The Daily Trading Report

We’ve all had some fairly exciting time of late. We are a global macro fund and most of what we do is aimed at identifying the longer term trends and positioning for conditions 2+ years hence. Market movements like we have seen over last few weeks have happened before and will happen again. Our role is to discern if we are experiencing a change of trend, or just normal market movements.

We’ve written numerous times of our belief in on-coming inflation and commodity price increases. Now is an opportune time to return to the this theme and ask; have the longer term themes of rising commodity prices survived the recent turmoil, or do we need a new set of assumptions?

To this end we are going to look at the relationship between CCI and UDN. The Continuous Commodity Index (CCI & the old CRB index) is based upon an equally weighted basket of 17 commodities and so is a reasonable indicator of supply & demand. We use it in an inter-market sense, both as originally devised as well as an indicator of equity and currency trends. UDN, on the other hand, measures short USD futures. Based upon the USDX futures contract, it attempts to replicate short USD against a basket of currencies (mainly EUR, then a varying mix of YEN, GBP, CAD, SEK, & CEF).

y looking at CCI verses UDN we are measuring the price trend of commodities removing the effect of the USD. Concentrate now, as there is much to be gleaned from this measurement.

One would expect that a that a rising USD would be bearish for commodities. But these are not normal times. A rising USD is usually seen as bearish for US interest rates as well but nobody expects interest rates to go lower than the extraordinary low levels as now. One also might be thinking that the rising USD has removed an inflationary threat.

However, what we are not seeing is commodity prices turning bearish in non-USD terms. This tells us a number of things; most importantly that there is real strength in commodity prices. This strength will only increase as the worlds economies gradually improve. The most likely outlook is that commodity prices will continue to increase against all Fiat currencies.

And so to answer our question; we think the longer term commodity trends are still in place. This is not apparent to the casual market observer who may be equating rising USD to bearish commodities. Keep in mind that markets can, and do move counter to fundamentals (and stay irrational longer than one can stay solvent!) for long periods.

Being macro traders will hold our positions for the long term (years, not days or weeks).

It has been some 12 months since we first highlighted the bullish build up in coal stocks. Since then the coal sector has been one of the best performing sectors in the US.

However, since about mid October last year the coal sector has more or less gone sideways. Does this lack of action suggest that the good fortunes of coal stocks are about to change? We think not. If one observes the chart below of the CSX coal price it too went sideways from mid October 09 until about four weeks ago. However, during April it has again taken off.

CSX 1 Month Delivery Coal Price

Given how depressed the coal price has been for the last 18 months material upside may well be in the offering. We have a number of contacts in the coal industry in Australia who act as agents between suppliers and buyers in the far east. They are finding it very difficult to source coal at the moment and they have informed us that they would not be surprised to see coal prices advance another 50% before year end!

The Global Financial Crisis resulted in a near total shut-down in mine expansion and maintenance for almost 12 months (essentially due to the inability to obtain financing). Of course this shut down has meant that mining capacity is just not there. It is relatively easy to shut down capacity but it takes considerable time to bring it back up. So perhaps a dramatic increase in the price of coal over the coming months is not out of the question.

CSX 1 Month Delivery Coal Price

Note how close the Bloomberg US Coal Mining index is breaking higher. Are coal stocks expensive? Well that entirely depends on the price of coal. We think that coal prices are going to surprise on the upside and therefore coal stocks are likely to have dramatic earnings surprises over the coming quarters.

Bloomberg US Coal Mining Index

We would use any weakness in coal stocks as a buying opportunity.

Our wealth creation portfolio is up around 25.70% since the beginning of the year with approximately 40% of the volatility of the S&P 500. This portfolio is not leveraged.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

We are not currently taking new subscribers. Please enter your email address if you would like to follow our commentary and be notified when we open our service for subscriptions.

Just how healthy is the advance in the equity market? Is the advance built on thin air…..is it merely the result of the massive government stimulus? If the advance in the equity market was for real then you would logically expect that industrial activity had also picked up. What would be the best leading indicator for the level of industrial activity? We think the cost of raw inputs would be rising as demand outstripped capacity to supply. By inputs we are referring to; cotton, burlap, steel, copper, aluminum, zinc, tin, nickel, hides, rubber, tallow, plywood, red oak, benzene, crude oil, natural gas, and ethylene. Of course if the prices of these commodities were falling it would be logical to assume that there was some sort of economic contraction.

Now look at the chart below. It is the performance of the S&P 500 and the Journal of Commerce Industrial Commodity Index (its components are listed above) indexed to 100 as of March 2008. Isn’t it fascinating how closely they track each other!

Perhaps even more remarkable is the degree to which the Russell 2000 tracks the JOC Commodity Index. It can be argued that the Russell 2000 is more economically sensitive than the S&P500 perhaps that is why both indices track each other to the letter!

Anyway, suffice to say this; while the price of industrial commodities continues to rise one should see any weakness in equity markets as a buying opportunity rather than reason to sell. How high is the JOC Commodity Index going to go? It isn’t over until it is over!

A casual scour of popular blog sites and the media of popular opinion reveals that there is a growing belief that inflation is no longer a problem in the “foreseeable” future. This belief is perhaps embodied in the results of the recent Merrill Lynch Fund Manager survey, highlighted by a recent Bloomberg article which stated:

March 16 (Bloomberg) — Risk appetite rebounded as concern eased that interest rates will have to rise later this year to cool inflation, prompting investors to cut cash holdings and buy equities, a BofA Merrill Lynch Global Research report showed. Seventy percent of survey respondents, who together manage about $589 billion, expect the Federal Reserve to keep interest rates at a record low until at least the fourth quarter of 2010, as concern that inflation will return dropped sharply. Fifty percent said they expect the European Central Bank to keep its benchmark interest rate unchanged until 2011. “The big change for investors is the drop in inflation worries,” Gary Baker, head of European equity strategy at BofA Merrill, said at a press briefing in London today. “Investors are now much less concerned about when they expect interest rates to rise and see it more as a 2011 event.

Well what is the market suggesting? Let’s go to the market and try to interpret what it is telling us as opposed to why we think is going to happen in the “foreseeable future”. Like when is the future ever foreseeable! We will look at the inflation “issue” from a number of perspectives;

1. The behaviour of long dated US Treasuries. If there were genuinely no inflationary fears then yields on the US 30yr should be nowhere near multi-week highs. Yet at 4.57 the 30yr yield is only a few good days away from breaking above the previous multi-week high of 4.75. OK one could argue that the 30yr yield has failed on at least three occasions in the last 10 months to break to a multi-week high. Then again perhaps it is getting ready for the big push over the top? In defence of a break above 4.75 over the coming days/weeks is the fact that the Fed has been an active buyer of treasuries over the past 10 months. What would the yield on the 30 yr look like if there wasn’t support from the Fed? We think a lot higher.

   

2. After reaching a multi-week high during the opening days of 2010 the “granddaddy ” of commodity indices has sold off and is now trading at the same levels it was in early August last year. This is not the sort of behaviour that one would expect if inflation was taking hold as commodity prices generally do well in times of high inflation. In support of the bulls though there has not been any evidence of lower lows or lower highs. The uptrend (as ragged as it may seem) remains intact.

   

3. And inflation premiums? It shouldn’t take someone with a finance/economics degree to figure out that if inflation expectations were moving higher then TIP 10yrs should be outperforming non inflation protected 10 yr treasuries…..yet as with commodities and the yield on the US 30 year something seems to have happened around about the 8^th of January. TIPs have begun to underperform. The inflation premium attached to TIP 10yrs is now at the same level it was in November. Is this enough to denote the start of a bear trend in inflation premiums? Well of course it is a start but we would have to see inflation premiums drop rather dramatically before we got concerned about a “deflationary” scenario. Of course given the “skulduggery” that has gone on in the treasury market as a whole we would not be surprised to see some manipulation going on in the TIPs Treasury market.

   

4. Perhaps this is a little unconventional but if there were no inflationary fears then Gold should be doing badly relative to US Treasuries (here we use TLT as a proxy for the US Treasury market). Well as with the three charts above gold relative to long dated US treasuries has gone nowhere since the start of December. We would to have to give the benefit of doubt to the bulls at this stage but of course if this chart broke down one would have to start asking questions about the “inflation trade”.

   

5. But wait what is this? This is the Journal of Commerce Industrial Commodities Index. Could this be the missing link? We are not conspiracy theorists but we suspect that the gold, crude, and treasury markets are subject to manipulation……but we are very confident that industrial commodities as a whole (yes all 18 of them) are not subject to manipulation. Anyway, conspiracy theories aside, industrial commodity prices moving higher in a linear fashion is not exactly the sort of behaviour that you would expect if there was “no inflation threat in the foreseeable future”.

   

On the face of it there is evidence that inflation expectations have declined over the last three to six months. When we say on the face of it we are referring to some of the conventional measures of inflation (the behaviour of US treasuries and commodity futures). But these measures have not behaved in a linear fashion and are perhaps subject to manipulation by the powers that be. So we have to be somewhat sceptical of any short term weakness that is being depicted (in the first four charts). However, it seems the deeper we dig the more the market begins to reveal its true intentions. In the real world commodity prices are on the rise. It is difficult to argue that rising commodity prices are not a dead giveaway for rising inflation pressures…..call it what you will.

The recent behaviour of the CRB index (and commodity ETFs in general) has been about exciting as watching wet paint dry! There has been considerable bullish (and bearish) talk on commodities yet as a “group” they have not moved since June last year! Certainly the behaviour of the CRB suggests that commodities have gone nowhere.

But wait, in the “real world” the picture is very different. Take a look at the spot commodity market. The CRB Spot index has almost reclaimed all its 2008 losses.

We place more importance on the behaviour of the CRB Spot index rather than the CRB Futures index because the spot index is free from the effects of differences such as backwardation and contango and thereby reflects the real world price behaviour of commodities. And what is in the CRB Spot All Commodities index? Here is a basic listing:

We think that it is only a matter of time before commodity futures break to the upside and with that so too will the big commodity ETFs (DBC, RJI, GSG, DJP)

Cotton, lumber, platinum, and copper are trading more or less at multi-week highs. We are not so specifically interested in trading cotton, lumber, platinum, and copper; rather we are more interested in the “subliminal” messages of multi-week highs in key industrial commodities. Like it or not we are unable to get away from these industrial commodities in our daily lives. The multi-week highs to us is more evidence of the developing bullish build up in commodities and inflationary pressures. How can one argue against economic growth and or inflation given the behavior of the charts below? If this behavior is not inflationary then we are missing something big time!

Of course the behavior of the four charts above are represented by the CRB Continuious Commodity Index (the old CRB Index which is an equally weighted index of 17 commodities). The CCI continues to etch higher quietly and in a seemingly controlled fashion. But wait there is more………look at what the CCI is doing in AUDs! If this behavior is not a leading indicator of economic growth/inflation what is?

There is a new trend developing in world financial markets right now…..and that appears to be a breakdown in the faith of governments. The ultimate price of years of excess is about to be paid – inflation.

Our wealth creation portfolio is up around 22.61% since the beginning of the year with approximately 40% of the volatility of the S&P 500. This portfolio is not leveraged.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

We are not currently taking new subscribers. Please enter your email address if you would like to follow our commentary and be notified when we open our service for subscriptions.

If seems that every which way we look evidence continues to mount in support of global inflation and economic growth. We have our suspicions as to why this is happening but to be honest these suspicions are of little significance. What’s important is simply that it is happening.

Note how the US Treasury market is behaving. TIPs are on the verge of breaking out against non inflation protected treasuries and long dated US Treasuries (20 & 30 yrs) are trading at multi-week lows. All this suggests that inflationary expectations are rising!

Of course for some time the price of crude and gold has been suggesting that something is up on the inflation front…..but few took notice!

Since the start of October the cost of hiring dry bulk carriers has rocketed! Someone is hiring ships, and someone has an insatiable appetite for coal (which still accounts for about 70% of global electricity production). You cannot store electricity and it is expensive to store coal.

Given that the trends above are all confirming each other we think that there is considerable more upside to come in commodities and US Treasury yields. There are two trades that we like that would catch rising commodity prices and US Treasury yields – long DBC and TBT and there is nothing more to it than that.

Our wealth creation portfolio is up around 19.48% since the beginning of the year with approximately 40% of the volatility of the S&P 500. This portfolio is not leveraged.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

We are not currently taking new subscribers. Please enter your email address if you would like to follow our commentary and be notified when we open our service for subscriptions.

Another nail in the coffin for deflationists! Gold traded at multi-week highs against paper currencies last night. Perhaps the most significant move was gold’s close above $AUD1180. The charts below suggest that something powerful is building in gold……perhaps something that will rival what we witnessed in the late 1980s. The evidence is there as plain as daylight for all to see, of course whether you choose to believe it or not is entirely up to you.

Now we wait on Crude and the CRB to breakout in Aussie dollar terms…..But given what has just happened with Gold (and what is happening with Baltic Freight rates, TIPs vs. US 10yrs we think Crude and the CRB will follow! Watch the CRB and Crude in Aussie Dollar terms. A break above 3.20 and 0.90 in the charts below will be the final nail in the coffin for deflationists!

“In religion and politics people’s beliefs and convictions are in almost every case gotten at second-hand, and without examination, from authorities who have not themselves examined the questions at issue but have taken them at second-hand from other“

This quote from Mark Twain applies equally to investing and economics as well. We say believe not in what others tell you but in what the market is telling you.

Our wealth creation portfolio is up around 17% since the beginning of the year with approximately 40% of the volatility of the S&P 500. This portfolio is not leveraged.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

We are not currently taking new subscribers. Please enter your email address if you would like to follow our commentary and be notified when we open our service for subscriptions.

Is this a pivot/tipping point in world markets where there will be a reversal of what we have witnessed over the last 6 months? We don’t know what the future holds but we do know that markets “themes” move in observable trends. Once in place a global theme tends to last for months if not years. For the last 10-11 months at least markets have embraced a “high yield” theme (call it what you will). What we will do now is look for evidence of “cracks” in this broad theme……for evidence that what we have observed over the last 6 months is about to come to tragic end!

We will approach this question from a number of different angles to try and form an objective conclusion. Now first things first – has the crowd’s appetite for risk changed? If the crowd was moving from a risk seeking to a risk averse condition we would see a stampede out of “risky” assets, namely:

• junk grade corporate bonds,
  
• emerging market bonds,
  
• junk grade relative to investment grade bonds,
  
• emerging market bonds relative to US Treasuries,
  
• emerging market and developed market small caps,
  
• high yield currencies,
  
• emerging market currencies,
  

From the 8 graphs below there is no evidence outside normal market “noise” that would suggest a turnaround in leading indicators of risk taking. Yes, if you are going to see a flight to “safety” you will pick it up first in these charts.

If money is coming out of risky assets it would have to find a home in “safe haven” assets namely:

• the USD
  
• the Yen
  
• US Treasuries
  
• Large cap equities at the expense of small caps
  

We did have a bounce in the USD Index yesterday and the day before, however that “bounce” was nothing out of the ordinary and perhaps more importantly did not occur at any support level. The next support level lies at the 72 level which is some way off. What relevance a weakening yen has got relative to the USD is open to debate and perhaps just a red herring. More important is the emerging breakout in US Treasuries, particularly the long dated. This behaviour is exciting (yes it is about time they fall over given the recent behaviour of commodity markets) and at the same time it is disturbing because goodness knows what will happen if the US 30 year really starts to crumble! Anyway all that being said there does not seem to be any evidence of a move to “traditional” safe haven markets/assets/securities.

And what about commodities? Is the deflationist camp about to get their day in the sun again anytime soon? Well before we could reasonably conclude that commodities are about to fall on their face/implode we would have to see evidence of the following:

• a breakdown in the CRB in both USD and non USD terms,
  
• Inflation linked bonds breaking down against non inflation linked,
  
• a breakdown in Baltic Freight Rates.
  

For now at least there does not seem to be any break of the recent trends. Everything seems to suggest that the next big move for commodities will be to the upside not downside and that the 1.6% fall in the CRB last night was merely “profit” taking.

So when it is all said and done………the only change in “trend” has been the breakdown in US Treasuries (although we need to see further downside before we get real excited).

The trade that seems to standout to us from all of this is long commodities and short US Treasuries. What about equities? We are not bearish (yet) but don’t know the implications of a falling US Treasury market, so perhaps long stocks with long dated out of the money puts (because vols are cheap) to hedge against Nouriel Roubini being right – yes stranger things have happened!

Our wealth creation portfolio is up 22.23% since the beginning of the year with approximately 40% of the volatility of the S&P 500. This portfolio is not leveraged.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

We are not currently taking new subscribers. Please enter your email address if you would like to follow our commentary and be notified when we open our service for subscriptions.

The final nail in the coffin for US Treasuries or the final “good to go” for the commodity bull? Well you take your pick! Look at how close the CRB is to breaking to a multi-week high against long dated US Treasuries (TLT). The behaviour of the CRB relative to TLT suggests that a significant bull market in commodities is about to kick into gear! What more of a bullish signal can you ask for if commodities start outperforming US Treasuries! Perhaps this is the ultimate inflation confirmation indicator.

We don’t know what the futures holds but we do know that once a primary trend is established then it lasts for months if not years. We are confident that we are about to see confirmation of a primary bull trend in commodities over the coming days (as opposed to weeks).

Our wealth creation portfolio is up 22.23% since the beginning of the year with approximately 40% of the volatility of the S&P 500. This portfolio is not leveraged.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

We are not currently taking new subscribers. Please enter your email address if you would like to follow our commentary and be notified when we open our service for subscriptions.