Thusday March 15, 2007

I was asked today how a falling stock market can have such an impact on the grain markets.  So what if the sub-prime mortgage market is seeing rising defaults on its mortgages.  It can be difficult to see the connection.  So let me make an attempt at explaining, using two examples of different events that are occurring at the same time.

One of the primary way hedge funds make money is by trying to exploit the interest rate spreads between various countries.  For instance, in the Yen carry trade, as it is called, a hedge fund may be looking to invest $100 million dollars.  One strategy they could implement is to put the money in short term U.S. Treasury bonds earning 5.50%.  They would then go to a Japanese bank and borrow $100 million in Yen at ½% and pledge as collateral the U.S. bonds. 

With the $100 million worth of Yen, they would convert that to another currency like the New Zealand Dollar and invest in their bonds getting a rate of 6-7%.  They are now getting a total return of 5.50% on the $100 million from the original investment that is used as the collateral, and 6.50% from the $100 million New Zealand Dollar bonds it owns.  Total return is 12.00% on $100 million dollars less the ½% borrowing costs. 

As long as the New Zealand Dollar remains strong, and the Yen remains stable to weak, this trade works well.  However, these trades are risky because usually one side of the deal is very liquid and the other side isn't.  During periods of calm, liquidity is not a problem.  However, should there become a need to suddenly liquidate large quantities of the spread all at once, then the illiquid side can get overwhelmed and panic can trigger sharp declines in the value of that bond as well as the currency.

So what triggers the panic?  In this case, it started in China.  When Chinese government officials said they were going to tighten credit for stock investment borrowing, it caused a massive sell off (8% in one day).  When traders get scared they move there money to a temporary safe haven, one that is liquid, can absorb large influxes of cash, and is considered very safe.  Two such parking places are the U.S. and Japanese treasury markets. 

So when all this money is moved out of Chinese stocks, into cash, and moved to a safe haven, it must be converted to the safe-haven countries currency and then to short term instruments.  In this case, the Yen suddenly saw large quantities of buying and the currency started to rally.  This threatens the overall yield of the portfolio.

Fearful that a rally of 10-15% in the Yen could cause losses to the portfolio causes the hedge fund to try and dump the New Zealand Dollar bonds and convert back to Yen.  This is where the slaughter takes place.  The sudden demand to sell these illiquid bonds causes their values to plunge; sometimes by as much as 25-50%.  In this example let's say it's only 25%.  Now you only have $75 million to pay back your $100 million, Yen denominated loan.  However, if the Yen is up 10%, then the amount of Yen you can buy is only worth $67.5 million.  The bank now seizes $32.5 million of your $100 milli on collateral, and the hedge fund is left with a 32.5% loss for their investors.  (I used New Zealand as an example and don't want to imply that this actually happened to them). 

There are all kinds of these time bombs out there.  Hedge funds have trillions under management and some of these funds specialize in this type of transaction.  So when they go bad, they really go bad.  The thing we never know is how much is out there and what might the domino effect be.  It is this unknown that scares the market and causes it to run for cover.

In our second example we consider the sub-prime market.  As housing prices went out of sight the last five years, it priced many people out of being able to afford a house.  To prevent losing so many potential buyers mortgage lenders got very cleaver.  They offered variable rate mortgages with front end teaser rates that were below the prime rate of interest, or they offered interest only loans with cheap variable rates.  This had the effect of lowering the monthly payment substantially, and those that couldn't qualify financially for a regular mortgage now could. 

The problem comes when the teaser rate ends.  Suddenly, re-priced interest rates jump, and the mortgage payments jump sharply higher.  As long as housing prices continued to rise 10% a year, home owners could refinance and use the rising equity in their house to bail themselves out.  This fed on itself until last year when the bubble burst.  Prices got so out of line that buyers backed away. 

The economy slowed just enough that suddenly housing inventories started to build up.  We went from a sellers market to a buyers market almost overnight.  I know because I helped sell my mother-in-law's house just a few weeks after the peak.  We just barely got it sold when the buyers well dried up.  Thirty days after the sale, if the house hadn't sold when it did, we would have had to lower the price $20,000 to move this modest home.

Many of the teaser rates are now ending and the new rates are so high that many of these sub-prime borrowers can't make the new payments.  Home values have gone down and in the interest only, 100% financed homes, there is no equity to borrow, and since prices have fallen, there's no windfall to borrow against.  The result is massive, record defaults. 

This is threatening to bankrupt numerous mortgage bankers who are going to take a loss on the house when it is repossessed and sold in a depressed market.  In addition, home inventories are very high and it is taking forever to sell a house. 

How bad is the situation?  We don't know.  A number of homeowners are renting their homes to capture some income while they wait through the crunch.  I know one case where the home owner was trying to sell a $1,000,000 home which has a $6,000 per month mortgage on it.  Instead he has rented it for $3,000 per month for two years.  He's supplementing the renter in order to not take a hit on the house.  His estimate is the house would only fetch $650,000 if he put it on the market now. 

All these unknowns are what have investors nervous.  Nervous investors want safety, so they buy bonds and stable equities like P&G, Kellogg, Johnson and Johnson, etc.  These are the kinds of stocks whose consumer products you find in the bathroom and kitchen. 

What people flee from is anything with risk.  High risk stocks, junk bonds, metals, and other commodities.  Commodities are highly leveraged and vulnerable to massive liquidations.  Just look at the silver chart from May 2006 to see how quickly a bull market can end and how vicious the sell off can be.

Because we don't yet know the depth of the risks that exists in the Yen carry trade, or the sub-prime mortgage market, we don't know how much more panic selling we might see.  This selling has nothing to do with the underlying fundamentals of the individual markets.  Corn fundamentals haven't changed since March 1st.  In fact, I would argue that cheaper corn only increases demand and given our current pace of demand, we can't afford this kind of increase.  We just don't have enough supply.

To show you how connected these markets are, just look at the 10 minute corn and S&P charts for Wednesday's market.  There patterns are almost identical.  After a steady opening, stocks attempted to rally.  When the Yen, which had been lower, suddenly turned and rallied 50 points, stock traders got spooked (think Yen carry trade problems) and the market dropped like a stone.  The Dow quickly fell 160 points.  Grain and metal prices went right down with the equity market. 

However, stocks managed to calm themselves.  The Yen started to fall, and stocks quickly recovered.  So did the grains and metals. 

During calm, orderly, normal trading times, each market will trade its own fundamentals.  During panic times, where credit risks are an issue, then markets get linked.  If you are a high risk, high leveraged and illiquid market, then you are likely to get hammered.  Low risk markets like Treasuries will go up as money moves into these markets as a temporary safe haven.

You can see why I don't see long term interest rates going higher.  Demand for bonds will keep rates low.  They offer security, a 5.5 to 5.8% yields, and liquidity.  With inflation at 2.0%, that's a real rate of return of 3.5 to 3.8%.  That means that every 18 years your purchasing power doubles in real terms.  Most money managers have a long term investment strategy that says, beat the averages and inflation by 3.0%, and I'll have more money to manage than I can handle. 

Higher interest rates would only mean a devastated housing industry.  The next Fed move will be a cut in interest rates, not an increase.  If interest rates decline, then the U.S. Dollar will come under attack.  I'm looking to get long bond calls and long Euro FX calls.  Volatility premiums in these options are very low so they are an excellent value.   

Therefore, I have no problem simply buying calls straight up.  This is one time you can keep it simple and easy.  One note of caution, especially in the bonds, you might want to give that market a week or so to correct.  It's a bit overbought and if market fears calm down, there might be some movement out of bonds.  This will push prices lower.  This is where I'd like to be a buyer.

EIA weekly crude oil inventories showed a surprising increase.  This put pressure on energy prices.  Gasoline and distillates saw draw downs, but they were less than expected.  Refinery runs were at 85.6% of capacity. 

Refiners are locked into a strategy of driving product inventory lower and prices higher.  Running at low levels have increased profit margins far more than the loss of volume revenue by running at the usual 92.0% of capacity.  As long as crude oil inventories don't start piling up on them, they will keep this strategy going.  Look for $3.00 gas again this summer.  This will be great for our corn investments because it will mean that ethanol producers will run flat out to maximum capacity.  They will effectively compete against the petroleum refiners. 

Did you see what happened in rough rice?  Here is a good example of panic selling in a thin, illiquid market and how bad things can get.  In a little under a month, rough rice prices moved 61 points higher.  Today, the market saw some technical selling early, this triggered some stops.  As more and more stops were hit, funds entered the market and pushed prices even lower. 

Then about mid-day, Mexico announced that any rice imported from the U.S. had to be certified GMO free (genetically modified).  This really spooked traders and there was a stampede for the door.  Volume Tuesday was 277 contracts traded in the pit and 189 in the electronic market.  Today the market was overwhelmed with 2,000 contracts traded in the pit and 675 in the elect ronic market.  No wonder the market fell 55 points.   

This one month rally saw 90% of its value taken out in one day.  The 4/5 System was long rice at 1059 and had a profit of $300 the night before.  Tonight, the trade is stopped out with a $589 loss.  (That's the trouble with using the "stop-close" only type of exit strategy; it's a refinement I'm working on correcting).

There are three new 4/5 Trades to recommend.  The two short trades are in cotton and the U.S. Dollar Index.  The lone long trade is in the Euro FX. 

The system took profits in the wheat and sugar trades when the stochastic fell below 10%.  The net hypothetical profits were $888.50 and $264.60, respectively.  The system was stopped out of the rough rice, soybean oil, and cocoa trade for net hypothetical losses of $589, $79, and $329, respectively.  I am dropping the orange juice trade as the stop is now in front of the entry price.

Friday March 16, 2007

Most of the economic news yesterday was negative.  The Empire State Index was 1.9 versus an expected 16.0 and a month ago of 24.4.  New orders in the New York area for manufacturing were slow and unfilled orders were contracting.  Inventories are being slashed.

The same was true for the Philly Fed Survey.  The number was .2 versus expectations of 5.0.  It shows a flat economy and no growth in manufacturing. 

The Producer Price Index was up 1.3% versus an expected .5% and a decline a month ago by .6%.  The sharp increase was mostly due to rising energy prices.  The core rate, when food and energy prices are factored out, was up .4% versus an expected .2%.  This inflationary number is too hot for the Fed's liking.  Bond prices dropped on the news.   

However, rising energy prices are more likely to have a negative impact on the economy.  It doesn't imply robust growth.  Bond prices managed to recover by the end of the trading session.

There were two bright spots.  The first was an unexpected drop in jobless claims.  Remember, all this negative news is related to manufacturing which we know is in a slump.  Services, which make up 65% of our economy is still humming along fine.  This could easily explain why employment wouldn't be showing signs of weakening yet.

The second bright spot was the Treasury International Capital report which shows a healthy appetite by foreigners for U.S. debt.  As I've mentioned before, the U.S. has the best real rate of return on interest rates and will attract capital.  Most of the demand was for our corporate and agency paper.  Treasury demand was a bit soft but that should improve next month with all the flight to quality buying we've seen recently.  Demand for our equities was also strong. 

Energy prices declined in spite of OPEC and the oil companies' attempts to increase prices.  There is plenty of oil around and no shortage.  Traders are smart enough to figure this out and have been putting prices down all week. 

The EIA weekly inventory report for natural gas showed a drawdown of 115 bcf.  This was in line with expectations.  Winter is almost over and inventories will start to build again soon so it is unlikely the market will rally much until summer.

Metals rebounded nicely and had a strong up day.

Lumber fell sharply on spreading fears that the recovery in housing is not going well.  Copper on the other hand rose sharply on news that China's growth rate last quarter was still running at the red hot pace of 10%.  This is higher than the Chinese officials expected and traders saw this as confirmation that their government is not going to be able to rein this economy in at all. 

Copper and lumber tend to be lead indicators about the health of the manufacturing sector.  However, lumber is more domestic oriented, while copper has a large international component to it.  So it's not surprising to see their prices diverge given the weakness in U.S. manufacturing, while China, a major manufacturer of goods, is influencing the price of copper. 

The U.S. Dollar had a slight rebound in quiet trading, but is getting hammered this morning as I write this.

Ex-Fed Chairman Greenspan was in the news.  He said that the sub-prime mortgage crisis has the potential to spread to other credit markets.  This put the stock market down sharply.  Later when the Yen started to fall, stocks recovered.  It was a very nervous and jumpy market yesterday.  There were some good day-trading opportunities.

The interlinking of markets has created a misleading impression that grain prices are falling because the fundamentals are turning bearish.  I've had numerous phone calls from farmers in the last few days asking if the bull market was all over and should they be selling their old and new crop corn and soybeans.  Let me be very clear about this.  The recent decline has nothing to do with the fundamentals of the grain market. 

Traders wanting to initiate or add to positions are on the sidelines waiting for the acreage intentions report.  They need a baseline number in order to know which market they should be focusing on.  Since the acreage numbers are so varied and have such important implications for prices, traders are not going to plunge into this market until they know where they stand. 

In addition, since the report was a month away when the credit crisis started, many traders have chosen to go to the sidelines, during this absence of crop related news.  They will re-enter the corn and soybean markets just before or just after the report.  The credit crisis was simply further inducement to liquidate positions to protect against a decline caused by a flight to quality. 

To read these agricultural writers talking about the bearish market as if the fundamentals had changed is nonsense.  It tells me they are only seeing the trees in their little part of the world and not the forest of a big international capital market that sees commodities as a mainstream investment and an asset class that is part of their overall portfolios.

World money flows are so huge it dwarfs our puny grain markets.  Last month net new money into mutual funds was $28 billion.  Recent merger announcements have been in the $8 to $30 billion area.  Compare this with last years U.S. corn crop of 11 billion bushels.  It is worth about $40 at today's prices.  This market is so small that the whole asset class can be bought for the price of a couple of mergers and acquisitions.  So when money moves, it will impact the prices in these markets. 

As for the fundamentals in corn, they haven't changed.  The current sell off is greater than I expected, but it wasn't unexpected.  Even in my corn report from last October, I indicated that March would be a sideways to down month and would give us an opportunity to initiate or add to our positions just before the report.

Cheap prices at this time only cements that demand will not abate.  Corn users were caught off guard on the strength of the first two rallies, but they understand better now the potential for corn prices to surge this summer.  This correction is giving them a reprieve and an opportunity to lock in prices and profitability for the rest of the year.

It has been my feeling that demand alone would be enough to push corn prices to all time record highs.  I never really focused on weather and how it might affect yields.  I've always known that droughts in the Midwest tend to come at the end of an El Nino (my mentor, the late Charlie McInerney, who had a master's degree in geography and wrote a thesis on the El Nino phenomenon back in the early 1950's, long before it became well known, taught me that). 

I also wrote in a recent Blaster that Seattle had all time record rainfalls in November, 2006 and that the previous record was in December 1933.  1934 was a dust bowl year. 

I have a very old set of encyclopedias of weather data, from around the world, that dates back to the 1880's.  In examining it, I noted that in the dust bowl years (1934 was the worst), while the Southwest was burning up, the east coast from Mississippi to Georgia and to New York had above normal to record levels of ra infall; a condition that currently exists.

In 1934, the drought started in Southwestern Texas and worked north towards Minnesota.  Look at the Drought Monitor, www.drought.unl.edu/dm/monitor.html.  Notice that there is severe drought in SW Texas, in the western plains and in northern Minnesota.  The same axis that existed in 1934 exists today. 

Now go to www.wxrisk.com and read this weather forecasters spring report on this summers growing season, (click on "Here").  He confirms everything I've said.  He starts by asking the question, what happens in the spring and summer when El Nino dies quickly the winter after being moderately strong, and a La Nina forms just as quickly right behind it in the spring and becomes moderate to strong by summer.  He then uses government agency data going back to 1950 and found comparable years when this same phenomenon occurred.  The findings are very compelling.  It suggests a very strong probability that we will have a severe drought in the Midwest this summer.

Notice in the report how his forecasts indicate above normal precipitation in the Northwest U.S. (Seattle area) and up the east coast, with a drought axis developing from Texas to Minnesota.  This is the same scenario that occurred in 1934.  Also note that one of the years where the El Nino/La Nina effect was similar to this year was 1988, the last major drought we had in the U.S.  In that year corn yields fell 33% while soybean yields were cut 22%. 

Given the very tight stocks-to-usage ratio for corn, (among the tightest in history), any weather scares are going to send prices through the roof.  The above weather forecast is implies that the weather scares this summer will likely have teeth and be justified.

The credit crisis has presented us with a gift by making the expected March correction much deeper than previous thought.  It's an opportunity to get in at much better levels.  They can pound this down all they want. 

I will start buying at the end of next week.  I'm waiting while the time value gets chewed up in the May options so I can buy them as cheap as possible.

There are no new 4/5 Trades to recommend.  The system took profits in the crude oil when the stochastic dropped to below 10%.  The net hypothetical profit was $1,241.  The system went into the cotton and U.S. Dollar Index.  I am dropping the Euro FX trade as the stop is now in front of the entry price.  Once again, the ink barely dried on my buy the Euro FX trade and the market takes off the very next day. 

I hope you all have a very nice weekend.

Kindest regards,
Peter Kordell