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Precipitous Drop Off in Demand for Money May Signal Repricing of Risk Assets

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Connecting the dots between the decline in the need to hedge to a decline in the demand for credit, and looking at early harbingers of the oil and scrap industries.

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MINYANVILLE ORIGINAL Last week Bloomberg reported its hedge fund index returns for the month of September, and Long Biased Equity HFs were the clear winners by multiple percentage points, posting an incredible 5% gain for the month. Despite this remarkable performance Long Biased HFs are still down 1% YTD, dramatically underperforming the S&P 500 (INDEXSP:.INX) which closed out last month +14.5% on the year.

I have been suspecting that the post Labor Day trade would be a performance grab by underexposed managers and that appears to be exactly what is happening. Back on August 13 in The VIX According to a 20-Year-Old 'Seinfeld' Episode I suggested investors were positioned for a repeat of August 2011, and if the rally held, the pressure would be on to get long:

But after two weeks into August risk assets haven't crashed and now the market is at the post crisis highs, looking like it wants to break out despite decelerating economic and earnings growth. Investors are hearing it from both Costanza and Kramer and the uncertainty with whether they will get suckered yet again gets more intense the longer the market rally lasts. It is a dangerous time for all investors, retail and professional alike, but if this market remains bid into the Labor Day weekend, there will be tremendous pressure to get exposed to risk into year end.

With a 5% gain on the month while remaining down on the year it's pretty clear to me that this performance grab has been largely responsible for the push to new highs. No doubt the underexposed speculative community has been pushing prices higher as they cover and get long. Also the consensus belief that QE3 will see a risk-on rally is an obvious display of confirmation bias and points to the fact that the market is long.

Friday the S&P closed out one of the worst weeks since the June lows, down 2.2%, with the equity market losing much of the momentum that has been behind the recent rally as further evidence the market was full coming into the week. There might be one last push into year end, but I believe we are in the late innings of this leg of the rally.

Everyone knows the known risks. BlackRock's (NYSE:BLK) Bob Doll writing in Bloomberg's Economics Brief Friday lays out the long list of concerns, but despite these risks, he argues that equities are still a buy because they are attractive compared to the alternatives:

Headlines through much of 2012 have been dominated by risks ranging from the fragile nature of Europe's financial system, to fears of a slowdown in China, sluggish growth in the US and the looming 'fiscal cliff.' Meanwhile US stocks have gained close to 20% this year and some other markets have seen even stronger gains. Why the disparity? And, more importantly, is the bull market nearing an end? While the risks are certainly evident, and markets may be overdue for a consolidation or corrective action, the bull market should continue and we expect stocks to outperform Treasuries and cash over the next year.

This short squeeze that has stock prices near the highs of the year is providing investors with a false sense of security, masking risks that are lurking under the surface. As an analyst, my job is not to guess about market risks that everyone already knows are the most systemically important, but rather to try to identify rising tail risks which are not yet in the general perception. It's an equation. I take various indicators that could be saying different things and try to align them to see if there is a common theme.

Friday there were two headlines that caught my eye regarding two events that had not happened in the last 20 years: the US 2YR swap spread hit 10.5bps, and the Chinese yuan traded through 6.28 per dollar. At first glance you would not assume the two are related, but I believe they could both be indicative of an important underlying trend.

Swap spreads have been falling since the Fed's commitment to keep a lid on short term interest rates and the general presumption is that it is due to the lack of demand for hedging rising interest rates. A Bloomberg story citing UBS strategists who were recommending 2YR wideners stated, spread tightened.. amid decline in short-term funding needs, "diminished tail risk"; stop-outs in spread widening trades exacerbated 2-yr tightening.

It's the decline in funding needs that I view as the most important reason for the fall in swap spreads. Another short-term interest rate that has been falling is the floating-rate loan benchmark 90 day LIBOR which on Friday hit 33bps, the lowest level relative to Fed Funds for the year at 8bps. Due to the volatility during the financial crisis, many assume the LIBOR spread is a function of risk in the banking system but really it is indicative of the demand for credit. When the demand for credit is strong LIBOR widens and when the demand for credit is weak LIBOR narrows.

In the 90 day LIBOR futures market, which is the eurodollar pit at the CME, the commitment of traders shows commercial hedgers (which are large money center banks) have gone from net long $1 trillion notional at the end of last year to currently being net short $1 trillion. From a historical perspective that is a huge swing. When you are long a Eurodollar contract you are hedging against falling rates and when short you are hedging against rising rates. Therefore the net position of commercial hedgers is indicative of the composition of the banking system's aggregate balance sheet.

Banks hedge assets from falling interest rates and liabilities from rising rates. The fact that hedgers have seen such a big swing in their net indicates there has been a collapse in the need to hedge credit assets on their balance sheets.

The 2YR swap spread and net position of commercial hedgers in eurodollar futures are highly correlated, both peaking in December 2011, bouncing together into the spring of this year and now making new lows in September. You could argue they are saying the same thing. There is no need to hedge against rising short term interest rates with the Fed committed to holding the Fed Funds rate down until 2015 however that doesn't explain why the LIBOR spread is also falling to near zero. When pitted against that the decline in the need to hedge looks more like a decline in the demand for credit.

This decline in credit may have been confirmed by the Fed on Friday in its H.8 release which showed September C&I loan growth of 1.3% to be the lowest monthly annualized rate since the rate was negative coming out of the recession. The previous three months saw growth of 8.8%, 14.6%, and 17.7% respectively so the 1.3% growth rate looks like a steep drop in lending confirming what falling LIBOR swap spreads and Eurodollar positions are indicating.

Last week in A Global Macro Paradigm Shift I suggested that the decline in global FX reserves was indicative of falling Chinese reserve accumulation, and that could be flashing warning signals.

China FX reserve accumulation is a large source of global demand for both financial assets and commodities. The US exports the reserve currency and China imports US dollar denominated assets. History has shown that when FX reserves decline on a YOY basis, as they appear to be doing now, it has the potential to manifest itself into a financial market disruption.

It's possible the yuan is rallying because there are fewer dollars being exported to China with which to convert to yuan to maintain the peg. Last week I also noted that declining FX reserve accumulation might explain some of this weakness in copper and the cyclical semiconductor space.

Two of the most cyclically sensitive market indicators are the price of copper (HG) and the Semiconductor Index (INDEXNASDAQ:SOX) both of which are highly correlated with each other and can be seen as a proxy for Chinese economic activity. Copper and the SOX both peaked in Q1 2011 and have made lower highs while US stocks (S&P 500) have made higher highs. This is notable divergence and should not be ignored.

This is no doubt showing up in the performance of copper and other metals such as the highly cycle price of scrap. Friday Bloomberg Businessweek reported that copper prices saw one of their biggest weekly drops of the year.

Copper fell, capping the biggest weekly drop in three months, as signs of slowing scrap-metal purchases and bank lending in China fueled concern that demand will weaken as the global economy sputters.

Scrap discounts to new metal widened 25% in the past three months as demand slumped in China, the world's biggest user, according to Metalsco Inc., a St. Louis-based recycler. In China, banks extended 623.2 billion yuan ($99.5 billion) of loans last month, below the 700 billion yuan median estimate of analysts in a Bloomberg survey.

It's amazing what you can learn by bellying up for a couple hours after work at the local watering hole. Friday I was enjoying a couple of pints and separately encountered two good friends who are both successful businessmen operating in cyclically significant businesses. The first is a former Wall Street investment banker who now works for a conglomerate primarily focused on the auto industry with domestic operations as well as operations in Latin America and Asia. The second runs a large family-owned multifaceted steel business operating in erection, fabrication, and mechanical installation. I had expressed to both of them that monetary aggregates that I follow were showing a big drop off in the demand for money. I didn't need to tell these guys; they are both on the front line.

My friend in the auto business asked if I had read about how China was now going to begin trading oil in yuan. He said the story had gone unnoticed but that it represented a significant shift in the role of the US dollar in global trade. I had responded that the yuan was making new highs vs. the USD and I had wondered whether it was indicative of fewer dollars being exported to China. However he raised a valid point. If China was going to purchase oil in yuan there would be less demand for dollars. Could this be behind the drop off in FX reserve accumulation?

As I often do, I asked my friend in the steel business about the price of iron ore. He responded that the price of scrap -- the most sensitive to global demand -- was collapsing, which I later confirmed in the aforementioned Bloomberg Businessweek article. He was no doubt on top of the price implications and seemed to prudently operate accordingly.

Was it something cyclical like the fiscal cliff or election that would soon pass, or something secular more akin to a paradigm shift that I had discussed last week? I can't be sure. We have a lot of indicators that, on their own, could be saying something different, but added together could be saying the same thing.

The consensus trade is to get long the QE asset reflation correlation, however what I am seeing is just the opposite. That big sucking sound you hear might be a precipitous drop off in the demand for money. When that happens, the price of risk assets are soon to follow.

Twitter: @exantefactor
No positions in stocks mentioned.
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