April 10, 2010

Market Insights - 10 April 2010

Here is the latest issue of Market Insights.  As always, please email any questions to: . 

In This Week's Issue
• Weekly Snapshot
• Chart Of The Week
• Weekly Barometers 
• The Dollar Yuan Hodgepodge
• Euro Upheaval: Is There A Potential Winner?
• More On ETF’s
• Recommended Video

Weekly Snapshot
• China reports $7.24 billion trade deficit in March as imports surge, first in almost 6 years (AP)
• US stocks close at 18-month high, Dow touches 11,000 (Marketwatch)
• US consumer credit fell at an annual rate of 5.6%, to $2.448 trillion in February (CNN Money)
• Rates on 30-year mortgages jump to 5.21% - highest level in 8 months (AP)
• Industrial producer prices up by 0.1% in both euro area and EU27(Eurostat)
• Canadian Dollar touched parity with the US$ for the first time in nearly two years (eSignal)
• Tim Geithner postponed report on whether China manipulates its currency (Economist)
• Greece to target US investors with a multibillion-dollar bond (FT)
• Greece has covered its funding for April, but needs another €10bn in May (Eurointelligence)
• Crude Oil prices touched $87 on Tuesday (Finviz.com)
• Iron ore price hit $160.5 per tonne, Copper at $8010 per tonne (FT)
• Euro area GDP stable and EU27 GDP up by 0.1% in Q4 of 2009 (Eurostat)
• Reserve Bank of Australia raises the cash rate by 25 basis points, to 4.25% (RBA)

Chart Of The Week
In case you were away on Spring Break this week, you may have missed one of those really exciting non-events reflecting how easily markets can still be rattled.   As Reuters reports in Timeline: Greece's debt crisis, it was just 2 weeks ago when “Euro zone leaders agreed to create a joint financial safety net, with the IMF, to help Greece and to try to restore confidence in the Euro.”  But the markets wanted nothing of it earlier this week and Greek Bond spreads reached over 4 basis points on top of German 10-year bonds.  Below is a nice illustration of how the Greek yields have fared thus far. All said however, the Euro recovered again on Friday on renewed news that support from Eurozone member countries would be forthcoming.  Confused?  Stay tuned...

Source: http://www.calculatedriskblog.com/

Weekly Barometers

Stock-2010-0409   FX-2010-0409

The Dollar Yuan Hodgepodge
Is the Chinese Yuan under-valued?  Is it just right or should it be a freely convertible currency and allowed to float like other major currencies? The number of opinions on all sides of the currency debate feels like a hodgepodge and figuring out what’s really in the soup is potentially an unattainable goal, even for the smartest market observers.  Anyway, let’s try to get a glimpse of what’s in the soup.

The debates about the “right value” for the Chinese currency are now at every level of the media, the government, the investment community and even the general public appears to weigh in on the issue.  Earlier this week, US Treasury Secretary Timothy Geithner announced that he would delay the highly anticipated report determining whether China “manipulates” its exchange rate until after April 15.  This politically motivated move might take some of the heat out of the discussions in anticipation of Chinese President Hu Jintao attending the Nuclear Security Summit in Washington early next week. But below the official line, public unrest is brewing and an increasingly hostile debate with some calls for trade barriers remind us of similar discussions about trade sanctions for Japan during the 1980s.

Before going any further though, let’s look at some historic rates to get a bit of a reference point.


Undoubtedly, the rise of the US Dollar during the 1980s and more so, the massive devaluation of the CNY in January 1994 from 5.8210 to 8.7219 created a favorable exchange rate environment for exporting goods from China.  To what extent that favorable exchange rate continued to help China’s as a whole is less clear though. For instance, the gradual revaluation of the CNY starting in 2005 does not appear to have made a real impact on the growth in imports from China (see red line in the chart below).  Perhaps the biggest dent in the trend was the global financial crisis of 2008-09 which put a big lid on US consumer demand.


Will the US trade balance improve from a stronger Yuan?
Many economists, Paul Krugman at the forefront, have called for China to re-value its currency and for the US to impose trade sanctions if Beijing were not to comply. Other economists feel that trade barriers are ineffective and that a revaluation of the Yuan won’t do much to reduce the US trade deficit.  The latter argue that most goods imported from China are those consumer goods that the US cannot or will not produce domestically anyway. If US consumers don’t buy from China, they will import it from somewhere else. Perhaps the trade with China may suffer but the overall US trade balance won’t improve.

Change is looming upon us however.  From within China, there are now some signs that indicate Beijing might pull the trigger and revalue its currency some time this year.

In the financial Blogs, the debate has been ravaging for a long time now and rather outspokenly so.  Opinions have been flying left and right with some increasingly aggressive stances, as if the financial crisis the global economic challenges could be solved by simply adjusting one currency to the upside. The issues are of course extremely complex and the ubiquity of possible implications is probably out of reach for one mind to fully grasp (certainly too complex for mine).

Please consider the following blog post “Why Re-pegging the Yuan and Other Non-Free-Market Solutions to Trade Imbalances With China Will Fail” by Mike “Mish” Shedlock.

This is one of the many articles featured in financial Blogs recently, but it’s a very good example of how complex the issue of the Chinese currency debate has been. Mish, a highly respected blogger who typically employs a healthy dose of common sense when examining financial markets seems to struggle wrapping his head around the issue in a sort of “all over the place” (unusual for him) approach to making sense of the debate.

How confusing the issue can be shows up in the information exchange between Mish and Michael Pettis.  Pettis, a professor at Peking University’s Guanghua School of Management, specializing in Chinese financial markets, first writes:

"...to use a controversial example, if the US were able to force up the value of the dollar by 20% or more against all other currencies, it would become far more profitable to produce cars domestically, it would revive the aluminum and chemical industries, and it might cause a significant divergence of electronics assembly to the US."

He then later replies:

“Mish, sorry, I meant force “down”, not up. The point is that if the dollar were devalued by 20%, the immediate impact would that US manufacturers would become much more profitable and foreign much less so. That would shift US and foreign consumption of cars from foreign producers to US producers, and would of course have a positive impact on US employment.”

Was that a Freudian slip by Dr. Pettis, a simple typo or was it just a reflection of how difficult the issue is in terms of deriving a somewhat simple solution?

Just taking a small bite out of Pettis argument with regard to cars, the answer is not entirely based on exchange rates nor is it simply price-driven.  US car manufacturers might export more cars but it is questionable if they would sell any more domestically.  US consumers have turned their backs against American car manufacturers because they have been building lesser quality cars.  It’s not the price alone that drives consumption, point in case - Apple computers. If the product is of exceptionally high quality, consumers will find the money to buy the product.  Conversely, if a product is “cheap” but not that attractive, why buy it?  The same argument goes for overseas consumers who are actually less price sensitive and given a choice would rather opt for a premium brand.

When and How?
What about a solution then? It’s complicated to say the least and for many analysts, the question is no longer if but when China will drop the currency peg.  That however, has numerous implications, not all of which are positive for the US.

Considering the latest developments, the “When” has become much closer to the near future.  “When” China lifts the currency peg, inflation will also be imported in the US which, at current levels of unemployment, will not bode well for the cash-strapped US consumer.  A fall in the value of the US Dollar and a possible crash in the Bond market may hurt both Chinese as well as US investors - with about $900bn, China is still the largest holder of US Treasuries.  And, the Fed will be required to raise rates to find buyers willing to fund the immense government debt.  None of these measures sound all that appealing. 

At the same time, China is beginning to realize that decades of managed exchange rates have come at a price as well.  Domestic inflation in China is as high if not higher than GDP growth.  As long as the Yuan is relatively cheap, the commodity hungry Chinese manufacturers will struggle maintaining their prices as commodity prices are on the rise again.  This month’s announcement of the first Chinese trade deficit in six years is a clear indication of the pricing challenges these higher priced imports place upon Chinese manufacturers. 

Last not least, China is sitting on upwards of $2 trillion worth of US assets and will not tolerate to have these asset values depreciate drastically.  Any move on the part of China will therefore be highly calculated and timed well, making small gradual adjustments only.

In the long-run, letting the markets determine the “right” exchange rate appears to be the most sensible solution. Because of the complexity and a myriad of unforeseen consequences that a managed exchange rate could bring, the market may have the best shot at finding the “right” exchange rate, even if that rate were to change on a daily basis. Getting there however, will take some time.  Meanwhile, today’s hodgepodge of a currency soup might not be to everyone’s taste.  But as Mish pointed out in his article:

I am certainly in favor of letting the free market solve all of those. Indeed many of them are so intertwined, that only the free market has a chance in hell of solving them.

Euro Upheaval: Is There A Potential Winner?
Just when we thought that Greece had finally taken care of funding its liabilities and convinced the EU and the IMF that their austerity measures would put an end to most of the concerns about a Greek default, it turns out nothing has really changed.  Greece appears to be unable to bolster its finances and to adhere to the austerity measures announced last month.   Instead, Greece has been promoting itself as an emerging market economy and is now targeting U.S. investors in a $5B-10B bond sale to help cover its May borrowing requirement of about €10B.  

Bad news from Greece instantly translated into market reaction.  On Thursday, the yield on 10-year Greek government bonds rose above 7%. The closely watched spread between Greek and German 10-year debt increased to above 4 percentage points.  Combine that with the flat Eurozone GDP numbers for Q4-2009 and the forecast that GDP growth in Europe’s powerhouse Germany is going to be benign at best and you have a recipe for an ongoing Euro crisis.

Not surprisingly, the Euro has been taking a hit this week and fell to the same level of late March before an EU wide support for Greece was announced.  Strangely, the Euro bounced back on Friday throwing the earlier Euro woes into question again.  A retest of the 14 month technical low at the 1.3265 area depends very much on how the Greek debt crisis plays out and whether there are any major fall-outs from the so-called Club-Med countries (Portugal, Spain, Italy) who are rumored to be similar financial shape as Greece.


Is there a potential winner from this Euro upheaval? 

Although Friday saw a marked recovery of the Euro on renewed pledge of support by European leaders, the single currency certainly remains under pressure on any hint that Greece or other “Club-Med” countries were to face further financing difficulties.

Much less publicized and yet much more vehement was the decline of the Euro versus other major currencies.  Topping the list is the cross-currency trade Euro versus Australian Dollar.  We previously looked at this currency pair a couple of weeks ago when the Euro hit a new  13-year low of 1.4605 versus the Australian Dollar. Since then, the Euro slid another 300 points to a low of 1.4348, a level not seen since August 1997, and bringing the Euro within a hair of the all-time low of 1.4025.


While the speed and intensity of the decline continues to baffle there are additional factors which paint a slightly rosier picture for Australia’s currency compared to the Euro. After the Australian Reserve Bank announced the 5th quarter percent increase in their cash rate earlier this week, Australia now enjoys a 3.25% spread over European deposit rates making the rationale for a carry trade against the Euro as a funding currency even more plausible than before. 


And, as a traditional commodity currency, the Australian Dollar could also enjoy further gains on the back of an increase in commodity prices, particularly the metals and other raw materials which Australia has an abundance of and which seem to be in big demand by many countries in the Far East.

Having said all that, the Australian Dollar has now gained so much against the Euro that one might hesitate to put on a trade that may have already run most of its course – and I realize I am repeating myself here.  There has been no significant technical correction to speak of since this dramatic currency slide began in February 2009, which poses the question as to when the major net sellers of the Euro would cover their short positions. 

With an ongoing Greek debt crisis continues and even a remote likelihood of a possible spill over towards other Southern European member nations, the Aussie Dollar is definitely an appealing alternative to an international investor via the favorable deposit rates.  Much of the Euro-woes may have already been priced in by now, bearing in mind the severity of the decline thus far.  But as long as serious doubts about the continued existence of the Euro remain, one should consider expressing that opinion via the cross currency trade rather than the more commonly known Euro versus US Dollar trade.

More On ETF’s
In our ongoing effort to uncover some myths about Exchange Traded Funds (ETFs) we came across this interesting article published by ProShares, the largest managers of leveraged and inverse funds.  Please consider: Facts and Fallacies About Leveraged Funds.

Proshares also published an FAQ About Leveraged and Inverse Funds. This is quite useful and for easy reference, we took the liberty of quoting from it verbatim:

1. What type of investor is an appropriate candidate for leveraged and inverse funds?
Leveraged and inverse funds are typically most appropriate for knowledgeable investors who are familiar with the risks and benefits of these types of products and have a thorough understanding of investment concepts and practices. Investors in leveraged and inverse funds – or their adviser – should monitor their positions closely and use them as part of a diversified portfolio.

2. What are the investment objectives of leveraged and inverse funds?
A leveraged fund is a mutual fund or ETF that generally seeks to provide a multiple (i.e., 200%, 300%) of the daily return of an index or other benchmark for a single day excluding fees and expenses. An inverse fund generally seeks to provide a multiple (i.e., -100%, -200%, -300%) of the opposite of the return of an index or other benchmark for a single day excluding fees and expenses.

3. Do leveraged and inverse funds seek to achieve their target returns for more than a day?
No. Nevertheless, although no one can predict future performance, Joanne Hill, PhD and George Foster, CFA conducted an historical study that showed a high likelihood of approximating the daily target over short periods. The shorter the period, and the lower the volatility of the underlying index, the more likely returns were to approximate the daily target. Longer and more volatile periods tended to show a greater deviation from the daily target. Using historical data, a model based on 2x the daily return of the S&P 500 index showed a 90% likelihood of producing a return between 1.75x and 2.25x the index return over any 30-day period over the last 50 years. (Models based on an index with higher volatility would have deviated more.)1

4. What causes the performance of these funds over time to be greater or less than the multiple of longer term index performance?
The cause is compounding, a universal mathematical concept that affects the returns of all investments. It is important for investors to understand how compounding affects returns in different market conditions – upward-trending, downward-trending and volatile. For leveraged fund investors, it is particularly important to understand that the effect of compounding on leveraged funds is magnified, and can cause gains and losses to occur much faster and to a greater degree.

5. Does this mean that you shouldn’t hold these funds for longer than a day?
The objective of leveraged funds is to seek a multiple of an index on a daily basis. Leveraged funds can be used for longer periods. An investor’s time horizon may be based on many factors, such as market outlook and risk tolerance.

6. Are there strategies that can increase the chance of approximating the daily target over longer periods?
Yes. Academic research2 supports the idea that a basic rebalancing strategy for leveraged funds can be used to reasonably approximate the daily objectives of leveraged funds over longer periods. This rebalancing strategy involves a calculation that looks to add to or reduce the amount held in a leveraged fund so that the investment exposure held is in line with the targeted return for the period. Rebalancing can be triggered at fixed time periods (e.g., weekly or monthly) or when a specified threshold is reached. A rebalancing strategy may involve transaction costs and generate tax consequences. Rebalancing does not guarantee specific future results and may result in investment losses.

7. Is seeking to approximate the daily target over time the only reason investors invest in leveraged funds over longer periods?
There are other strategies that investors pursue by holding leveraged funds for longer periods other than to seek the daily target over the period. For instance, an investor may choose to hold a long-term position in a leveraged fund based on a view that the index will rise (or fall) in a trending manner in a low-volatility environment. If the investor is correct, this could result in the leveraged fund outperforming the daily target multiple times the period index return; if incorrect, the fund could underperform.

8. What are some common uses for leveraged and inverse funds?
Leveraged funds can be used to help manage risks in other investments. Examples:

a. Use a short fund to hedge portfolio gains.
b. Fine-tune exposure – e.g., use a leveraged fund to overweight a sector
    without using additional cash.
c. Seek to capture returns while eliminating market or sector exposure.

All this sounds very clever and does in fact give a more concise view than the legal jargon of the exhausting prospectus.  However, we cannot stress enough that these instruments are more risky than normal ETFs and are generally not suitable for the average investor.  We have talked about risks of leveraged ETFs on several occasions, for instance at: http://fxinvestmentstrategies.blogspot.com/2009/06/market-insights-6-june-2009.html

I highly recommend doing a few simple investigations prior to considering an investment (a trade rather) in any of these leveraged or inverse ETFs. 

a) Use one of the many free financial portals to find out the expense ratio and other vitals stats for the ETF.
b) Use a charting tool e.g. Yahoo Finance or Stockcharts.com to see comparative performance charts.  I find those to be the fastest way to establish how close an ETF comes to fulfilling what it says from the outset.
c) Establish your time horizon and assess whether the performance towards the ETF versus the underlying is making sense for your time frame.

A few simple examples are below:

Ultra Gold, the double leveraged Gold ETF versus the Spot Gold price.  Turns out this leveraged ETF does an OK job at near double returns.  Over the sample 200 day time period, UGL is up 47.43% when the Gold price was up 24.69%.


If you are extremely bullish on the Japanese Yen, you could consider the 200% leveraged YCL.  Compare that to the underlying FXY Currency Shares Japanese Yen which in itself is again an ETF and the performance doesn’t look that appealing anymore.  In the sample 200 day time frame, FXY was up 2.21% whereas YCL was only up 3.02%.


Lastly, consider the Ultra Silver: AGQ compared to Spot Silver, revealing again a distortion of returns even over a shorter time period.  Since the beginning of the year, Spot Silver is up 32.59%.  However, year-to-date returns for the double leveraged ETF is only 50%, clearly falling short of a a value closer to double the returns. 


Possibly more important than chasing after illusive double returns is a good dose of risk management.  Please be aware that leveraged and inverse ETFs can be useful tools at increasing returns (in the short run) they can potentially increase your risk twofold or more as well.  You should carefully consider how a leveraged or inverse ETF increases the overall risk in your portfolio.

Recommended Video 
If all these market gyrations sound confusing, please consider this enlightening interview with Justin Fox as he gives his views on the “irrational market”.  The author of "The Myth of the Rational Market" discusses the implications of maintaining last century's assumptions and concludes: There is no right answer.

 Click here to view the interview

Good luck and good trading!

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