| MacroMarketMonitor November 2009 |
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| Written by Matt Blackman | |
| Sunday, 15 November 2009 | |
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Macro Market Monitor November 2009 Buffett’s Desert-Island Indicator Update Rail traffic – Resurging product demand? Baltic Dry Index on the move… One “mother” of a trade Carry trade elephant in the room? Chart updates Late breaking news and updates Want more? Daily commentaries here… Last month we took a look at the indicator Warren Buffett would use if he could only pick one. This month we take a look at slightly different perspective with monthly data from the Association of American Railroads (AAR). In their latest monthly report, the AAR reported that October overall rail traffic was down 15.3% from October 2008 and down 18.1% from October 2007. As the next chart shows, after four consecutive months of improvements, October traffic fell on a year-over-year basis from -14.2% in September although October traffic (324,836 carloads) was slightly better month-over-month versus 321,704 carloads in September.
Figure 1 – Total railcar traffic for 2006 through 2009. Source aar.org Average weekly traffic was also down from September which is the second monthly decline. Intermodal (trailers on rail cars) traffic, which is a good measure of manufacturing/retail demand, was down 11.2% y-o-y in October but up 4% from the September weekly average. This is an important indicator showing that retailers are stocking their shelves for the upcoming holiday season. So far in 2009, seven of the eighth highest-volume intermodal weeks were in September and October – a positive sign. The highest-volume week so far this year occurred in week 40, the first week in October. Rail traffic – Resurging product demand? This next chart shows this trend more clearly. With a nearly perfect inverse correlation between the manufacturing inventory to sales ratio and U.S. rail traffic, it shows real demand and a drop in inventory levels. And as long as rail carloads increase, it bodes well for the current fragile economic recovery. Could this be one big reason why Buffett recently made his biggest purchase ever when he spent a reported $34 billion for Burlington Northern, the nation’s second largest railroad? It is certainly no coincidence! This data is also in conflict with the latest consumer credit data that showed its eighth monthly decline in October. This has two possible meanings – either consumer demand is not the main reason for inventory reduction or if consumers are part of this trend, they aren’t burrowing as much to go to the mall. Given the drop in real incomes, the first possibility appears most likely but we will get more clarification with the release of early holiday shopping data.  Figure 2 – Source aar.org BDI on the move… Increasing transport demand is also being shown in the rise of the Baltic Dry Index that tracks shipping rates for dry goods transported by sea and since it is not traded on an exchange is less subject to speculation and manipulation. It is therefore a good indicator of real demand for goods and commodities used in manufacturing a wide variety of products around the world, as well as an economic bellwether. Although the BDI is up 520% from its lows in December 2008 but was up just 0.52% November 13 from a year earlier… so demand has been somewhat choppy. But as the dashed trendline shows, it is still up.
Figure 3 – Daily Baltic Dry Index changes showing the rise from the lows in early October to November 13, 2009. As the right-hand trendline shows, the trend has so far remained positive. Rising transport demand is bullish for both commodities and stocks (see Figure 4 in our October MMM). One “mother” of a trade From its humble beginnings in 1982, the biggest stock rally in history saw impressive increases in stock prices and our ‘apparent’ standard of living (more about that later). Everyone has his or her theory about why markets did so well for eighteen years. Their reasons include everything from technology gains and the rise of the computer and later the Internet, to an increase in good old American productivity and ingenuity.  Figure 4 – Monthly chart of 30-year Treasury bond yields (TYX) and the US Dollar Index (DX). Yields hit a low just under 2% in 2009 and have since recovered to just above 4%. The dollar is now worth a little more than half of what it was in 1985 in nominal (dollar) terms. Chart Metastock.com These were no doubt important factors but the next graph shows something of which few may be aware. Since 1982 when the 30-year Treasury bond yield peaked at 15.3%, interest rates have been slowly but steadily falling, thanks in large part the post high-interest rate policies of Paul Volker that were responsible for finally getting 1970s style inflation under control. And Chairman Greenspan was not wholly responsible for the decline – he took over the reins of the Federal Reserve in 1987 just before the October 22% stock market melt. Rates had fallen significantly before he took over and continued to fall after his exit. But as the above chart clearly shows, lowering interest rates (quantitative easing) has been a big part of Fed policy for keeping politicians and voters happy. If this was a major goal, it has worked. But it has come at a cost. As we see from the next chart, the years from 1970 through 1982 had their ups and downs. Inflation and stagflation ravaged our economy, followed by crushing high interest rates that were necessary to rid the excesses from poor economic policies during the Johnson through Nixon then Carter years. But by 1982, real incomes had increased dramatically. One thing that stands out in comparing Figures 4 and 5 – falling interest rates have coincided with falling real incomes. Yes, lower rates allowed us to borrow like never before but this easy money had its price.  Figure 5 – The double whammy of falling incomes and falling average hours worked has meant that we are now making less than we did in real terms than in 1982. So what has this to do with markets and trading portfolios? First, it is a reality of which all traders should be aware. Their real returns aren’t always commensurate with what their trading accounts say. As this next chart (Figure 6) shows us, it all comes down to what’s left after the inflationary tax and that is not declining contrary to what the official Consumer Price Index or Personal Consumption Expenditures data would have us believe. The inflationary impact on the dollar has been very similar with the impact on stocks as Figure 7 shows.
Figure 6 – Value of the dollar priced in gold. Since peaking in early 2001, the dollar has lost 85% in real terms and there appears to be no end in sight. Chart by GenesisFt.com  Figure 7 – Since its peak in mid-1999, the Dow Jones Industrial Average priced in gold has lost a similar amount and was down 84% before stocks rebounded in March 2009. Chart by GenesisFt.com And now that the Fed funds overnight rate is effectively zero, the Fed must resort to other methods to give consumer (voters) that ‘wealthy’ feeling. The problem is that like interest rates, the last resort of printing money has an even more negative impact on the dollar. It has also re-energized the carry trade and this time the Japanese yen is not the principle victim. Carry trade elephant in the room? The point of the above four charts is to demonstrate the real cost of quantitative easing. Now that interest rates have fallen to zero, the stage is set for Act IV in The Dollar Tragedy. Like the case with the yen, global investors now have the ability to borrow US dollars at next to nothing and buy assets that have a better potential to appreciate – assets like high-yield foreign bonds, commodities or anything else that is a storehouse of value. In a recent Financial Times article entitled Mother of all carry trades faces an inevitable bust, economist Nouriel Roubini outlined his concerns for what is behind the nearly 60% stock rally (not to mention the rallies in commodities, precious metals, real estate and emerging markets) currently underway.  Figure 8 – Weekly chart of the New Zealand dollar – USD showing that although the NZD-USD broke its trendline support recently, it is showing signs of recovery. Chart by GenesisFt.com “Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualized – as the fall in the US dollar leads to massive capital gains on short dollar positions.” So where does “Dr. Doom” think will occur when this bubble ultimately breaks? “This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.” So these rallies could continue for weeks, months, or longer – as long as interest rates remain contained and investors around the globe are willing to accept the risk of buying US dollar-denominated assets in spite of a real decline in value. However, if something alerts them to the real risk, like has occurred in smaller economies like Iceland and Latvia, they could quickly demand higher returns pushing interest rates significantly higher. This would rapidly take the premium out of the USD carry trade as beneficiary currencies (like the New Zealand and Australian dollars) declined amid a strengthening in the greenback and cause dollar short positions to unwind with a vengeance as traders race to cover. As in life, there are no carry-trade free lunches! At some point the interest-rate Genie that has helped turbo charge markets and our standard of living over the last few decades, must have his due. Traders who are short the USD and US interest rates (and that includes those who are long commodity currencies like the Australian dollar and New Zealand dollar as well as commodities and emerging markets) can protect themselves with a USD long hedge like USD calls or call LEAPs for longer-term positions. Chart updates
Figure 9 - Chart by GenesisFt.com On the topic of carry trades, one very important one has been the New Zealand dollar – Japanese yen. As a result it has become a good leading indicator of stock market movements as it has been used to fund stock investments. As Figure 9 shows, the trade is still on. Next we look at the four major markets we are following and how they have moved since our last MMM. Since August, US stocks (SPX) have outperformed the other three indexes but as we saw above, much of that upside has been due to the falling dollar.  Figure 10 - Chart by GenesisFt.com Late breaking news and updates After publication, we received some very interesting Los Angeles port traffic data courtesy of Calculated Risk. According to the site, port traffic provides both an early hint of changes in the trade deficit as well as provide insight into the volume of goods being imported and exported. This, along with the AAR railcar data and Baltic Dry Index provides valuable information on underlying economic demand. The good news is that although LA port inbound (import) traffic was 14.7% below October 2008, outbound (export) traffic was 1% above October 2008. There is a clear recovery in exports but they have been flat since May. However, import traffic is below what it was in October 2003 and 2009 will be the weakest for imports since 2002. According to Calculated Risk, the lack of further export growth to Asia is discouraging. Stay tuned for more data...
Daily Updates If you’re interested in more timely updates and articles, you can follow me on at http://www.twitter.com/matt__blackman (double underscore between first and last name). You don’t have to join twitter, simply click on that link to see what I’m tracking.
If you already use Twitter, forget the bad media diatribe about how it’s a waste of time for those who have nothing better to do than post daily banalities. From a market perspective, it’s a great way of staying informed by following those who have useful things to say without having to continually check to a bunch of web pages. All that work is done for you! I use a free program called TweetDeck (http://www.tweetdeck.com/beta/download/), that makes the job even easier.
Related Reading: Buffett’s Berkshire buying Burlington Northern http://www.latimes.com/business/la-fi-berkshire4-2009nov04,0,6604215.story Housing starts and the unemployment rate http://www.calculatedriskblog.com/2009/11/housing-starts-and-unemployment-rate.html Mother of all carry trades faces inevitable bust - Roubini http://www.ft.com/cms/s/0/9a5b3216-c70b-11de-bb6f-00144feab49a.html?nclick_check=1 The Power of Zero – Don Coxe http://www.scribd.com/doc/22536643/BMO-CM-Basic-Points-Nov-2009 Zimbabwe: A Fresh Start http://www.kitco.com/ind/Field/nov112009.html Fed’ Zero-Rate Policy May Cause Next Crisis – Bloomberg http://www.bloomberg.com/apps/news?pid=20601068&sid=aU3AiTc_Q_vk
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