$GLD Archives - LXV Research

Loan Growth, US Dollar Liquidity Dynamics and Gold

“A man who is used to acting in one way never changes; he must come to ruin when the times, in changing, no longer are in harmony with his ways.” ― The Prince (1532), Machiavelli Niccolò

A quote-heavy piece to aid us as we start thinking about and preparing for 2020. In this week’s piece we focus on US dollar liquidity and gold.

Before the update, we wanted to comment on many people bemoaning President Trump’s habit of tweeting market moving news, or that purported to be news, in and around market trading hours. Whilst unfortunate, as the following quote from Robert E. Shiller shows, President Trump is not the first and unlikely to the be the last US President trying to nudge the equity market higher:

President Calvin Coolidge was an exceptionally pro‑business president. His most famous quote is “The business of America is business.” He was criticized for not bringing artists and classical musicians to the White House. He just brought businessmen. He liked businessmen. He believed in them. Whenever the stock market had a downturn, he would get on the radio — or Andrew Mellon, his US Treasury secretary would. Coolidge thought that was his job, to reassure the Americans that business is sound and profitable. It led to the biggest stock market boom seen at that point in history. I think it shows that political leaders do have an influence on the markets, so we can learn lessons.

On to the update.

Commercial and Industrial Loans

From Interest Rates, the Markets and the New Financial World (1986) by Henry Kaufman (emphasis added):

With the onslaught of deregulation, financial innovation, and new technology, government officials have urged private market participants to limit their zeal―as one authority recently put it, “to suppress the drive to reach out for that one last deal or that last basis point of profit.” These pleas are laudable but ineffective. Market participants cannot avoid being caught up in debt creation. If they turn their backs on the world of securitized debt, proxy debt instruments, and floating-rate finance, they will lose market share, fail to maximize profits, and be unable to attract and hold talented people.

The driving force for underlying profits is credit growth, and in the process the most conservative among institutions compromise standards and engage in practices that they would not have dared pursue a decade or two ago. The heroes of credit markets without a guardian are the daring―those who are ready and willing to exploit financial leverage, risk the loss of credit standing, and revel in the present casino-like atmosphere of the markets.

From Money creation in the modern economy, issued in the Bank of England’s Quarterly Bulletin 2014 Q1:

Banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy. But they are far from the only ways. Deposit creation or destruction will also occur anytime the banking sector (including the central bank) buys or sells existing assets from or to consumers, or, more often, from companies or the government.

Banks buying and selling government bonds is one particularly important way in which the purchase or sale of existing assets by banks creates and destroys money. Banks often buy and hold government bonds as part of their portfolio of liquid assets that can be sold on quickly for central bank money if, for example, depositors want to withdraw currency in large amounts.

According to the Federal Reserve’s most recent senior loan officer survey released last month, banks left commercial and industrial lending standards mostly unchanged amid weakening demand in the third quarter of 2019. Weakening demand for credit from the commercial and industrial sectors means that residential mortgage demand is the only engine for credit growth in the US economy at present. That is not a healthy dynamic. If not loan demand, particular from corporations, remains weak this will call into question the continuation of the US’s record long economic expansion.

Liquidity Metrics Do Not Signal A Continuation of the Gold Rally, At Least Not Yet

The below chart is of the price of gold, in US dollars, versus and adjusted metric of US broad money supply, M2.

Gold and M2.png

We have adjusted money supply such that a rising (magenta) line indicates that the creation of dollar liquidity in the monetary systems exceeds the needs of the economy. Excess liquidity creation translates into a debasement of the currency relative to real assets. A declining line is indicative of the monetary system not generating sufficient liquidity as demanded by the economy.

Gold functions both as a safe haven and a real asset. Therefore, its price has three broad drivers: the demand for safety (or high-quality collateral), the amount of excess liquidity being created by the monetary system and the level of real interest rates. Outside of periods of economic uncertainty, the primary determinate of the price of gold is the level of excess liquidity being generated.

As we can see from the above chart, there has been very little excess US dollar liquidity being generated by the economic system. Rather, the level of liquidity has just about been sufficient to support the US economy’s demand for dollars and this does not take into account the demand emanating from other economies. Therefore, the price of gold has been driven by demand for safe haven assets and declining real yields, which to an extent also reflect safe have demand.

With demand for credit in the US remaining tepid, as discussed above, we do not expect excess dollar liquidity manifest. Rather, an accelerant coming from either a further loosening of monetary policy by the Fed, the US Treasury draining its cash reserves or some form of fiscal stimulus are the obvious candidates that can lead to increases in dollar liquidity.

For now, with real yields starting to rise gradually, the only bid in gold, we think, is that of capital in search of high-quality collateral.

The Repo Facility is not Gold Neutral

The repo blow-up earlies this year set markets on edge and prompted the Fed to pump billions of dollars of emergency funding into the financial system. That is not all, the Fed has indicated that it will pump almost half a trillion dollars into the financial system over the end of the year, dramatically increasing intervention in the market in an attempt to avoid a repeat of September’s alarming rise in short-term borrowing costs.

The expansion of the Fed’s balance sheet and the pumping of US dollars into the repo market has been seen by some as bullish for gold. We think that drawing such conclusions is perilous for investors. Adding liquidity to the repo market to increase reserves is not akin to generating excess liquidity because adding liquidity into the financial sector’s “plumbing” does not result in said liquidity making its way into the economy. Rather this liquidity remains in the financial system, allowing it to operate without, hopefully, any further hiccups.

If this is not completely clear, we apologise and request you to please get in touch as we can share articles from those better placed to discuss the intricacies of the repo market and the plumbing that underpins the financial system.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Inflation, Earnings Yields, Stock Prices and Gold

We examine the relationships between inflation, stock prices, valuation multiples, real yields and gold. 15 Nov 2019.

“To understand is to perceive patterns.” ― Sir Isaiah Berlin (1909 – 1997)

“The great hope for a quick and sweeping transition to renewable energy is wishful thinking.” ― Vacliv Smil

Amazon has been in the news lately and not for the right reasons:

Nike has ended its deal with Amazon to sell its shoes and clothing directly to consumers on the e-commerce website. Nike cited a lack of follow through on Amazon’s part to crack down on sales of Nike branded products by unlicensed distributors and knockoffs by third-party sellers.

Amazon has accused the US government of having exhibited an “unmistakable bias” for the Pentagon awarding the US dollars 10 billion Jedi cloud computing contract to Microsoft after several rounds of bidding.

All does not seem right at Amazon. Probably making it one of the large cap stocks to avoid even as the US equity market continues to head higher.

On to this week’s update.

Inflation, Earnings Yields, Stock Prices and Gold

Federal Reserve Chairman Jay Powell told lawmakers at the Congressional Testimony that he saw little need to cut interest rates further after making three reductions since July. He also expressed that US inflation should progressively rise toward the Fed’s target rate of 2 per cent.

The day before Chairman Powell’s testimony, President Trump criticised the Fed for keeping rates too high and expressed envy towards nations in Europe that have interest rates below zero.

President Trump, understandably, wants higher stock prices and a booming economy as the US heads into an election year. Since stock prices are supposed to reflect the values of discounted future cash flows, a lower discount rate and / or high earnings growth expectations should translate into higher stock prices. President Trump cannot goose up earnings as easily as the Fed can cut interest rates, from his perspective, it then makes sense that he goes after the Fed and its hawkish stance, relative to that of the European Central Bank and Bank of Japan, on monetary policy.

Assuming lower policy interest rates translate into a lower discount rate, the US equity market’s earnings yield should decline (or price-to-earnings ratio increase). Barring a sharp drop in earnings, a lower earnings yield equates to higher stock prices.

The fly in the ointment is that, historically, US earnings yields have been more closely related to the rate of inflation than to nominal or real bond yields. And, high price-to-earnings ratios have had modest predictive power over future earnings growth.

The chart below is of the trailing earnings yield of US stocks and realised inflation rates.

Earning Yield and Inflation.png

A comparable relationship between inflation and earnings yields exists in many other markets as well.

Theoretically, since stocks are real assets, changes in the rate of inflation should not have a meaningful impact on stock prices or valuation multiples. In practice, however, the principle does not hold. Studies in behavioural finance suggest that a cognitive bias, known as the “money illusion”, explains the theoretical and practical disconnect that makes equity markets undervalued when inflation is high and overvalued when inflation is low.

The money, or price, illusion is to think of money in nominal, rather than real, terms. That is, when inflation is high (low), market participants incorrectly discount real cash flows using nominal discount rates, resulting in an undervalued (overvalued) price.

Explanations based on cognitive biases, such as the money illusion, while appealing, lack explanatory power however. That is, analysis reveals the ‘sweet spot’ for equity valuations occurs when the rate of inflation is in the range of 1 to 4 per cent. Valuation ratios compress at rates of inflation both above and below this range. Markets like neither high-levels of inflation nor deflation.

This is bad news for long-term equity investors that consider the probability of one of either deflation or high inflation occurring in the future to be higher than the level of inflation being witnessed in the US economy at present.

Relation Between Gold and the Price-to-Earnings Ratio

PE vs SPGOLD.png

The above is a chart of the S&P 500 Index express in terms of gold (in US dollars per Troy Ounce) versus the index’s price-to- ratio. In simple terms, the price of gold is inversely correlated to the price-to-earnings multiple of the index.

This relation can be better visualised by using the cyclically adjusted price-to-earnings (CAPE), or Shiller price-to-earnings, ratio as the impact of the Global Financial Crisis is smoothed out.

CAPE SPGOLD.png

Outside of periods when demand for high-quality, liquid collateral is at a premium, such as during a financial crisis, the price of gold is generally driven by the trend in US real yields. Rising real yields, that is rising interest rates and / or declining inflation, tend to push gold lower. While declining real yields, that is declining interest rates and / or rising inflation, tend to push gold higher.

The critical question for investors in US equity markets, or any other stock market for that matter, to ask then is: where are real yields headed?

Higher real yields translate into expanding valuation multiples implying that positive returns can be generated even with benign levels of earnings growth. While shrinking real yields are likely to spell negative returns unless earnings really surprise to the upside.

With Mr Powell signalling that the Fed is done cutting rates for now, if a drop in real yields is to manifest, it is more likely to come from a spike in inflation. With the continued reluctance of US corporations to make capital investments, the most likely candidate to lead a spike in inflation, in our opinion, is an unexpected rise in the price of oil.

Equity market multiple contraction risk can be hedged by owning gold or by investing in oil related plays such as companies operating in the energy sector. With gold having rallied to multi-year highs just recently and energy stocks trading at or near multi-year lows, our preference is for the latter.

Confusing the Cyclical with the Secular | The Iran-China Strategic Partnership

“The reason a lot of people do not recognize opportunity is because it usually goes around wearing overalls looking like hard work.” ― Thomas Edison

“The most important lesson I’ve learned is to understand and to trust abstractions. If you can learn both to see and to believe in life’s underlying patterns, you can make highly informed decisions every day.” ― Nathan Myhrvold, former Chief Technology Officer of Microsoft

Confusing the Cyclical with the Secular

We have, since late last year, been bullishly positioned in precious metals and have reiterated this view on several occasions over the course of this year. That being said, however, we are not of the view that precious metals have entered a new secular bull market and will be making a run for new highs, in US dollar terms, in the near term.

Similarly, in last week’s piece, we highlighted cyclical factors indicating that long-term US bond yields were likely to rise, in the near-term, as opposed to going even lower. Once again, this is a cyclical, not a secular, view.

Below we share two passages that provide a framework for understanding the conditions that would lead to a bond market rout and a new secular bull market in precious metals.

The following passage in an excerpt from The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money on the discussion between the author, Steven Drobny, and his (unrelated) colleague at Drobny Global Advisors, Dr. Andres Drobny (emphasis added):

Many people think there is a limit on public debt, but I am not so sure. Apart from a country constrained by a gold standard or fixed exchange rate, the only scenario where the government might bot be able to fund its debt is an inflationary scenario. However, the scenario only seems likely to emerge after the policies succeed in promoting growth. One of the reasons that a much-anticipated financing problem has never materialized in Japan is that reflationary policies failed to stimulate a sustained rebound and a return of inflation. Interest rates have remained low and fund the deficit has been surprisingly easy.

Consider what happens if the public debt and financing fears prove correct and bond markets start to tank. This is an issue that came up during a debate at our recent conference in London. Without inflation, rising nominal bond yields push up real yields and deflate the economy; bonds become more attractive again and buyers bring yields back down. Without inflation, it is hard to get a bond rout. It is only when inflation rises that government financing becomes a real and sustained problem for bond markets. That is when bonds no longer get cheaper as they sell off and nominal yields rise, which is when you get a real bond crisis.

The key takeaway from the above passage is that a secular turn in the bond market will only occur when rising nominal yields do not translate into rising real yields, that is when the rate of inflation outpaces the increase in nominal yields.

RR10CUS Index (Real 10 Year Yiel 2019-09-11 15-57-15.jpg

In the 1960’s and from the mid-1970’s through the early 1980’s, rising nominal yields in the US coincided with sharply declining real yields. Until such a disconnect begins to manifest, the secular bull market in bonds is intact.

The following passage in an excerpt from Peter Warburton’s essay The debasement of world currency: It’s inflation but not as we know it (emphasis added):

An excessive expansion of credit can create an environment where the factors of production — land, capital and labour services — appear to be in infinite supply. If sufficient (borrowed) financial resources are made available, then sterile, parched and polluted land can be fertilized, irrigated, cleaned up and turned to productive use. Similarly, more factories, kilns, assembly lines, steel mills, semiconductor plants and so on can be built using state-of-the-art technology. Idle and untrained workforces can be mobilized and organized into productive units. A rich country, with plenty of collateral assets against which to borrow, can indeed face a supply curve that is seemingly infinitely elastic. I can assure you that consumer price inflation will not be a problem for such an economy.

The United States still has plenty of collateral assets to borrow against. The US dollar hegemony may be on its last legs but there is no credible alternative making it still too early to bet against it.

BBDXY Index (Bloomberg Dollar Sp 2019-09-11 17-08-03.jpg

In the chart above, the magenta line is a custom index tracking the relative performance of US liquid assets (equities and investment grade bonds) to that of global liquid assets ex-US. The orange line is the Bloomberg Dollar Index ― the index is broader than $DXY, which is just a proxy for the EURUSD cross.

The continued out performance of US capital markets relative to the capital markets of the rest of the world is supportive of the US dollar and indicative of the superiority of US collateral relative to ex-US collateral.

The Iran-China Comprehensive Strategic Partnership

Speaking of the end of the US dollar hegemony, it was reported last week that Iran’s foreign minister Mohammad Zarif paid a visit to his Chinese counterpart Wang Li at the end of August to present a road map for the China-Iran comprehensive strategic partnership, signed in 2016.

As part of the deal, China will invest US dollars 280 billion in developing Iran’s oil, gas and petrochemicals sectors. There will be a further US dollars 120 billion of investments made by China in upgrading Iran’s transport and manufacturing infrastructure. Notably, the deal also includes “5,000 Chinese security personnel on the ground in Iran to protect Chinese projects, and […] additional personnel and material available to protect the eventual transit of oil, gas and petchems supply from Iran to China, where necessary, including through the Persian Gulf,” according to Iranian sources.

According to reports, the deal also includes a long-term commitment by China to buy Iranian oil. Based on these reports, Iran has agreed to sell its oil and gas to China at a guaranteed discount to prevailing market prices of at least 12 per cent, plus a further discount of up to 8 per cent to account for the risk ― presumably of a backlash from the US. China, of course, will pay for the oil in renminbi.

The benefits of the deal for Iran are obvious. It receives much-needed foreign direct investment. It secures a market for its hydrocarbon output. And secures a deterrent against possible military strikes by Israel or Saudi Arabia and its allies. Iran, though, does not simply want to be China’s discount oil dealer. It wants more, it wants a strategic alliance. Iranian foreign minister Mohammad Zarif penned an op-ed in the Global Times clearly articulating what Iran wants. It is unclear, however, if they will get it by “looking east”.

The benefits to China are somewhat mixed. Cheaper energy imports paid for not in US dollars but in local currency eases China’s dependence on the greenback and furthers its ambitions to form an independent monetary bloc. Buying Iranian oil and defying of US sanctions, on the other, is only likely to infuriate President Trump and further complicate ongoing trade negotiations.We see China’s willingness to defy US sanctions as a signal that its leadership is unwilling to do a deal with President Trump that it does not deem to be fair. By agreeing to buy Iranian oil, China is either hedging itself and preparing for a new economic reality or it is posturing to show strength in its negotiations with the US.

Aside from trade, the most interesting near term takeaway from China’s agreement to buy Iranian oil is that it did not lead to sharp pullback in the price of oil. Rather oil has moved higher, suggesting oil could move higher still.

Safe Haven Bid: Ahead of Itself?

Marilyn: Thank you for coming over, Mr. Baer. Welcome back and forgive me if I wade right in, but forgetting for a second your bureaucratic checklist, I’m trying to get undigested information, so if you could give me a reading of the temperature over there?

India is now our ally. Russia is our ally. Even China will be an ally. Everybody between Morocco and Pakistan is the problem. Failed states and failed economies, but Iran is a natural cultural ally of the U.S. The Persians do not want to roll back the clock to the 8th century.

I see students marching in the streets. I hear Khatami making the right sounds. And what I’d like to know is if we keep embargoing them on energy, then someday soon are we going to get a nice, secular, pro-Western, pro-business government?

Bob: It’s possible. It’s complicated.

Marilyn: Of course it is, Mr. Baer. Thank you for your time.

Intelligence is the misnomer of the century.

Bob: They let young people march in the street and then the next day shut down fifty newspapers. They have a few satellite dishes up on roofs, let ’em have My Two Dads, but that doesn’t mean the Ayatollahs have relinquished one iota of control over that nation.

Distinguished Gentlemen: Mr. Baer, the reform movement in Iran is one of the President’s great hopes for the region and crucial to the petroleum security of the United States.

Terry George: These gentlemen are with the CLI.

Distinguished Gentlemen: The Committee for the Liberation of Iran, Mr. Baer

Bob: We’ve had Iran in embargo for almost thirty years, we backed their neighbor, a neighbor we invaded twice, in a ten year war against them, we’re hanging on by a thread with a massive occupation force, so I got news for you… Thomas Jefferson just ain’t that popular over there right now.

― Syriana (2005)

Iranian foreign minister, Javad Zarif, made a surprise visit Sunday to the the Group of Seven summit, meeting with a delegation including French President, Emmanuel Macron, as leaders grappled with how to defuse tensions and salvage the landmark nuclear deal after a US pullout.

Mr Javad Zarif did not meet with the US delegation in Biarritz, France, although President Trump has indicated that he is open to meeting Iranian officials without preconditions.

The narrative in the noughties when oil was rallying and the spectre of peak oil (supply not demand) was of popular concern ― the BBC even produced a film titled The Crude Awakening: The Oil Crash in 2007 to warn of the end of life as we know it because the world was running out of oil ― was that of the US’s need to ensure hydrocarbon security. Today, the narrative is that the world is awash with oil and the US is energy independent, affording President Trump the luxury to scrap the deal with Iran and to re-impose economic sanctions.

As it relates to oil, the truth lies somewhere in between the fears over peak demand and peak supply but almost never, barring a energy paradigm changing supply- or demand-shock, at the extremes.

As it relates to geopolitics, should oil prices rise sufficiently, driven by a flurry of bankruptcies in the US shale patch or US shale production plateauing, it would be of no surprise to see the US either return to the negotiating table with Iran or to ease sanctions.

The overarching consensus for oil appears to be that of lower oil prices. With some even calling for a crash to below the US dollars 30 per barrel level, that would lead to global deflationary bust. In our opinion, these calls seem premature. Rather, if anything, we see the greater risk being to the upside.

We often use the 48-month moving average, for commodities and major currency crosses, to guide our trading strategy. For now, WTI crude prices remain above the moving average, albeit just barely. Given the proximity of the current price to the moving average, the best course of action may be to be on the sidelines. That being said, as long as prices do not meaningfully breach the 48-month moving average, our bias is to be long in expectation of prices climbing the ‘Wall of Worry’ over the next 6 to 12 months.

USCRWTIC Index (US Crude Oil WTI 2019-08-26.png

Has the Safe Haven Bid Got Ahead of Itself?

In the below chart, the magenta line is the ratio of the price of gold to the Merrill Lynch 10-year Treasury Total Return Index. The orange line is that of core price index.

XAU Curncy (Gold Spot $_Oz) GL 2019-08-26 11-47-07

The US dollar price of gold, loosely an inflation hedge, rising relative to the 10-year Treasury index generally coincides with rising core inflation. There, of course, are periods that the ratio over- or under-shoots core inflation but over time the roughly coincident movement of core inflation and the gold-to-ten-year Treasury index tends to reassert itself.

In recent months we have seen safe haven assets, government bonds and precious metals, get bid up. Notably, gold has outperformed 10-year Treasury bonds in 2019 even as core inflation has witnessed a sharp drop. Between early 2017 and early 2018 we saw a similar dynamic play out, when long-term bond yields rallied (long bonds sold off) and gold remained steady while at the same time core inflation moved sharply lower.

In 2018, core inflation eventually moved higher and caught up with the gold-to-Treasuries ratio. Suggesting that markets had correctly anticipated the move higher in core inflation.

We will know in time if the markets have got it right again or not. If core inflation does not move higher, it is likely that the safe haven bid, specifically in gold and other precious metals, has gotten ahead of itself and investors are better off owning government bonds over precious metals.

With long-term bond yields near all-time lows, it is difficult to make a strong case for bonds, however.

The below chart is that of WTI crude (magenta) and gold (orange). The two commodity prices tend to, over the long-term, have the same directional move. Oil does not have the safe haven characteristics of gold and therefore has stronger moves than gold both to the up and down sides.

USCRWTIC Index XAU (US Crude Oil WTI 2019-08-26.png

Much like the relation between the gold-to-Treasuries ratio and core inflation, a gap has opened up between the price of gold and that of oil, much like it did in 2017. In 2018, the gap was closed with oil moving higher. Will that also be the case this time around?

Finally, the last chart in this week’s piece. This one compares the price of oil to core inflation.

USCRWTIC Index PCE.png

The price of oil is one of the primary drivers of core inflation, albeit with a lag. Should oil prices move higher from here, core inflation will be higher 6 to 12 months down-the-line; justifying the move higher in gold and likely proving the current rally in government bonds to be a bull trap.

On the other hand, if oil prices make new lows, gold should be sold in favour of government bonds.

The price of oil is probably the most important price in capital markets today. The next move in oil will drive many of key tactical decisions for asset allocators.

If oil moves higher, portfolios will be found to be lacking allocations to assets that do well in periods of rising inflation ― resource and mining companies, resource rich emerging markets, high yield credit and precious metals ―and over exposed to high duration assets such as loss-making technology companies as well as utilities and long-terms bonds.

If oil moves lower, the stampede into developed market government bonds, technology stocks and utilities is likely to continue unabated.

We will be following the oil price ever so closely hereon out.

Trading the Thin Zone | Healthcare Follow Through

“If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience.” ― George Bernard Shaw

Goldbugs are gloating. Dollar bulls are hurting. Ellioticians are cursing. This, we hope, is not one of those pieces.

Trading in the Thin Zone

Actions speak louder than words. Well, except for the Federal Reserve. They talked a big game, did very little yet markets popped. None more so than precious metals.

Rather than discussing the what and why of the latest Fed meeting, we discuss our thoughts about trading strategies for the US dollar, gold and silver.

Before we explain, the summary:

The critical level for US dollar bears is around 92 on the $DXY or US dollars 24 for the Invesco DB US Dollar Index Bullish Fund $UUP;

Above US dollars 1,375 per ounce for gold; and

Around US dollars 17.50 per ounce for silver.

In the price charts below, we overlay the volume around each price level to identify what may be called “thin zones” ― areas where prices can move quickly and where positioning should be biased in favour of the shorter-term trend. The investment instruments we chart are ones we deem suitable proxies for the US dollar, gold and silver.

Thin zones are price levels where there has been relatively little buying or selling. Making them areas where there should be little to no support or resistance and so prices can move quickly through them.

These thin zones are typically preceded by, from above or below, price levels where there has been a lot of volume both on the way up and on the way down. These price levels are likely where institutional buying or selling has been heaviest in the past and where there are been a lot of push and pull between bulls and bears. And therefore the breach of such price levels can cause one set of market participants immense amount of pain while reap handsome rewards for the other set of participants.

Winners are unlikely to suppress a favourable move and instead may add fuel to the fire by increasing their positions and heaping yet more pain on those on the other side. The losers, except the most stubborn, are likely to cover adding yet more fuel to the move. With demand being almost unidirectional, prices can spike on very little volume ― making it profitable to position at the edges of thin zones.

Using $GLD as a proxy, gold given the recent sharp move higher is right at the very edge of the thin zone and any continuation of the move higher should be used to add to longs.

Based on $UUP, the US dollar is still someway from getting to the thin zone on the downside but is close to one on the upside. It is still too early to have a full short position in the US dollar and if the current move down is a head fake, shorts should close out positions and even look to go long.

We suspect, 92 on the $DXY is close to the pain threshold for foreign pools of capital holding US Treasury securities without hedging foreign currency risk. If the US dollar breaks 92, it will be time to put on a full short position in the greenback.

UUP

Silver has a lot of work to do before it too can get closer to the thin zone. Gold is probably the better instrument to trade if you want to be long precious metals at present. If, however, silver moves through US dollars 17.50 per ounce, all bets are off and gold longs should be rotated into silver.

slv

Another proxy for silver is to watch for a sustained move above its 48 month moving average.

XAG Curncy (Silver Spot $_Oz) 4 2019-06-20 12-54-14.png

Healthcare Follow Through

A few weeks ago we highlighted the sharp recovery in healthcare stocks and started thinking about the sector as hunting ground for new long ideas. Since then we have witnessed a follow through with the SPDR Health Care Select Sector ETF $XLV continuing to push higher, particularly on the back of mergers and acquisitions activity in the biotechnology space.

The sector has been a laggard year-to-date but a leader in the last month. If the current iteration of the US bull market still has legs, we expect healthcare to continue going from strength-to-strength.

XLV US Equity (Health Care Selec 2019-06-20 11-27-42.png

We remain long Repligen Corp $RGEN and Novocure $NVCR and identify two additional names as long ideas in the healthcare sector. (A long in $AbbVie has still not been triggered.)

RGEN US Equity (Repligen Corp) H 2019-06-20 12-07-54.png

Medtronic $MEDT

Medtronic is the world’s largest medical devices company that infamously acquired Ireland-based Covidien to enable Medtronic to shift its legal headquarters from the US to Ireland to benefit from the favourable tax-regime in Ireland.

We will look to enter a long position should the stock close above US dollars 100.

MDT US Equity (Medtronic PLC) He 2019-06-20 12-10-26

Edwards Lifesciences Corp $EW

Edwards Lifesciences is another medical equipment company. It specialises in artificial heart valves and hemodynamic monitoring.

We are long here.

EW US Equity (Edwards Lifescienc 2019-06-20 13-12-18.png

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Charts, Ideas and the Euro

“There is nothing more deceptive than an obvious fact.” ― The Boscombe Valley Mystery by Arthur Conan Doyle

Gold vs. US 10 Year Treasury Real Yield

Source: Bloomberg

The above chart compares the year-over-year change in the US dollar price of gold versus the year-over-year change (inverted) in the real yield on US 10-year Treasury Securities. (The deflator used to calculate real yields is core inflation.)

Ever since the gold-bubble popped in 2011, the year-over-year change in its price has been negatively correlated with real 10-year yields. Intuitively, this makes sense given gold is a non-yielding asset and the lower the real yield on bonds the more attractive a non-yielding asset becomes on a relative basis.

Real yields can, of course, decline either due to nominal yields in bonds declining or by inflation picking up. In either case, if the relationship between gold prices and real yields holds, gold prices should move higher. With little seeming desire on the part of the Federal Reserve to jawbone rates higher — especially with a Twitter-happy president and global trade uncertainties rising — precious metals, other than their customary volatility, could be primed to move much higher. Our conviction will be increased if see gold take out its 2016 highs of around US dollars 1375 per troy ounce.

Thinking About the Euro

Try and go back to the start of the year and imagine:

(1) the trade dispute between the US and China escalating;

(2) global risk aversion — measured using the BNP Paribas Global Risk Premium Index — reaching levels last witnessed at the start of 2016;

(3) Italian bond yields blowing out;

(4) economic data coming out of Germany deteriorating;

(5) systemically important European banks, such as Deutsche Bank, crashing to new lows; and

(6) the positive carry (higher interest rate) for the US dollar over the euro sustaining.

Given the above scenario, most investors would want to be long the US dollar and short the Euro. And, indeed, positioning in futures markets suggests that investors are indeed long the greenback and short the euro. Yet, the US dollar is not moving higher. What gives?

EURUSD Curncy (EUR-USD X-RATE) 2019-06-07 18-06-14.jpg

The above is a monthly chart of the Euro US dollar cross. If we get follow through in the recent move higher in the euro by the end of this month, the probability is the euro strengthens from here at least to 1.20 and possibly higher. If, however, the recent move fails and the US dollar strengthens, then we may well get the doomer scenario of a US dollar that is too strong for the rest of the world to handle.

Our base case view is that a weakening greenback finally gets us the blow-off top or ‘market melt-up’ in US equity markets that many have been waiting for.

Watch the euro-US dollar cross and position yourself in stocks accordingly.

The ECB: Not Doing Enough to Prevent the Worst

At this week’s governing council meeting, the European Central Bank (ECB) left the deposit rate at -0.4 per cent and extended forward guidance into 2020, with rates expected “to remain at their present levels at least through the first half of 2020”.

The ECB also confirmed that the proceeds from maturing bonds in its portfolio will be reinvested to keep the stock of assets steady. Details of a third Targeted Longer-Term Refinancing Operation were also revealed: it will be held quarterly from September at interest rates as high as main refinancing operation rate (currently at 0 per cent) + 10 basis points and as low as the deposit rate + 10 basis points. The precise rate will depend on banks hitting their lending targets.

The ECB’s measures should support the European economy and potentially slow down the upward pressure on the euro from an increasingly dovish Fed. However, we do not think the ECB has gone far enough to address the challenges faced by its banks and a further deterioration in global trade activity. It might be that Mr Mario Draghi is passing the buck onto his yet to be named successor but we think the ECB may have at least one trick left up its sleeve: Open Monetary Transactions.

The Open Monetary Transactions (OMT) facility, established during the European crisis, has never been utilised. Currently, the ECB can only buy government bonds according to member states share of its capital. Under an OMT program, however, it would have the power to buy bonds of a specific member state if said member’s government accepts conditionality along the lines demanded by the International Monetary Fund for countries in its funding programs.

If the ECB eventually, albeit reluctantly, comes through with an OMT like programme or another measure to reduce the burden of negative interest rates on European banks, that too could push global stocks much higher.

Sharp Recovery in Healthcare Stocks

Take a look at the relative chart of the SPDR Health Care Select Sector ETF $XLV to the S&P 500 in the second panel below. After a more than four-moth period of drastic under performance by the healthcare sector, we have witnessed a sharp recovery in recent weeks.

We think healthcare stocks might be ripe ground for stock pickers.

XLV US Equity (Health Care Selec 2019-06-07 18-21-02

Some of the names we are tracking closely in the space are highlighted below.

Novocure $NCVR

Research and development company focused on developing cancer treatments with a market capitalisation of US dollars 5.3 billion. We recommend a small position here with a view of adding if it breaks to new highs, above US dollars 56.67.

NVCR US Equity (Novocure Ltd) VE 2019-06-07 18-44-57.jpg

AbbVie Inc $ABBV

Pharmaceutical behemoth $ABBV is starting to looking interesting to us at current levels. A move up US dollars 81.50 and we would be buyers. We recommend buy stops at the level.

ABBV US Equity (AbbVie Inc) VEEV 2019-06-07 18-50-15.jpg

Repligen Corp $RGEN

Massachusetts based $RGEN is engaged in the development and production of materials used in the manufacture of biological drugs ― substances made from a living organisms or its products and used in the prevention, diagnosis, or treatment of cancer and other diseases.

We are long here.

RGEN US Equity (Repligen Corp) V 2019-06-07 19-18-03.jpg

Pick-and-Mix

“The whole world is simply nothing more than a flow chart for capital.” – Paul Tudor Jones

“It’s still true that the big players in the public markets are not good at taking short-term pain for long-term gain.” – Jeffrey W. Uben, ValueAct Capital

In this week’s piece we (i) revisit our call on cloud-based software stocks, (ii) touch upon Dollar Tree Inc. $DLTR, which we think is poised to outperform in the near term, and (iii) consider the possible ramifications of the recent policy statements by the US Treasury and the Fed.

Cloud-Based Enterprise Software Update

We highlighted cloud-based enterprise plays as a potential long idea in Two Investment Ideas on 14 January, 2019. Two out of our three preferred names, Veeva Systems $VEEV and Workday Inc. $WDAY, are up 16.46 and 13.92, respectively, from market close on 14 January through 2 February. In comparison, the S&P 500 Index is up 4.88 per cent during the same period.

We think it is a good time to tactically take profits in both names and to continue playing the theme through Benefitfocus $BNFT and the two additional names we highlighted in our weekly piece on 21 January. We will look to re-enter long positions in $VEEV and $WDAY at lower levels, should they correct.

Dollar Tree Inc.

We have been long $DLTR for more than a year now. Initially the stock did really well, outperforming the S&P 500 Index. Alas, it did not last and performance was lacklustre between February and December last year.

DLTR US Equity (Dollar Tree Inc) 2019-02-04 14-06-14.png

The underwhelming performance of the stock stems from the declining sales and earnings at its Family Dollar franchise. The company acquired Family Dollar for US dollars 9 billion in a fiercely contested battle with Dollar General $DG during the second half of 2017.

The Family Dollar acquisition was motivated by management’s desire to scale up to better compete with larger players such as $DG and Target $TGT. What transpired, however, is the company ended up buying an under performing business that it has, to date, been unable to turnaround.

What has made the failure to turnaround Family Dollar even more vexing, for shareholders and management alike, is that following $DLTR’s ill-fated acquisition, its direct competitor, $DG, has managed to grow strongly, open up new locations and increase its market share.

$DLTR’s troubles with Family Dollar have attracted the attention of activist investors and in January of this year Starboard Value – the New York Based activist hedge fund – announced that it owned 1.7 per cent of the company and had nominated seven directors to its board.

Starboard wants $DLTR to consider a sale of Family Dollar, even if it means selling it for significantly less than it paid for it. It has also suggested that the company should make changes to its current business model including selling some items at price points above US dollar 1, such as US dollar 1.50 or 2 – something that $DLTR’s competitors already do.

Whether a sale of Family Dollar transpires or not, having an activist hedge fund as a vocal shareholder, we think, is likely to place pressure on $DLTR’s management to make meaningful improvements in the company’s operational performance and create shareholder value.

We have waited on commenting on the stock following Starboard’s announcement as we wanted the initial euphoria to die down and for long frustrated shareholders to take the opportunity to sell following the news.

We think $DLTR is well placed to out perform in the near term and we will be adding to our existing position.

US Treasury Refunding Statement

From the US Department of the Treasury’s press release issued on 28 January:

During the January – March 2019 quarter, Treasury expects to borrow $365 billion in privately held net marketable debt, assuming an end-of-March cash balance of $320 billion. The borrowing estimate is $8 billion higher than announced in October 2018. The increase in borrowing is driven primarily by a lower than previously assumed opening cash balance.

During the April – June 2019 quarter, Treasury expects to borrow $83 billion in privately-held net marketable debt, assuming an end-of-June cash balance of $300 billion.

The US Treasury’s deposits held in its general account with the Fed stand at US dollars 411.4 billion as of 30 January 2019.

Based on the US Treasury’s press release, around US dollars 110 billion of deposits held with the Fed will be injected into the global banking system between now and 30 June.

This announcement is important because deposits held by the Treasury with the Fed are unlike deposits held with banks. Outside periods of extreme economic instability, the Fed is not engaged in the business of lending money, it only takes money in as deposits. Cash taken in by the Fed does not percolate through the global banking system, rather it sits idly in Fed’s accounts in New York.

Consequently, the build up of cash in the Treasury’s general account, to park funds generated through the issuance of Treasury bills, tightens monetary conditions while withdrawals from the account tend to ease monetary conditions. With the US Treasury contributing to tightening financial conditions for the better part of 18 months, it will for the next five months, at least, reverse course and become a source of monetary easing.

The Fed’s U-Turn

From the Wall Street Journal:

In what arguably was Mr. Powell’s most significant statement on Wednesday, he struck a dovish tone on this process of “balance-sheet normalization.” The signal was that so-called quantitative tightening would continue for now but end sooner than expected. Moreover, he also raised the possibility that the balance sheet could be “an active tool” in the future if warranted—in other words, more bond purchases if markets or the economy cry out for help. Until recently, Fed officials had been insisting the balance-sheet shrinkage was on autopilot.

As discussed last week, the Fed has little choice but to maintain a large balance sheet if it wants the US banking sector to continue being governed under the stringent Basel III framework. Chairman Jay Powell confirmed as much during his press conference on Wednesday last week.

The combination of:

(i) the US Treasury releasing dollars into the banking system;

(ii) the Fed putting interest rate increases on and introducing language that opened up the possibility that the next move in interest rate could either be down or up; and

(iii) increased clarity on the Fed’s plans for shrinking its balance sheet

we think, should be conducive for risk-assets during the first half of the year.

After a strong showing by global markets in January and the little matter of the US-China trade resolution deadline fast approaching, we think caution is warranted in February. Nonetheless our highest conviction ideas for the first half of the year are: long selective emerging markets, long precious metals, short US dollar and long selective US technology companies.

With respect to precious metals, the Chinese New Year holidays have more often than not proven to be periods of weakness. Those with a bullish disposition should take advantage of this seasonal weakness.