Calm continues but for how long?

All quiet on the western front. But hold on fireworks can be seen on the horizon. This Tuesday September 18 could prove to be the pivotal date. That is the day the Fed meets. What is amazing is there is not been a Fed meeting more anticipated since …. Well we don’t know when. You would think the markets were down 20%, 30% or more thus prompting the Fed to throw reason to the wind and cut rates. Instead as we sit the S&P 500 is only down about 5% from the highs seen in mid July. Hardly a time for panicking and cutting interest rates. Oh sure the jobs numbers recently saw a decline for the first time in four years and retail sales while not a disaster were weak (retail sales up 0.3% vs. the expected up 0.6% while ex auto retail sales fell 0.4% vs. the expected flat). Business inventories were slightly higher at up 0.5% vs. expected up 0.3% but surprisingly the consumer doesn’t feel too stressed yet as the Michigan sentiment indicator came in at 83.8 slightly above the expected 83. Even consumer credit out earlier this past week was only up $7.5 billion below the expected $8 billion and well below the prior months revised upward gain of $11.9 billion. Rounding out numbers was industrial production up 0.2% below the expected gain of 0.4% and Capacity Utilization was 82.2 basically right on target.

So why the big expectation on the Fed this Tuesday? Well simply given the strains that are being caused by the collapse in the sub prime mortgage market, the blow up in the asset backed commercial paper (ABCP) market, the strains in the derivatives and structured finance market the big major firms, the banks and just about anybody associated with the financial industry (hedge funds, pension funds, mutual funds, banks, loan companies, investment dealers) all are desperate for the Fed to cut rates. Some major investment dealers are even brazenly predicting the Fed will cut by 50 b.p. while more cautious ones are calling for the mere 25 b.p. cut.

But hold on. Oil prices hit $80. The Fed keeps babbling on about inflationary concerns. No other central bank is talking about cutting rates indeed all the recent moves by central bankers was to hike rates including our own BofC. China recently hiked rates and tightened reserve requirements trying to cool off their hot stock market. Okay  maybe the Bank of England might be considering it but instead all they did was bail out Northern Rock (NRK-LSE) a large mortgage lender who was in deep doo-doo in Britain. They provided NRK a big loan after they announced a profit warning. Obviously huge political pressure is building to bail out the system. David Dodge, BofC Governor, said it is not likely to succeed and wasn’t sure “whether it would do anything”. It was not the duty of central bankers “to bail out people who have made losses”.

Wise words Mr. Dodge so we can expect that Canadian financial institutions are on their own (take that Coventree (COF-TSX)). But what if it was the Bank of Montreal?  Not that we are suggesting that could happen but Mr. Dodge is right but obviously that is not stopping the Bank of England and it may not stop the Fed from trying to bail out the system because of their own stupidity. That brings us back to the “can’t lose” mentality that has dominated the market and that is what creates bubbles as lenders fall all over themselves to get behind the next “big” thing (tech stocks, housing, mergers and takeovers – whatever). And that sets us up for the creative financing that we found ourselves in as financial innovations (weapons of financial destruction as Warren Buffet called them) grow abundantly and everyone declares the markets are safe and we are all going to get filthy rich. Too bad that statistics keeping telling us that only a few very rich get richer, another large group benefits hugely from all the activity and as for at least 80% of the population. Well their wages have stagnated for the past decade and plants continue to close as $25/hr. Jobs are exchanged for $10-$12/hr jobs assuming you can get a job or not have to work at three to make up one.

Now if only this kind of mania would find its way to the gold stocks and junior exploration stocks ….. Anyway we muse and need to slap our way back to reality.  The reality is that over next year billions of dollars worth of sub prime or adjusted loans or just loans at lower rates are due to jump sharply and what that means is that there is going to be more ongoing disruptions in these markets. The biggest problems are currently in the commercial paper market and these problems are not going away any time soon. We noted that here in Canada there was roughly $35-40 billion of the ABCP paper and in the US there was upwards of $1.2 trillion of this paper in a market of $2 trillion or so. Not let’s be clear here commercial paper is short term notes. Corporations and financial institutions run these huge programs to fund ongoing programs. In the case of financial institutions they are usually taking advantage of yield spreads on a normal yield curve where they have lent long term money at higher rates and they finance it at lower rates in the CP market. In my years as a money market dealer/manager we had these programs in full force at Export Development Corporation (EDC), Canadian Imperial Bank of Commerce (CIBC) and Confederation Treasury Services Ltd. (CTSL) the former treasury arm of the now defunct Confederation Life Insurance Co. (CLIC). (note: it was not the CP program that bankrupted Confed). These programs were usually quite significant and the money market dealing arms of major financial institutions were normally a hub of activity.

We have CP programs here in Canada and Canadian issuers often issued in the US as well and even in Europe (Euro CP). As the manager of the dealing desk we managed all three programs. Cost (often using hedged foreign exchange to bring the paper back to Canadian Dollars), availability and diversification was behind the different programs. As part of these programs you had to get your paper rated by the major rating agencies DBRS here in Canada, S&P and others in the US. Key was to obtain the best ratings as that meant you normally had the widest distribution possible. And for the ratings we paid the rating agencies. We issued our paper through brokers (investment dealers) and it was a daily chore to roll over maturities, raise new funds (we had to always determine fund need and know when funds were needed). The highest ratings DBRS- R1 high and S&P A1 meant your paper got wide distribution to pension funds, mutual funds, and a myriad of others who were buyers of paper to earn the yield. Even corporations and sometimes even ourselves were buyers of commercial paper when we had excess cash to go or the corporations had excess cash to park awaiting plants or other investments. No wonder then that the CP market is so important and that market is one of the largest most diversified of the over the counter markets in the world. As an issuer ourselves our programs were often a billion dollars or more and someone like GMAC for example would have a CP program in the multiples of billions.

So for a big chunk of this market to just seize up is major. But that is exactly where it stands right now. It seized up. Officially no one has lost money –yet. But issuers suddenly can’t roll over their paper if it was backing sub prime loans or other structured finance deals (see Coventree) while buyers of the paper are suddenly stuck with paper they can’t redeem. It is estimated that probably at least half the paper is now worthless. Oh games are being played to cover the debacle up but everyone involved – dealers, banks, pension funds, money market mutual funds, rating agencies and of course many more, are now all running around like chickens with their heads cut off trying to find a way out of this mess. Your short term paper is now long term – oh how long a year, 5 years, 10 years, forever or maybe the central bank will bail us all out. Ergo why every one is now looking for the central banks to bail everyone out of this mess just like the Bank of England appears to be bailing out Northern Rock. It is widespread – Canada, the US, Europe, Asia even China had paper they now regret. And therein lies the problem it is so widespread. It is not nice and contained like it was with Long Term Capital Management (LTCM) in 1998. It is not just a one big day hiccup like October 19, 1987 it is widespread and all solutions lead to – bankruptcy. Which of course is what everyone is trying to avoid because it is not just one it is many and the Fed, the BofC, the Bank of England can’t bail everyone out. So who? How many? The Bank of England bails out Northern Rock (even as it credit default swaps spreads soared – wouldn’t want to be on the wrong side of that one) and therein lies the other problem is that it is not just the CP it is the derivatives attached to all these programs.

As a dealer/manager at CIBC and CTSL we managed huge derivative portfolios as well. These programs were different but to us it was one big pool – CP, loans, securities, swaps, foreign exchange, futures, future rate agreements, options, repos and much more. Cash was cash of course but in terms of managing interest rate risk and position risk or just seeing opportunities whether it was a cash instrument or a derivative it didn’t matter what it was. And as the pool of derivative products grew we just entered the market to make a buck on these new products because in the early days there was often nice arbitrage spreads to make. We managed institutional portfolios but the reality was the market was one big gambling casino full of different games for the clever and knowledgeable dealer to play. Hence the huge growth in hedge funds in the 1990’s as the dealers that learned the trade at the big financial institutions in the 1980’s  leaped to run their own funds playing the same games and quite often having the bank or dealer they just left be a major client. As the market grew in sophistication and spread elsewhere to the stock market, then the securitized asset market the dealers everywhere made hordes of money and the money managers ruled.

So is the game over? Of course not. But we are certainly going to hit a very rough bump and we don’t know where it is going to take us at this time because we don’t know the extent of the capability of the Fed to bail this out and of course should they and more reasonably leave it to the market to sort itself out even if won’t be pretty. Maybe it will all blow over then again maybe not until there has been considerable pain and as we know numerous mortgage companies in the US have already blown up and thousands of people have already been let go. With the massive growth of debt in the past 35 plus years plus the even more massive growth of derivatives since the early 1980’s the day of reckoning is coming upon us. Ergo why all these dealers and others are so anxious to have the Fed cut rates next week. It will be a signal for them the Fed may be willing to help bail them all out from their own arrogance. And the Fed might bite as they know well that it will eventually flow through into the broader economy in the form of more bankruptcies and rising unemployment.

So how will this impact other markets. Well the US Dollar Index has been falling and today is just hovering above its all time lows at 78.50 seen in 1992. Against the Euro the US Dollar has already hit record lows. Here in Canada we are barely 3 cents from parity and numerous business will now only accept US$ at par. We might even see the Cdn$ worth more than the US$ going forward. But against the US$ as it falls gold rises. We sit just below the highs seen last May 2006 and in terms of the Euro, the Yen and the Cdn$ we are below the highs as well seen a year ago. So is gold holding back or is gold just concerned that it may get itself slammed again as the Fed and other central banks manipulate things? One of our concerns for gold going into the Fed next week, is that the Fed does not do anything on the rate front. Short term that could cause the US$ to rally and gold to fall swiftly. We can’t help but note that even as gold broke out of its multi month barrier at $690-$700 the Gold Bugs Index (HUI) – i.e. the stocks, silver and platinum remain below their recent highs. As well gold remains below the highs of last May. So these are divergences that may mean nothing but continues to give caution for us on this recent gold rally. If we are long term right we won’t lose too much sleep missing some of the move. But if there is another set back coming we would view it as another buying opportunity and given the long correction since last May 2006 a major bottom is due on gold. If we continue to go forward and when everyone confirms each other we will still have lots of time to get on board for a longer move. Traders can play this but use stops and investors should always have a position.

Gold does have resistance up here at $730 while silver remains below $13 resistance. The HUI is struggling at 370 and even today it failed that level again and even as gold was higher on the day the HUI dipped back into negative territory. The US Dollar Index at 79.50 is above those 1992 lows and again if the Fed did not cut on Tuesday it will rally. The area in here is also a big one for the central banks to defend against a falling US$. If we do break through to the downside then we will be headed to 70-72 and gold will soar to $850-$900 at least initially. The US$ does not become a major concern on the upside unless we broke out above 81/82.

We read a story on the gold carry trade recently the first one we have seen in a while. Thought this was old news? Anyway it outlined once again how the central banks in the 1990’s lent their gold out at 1% while the bullion banks sold the gold to others and invested the proceeds at spreads up to 3-4% and earned the differential. To hedge their position they bought gold futures. Of course as long as things remain stable then the trade works and as long as central banks don’t go and do something stupid like actually ask for their gold back then times are good. But if things become destabilized or the central banks ask for their gold back then their could be a big problem as the bullion banks scramble to buy gold. Probably won’t happen but then who knows. It is estimated that there is upwards of 16,000 tonnes of central bank gold (half the worlds central bank gold reserves) sold over the years in this manner making it one huge short position and went a long way in the 1990’s to holding down gold prices. But gold has now been steadily rising for years and no major crisis has broken out. But that is not say one can’t. Even official estimates pin point the short gold position at a least 5000 tonnes so there is an acknowledgement out there that there is a large short gold position.

Gold as we have noted has been trading in a huge symmetrical triangle for the past 15 months since the May 2006 top. This puts a different spin on those who claim gold has been in a bubble. Usually bubbles spike then collapse they don’t consolidate for 15 months. We see somewhat similar patterns on many metals and even the CRB Index. So we wonder where these guys are on the bubble in metal prices. Gold appears to have broken out of this consolidation triangle but others (silver, the HUI) remain in the triangle but are close. We need these to confirm gold and until we do we remain somewhat cautious but we firmly remain bullish for the longer term.

Oil prices have soared to new all time highs hitting over $80 on the weak supply numbers (crude oil supplies fell 7.1 million barrels on the week and are down 5.1 million barrels from a year ago, gasoline supplies were down 0.7 million barrels and distillates were up 1.8 million barrels). All this happened despite the Saudis announcing a hike in production of 500 thousand barrels daily. Technically that too appears as a break out on the charts. But once again we want others to confirm. The TSX Energy Index, the XOI Index and Natural Gas of course remain below their highs. Not that we need NG making new highs but of course it would help. We did have targets of $79/$80 on oil prices and we are now at these levels. If we break through $80 and close over that level for a few days we will target $88 as the next major level. $74/$75 will provide key support. Only below $70 would we say that we are entering a new down phase. We are at the top of a channel that has been in place since the lows of early 2007 near $50 so a pull back would be normal. NG prices have jumped on the week to over $6 (good news) but it is on the back of hurricanes in the Gulf of Mexico. So if the hurricane threat abates we could see this settle back again.

We remain energy bulls and we remain convinced that war will eventually occur with Iran and that will cause oil prices in particular to soar past $100. Noise on that front continues in the background but that is where it remains – in the background where most people ignore it or don’t even know it exists.

So the real focus will be on the Fed on this Tuesday. It surely will be a highly anticipated day. This is the key day where the market hopes (prays) that the Fed lowers rates. There are even some indications that has already happened as over the past month the Fed Funds rate has fallen to the 4.95% to 5% range a full quarter point below the current Fed rate of 5.25%. Surely the US Dollar sees this and it is one reason it has been falling and of course gold rising. Everywhere there are signs of stress in the market as Countrywide continues to try to save itself (has borrowed some $25 billion in the past month – they find lenders to this sinking ship?). A large Goldman Sachs quant hedge fund announced 22.5% losses in August. Ouch!

We could go on of course but clearly there are losses out there but they are desperately trying to contain this. Trouble is the markets for a lot of this are not transparent at all. And that will be the next big fight to make the markets more transparent. Ought to be interesting as the hedge funds and many players do not want that kind of scrutiny. At least the stock market is transparent (to some extent) as we can at least see those prices recorded but in many markets of structured finance, derivatives there is little or no transparency. And the rating agencies must be bracing for the inevitable law suits.

No bank has closed its doors yet (they did in the famous 1907 banking panic and of course they did that again in the 1930’s) and many of course expect that won’t happen this time. We live in more sophisticated times. Or at least we believe we do. But in a  real panic there is no guarantee that a bank doesn’t just close its doors shutting out thousands of investors (depositors). And then of course the government insured paper would all kick in. But what if the government couldn’t do it either as remember ultimately it comes from the taxpayer or they have to get out the printing presses. 

Technically the S&P 500 continues to see resistance around 1480 and up to 1500. Only above 1505/1510 would we need to adjust and suggest we could make an attempt once again on the highs above 1550. Long term interest rates are up from last week last for the 10 year bond at 4.48% up from 4.39% last Friday. There was some flow into the Fed this week from foreign institutions for the second week in a row. But it was small only $1.1 billion leaving us still with a huge $38 billion plus draw since August. The breakdown level on the S&P is at 1450 and we get more concerned for new lows below 1425. The past couple weeks still appears to us as a consolidation within the context of a drop that got underway in mid July. Some of course construe this as a bottoming pattern and we won’t argue against them but instead go with the flow whichever way we break. There is nothing magic breaking higher but it would tell us that the collapse is delayed not that it won’t happen. There are just too many problems out there all behind the scenes and everyone attempting to sweep them under the rug. And of course they need the Fed to help bail them out. And come Tuesday afternoon we will know how far the Fed is willing to go.

It may be calm again but it could also be the eye of the hurricane.

D.C.