Risk trade under pressure

Today the risk trade continues to be under attack with the US dollar strengthening against other more emerging economies. As I have pointed out a few times in the past couple of months, the over-exuberance in emerging markets, commodities and their currencies, has been primarily speculation against the US dollar and not in response to increasing global demand or economic expansion. These sentiment driven speculations can be wild and reckless; capital protective strategies are needed.
A few key themes are slowly seeping into the collective consciousness at this point:
1. A flood of bonds for sale has driven existing bonds prices down and bond yields up over the past few weeks. This is pushing up rates across the curve.
2. Mortgage rates have followed suit and ballooned out. The Freddie Mac measure of U.S. 30-year mortgage rates shows that there has been a sharp 77 basis point increase in rates over the past three weeks, reaching a level of 5.59%. Other measures suggest an even larger increase. This is the highest level since November of last year.
3. Rate pressures have been equivalent to a 133bps rate hike by the Fed in the US and a 20bps rate hike by the BOC in Canada. The gap between the fed funds rate and the 30-year mortgage rate is now huge, with the release of the June data it will rise back towards record-high territory of around 5.39%. As recently as May 2007 it was less than 1.00%. So while fed fund rates are at record lows of just 0.00-0.25%, mortgage rates have managed to very significantly decouple from the central bank’s actions. This has effectively removed a significant portion of the stimulus efforts for recovery that the governments have been working to implement.
4. Although rates still may seem relatively low on a historic basis, it is the absolute increase in rates that has the hardest impact on over-levered companies and people. A loan rate of 5.6% may sound low, but not if you were levered to the max when rates spreads were 1%. It amounts to more than a 500% increase in carrying costs.
5. The next wave of mortgage resets and delinquent commercial loans are about to take another swipe at corporate earnings both for banks and most other companies. It’s very hard for any sector to escape the depth and breadth of this broad recession.
6. Responding to the falling US dollar, oil prices have risen more than 100% over the past several months, levying another substantial drag on the struggling economy.
7. Tax hikes will be needed to help support fiscal spending which has already been announced.
8. As the US dollar has weakened, export nations (like Canada and others) have been hit with another impediment to selling our goods—they are more expensive just when we desperately need them to be affordable.
9. Although there has been evidence of some inventory re-stocking over the past 3 months, we have so far not seen a confirmation in the transport sector. In other words, there has been a pick up in some orders but there has been no evidence of a pick up in shipments to end users. This is the reason that Dow Theory holds you need to see new highs in both the industrials and the transports to confirm an expansionary cycle. Re-stocking of inventories is not enough to signal a pick up in demand unless goods are also being shipped out. So far shipping, transports and rail are all pretty much at a standstill.
10. The airline industry has said that it is seeing twice the decline in world air travel this downturn as it did after 9/11. (read this sentence again-it is remarkable)
The net effect of these factors is likely to be a continued economic malaise and much slower economic recovery in 2010 than world stock markets have recently been pricing.
Gold meanwhile has broken down once again. Unless and until gold can make a run through $1000, inflation is not likely to be in the picture and rates are likely to stay at the lower end of the historic range. The longer-term effect of the stimulus spending may one day be inflation, but in the short and medium term, over the next couple of years, deflation and disinflation are likely to be still at the fore.
The stock and commodity markets seem ripe for a reality check in the weeks ahead. Price risk measures high once again.