8/13/08 (Inflation, Rates, Dollar Rallies, Commodities Fall)

Traders,

We got a mixed opening reaction and follow-up move yesterday. Clearly inflation is ramping – but an interesting (and possibly) correct observation was made on Bloomberg yesterday by an economist. It went something like this, the CPI is showing inflation ramping, thus Bernanke will HAVE to raise rates. The belief that he will have to raise rates was clearly reflected in the fed fund futures and also the strong reaction of the dollar. This helped fuel equity prices higher and commodity prices lower. That was it in a nut shell, so let me paraphrase – bad news (rising inflation) is good news (raising interest rates). It’s crazy I know – the consistent double speak, one month lower interest rates is good, the next month raising interest rates is good. The dollar did strengthen and I think the economist hit the nail on the head – the perception is that the dollar will strengthen IF Bernanke raises rates.

That’s a big “IF” – why because Bernanke should of raise rates last meeting if he was really focused on fighting inflation, even some of the other Fed members indicated as much. However, he is caught in a very tight spot. The Discount Window has been opened to all and the Fed is lending 100s of billions in short-term loans to financial companies that are already tight with cash (yesterday’s market preview news of these firms also settling to buy back BILLIONS of bonds at par value is also reducing cash holdings). If Bernanke raises rates he is going to really put the squeeze on money and lending is going to tighten to a pin hole. Remember, he is considered one of the best experts of the Great Depression and he has stated that the tightening of money was one of the greatest mistakes that help cause the Great Depression. While he is pouring liquid money into the market place through every orifice possible – raising rates is going to choke down on these pipelines and put bigger stress on interest payments. Bernanke has made it clear – he does NOT want to raise rates, but dissention among the Fed has already started and if he stands pat next meeting – well internal disagreement and concern is going to ramp. We don’t need the Fed members fighting with each other and that fight is brewing. Volatility among members means they really don’t have a solid handle on the problem.
One thing for sure, NONE of the financial firms want to see the rates go up!

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Dollar Rallies

There was a huge short covering rally in the dollar the other day - which sent the dollar up on the biggest gain against the Euro in several years. The unwind came from massive shorts covering – the catalyst could be blamed on anything, ECB’s voiced concerns about a slowdown, Oil prices, etc. What was on the line was the big 1.54 Euro/dollar mark that broke and fueled the big move.

The perception of a rate increase now in the cards from the CPI news yesterday – means more strength returning to the dollar. The Euro is a 1.475 against the dollar and that has been a huge run on the dollar, once a the biggest in a decade.

The next volatility injection will be what does Bernanke do at the next meeting and the volatility of that decision is huge – half the economist said he will raise the other say he will remain the same for the rest of the year. At this point it is a toss-up! However – I don’t see big changes in the US economic landscape in the near-term (at least through the 1st quarter of 09) – even with a raise in rates – which would be a small 25 bps move IF anything. That means I think 1.45 is a good bottom area – and even if he did, that treasuries (even with a small bump in rates) are still seriously getting out stripped by the CPI.

Note – Gold and Silver has also pulled off pretty hard as the dollar rallies. I think we are seeing a good bottoming area at the 14 per oz in AU for now, if that doesn’t hold then 12 per oz (which is a serious back up the truck and load up area).

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Russia turning up the heat in Georgia

I saw Sec. of State Rice say yesterday that Russia can’t not invade a sovereign nation, over-through the country, and occupy a sovereign nation. This isn’t 1968! (to paraphrase). I think Ms. Rice’s short-term memory failed, didn’t we just do that in Iraq? I am not justifying Russia’s invasion – but while we might be against such an act by Russia, we certainly should be holding our tongue as on making such blanket statements such as that.

The concern in the financial markets will be that massive pipe-line that feeds Europe. Keep an eye on this story as it COULD inject premiums back into oil if it does escalate and concerns about supply mount.

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Commodities coming off hard

We could see a drop in the next CPI, yeah it IS possible – Oil and the rest of commodities have been coming off pretty hard as the dollar has strengthen. The HEAD LINE inflation of the CPI was really juiced by higher energy and food prices. It does take some time for it to trickle down to the consumer level – (as we just saw with the CPI after was released) – I am guessing about 2 quarters. However – if oil and commodities do remain weak we could see the CPI in the next report slip some, but I doubt too much of the saving’s from lower prices will trickle down to the consumer level that fast, but some could.

The dollar rally and the expectation of a rate increase and thus future strength in the dollar is putting pressure on prices. The send blow is the slow-down in spending by the consumers that are tapped for cash. Slow spending means less need for commodities. The question is what does the picture look like beyond our shores, China and India are still ramping and will probably continue to do so.

The concern with the dollar rally is that it’s combination from the big short-covering the other day and on the back on speculation that rates will go up. If we ramp to hard and fast – if and when he cuts it most certainly be too little (25 bps) and we could see another big pull back in the Greenback and rally in the commodities. Pickens’s expected a pull back in oil this summer, so far he is right. However, Pickens, Goldman and others expect it to rally again going into the 4th quarter and into early 2009 – back to $150 is there expectations. Those expectations also imply (IMHO) that the dollar will weaken and inflation will continue to ramp.

Where is the bottom in commodities? I don’t know – but I don’t think we are now in a commodity bear market because of the recent pull back.

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Futures Pre-market

The futures are looking higher by a few points and the spread is in there, expect ARB traders to short futures into the opening and buy the cash basket. If the spread remains going into the opening – expect a gap up.
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Support / Resistance

Talk about MORE intra-day volatility. The news of the CPI initially saw big negative opening market impact. The futures came off – we hit or broke through some of those supports in the early session and then like an Olympic Gymnast we bounced off the spring board and rally (maybe the economist is right – bad news is good news? – I really hate that oxymoron saying).

INDU 11,500 / 11,800 (We were down below the 11,500 area two days in a row to bounce intraday and close above it. 11,500 is a straddle strike, if you played that yesterday you made some serious cash. 11,800 or 11,500 is in the cards for expiration and since we have had some hyper moves – don’t expect Pinnage, but rather more volatility. The close is anyone’s game. We have been trending higher – so be careful at 11,800 as per shorts. 12,000 would not be out of the question next week – if the euphoria continues.)

NDX 1900-1925 / 1950-1975 (I thought we saw a “tap out” in the last three days – wrong. The phoenix rose yesterday after the massive pull off at the opening. With fewer players, bigger single trades, and the overweight’s driving – the volatility in this beast is high – regardless of what the VXN says. Expiration is a big ?)

SPX 1275 / 1325 (Yeah I am raising my resistance – 1325 is possible after the trending rally. I think we could move higher and possible touch that 1325 area before pulling off. I don’t think 1300 will be much resistance today – however if you wish to play it as a straddle strike – that would be a good play too. There is still lots of volatility – if we do NOT break through 1300 – which after yesterdays optimistic rally in the face of mounting inflation – well I maybe reality just set in. I guess the safe bet is to treat 1300 as a straddle strike.)

RUT 720 / 760 (BOOM! This massive move up is still in a very big trading band – When does it run out of steam – well maybe 760, but a breakout there could send this spiking higher like a massive short cover. August has been full of surprises and we are rallying into the 3rd quarter and more volatility. Yikes! Roll up hedges, lock in gains, and ride the train to the upside, just don’t be surprise on a massive shocking pull-back which is definitely in the cards – when? Depends how parabolic we get. I think we are already reaching pretty hard.)

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Conclusion

We are seeing some interesting action, much of it has come from massive positions that have been forced to cover because of capital leverage restraints (like the massive SemGroups covering in oil) or in the dollar on the massive volume currency trading day with the biggest gap in almost a decade. These massive positions by firms seem stable until they are not, and when a position is closed or forced to cover we inject massive volatility (moves into the market). If you didn’t know better you might get long or short because of one of these moves, the problem with these hyper moves is that they are NOT based on a fundamental shift in the economy, but rather just a massive position being traded that moves the market at unprecedented levels. What do you think would happen if you had to buy 100,000 future contracts? Yeah – you could get a massive rally in the market.

The economic news is not getting any better, more inflation, more foreclosures, more tightening of money, more borrowing at the FED window, more jobless, etc. Whenever we get big moves up or down – I get a emails (mostly from retail people) like “We are not in a recession, how come the market just sold off 300 points?”, “The CPI is the highest in 17 years, how come the market rallied?”, “The government reported supply issues in oil, how come it sold off?” - I try to continue to clarify that the market moves on PERCEPTION and SPECULATION! If you watch talking heads all day long – they have a tough job of trying to explain why the market went up or down and tie it to some piece of news or data as if to justify the move. The reality when a big firm wants to (or is forced to) buy or sell 100,000s of contracts or shares it’s going to move the market regardless of news.

By why all the massive volatility? We are in the biggest deleveraging action the world has ever seen. Positions in both the OTC and LISTED market by firms have never been bigger, but remember these are massive positions with massive leverage. If the firm doesn’t have the capital to carry these positions they may be forced to close them. With all the borrowing at the Discount Window, the tightening of money (via write downs and credit crisis) these massive positions which traditionally are slowly increased and decreased are now done in bigger blocks in a more illiquid market, that spells one thing – massive volatility. The pricing in the options market (premiums based on volatility) has been disjointed like never before – it’s almost impossible to price correctly if a product could see a 2 or even 3 standard deviation move in a day. The VIX is not even close to handling intra-day volatility action in this market.

When will we get back to normal? When we stop deleveraging – so far that has NOT happened.

So don’t read too much into any rally or sell off. Just get your hedge on and lock in gains when you can.