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Friday, July 07, 2006

Yield Curve Lessons Part I

Allez les bleus! The magic is back in team France as they face Luca Toni and the Italians in this year's World Cup Finals. A win by France would be the greatest win in history by a team most underrated coming into the finals.

After winning against Spain 3-1. "You have to congratulate the winning side but they weren't that much better than us." Luis Aragones, coach Spain

After winning against Brazil 1-0. "They were not better than us." Roberto Carlos, Brazil.

After winning against Portugal 1-0. "Portugal deserve to be in the Final more than France, and obviously I’m sad because our opponents took their only chance in the whole game." Fernando Meira, Portugal.

At this point, the French team are already winners.

Is this the yield curve the US Fed is so concerned about? If that's the case then the Fed has to put more signs on the streets to warn us.

So what is so important about this yield curve?

The yield curve, in simple terms, is where all the possible rates of corresponding maturities of debt instruments lie. In this case, maturities of treasury bills with a tenure of 1 year to treasury notes of 10 yrs to 20 yrs(these long-term notes are also called bonds). This means, the Fed has debt instruments for public consumption either in the short term or the long term. They even have 90 day bills but even that has a different rate.

From the chart above, as you move from a 1 year tenured instrument to a 10 year tenured instrument, the corresponding rates move through the curve!

To better understand the movement of the yield curve, let's divide it into two parts: short-term and long-term. Short-term will have a range of 1 year to 5 yrs (cycles now are short, this is sometimes considered long-term). Long-term will have 10yrs and 20yrs.

Looking at the short-term rates, as you move from the 1 year instrument to the 5 year, the movement of the rates is steep. What does this mean? This means a higher rate is required by those who buy the instrument as maturity increases. The longer I hold the debt instrument, the more risk I assume, therefore the higher rate I would demand as a return.

The explanation on the long-term part is the same as the short-term but you wonder why the curve is almost close to flat rather than steep? The flattening of the long-term highlights the spread between the rate of the short-term vs. the long-term. The tightening spread is brought about by two things: (1) uncertainties of the future of the economy; (2) excess liquidity in the market.

First, the uncertainties. If a future slowdown of the economy is expected (which is accompanied by falling rates), then there is no point investing in a long-term instrument since the rates, are as expected, going to fall.

Second, excess liquidity in the market. You have to understand that such excess liquidity should go somewhere. Because investment intruments (risk-free at that) are limited, the excess liquidity can really crowd itself into that safe instrument and cause certain "abnormalities". Take note that the long-term instrument is like a bond wherein buying too much of it would cause its price to go up and cause its yield to go down. The sheik in the desert with his billions of petrodollars would not mind dumping all of his money into the long-term note as this instrument is "liquid"(in trader terms, it has volume and can absorb such demand). This is the safest haven for his billions. If he still has money left, some of it can go to Osama.

The abnormality that happens is the inversion of the yield curve wherein the long-term rate is lower than the short-term rate. More on the inverted yield curve in our next class!


Thursday, July 06, 2006

Where in the cycle?

Sam Stovall's sector rotation model helps us identify where we are in the stock market cycle by identifying the sectors that historically outperform in certain stages of the economic cycle. Using stockcharts.com's SPDR Perfcharts, we can see which sectors are outperforming the past 65 days. We see that the outperforming sectors are Energy, Utilities and Consumer Staples. Based on the sector rotation model, we are in early recession. But have no fear, we personally don't think we are going into one. We think we are going into a soft landing, to be explained in a future post. But it does mean we have seen the peaks so don't expect new highs. We also think we've seen the lows and it's probably going to be a sideways market. This tool however is very useful for a top-down approach to investing. Take note the strongest stocks are in the strongest sectors!


Words from Getaheadinvestments Founder

Congratulations to the defendants of the universal word "citi", after several cycles of the market, we can now say we belong to that same merry go round.

To all those companies having the word "citi" in their names (special mention: Citilaundry, near Jollibee in Manggahan), UNITE!!!!

You really have to give it to those plaintiffs, even Dwayne Wade got sued for using his own name.

All I can say is, it is darkest before dawn! July 12 will be the New Era for the small investors of the Philippines.


I am such a big fan of Marc Faber. He definitely sounds like Wolfgang Puck fighting it out on the Iron Chef. His theories written in his book Tomorrow's Gold is the bible of village bear. To him, its all about supply and demand. If the US prints too much greenback, it definitely is a bear signal for the currency. And gold! Gold cannot be printed or even synthetically reproduced by man so he is definitely buying his wife tons of it.(Not to mention all the uranium, copper, silver, titanium he has in the fridge. Supply and demand baby!

And I thought his theories are out of the box! I read through the John Mauldin article (called to attention by "Mr. Santos" and summarized by Terence) and I said to myself, Faber is definitely the one inside the box! By saying Mauldin's ideas as out of the box is an understatement - it is out of this world (too much). His ideas are fresh, well-investigated, insightful, and painfully logical. If you really want a balanced view of this crazy market, then you have to check Mauldin's articles as much as Faber's.

How do we strike a balance? I say don't sweat the small stuff. Leave it to Mr. Bernanke to do the balancing act for us(US?).


Attention Mr Faber and Company

Interesting article courtesy of Mr. Santos, its a newsletter called "Outside the Box" by John Mauldin. In his newsletter he published this article by GaveKal Research called "The Leverage in the System and the Weak US$". In this article they linked crude oil demand and prices, petrodollars, currency bets and finally US$ and indirectly the US stock market.

What?!! How can all these things be clearly correlated? Well this article is certainly out of the box. To summarize for those people who are allergic to reading long and confusing documents, here it is. The article argues that countries need to have reserves of two things: crude oil reserves (since a lot of countries are short of oil) and central bank reserves (for international trade). Logic should dictate that if oil reserves go up, central bank reserves should go down as US$ must be used to buy this oil. However this is not happening... as oil reserves have been growing (due to higher prices and shortage), central bank reserves has also been growing the past few years! In the past year, central bank reserves grew 12%... so countries have been spending more on oil yet saving more US$?!! Has the US central bank been dumping US$ into the system? Is this the effect of the US current account deficit reaching new records?

There is a less obvious though very probable answer. It happened in the late 1970's and look like is happenning right now. Oil prices have increased, forcing some countries with current account deficits that are "short oil" to borrow large amounts in US$ to pay for the oil imports. Meanwhile, commentaries from Faber and the like, preaching about the demise of the US$ and the fiat currency and rampant inflation, are forcing the diversification of petrodollars. As a result, all these feed the perception that the US$ will fall further, forcing investors to make currency bets by borrowing even more US$ to buy assets in other currencies which they think will appreciate.

The large amounts of US$ borrowings can help explain the increase in central bank reserves. For example, data shows that 30% of China's US$ reserves are in the form of US$ borrowings, since the Rmb is widely expected to appreciate 5% this year. This builds up an increasingly "short" position on the US$ (investors have to sell the dollar to convert them to local currencies to buy assets) and any event that may tilt this massive imbalance the other way will force a rapid "covering" and thus appreciation of the dollar. It happened in 81-84 and 97-2000 (the US$ rose higher than expected due to the unwinding of US$ "shorts") and can happen again.

What can currently cause the shorts to unwind? Rising US interest rates, some increasingly weak emerging market currencies and the least likely an improvement in the US current account deficit. These events may take a while to happen, or they may never happen, but an increasing amount of bearishness on the dollar will increase their impact (potential rise in the US$) if ever they do. Just food for thought for Mr. Faber and company. Thus the US stock market may be weak or move sideways with all the problems they have with the economy but it may never crash. In short it all boils down to sentiment... high expectations, whether bullish or bearish, lead to even bigger disappointments!


Explaining the fear

This blog was created so that the perpetrators of the colfund can voice out their thoughts on the stock market, bonds and other investment ideas. Citisec traders and bosses and whoever are welcome to post their comments, they will be highly appreciated...Why the fear of missing out? Our goal here is to provide returns for the fund, not just returns but spectacular returns. Being traders by nature, we have been trained to avoid losses and be patient to make the profits.. Now that COL is listed, we the managers of the fund have adopted a more aggressive mindset. In the past we have had so many ideas to make money, but just couldn't execute them because of our conservative nature. In the end a lot of them worked out, though not all, and some opportunities were wasted. Now that we have experienced the full cycle of the market... the momentum phase, the euphoria and the crash.. we have learned a lot and opportunities are always there, you just have to be open and flexible enough to execute them (take note flexible: it means we will not abandon our risk management strategies learned as traders). We will learn to use every trick in the book. Here at the COL fund... we can't afford to miss out. TERENCE