february 10, 2016 - amazon s3 · february 10, 2016 greetings, albert einstein once called compound...

February10,2016

Greetings,

AlbertEinsteinoncecalledcompoundinteresttheeighthwonderoftheworld,adding,“Hewho

understandsit,earnsit...hewhodoesn’t…paysit.”It’soneofthemostbasictenetsoffinance,andthe

principleonwhichmodernbankingsystemsoperate.Unfortunately,inEuropeandJapan,theworld’s

largestandfourthlargesteconomyrespectively,evenifyouunderstandcompoundinterest,you’restill

payingit.Americansreallyneedtostartdoingtheirhomeworkbecausenegativepolicyratesprobably

won’tbeanoveltyoverthenextfiveyears,andcouldbecommonplace.

BeforeeachofthepastsevenUSrecessions,long-terminterestratesfellbelowshort-termrates,

producingwhateconomistscallaninvertedyieldcurve.However,the(potential)upcomingrecession

wouldalmostcertainlybuckthistrend,becauseshort-termratesarealreadyzero.Asperverseasthis

environmentis,itseemsunreasonabletoexpectaninvertedcurveoutto10yearswiththeshort-endat

orbelowzero.Nevertheless,theNewYorkFed’syield-curvebasedmodelimpliesalessthan5%chance

ofrecessionin12months.TheClevelandFedputsthechancesslightlyhigher,at6.19%.Arecessionis

certainlyavoidable,buttheoddsaremuchhigherthanthat.

Investorsarestunnedtosee10YUSTreasury’syieldinglessthan1.75%,butthat’sstilla

whopping150bpsmorethana10YGermanBund.In2008-2009,theFedreactedfasterandstrongerthan

theECBinalmosteveryrespect,whichdroveuplonger-termyields–atleastrelativetoEurope.You’ll

recalltheECBactuallyraisedbenchmarkratesin2008,albeitbeforetheLehmanbankruptcy.Europe,

weigheddownbyGreeceandacommoncurrency,hasbeenstuckinthedeflationarymudeversince.But

itappearsthosedeflationarywindshavenowentangledtheUS,andit’sentirelypossiblethespread

betweenTreasury’sandBundswillcrosssomewherebelow0.50%.

ItseemsasthoughtheUSisfollowingthepathofEurope,butEuropeansarereallyjustfollowing

Japan’slead,where10YJGByieldswentnegativethisweek.Excessdebtisthecommondenominatorin

alloftheseeconomies,andyettheleveragejustkeepsbuilding.TheUSisstillalongwaysfromJapan,but

Chinaisthelastdomino.TheChinesepreventedaglobaldepressionin2008,andit’sunclearwhether

they’llbeableorgenerousenoughtocomeupwithanencore.

Havingsaidallthatit’simportantforinvestorstorealizethatthisisn’tadeathsentenceforyour

portfolio.Thereareassetsthatdowellincrisesanddeflation.Bondsshouldbefine,especiallythosewith

longermaturities.The30YUSTreasuryoffers2.6%yieldversus0.9%inGermany.Theknockongoldhas

alwaysbeenthatitdoesn’tofferayield,butthatopportunitycostisnowgone.Itmayseemlikeyou’re

chasingtherallyingoldhere,butthat’sashortsightedview.We’reonlyafewweeksawayfromthe

secondhighestlevelofCFTCgoldshortsinhistory.Bearishsentimentlikethatdoesn’tjustgoaway

overnight.Themostimportantthingtorememberisthatbearmarketsaretricky,andalwaysinclude

dead-catbounces.Doyourhomework,haveaviewandstickwithit.

TheCup&HandleFundisuparound+3.0%YTD,and+12.0%Y/Y.We’veheldsteadythroughall

ofthisvolatility,andtheportfolio’sconstructionisholdingupprettywell.We’vestillgotadecentchunk

ofcashavailablefordeployment.ObviouslyIwouldlikesomeofourwinning,highconvictionpositionsto

belargerbutsuchisthenatureofmanagingaportfolio.SincelaunchinginAugust2014theC&HFundis

+24%versusa-5%declineintheS&P500.Someofourmonthlypicksaredown,butothershavewon

huge.Intheendit’stheaggregatethatmatters.Ifyou’dliketostartreceivingtheselettersclickhere.

Asalways,ifyouhaveanyquestionsorcommentsorjustwanttovent,pleasesendmeanemailat

mike@cup-handle.com.

Untilnexttime,treadlightlyoutthere,

MichaelLingenheldManagingEditor–Cup&HandleMacro

CanYouHeartheMarket,Janet?

InJuly2008,theECBstucktotheinstructionmanual.UnliketheFederalReserve,theECBdoesn’t

havetotakeemploymentintoconsideration,onlypricestability.TheECBin2008wasn’tthecentralbank

weknowtoday;backthenmonetarypolicywasdictatedbyGermanyandmuchmorehawkish.And,at

thetime,theECBwasextremelynervousaboutinflationbecausecrudeoilhadmorethandoubledover

thepastyear.Sotheywentaheadandhikedrates25bpseventhoughtheFedwasintheprocessof

cuttingratesfrom5.25%toQE3.

Wenowknowthattheoilbubblewasthestrawthatbrokethecamel’sback,andsparkedthe

FinancialCrisis.ButtheECB’sdecisiontoignoreilliquidcreditmarketsandteeteringbankswasthe

greenlightforinvestorstokeepselling.Itsignaledthatpolicymakersdidn’tunderstandwhathas

happeningbecausetheyweren’tlisteningtothemarket.

JanetYellenisheadingtoCapitalHilltoday,andhopefullyshe’slearnedfromtheECB’smistake.

Ostensiblyshehasareasontosoundhawkishinhertestimony.LastFriday,itwasrevealedthatthe

unemploymentratefellbelow5%andwagessurprisinglyjumped+2.5%Y/YinJanuary.Inflation

breakevens,whichtheoreticallymatteragreatdealtowardstheFed’smandateofpricestability,are

collapsing,butthatdidn’tstoptheFOMCfromhikinginDecember.They’vebeenbeatingthe“oil’simpact

istransitory”drumformonths,andcrudeisnowwelloffthelows.ButsurelyYellenmustrealizethatthe

bankingsector,especiallyinEurope,lookslikeit’sabouttocollapse.Right?

Yellenunderstandablydoesn’twanttofeedthe“FedPut”narrative,wherethecentralbankcomes

totherescueeverytimestocksdecline,butsafehavenassetsarerallyinginabnormalfashion.Japanand

Switzerlandbothnowhavenegativeinterestrates,yettheircurrencieshaveralliedquiteabitthisweek.

TheYenrallyinparticulariscauseforconcern.

TheBoJisstillbuyingahugepercentageofthecountry’sdebtissuance,ratesarenegative,andyet

capitalkeepspouringintothecountry.SomeofthatisrelatedtoinvestorsassumingYellenwillwalkback

the“fourhikesin2016”narrative,whichthemarketneverbelievedinthefirsttheplace.Exceptthat

muchofthisweek’sturbulencecouldhavebeenavoidediftheJanuaryFOMCstatementwasevenslightly

dovish.Instead,we’relefttowonderwhetherornotthemarket’smessageisgettingthrough.Ifit’snot,

investorsneedtobuckleupagain.CarnageinCaracas

Inaworldwherewe’reconstantlyremindedofthedeflationarywindssweepingacrossdeveloped

economies,it’salmostrefreshingtoseesomegoodoldfashionedrunawayinflation.TheVenezuelan

Bolivar(VEF)haslostsomuchvaluethegovernmentisimportingplanesfullofnewcurrencynotes,

totalingmorethan5billionoverthesecondhalfof2015.Theofficialexchangeratesis6.32VEFtothe

dollar,butit’smorelike1,000VEFperdollarontheblackmarket.

Thegovernment’sofficialinflationrateis142%Y/Y,buttheIMFbelievesit’scloserto720%-

highestintheworld.Venezuelahasthemostoilreservesintheworld,sothatsectionoftheeconomyhas

reallyputthesqueezetothegovernment’sfinances.Butthemonetarymismanagementhassentthe

moneysupplysoaring,up+130%overthepast12months.

It’sexampleslikethisthatreallyprovethevalueofgold,ofwhichVenezuela’sgovernmentstillhas

adecentchunk.Italsoseemstoprovethatifdeflationistherootproblem,wehaveananswer:print

moremoney.PaulVolckerprovedthatyoucouldstampoutinflationwithhigherratesandVenezuela,

liketheWeimarRepublicandZimbabwebeforeit,isshowingthatenoughcurrencydebasementwill

eventuallycreatehigherprices.Itmightnotbepopularandcoulddestroytheeconomyintheprocess,

butifdeflationispublicenemy#1,weknowhowtofightit.

GreatestofAll-Time

Thereareblowhardycommentsfromcentralbankersallthetime,butrarelydoweseea

performanceonparwithHarukhikoKuroda’sfromlastweek.InthecourseofonespeechtheBoJ

Governormanagedtospitoutthesebeauties:- “Theconstraintofthe‘zerolowerbound’onanominalinterestrate,whichwasbelieved

tobeimpossibletoconquer,hasbeenalmostovercomebythewisdomandpracticeof

centralbanks,includingthoseoftheBankofJapan”

- “Itisnoexaggerationthat[ours]isthemostpowerfulmonetarypolicyframeworkinthe

historyofmoderncentralbanking.”

- “Thisisauniquepolicyframeworkofnegativeinterestratesthatfitswellintothe

Japanesesystem.”

Idon’tspeakJapanese,somaybetheyweretakenoutofcontext,buthesoundsalmostself-

congratulatory.Thesepolicymakersaren’tinventingnewformsofstimulusandresortingtothem

becausepreviousmeasuresfailed.

Again,Idon’tliketodumponcentralbankerstoomuchbecauseoftentimestheyaremerelytryingto

offsetdamageorinactionfromthegovernment.Butthey’renotdoingasgreatajobastheythink.Draghi

misleadinvestorsinDecember,deliveringlessthanmarketsanticipated,causingEURtorally.And

Kurodaseeminglywentoutofhiswaytodisguisethenegativeratesannouncement.Morethananything

marketsdon’tlikesurprises,andifthesecentralbanksaresoconfidentintheirabilitytomanipulate

assetsprices,itwilleventuallybackfire–evenworsethantheJPYmovelastweek.ChartoftheWeek

Despitethecollapseinriskassets,palladiumisholdingupfairlywell.Eventhoughpriceshave

fallen-45%sincethe2014highs,palladiumcontinuestooperateatasupply/demanddeficit.Morethan

80%ofproductionscomesfromRussiaandSouthAfrica,wherethelocalcurrencieshavebeendestroyed,

meaningtherehasbeenlittleincentivetoslowproduction.PalladiumpricedinSouthAfricanRandis

downamere-14%fromthepeak.Someoftheresilienceisrelatedtotheoutperformanceingold,asafe

havenasset,butsentimentissonegativethatit’sreasonabletowonderwhetherpalladiumwillgeta

decentpopifandwhenstocksbounce.

Netpositioninginthefuturesmarketisasbearishasit’sbeeninnearlyadecade.Chineseauto

sales,whilenotgrowingasquickly,stillgrew+7.3%lastyear.There’snotmuchofarecyclingprogramin

China,somostoftheconsumptionisfromnewmineproduction.TheoutlookforUSautosalesmightnot

begreat,butsetarecordin2015aslowgasolinepricesencouragedthepurchaseofbigger,gasguzzling

cars.Andemissionstandardswon’tbegettingmorelaxanytimesoon,soifyou’relookingtogetexposure

toPGM’s,nowmightbethetime.

**Editor’snote:We’regoingtotrysomethingnewthisyear.Iloveinteractingwithreadersandrespondingto

questions,butthevastmajorityaren’tfitforpublicconsumption–i.e.oftenregardingpositionsorstrategieswithin

somebody’sportfolio.Instead,I’mgoingtolinkatimely,macro-related,long-formarticleeveryweek.Tobeclear,

keepthequestionscoming,sendmeanemailatinfo@cup-handle.comandI’llgetbacktoyouinshortorder!**

The Secretive Hedge Fund That’s Generating Huge Profits for Yale–BloombergComment:Grantedthisisn’texactlyahard-hittingprofile,butit’stellingthatthesefundsareportrayed

assuccessfulwhilespittingout2%gainsin2015.Notacriticism,$10.5billionisalotofAUMandit’s

hardertogeneratereturnsonlargeassets.Itjustgoestoshowyouthathedgefundsarestillstayingfar

awayfromrisk,despiteclaimstothecontrary.Therealquestionis:howsecretivecanthisfundbeifit’s

beingprofiledinBloomberg?

That’s all. See you next week! Foranyquestionsorcomments,pleaseemailusat:info@cup-handle.comPleasevisitourwebsite.FollowusonTwitter:@cuphandlemacro

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