The Bubble Pops In Silver

05/08/2010 - 05/08/2011

The chart above is a chart for ishares Silver Trust compard to the S&P GSCI (Goldman Sachs Commodity Index) for the past year.  The ishares Silver Trust closely follows the movements of silver while the S&P GSCI serves as a benchmark for investment in the commodity markets and as a measure of commodity performance over time.  In this chart, the ishares Silver Trust is the black line and the blue line is the S&P GSCI. As you can see, ishares Silver Trust is still up 90% even after last week’s 70% decline, while the S&P GSCI is still up 20% after declining about 10%.  At this time we believe that commodities, especially Silver have a ways to go before getting back to more reasonable levels.  There will probably be buyers on dips, but I wouldn’t be surprised to see Silver go towards $25 as speculative positions are reduced further.  The next major support level for Silver now comes in around $26, with immediate support being at $34.  Considering Silver led the way down on last week’s commodity sell off, we think that silver is the “canary in the coal mine” for commodity movements and will be keeping our eye on it. Given that QE2 ends next month, we believe that commodities and stocks will sell off and then consolidate in the weeks ahead.

AUD/USD and Copper Breakdown

Febuary 15th,2011 - Present

Back in February 15,2011 when Copper peaked at $4.64, AUD/USD was at parity or 1.0. Between February 15 and May 2nd Copper declined 10% to 4.1 while AUD/USD rallied 10% to 1.10. Since May 02,  Copper has continued to decline by another 5.26% while AUD/USD has declined 3%. Based on these movements and calculations, it means there is still a 13%  spread between these two assets.  So either copper is undervalued by 13% or AUD/USD is overvalued by 13%. Given that commodities took a big hit last week,  we believe that it is AUD that is overvalued and will continue to sell off. A 13% decline for AUD/USD at the current level of 1.0700 means it would have to decline to  about .9400 before the spread was closed. The only major support for AUD/USD comes in at .9700, with short term support at 1.0450.

We will post updates about this as the market progresses in the weeks ahead.

FXIB 2011 First Quarter Review and Market Outlook

Foreign Exchange Market

Since the start of the year, the US dollar has weakened considerably against the other major currencies with the Dollar Index declining from 80.85 to 76.84. The US Dollar performed the worst against the Euro, losing 6.56%.  The US Dollar also lost 4.03% to the British Pound, while losing 1.02% to the Swiss Franc,. The US Dollar  lost 2.14% to the Australian Dollar, and it  lost 3.08% to the Canadian Dollar respectively. The only major currency the US Dollar ended the first quarter stronger against was the Japanese Yen which the USD gained 2.84%.  We believe the primary reason for the US Dollar decline this quarter can be largely attributed to QE2 program which is injecting $3.4 billion excess dollars every business day into the market. In turn, these funds are then seeking out high yield or “risk assets” in foreign countries which drives the US Dollar lower. As of late, some of the most popular risk assets have been in Europe and Australia. We believe on fundamental level  the Euro is severely overvalued considering that Ireland is still experiencing problems with their banking system and certain European countries  interest rates spread (compared to German Bunds) continue to increase.  A report was released last week that showed some Irish Banks require a total of $20 billion more  in capital, which would bring the total amount to about $57 billion. The Irish government is in the process of shoring up its banking system with assistance from the ECB. Over the last month, we have been hearing more hawkish comments from the ECB about inflation and interest rate hikes.  The ECB  tends to pays more attention to headline inflation rather then core inflation.  We feel that this is the wrong time for the ECB to be raising interest rates as it can compound Europe’s problems further due to the problems not being fully resolved at this time. Regardless, the market seems to be enjoying the more hawkish talk from the ECB by driving the Euro higher to a recent high of 1.4247 . We believe that the Euro is setting up a classic “buy the rumor, sell the fact” in regards to a ECB rate hike. There is no guarantee the ECB will hike rates and we believe cooler heads will prevail.   As for the Australian Dollar, recent estimates show that the Australian dollar is overvalued by 30% on a PPP adjusted basis. The rise of the Australian Dollar has been very impressive considering all the bad weather over this quarter from excessive flooding, earthquake to a typhoon. The Australia government and RBA is predicting that the damage from the flooding will cost the economy $9billion and that in all the natural disasters will cut about .5% in GDP growth.  Considering that Australia expanded 0.70 percent in the fourth quarter of 2010 over the previous quarter, we feel a .5% decline in GDP growth could push Australia into a recession. If this was to occur, we believe the RBA would  lower interest rates and consequently weaken the Australian Dollar.  It is interesting to note that the odds of an Australian rate cut now higher than a UK rate hike, with odds of a rate cut around 34% while previous odds were at 5%. Another currency pair that we are closely keeping an eye on is the Swiss Franc. Even though it ended the first quarter virtually unchanged against the USD,  it seems that there is no limit to how far the Swiss Franc can strengthen. During the quarter, the Swiss franc strengthened as much as 4.63% to a new record low of .8907 but ended the quarter at .9188. The SNB has recently been commenting that the “strong Swiss franc and the weak global economy are urging the central bank to continue to stick to its cautious monetary policy”.  We believe the primary driver behind the rise of the Swiss Franc over the past year is that the Swiss Franc is now viewed as a safe haven in a environment of European sovereign debt crisis and a uneven global recovery. The strong Swiss Franc is helping keep inflation under control but is negatively affecting Swiss exporters.  The SNB believes that a strong global recovery and resolving Europe’s sovereign debt problem will make the Franc weaken and we are inclined to agree with them.

Commodities

Commodities saw their third consecutive quarterly gain as geopolitical risks stemming from unrest in North Africa and the Middle East drove energy prices higher. We also saw some unfortunate natural disasters strike the Asia-Pacific region in which commodity production will be reduced. In this process, all of the three major commodity indices outperformed the MSCI World stock index, which returned 4.3% for the quarter. Strongest was the S&P GSCI, with its heavy exposure to the energy sector, returning 11.6% while the DJ UBS, with its broader approach, returned 4.4%. In the middle we find the Reuters Jefferies CRB index coming in at 8% for the quarter. Gold finished slightly higher gaining .98%,  the tenth quarterly rise in a row and  the longest winning streak in more than three decades.  Resistance is currently firm towards 1,450 as investors have been scaling back positions ahead of the possible cessation of quantitative easing in the U.S. and a return to normalized interest rates. This reduces the competitiveness of gold and silver being non interest bearing assets. Cotton, a market with rising demand from Asia and problematic supplies, was the big winner in the commodity arena posting gains of 38% for the first quarter. This is after coming off 2010, a year that saw cotton prices skyrocket by 90%. This  market has rallied by more than 400% since 2008. Grain markets wound up with mixed results for the first quarter: wheat was down 4% while corn was up 10% and soybeans gained 1%.

Looking Ahead at the Second Quarter

Higher commodity prices and a weaker US Dollar is a good recipe for inflation, so we do expect core inflation to increase this quarter. Based on comments from the FOMC members over the last few weeks,  we believe that the US Federal Reserve will end QE2 as planned in June of 2011.  By our estimate Bullard,  Fisher, Plosser, Lacker, and Kotcherlakota  have all advocated that the US Federal  Reserve start looking at an exit strategy, a “preemptive strike on inflation”. Some of the FOMC members have not only called for raising interest rates by end of 2011 but that the Federal Reserve also start draining excess liquidity from the market at the same time. We did get reports last week that the US Federal Reserve was testing its reverse repo liquidity drain facilities. The trouble that the US Federal Reserve now faces is when and how to start exiting from a very accommodating monetary policy without negatively affecting the US economy,  but before the US is saddled severe inflation.  On another positive note,  the US economy  added 429,000 jobs in the first quarter – which will allow the US to have a more sustainable recovery. Once QE2 ends:  we  believe that commodities, stocks and bonds will sell off while the US Dollar rallies.  We do not foresee another Quantitative Easing program unless the US economy takes a turn for the worse.

G-7 Start Coordinated Intervention On The Yen

Yesterday, the G-7 had a conference call and have approved the Bank of Japan (BOJ) to conduct interventions in the Forex Market to weaken the Yen.  The G-7 also said they will intervene to help weaken the Yen to help the BOJ. We believe the BOJ may be drawing its line in the sand in the 80.80/81.00 area. We are receiving reports from other  traders saying one of the big Tokyo City banks was a sizable 80.80 bid on the recent dip. The BOJ is probably out-sourcing some of the intervention to local banks. There is a rumor in the market that Japan has asked the country’s large exporters to deal with the BOJ directly. If that rumor is true, it would be a very good move by the BOJ.  If the order flow were to leave the interbank market, the big banks would essentially be flying blind. They would not be able to use customer orders as natural stop-losses. It would also allow the BOJ to gauge the actual corporate flows from the speculative flows. For the moment, model funds and US custody banks are heavy USD/JPY sellers. Bids are expected toward 81.00; stops are below. Stops have been building below 81.00 from intraday longs. Long-term model funds were heavy USD/JPY sellers this morning. We also got confirmation that the US Federal Reserve intervened in the USD/JPY earlier today when USD/JPY topped out around the 81.75 area. The market  quickly dropped back to the 81.25 area and has now stabilized around 81.00. Nomura estimates European Central Bank (ECB) bought around 5 yards of EUR/JPY overnight.  We are also hearing that the Bank of Canada (BOC) has been selling yen via CAD/JPY. BOC  says the size of yen intervention will be disclosed in monthly foreign reserves report in early April.

The last time the G-7 conducted coordinated intervention in the Forex Market was back in 2000 when the Euro was at .85. It will be interesting to see how successful this coordinated intervention on the Yen will be. It certainly has higher odds of success then it would if the  the BOJ intervened single handily. We just have to look at the Swiss National Bank (SNB) and the Swiss Franc to see how unsuccessful intervention can be if it is not coordinated.

What Does Europe’s Latest Stablity Pact Mean For the Euro?

What is in the agreement:

• Size of bailout fund raised to EUR 500 bln
• EFSF will be able to buy bonds directly from weak states
• There will be cash contributions to the fund rather than only debt guarantees
• Greek loan rates cut by 1%

They will ratify the pact at the summit scheduled in two weeks.

What is NOT in the agreement:

• An extension of bailout terms for Ireland since they refused to raise  their corporate tax rate
• No agreement to buy the ECB’s portfolio of PIG bonds by the EFSF

On Friday we received reports that large US custody banks have been buying the Euro. EUR/USD has also pushed higher in early interbank trade, currently trading around 1.3960 compared with a NY close around 1.3900. We believe that with this new stability pact coupled with the ECB talk about rising interest rates will give Euro bulls more vigor to push the Euro higher.  However with  that being said, based on the latest COT report by the CFTC – open interest on the Euro reached 263,702 contracts which is the largest amount since June 08,2010 when the Euro was at 1.19, at which point the Euro then rallied to 1.3300 a few months later. Based on the COT report, and the new stability pact from the EU we believe that the Euro could rally to 1.4250 before selling off.  The immediate area of resistance comes in around 1.4035,  if that level breaks the next area of resistance does not come in till 1.4250.

Has USD/CHF Formed a Bottom?

Earlier today, USD/CHF broke above .9330 level triggering stops at .9335 which had been capping rallies over the last few weeks.  This bullish momentum should be sustained till the 100 day moving average (light blue line) at .9391.  The 20 day moving average is down at .9293 with further bullish trend support down around .9250. At this time we see more upside potential due to the fact that the Swiss Franc has sold off tremendously over the last few months.  For the past 18 months, we have witnessed some massive flows in USD/CHF where long-term petrodollar accounts in Switzerland have moved out of the USD and into the CHF.  In more recent days what we have been seeing is fresh ‘petrodollar’ money moving immediately out of USD and into EUR in particular.  We have also heard of reports that Middle East accounts are moving out of CHF and into USD. This might be only a very temporary phenomenon or there could be something more to it. The Swiss Franc is sort of the canary in the coal mine and it could send us a powerful signal that the dollar is bottoming for this cycle. We will also be keeping an eye on EUR/CHF since this cross has considerable influence on USD/CHF.  As a word of caution, if the Middle East turmoil picks up it could send safe haven currencies such as the Swiss Franc to new record lows against the USD. We have also been watching the economic data from Switzerland and keeping an eye on comments from the SNB, we believe the SNB will refrain from raising interest rates for awhile due to the current level of the Swiss Franc.

03/08/2011 Click-to-Enlarge

AUD/USD and Copper Correlation

For the past 20 years, the correlation between copper and the Australian Dollar has exceeded 70 percent. Over the past three years, the correlation has been as high as 93 percent. Although copper may not be one of Australia’s top commodity exports, it is still equivalent to more than AUD$5 billion of annual trade. The following chart shows the correlation between the AUD/USD and copper.  As you can see, in October of 2008 the Australian Dollar hit a new low of 0.6006 against the US dollar. Over the preceding years, the Australian Dollar rallied to record high of 1.02542 in December of 2010 and is currently at 1.0136.  This is a 70% rally  and consequently we believe that the Australian dollar is unsustainable at these levels.  At the same time, in December of 2008 Copper hit a all time low of 1.255  and in February of this year put in a new high of 4.6495 and is currently at 4.495. China is one of coppers biggest consumers, so the economic data that comes from China can significantly impact the movements of copper. China will need to start slowing down their economy to avoid overheating which could reduce the amount of copper China imports.  To capitalize on this correlation, I would look for divergences. Say for example  copper rallies, but the Australian Dollar sells off,  you could trade it by going long AUD/USD and/or shorting copper.   It is important to keep in mind that correlations can and do change over time, so what may have worked before may not necessarily work again. It is hard to say whether it is the price of copper that influences the Australian dollar or the Australian dollar that influences copper, all we can say for certain is that these two move in tandem due to Australia’s commodity based economy.

03/06/2011 Click-to-Enlarge