Sicko

Two days watching sport in the sun Tuesday and Wednesday finally coddled my brains – my body temperature started yo-yoing – I had chills and fever. And not in a good way. Then yesterday I slept for 16 hours, and I was in such bad shape when I woke up I couldn’t even eat a curry. That got my wife properly worried.

So I only looked at the market two or three times over the last couple of days, and then only briefly. But from everything I’ve seen the first rule of global macro still holds;

If the Fed does not control global liquidity, then global liquidity will control the Fed.

Now when I saw the market reaction to the Fed on Wednesday I was a bit, er, confused. After all, if it was ‘dovish’ then shouldn’t stocks go up while the dollar falls? But when I thought on it, it made sense. Three speeches & comments from Lacker, Poole and Bernanke himself in recent weeks had indicated a strong desire to ‘take back some of the stimulus’ this year. The statement, while not reversing that possibility (inflation was still the bigger threat), also allowed for flexibility if the ‘downside risks to growth’ came through.

That’s genuinely dangerous, in my book. It’s the Fed saying that it will loosen liquidity again if growth falls off. This in a world where 40% of the world’s population is facing double digit inflation, where oil has hit $140/bbl. And right now rates are lower across emerging markets than in 2000, despite the fact that inflation and resource utilisation are higher.

It’s like the 90’s through the looking glass. Back then US growth was strong, and inflation kept undershooting. When the risk of inflation rose, the Fed would hike (’94 is the standout) – which would undermine the emerging economies, and put major downward pressure on resource prices. Now growth is undershooting and inflation overshooting, the Fed is struggling to hike because of weaker growth. And that’s causing oil prices to run higher, weakening growth and ramping up inflation. It’s no use complaining that they can’t control the oil price. Of course they can, they can hike rates sharply. It’s just that the costs – in the face of a weak domestic economy and a banking crisis, would be high. So a dual mandate of growth and inflation is all very well, but at times like these it is staying the Fed’s hand, and setting us up a more insidious end-game.

It’s no wonder that Paul Volker came out of retirement to warn on inflation a couple of months back. If the Fed lets liquidity loose – when most everyone else is loose – most likely, oil keeps going up – boosting inflation and sapping US consumer spending. And the Fed does it again – vicious circle.

So, structurally, I’m still very bearish. The Fed needs to induce a global recession to set up a better outlook. When the dollar gets strong, and oil weak, then I get bullish. Without that, the structural pressure will likely ensure a sustained bear market.

If that’s my big picture call, what do I think is going on right now?
I think we’re seeing forced selling. I think the insurance companies are now bailing out of stocks. I wrote about the problems at the insurers in my piece ‘shrink wrapped’ a few weeks back. They received another deep blow last week as Moody’s delivered a doubled downgrade to MBIA and AMBAC. So the insurers – faced with a sudden jump in the risk value of their portfolios, and a sudden drop in value – are now cutting their risk.

But it’s not easy. Because all the insurance companies want to sell the high yield instruments they own to reduce the discount on their future liabilities. Only problem, everyone wants to sell them. They’re very hard to sell.

That goes double for property. And there’s an interesting dynamic in property. While the boss might have wanted to sell for a while, it is not in the interest of the property fund manager to do it. Because the fund manager is paid on performance relative to benchmark. The chances are they’ll be close to benchmark – maybe ahead - if they do nothing. But if they sell, they have to accept an ugly discount to listed price. Selling creates underperformance. So they’ve dragged their heels selling, leaving the insurance companies even more exposed.

Facing a rapidly rising risk profile, and an unpleasant hike in the present value of their liabilities, my guess is that the insurance companies are now selling what they can. And that means equities, indiscriminately. It was no coincidence that yesterday Xstrata finally broke down below its rising trend.

And once you have big trends broken – the CTAs – the futures trading funds – get stuck in.

Now, my own view is that, when you’re in a trade that’s getting increasingly crowded, you’re risk/reward in that trade deteriorates. And if there are big irrational players in the market acting under duress – like the insurance companies today – then the risk reward gets worse again.

So I’ve quietened down my short positions – and I now stand 50% short, down from 180% short at their max a fortnight or so ago. I’ve taken a chunk of profit on shorts in a number of individual names like Swedbank, Erstebank and Allied Capital. And I’ve taken some profit on my short Indian Nifty and FTSE trades.

On the currency side, my yen long finally moved into the money, so I doubled it. The yen tends to come into its own in the final stages off a sell-off, and so it tends to offer better risk/reward than a vanilla short stocks as an equity sell-off matures.

I stepped out of the way of the speeding train on cable and the euro immediately post fed – which saved a few bob, but I’m looking to build again. And I kept my short kiwi trade intact. Clearly I’ve been too early on the euro trade – but I stand ready to ramp back up at the right time. Overall my stock shorts and my yen long outweighed the loss on my euro and cable positions over the past few days, leaving me 37% up from the mid-February start.