Global equity markets are volatile and chaotic. Seemingly distressed paper is only getting more distressed by the day. Sovereigns will be forced to issue trillions of debt over the next 12-18 months to pay for aggressive stimulus programs. US Treasury yields are at historically low levels, notwithstanding massive deficit spending as far as the eye can see. Western Europe is crumbling, with special mention to the UK. Japan is on life-support. So with all this uncertainty and the deeply troubled US Government trading as if everything is rosy, e.g., why aren’t both the USD and Treasuries getting crushed in the face of persistent trillion-dollar deficits, the question is: where’s the trade?
A few observations:
- It appears that the “flight to quality” trade in the credit markets will continue for the foreseeable future, keeping Treasury yields low and the dollar strong. This has become a relative, not an absolute, issue. The US is in relatively good shape and absolutely poor shape, but given that money has to go somewhere it will continue flowing into Treasuries until the crisis abates. The “best guess” of when this might happen is a key input into the macro trading strategy.
- It also appears that the UK is trashed. As sick as the US banking sector happens to be, the UK system is even sicker. They have a broken financial system, massive public sector deficits and a collection of old, dying industries. This is not a formula for a strong currency and tight debt spreads. Unlike the US, there will be no “flight to quality” into Gilts. A decent trade might be long 10-year Treasuries/short 10-year Gilts, as I’d expect the sell-off at the long end of the yield curve to be way more ferocious in Sterling than I would in USD. The trade certainly works across the Euro-zone as well.
- Crude prices are likely to continue falling. The X factor, of course, is China. The Chinese Government can stomp its feet and say “We’re going to spend in order to make sure we’ll hit 8% GDP growth, come hell or high water,” but where is this growth coming from? Assuming they’re not making up numbers (yeah, they’ve never done that, right?), and considering they are experiencing one of greatest human flights in recorded history from cities back to farms, and that their key trading partners aren’t going to be buying much for quite some time, does all of this domestic stimulus really matter? I think not. Production may spike to make the Government planners feel better for a while, but it won’t be sustained. Crude demand simply has to fall, and with it prices that I could imagine hitting $20/bbl before it’s all said and done.
- Commodities prices will also continue falling. With global demand cratering and quiet protectionist barriers being erected all over the world, as with oil, who is going to be buying? Production capacity will be taken offline, new equipment purchases will be deferred, exploration will stall.
So, long Treasuries, short UK/Euro-zone Governments, short oil and commodities. Until… All this deficit spending coupled with mothballed production capacity is laying the foundation for explosive inflation. When? At least a few years out, I’d hazard 3-4 years from now. But when it turms, it will be dramatic. Oil won’t go from $20 to $60, it will go from $20 to $200. Base metals? Up 5-10x also. Those businesses will have been starved for capital for years, only to be caught in a demand shock. Erect new rigs. Build new tankers. Invest in upgraded mining equipment. Get the exploration process going again. These industries can’t turn on a dime, especially after being offline for several years. At that point I can imagine the “flight to quality” premium in Treasuries will evaporate, as the US will be at the epicenter of these inflationary forces. Differentials between the US, EURO and JPY will crash, and the dollar will get smashed. This will, of course, cause the Fed to jam on the brakes of money creation, working feverishly to choke off incipient (but now embedded) inflation. If done poorly (which I’m almost willing to bet on now), it could throw our economy right back into recession. In the mood to re-live the early 1980s? They were not fun times. We’ll be experiencing that sometime around 2013/14, I’d say. And we’ll need several years of purgatory to strip out those gobs of cash that the Fed and the Treasury have and will continue injecting into the system. I figure by 2020 we might be back in some kind of stasis.
In the end, are there some pretty interesting macro trading opportunities out there today? I’d say yes. But please, be very, very careful out there.