The US Treasury Fakeout

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Global bond market volatility was at a relative extreme this week. Following the markets you would see headlines like this:

The basic premise being that the world is awash in liquidity and as a result of the prices of government bonds, investment grade bonds (IG), and high yield (HY), have been bid so heavily that the yields of these instruments no longer reflect the credit and/or currency risks associated with the issues. 

Of particular interest to me was the relentless selling in USD based assets especially treasuries. 

$TYX=30 year, $TNX=10 year, $FVX=5 year, $UST2Y=2 year

As an investor the question became "Is this the beginning of a new trend or a false (counter) trend within the larger trend?". To answer questions like these I try simplify the logic. 

  1. Are the other global central banks committed to active devaluation of their currencies while the FED is not? Yes, they are. That's (USD) positive. 
  2. Do current global market conditions allow for gray (black) swan events? Yes.
  3. Given a gray (black) swan event, which markets are creditworthy as well as deep and liquid enough to absorb multiples of Billions of investor capital in a 'flight to safety' response? The U.S. government bond market is the only one to meet all the aforementioned criteria. Again (USD) positive. 
  4. Examining bond yields relative to credit/currency risk are there more attractive international government bond instruments available? No. Even with the recognized overvaluation in US bonds US gov't yields are still the most attractive relative to credit/currency risk. 

http://online.wsj.com/mdc/public/page/2_3022-govtbonds.html

Currently examining the chart only Portugal, and Australia are offering better yields than the US 10 year. Clearly risk is being artificially repriced according to central bank machinations. Keep in mind Eurozone member bonds were priced for default within the last 24 months. Now government bonds in Spain and Italy are priced as if they represent better credit risk than the US! That's pure foolishness.

As a fixed income portfolio manager you can't find a better setup.  As a result it is my belief that the previous sell-off in global bond markets represented more rotational and risk management behavior as opposed to a new trend. Again, put yourself in a fixed income PM's shoes. You have a multi-billion dollar bond portfolio to manage, your options are limited in terms of investable markets. The best credit risk in the world (USD) is yielding higher than 80% of your available options. On a relative basis you better believe there will be a bid under treasuries as long as the current capital market framework is in place. 

Examining the % change in yields of US treasuries from their Wednesday highs to Friday's close, it appears as if portfolio managers were moving to the shorter end of the curve as the 2, 5, 10 year all outperformed the 30 year. 

http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

Swiss FX Shock

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On January 15, 2015 the Swiss National Bank (SNB) shocked the world with a surprise break away from the Euro peg which caused a cataclysmic revaluation of the relative value of the Euro and Polish Zloty.

Some context: During the summer/fall of 2011, in response to the European debt crisis the SNB stunned FX traders ~2.5 years ago when it announced it would peg it's currency to the Euro in an attempt to neutralize the Swiss Franc's (CHF) rapid appreciation due to its safe haven status. The SNB did this to protect the Swiss local economy which is 70% based on exports according to The Economist. Clearly, the SNB is no stranger to catching the market off guard.

As a trader I'm always interested in the circumstances surrounding these major announcements. Let's take a look at some of the relevant headlines from the 2011 European Debt Crisis.

Portugal’s $111 Billion Bailout Approved as EU Prods Greece to Sell Assets - May 16, 2011 - Bloomberg.com

Agency Cuts Greece’s Debt Rating Again -June 13, 2011- Nytimes.com

Greece set to default on massive debt burden, European leaders concede -Monday 11 July 2011 - theguardian.com

Debt Contagion Threatens Italy -July 11, 2011 - Nytimes.com

Global Finance Leaders Pledge Bold Action to Calm Markets - August 7, 2011 - Nytimes.com

Swiss bid to peg 'safe haven' franc to the euro stuns currency traders - Tuesday 6 September 2011 - theguardian.com

5 Central Banks Move to Supply Cash to Europe - September 15, 2011 - Nytimes.com

Clearly these were some hectic times in 2011. The headline risk was high as bad debt blowups lurked around every corner and Greece's default was all about assured. Let's look at how various markets were holding up then vs now. 

During 2011

In 2011 you can see ( TLT ) marching higher and higher all year, even after the surprise SNB peg to the Euro ~ 9/6/2011. Furthermore you can see the extreme appreciation of the ( CHF ) reaching ~30% in August basically forcing the SNB to act. Also of note, ( SPY ) tanked in late July, and increased volatility followed through November.

Current - 2015

Examining 1 year to today, we can see that ( TLT ) is similarly strong and gaining as headline risk increases. Of particular interest is the low relative volatility in ( SPY ) compared to 2011. Note however there was a market selloff prior to the current surprise SNB announcement. Look how big that   ( CHF ) revaluation is. 

SPX, FXF (CHF) daily log returns since 2010

Just to put the move in perspective the above chart shows the returns of the ( SPX, FXF ) since 2010. Talk about an outlier... 

The Bureau for International Settlements (BIS) triennial survey in April 2013 estimated that average daily turnover in the currency markets had reached $5.3 TRILLION! Factoring the size and breadth of the FX markets and the inherent leverage involved, a ~20% move in a major currency like the Swiss Franc is a major change in market dynamics that has wide reaching implications that aren't always immediately apparent.

Something like the Polish Zloty's ~20% decline vs the Swiss Franc could cascade into something bigger. According to Bloomberg News Poland has ~46% of total home mortgages denominated in ( CHF ) for a dollar value of ~$35 Billion. Imagine your monthly mortgage payment increased 20% overnight, would you be able to pay it? What would you have to give up to make good on your house note? This is the reality staring Polish citizens and banks in the face. My guess is a massive increase in bad debts, and asset writedowns are soon to follow. Accordingly, I'm not sure how much, if any of this is priced in equity markets with ( OIL ) dominating headlines and investor focus.

With that said I believe a bearish bias is prudent at this time as any 'unexpected' shock is likely to increase volatility in equity markets.  IMHO, the risk of the unexpected including: asset writedowns, profit warnings, bankruptcy's etc. likely resulting in margin calls, and forced selling; has increased dramatically. Be nimble, be adaptive, and manage your risk.

Is Canada a short?

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In previous blog posts, I've discussed my bearish stance on the Canadian economy as expressed through ( EWC, FXC ) due to the collapse in global oil prices. My original hypothesis was Canada is a resource/energy based economy and declining oil prices would make the 'expensive' oil produced in the oil sands less attractive economically from a producer/investment standpoint. Let's explore that thesis a little more and see if it's validated by facts.   

Alberta, Canada contains the 'oil sands' deposits and had an estimated contribution of ~18% to Canadian GDP in 2013 - statcan.gc.ca via wikipedia

According to albertacanada.com, energy is ~23% of Alberta's GDP, and the ancillary sector of construction is ~11%. Back of the envelope calculations tell us that ~34% of Alberta's 18% Canadian GDP contribution is energy related. In other words ~6% of Canadian GDP is exposed to Alberta's energy sector.  

$1 per barrel drop in the price of Alberta's oil over 12 months = $215 million less in revenue - alberta.ca

In October of 2014 Bloomberg news reported that Alberta's budget forecast was based on oil prices at $97 a barrel. As of this writing the spot price of WTI crude is $51! That's a $46 gap, or ~47% drop. If crude averages ~$50 a barrel over 12 months that's an estimated ~$9.9B drop in provincial revenues. That will certainly blow holes in budgets and earnings expectations across the board. 

According to a RBC March 2014 provincial economic outlook Alberta was forecast to post the largest real GDP gains of any province for 2014 and 2015. I think that forecast will have to be altered drastically if it hasn't already. As of October 2014, BMO has already slashed Alberta's growth forecast to 2.9% from 3.3%. This might be revised further as the oil drop continues. 

How important is Alberta to Canada's economy? theglobeandmail.com reports:

“Alberta contributed one-third of Canada’s economic growth last year, and is by far the fastest-growing province in the country again this year. Since the beginning of 2013, nearly half the jobs created in the country were in Alberta.”
— http://www.theglobeandmail.com/report-on-business/industry-news/energy-and-resources/panic-time-as-oil-goes-so-does-canadas-economy/article21116012/

Civeo Corp. ( CVEO ) lost 53% of it's value on Dec. 29 after announcing a suspension of its dividend and closing sites - bloomberg.com

Why should you care? 

“Civeo Corporation provides workforce accommodations in the Canadian oil sands and the Australian natural resource regions. The company offers solutions for housing of workers with its long-term and temporary accommodations; and provides catering, facility management, water systems, and logistics services.”
— http://finviz.com/quote.ashx?t=cveo

( CVEO ) is on the front lines of Canadian oil sands production and announced it would cut staff in Canada by 30% and in the US by 45%. CapEX will drop ~78%! This is telling me that the fallout from the collapsing oil prices has only begun as capital budgets get cut across the board. 

Several oil majors have already cut or suspended major oil sands projects. Reportedly there is a tendency towards significant cost overruns for large scale oil sands production projects, that when paired with declining oil prices, make projects economically impractical. 

“The Joslyn oil sands mine has been shelved indefinitely, a result of rising industry costs that made the $11-billion project financially untenable.”
— http://www.theglobeandmail.com/report-on-business/joslyn/article18914681/
“CALGARY – Royal Dutch Shell PLC told regulators it is halting work on its Pierre River mine in northern Alberta’s oil sands and that it has no idea when it may revive the blueprints”
— http://business.financialpost.com/2014/02/12/shell-halts-work-on-pierre-river-oil-sands-mine-in-northern-alberta/?__lsa=09a5-a82e
“CALGARY — Statoil has put its Corner oil sands project on hold for at least three years as it grapples with rising costs.

The decision means about 70 jobs will be cut, the Norwegian energy firm said Thursday.”
— http://business.financialpost.com/2014/09/25/statoil-puts-corner-oil-sands-project-on-hold-for-at-least-three-years-cuts-70-jobs/

That's a pretty grim outlook moving forward, however there are risks to this thesis that must be noted and factored into any trade or investment decision. 

  • As oil price declines oil consuming provinces like Ontario stand to benefit
  • Oil prices in conjunction with a declining ( CAD ) make Canadian exports (including energy) cheaper for international buyers (primarily the U.S.), which is likely to offset some of the declining domestic economic activity
  • If Canadian exports rise enough to offset the domestic energy fallout   ( EWC ) may bottom more quickly than expected and even rise in the face of negative investor sentiment.
  • Canadian manufacturer's which use oil as an input also benefit from the declining oil price and may be in position to increase sales as consumers in other provinces and the U.S. have more discretionary cash to spend, again potentially causing ( EWC ) to bottom more quickly than expected and even rise in the face of negative investor sentiment.

I'm still bearish on ( EWC ) but not as aggressively as I was previously. In fact I think a long ( USD ) short ( CAD ) position may be a better, more direct play to capitalize on the current global macro dynamics. 

What I'm Watching ( Week of 12.29.14 )

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This week it's simple. I'm watching/waiting for volume to reenter the market and confirm or reject last week's holiday action. 

Last week ( SPY, DIA, QQQ ) all traded to new 52 week highs with my short target ( EWC ) bouncing significantly in sympathy.

( OIL ) price action appears to have moderated a little in terms of downside volatility; buyers and sellers that remained haven't shown conviction one way or the other yet.

There is good reason to be skeptical of last week's broad market moves. See the disparity between relative volume and average volume across the board. Below I've highlighted the lack of volume of some popular ETF's I'm tracking. 

Except for ( OIL ) which traded at 1.7x average volume the other ETF's experienced anywhere from 0.5x to 0.2x their average volume during the last session. With this week's market open minutes away we will find out if conviction has returned via volume/relative volume throughout the week.  

What I'm Watching ( Week of 12.15.14 )

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Canada iShares ( EWC )

Canadian assets are facing major headwinds in the current environment. 

1. The fall in global oil prices hurt producers' bottom line. Alberta is bracing for a decline in GDP into next year as a result. Click for links to articles.

Quarter of new Canadian oil projects vulnerable if oil falls below US$80: IEA 

With oil trading below US$60, provinces brace for impact of global oil price shock

The above chart shows that there are some producers' breakeven Oil price as low as $45. That estimate may well be tested. My concern is that Canada has the lowest return on net cumulative capital cost according to Barclays et al. 

Bottom line, low prices make new projects uneconomic and projects with a higher cost basis return even less than before. This is a net negative. 

2. The $USD continues to strengthen relative to other global currencies. This is especially true for the commodity currencies of Australian and Canadian dollars. 

Therefore $1 USD will in effect be able to buy more Oil when priced in CAD effectively increasing U.S. purchasing power for Canadian production. 

I'm actively looking for a trading opportunity here to the short side. Oil prices are weak, and the producers' currency is declining in relative value. Here are the setups I'm watching in charts.