of a stronger-than-expected economy, and that in turn calls for the Fed to begin to reverse its liquidity injections sooner than expected.




Gold prices fell by about 4%. Just two days ago I cautioned that gold was approaching levels that made it highly vulnerable to any sign that the economy was stronger than expected. Bingo, here's the proof. The jobs data was definitely stronger than expected, and that in turn means that the Fed is much less likely to continue to be super-accommodative for a long time. It is thus no longer easy to be long gold. To be comfortable buying gold at these levels you have to be real sure that the Fed is going to make a massive inflation mistake. Thoughts along these lines likely forced the weak longs to cover.




The dollar jumped by 1.4%, because the rationale for selling the dollar (the Fed will keep rates at zero forever because the economy will be hopelessly weak forever, so you can sell the dollar with impunity) was seriously challenged today. The economy is doing better than expected and improving significantly on the margin. The Fed therefore looks to have been way to pessimistic about the economy's prospects, and the market takes its cue from the Fed. As a result, the market realized it had gone too far with the dollar "carry trade."

It's not clear whether today's action marks a clear turning point for these three variables, but I do think it marks at least the beginning of the end of the long gold and short dollar trades. The Fed is not going to tighten anytime soon, unless we see more good news that challenges the still-prevailing consensus that the U.S. economy is a basket case; undoubtedly there will be opportunities for gold to resume its rise and for the dollar to resume its fall in the next few months. But I think we have seen an important inflection point today. Buying gold and selling the dollar are no longer one-way, no-risk trades. They are highly speculative trades, and they depend heavily on the economy remaining weak and the Fed remaining on hold.

14 comments:

Bernard said...

Scott, I´m a constant reader of your blog and I also think that today mark a turning point in various assets.

But I`m particularly curious about your view of commodities from know on. In one hand, you have the american economy performing better than expected, as the job data confirms today. So that can push, as well, the emerging economies even stronger next year than consensus think. But in the other hand, you have the FED pulling of the zero interes rate sooner than market expected. So the money goes from commodities back to US.

This is also important for stocks because knowdays, as you know, energy/commodities have a lot of weight in the stocks. We have seen, for the last months, a strong negative correlation about dollar and stocks as you mentioned. I also think that this is going to reverse. But what I´m less sure is the correlation beetween dollar and commodities. How can we have strong dollar and commodities going up? I record a post of your blog, in 12 of october, where you mentioned that real commodities price was still cheap because of the easy money. So the point is ok the FED is going up, but the fears of tight money are real? Probably very very soon I think...

Anyway, thanks a lot. I really enjoy your blog! Have a nice weekend!

Scott and Fran said...

Scott, I am certainly not as optimistic as you are - -depending on what number you look at, headline at 10% or U6 number at 17.2% - -neither of these are particularly impressive. And who is to say the numbers yesterday are real - -and will not be revised. I am not convinced. Even though you addressed it before, I am still concerned about both individual and federal debt levels.

I too enjoy your blog - -along with calculated risk. Thanks rsh

Scott Grannis said...

I think the fear of tight money is overblown. It will take a long time for the Fed to get tight. Interest rates would have to be at least 5% in my view for monetary policy to be "tight." Until we get to 5%, rates are not going to be a problem for the economy, but they should definitely help the dollar. Commodities might suffer a minor setback, but before calling for a secular decline in commodities I would want to see monetary policy being really really tight.

As for the unemployment rate, it doesn't really matter whether it's 10% or 17%. It is what it is, it's already happened, whatever it is. All that matters is how things change on the margin. On that score I think things are improving and will continue to improve.

Scott Grannis said...

Calculated Risk has been pessimistic all year long and continues to be, right? The make a good counterpoint to my views.

Bernard said...

Thaks scott! But would it be the case for commodities underperforming other assets classes from know on, for example? Many have began, already, to argue that we could see commodities goind down because of FED hikes. I really don´t agree with this view as you already mentioned that rates are still very low. But I do think that may happen an underperforming. Thanks again!

Scott Grannis said...

I should add an important point about commodities, which is that they can be incredibly volatile and they don't pay interest or dividends. Commodities are a play on growth, and a play on inflation, and it is hard to separate the two. I think the monetary environment and the growth environment for commodities are favorable, but wouldn't want to bet a lot of money on it. Commodities are speculative investments.

Bill said...

Scott,

What is your view on asset allocation for the average investor, like myself (pushing 50), who does the majority of his investing through a 401(K) SEP plan? I'm wondering if 50% bond fund and 50% stock index fund makes sense to smooth out the ups and downs of the market. I read in one article that said over time there isn't much of a difference on the up side and better protection on the down side.

alstry said...

Scott,

I had this debate with a friend of mine telling him that I was a convert to on the margin thinking....

His response was the American economy is simply a Ponzi Scheme driven by an unsustainable $2 Trillion dollar deficit funding Health Care, Welfare, and over 20,000,000 government employees.

He said America is not too much different than Dubai of lend and spend to pretend....except we carry over $50 trillion of public and private debt and that Dubai looked great on the margin on Monday before Thanksgiving and a few days later it was a bust......

Does his argument hold any water and how can I respond?

Scott Grannis said...

Bill: A person who is only 50 has a very long time horizon for investing. Given that I think equities are relatively cheap, I would recommend that you devote a large portion of your portfolio to equities (>50%). Bonds do help mitigate the ups and downs, but be careful what kind of bonds you choose. Treasury bonds and mortgage-backed bonds don't have much upside these days, while they do have plenty of downside. Corporate bonds are better, especially those of lower quality, since they have decent yields and should do well in an inflationary environment because default rates are not likely to go much higher. TIPS are the best choice for safety; if you are holding cash then TIPS would be a better choice.

Scott Grannis said...

alstry: The U.S. economy may look like a Ponzi scheme, but it isn't, and it has nothing to do with margin. The federal deficit and debt are still relatively small compared to GDP; other countries have survived this level of debt before. The government sector is still only a fraction of the total workforce. The unfunded liabilities of social security and medicare are not cast in stone, and can be unilaterally altered or inflated away. Even our federal debt can be inflated away by debasing the dollar (which, by the way, is an ongoing process).

I'm not endorsing this situation, however, since I would rather we were in better shape.

Family Man said...

Stronger USD will diminish speculative factor on commodities, ie. will help prices to get closer to real supply/demand levels, and helps mining/oil companies to make a better capex decisions.But that also affects positively the whole production chain Also will lower input prices and in that sense, lowers inflation. For energy sector that means better margins, for consumers cheaper gasoline, etc. BTW even equities sceptical analysts like mr.Rosenberg call for commodities beeing in a secular uptrend (with a short term setback risk)
Thanks Scott for your excellent writings.

Gene Prescott said...

Scott said:

((....The government sector is still only a fraction of the total workforce.))

Where are the figures on what this relationship is now?

Scott Grannis said...

Gene: check my post from Thursday on this subject:

http://scottgrannis.blogspot.com/2009/12/thoughts-on-job-creation.html

Scott Grannis said...

Family Man: As you note, a stronger dollar can never be a bad thing. Give me a strong currency anytime over a weak one. I wish the politicians would understand this. One of the best parts of Clinton's presidency was Rubin's understanding that a strong dollar truly was in our best interests. Unfortunately the Fed got carried away with its tightening campaign, and the dollar went up so much in 2001-2002 that it created deflationary pressures which then led to overly-easy money a few years later, etc. Ideally, a currency should be strong but also stable.