In my email today FWIW -- we seem to mostly be on the same page in terms of analysis if not necessarily strategy.
Only meant to be a reflection of what others are thinking.
How to Play the Fed's Inflation Game
By Drew Klein
Central bankers love to talk about how inflation expectations are ‘well anchored’. Here’s a small sampling from the last 6 months (all courtesy of Dow Jones Newswires).
09/28/2007 -- Fed’s Lockhart: Inflation Expectations Remain Anchored
10/09/2007 -- Fed’s Poole: Inflation Expectations Remain Well Anchored
11/05/2007 -- Fed’s Mishkin: Inflation Expectations Remain Well Anchored
11/16/2007 -- Fed’s Kroszner: Inflation Expectations Reasonably Well Anchored
**no anchoring necessary during holiday season
01/10/2008 -- Fed’s Bernanke: Inflation Expectations Reasonably Anchored
01/11/2008 -- Fed’s Mishkin: Inflation Expectations Reasonably Anchored
02/07/2008 -- ECB’s Trichet: Successful in Anchoring Inflation Expectations
02/07/2008 -- Fed’s Yellen: Must Ensure Inflation Expectations Stay Anchored
02/19/2008 -- Fed’s Stern: Inflation Expectations Well Anchored at Low Levels
02/20/2008 -- FOMC: Inflation Expectations Edged Higher But Still Anchored
So what does it mean -- that inflation expectations are ‘well anchored’? Are central bankers obsessed with a new yachting technique, or are they trying to convince us that the public believes inflation to be low? Have the Fed policymakers filled up their Hummers or priced a Beemer lately? Do they not buy milk or bread from the supermarket?
The current stance of the Fed, to try and convince the public that inflation is under control, falls right along the lines of the ‘Strong Dollar Policy’ held by Treasury Secretaries over the past 8 years. It is outright propaganda -- the complete and total spread of disinformation to fool us into believing that our currency isn’t being destroyed.
It’s pretty clear to me that the Fed’s mandate has nothing to do with growth or employment. The Fed’s current order of business for the economy is to "Inflate or Die". Here’s how it happens: team up with your cronies in ‘Warshington’, print as much money as you possibly can to bail out your defaulter buddies, drop enormous amounts of cash to the public from helicopters calling it ‘stimulus’, and devalue the currency to the point where your $9 trillion debt doesn’t really matter anymore. This is not uncommon; this is basically a central bank’s directive during the inflation-correction phase of a typical credit bubble cycle. It’s the Fed’s way of saying "OK, restart, new game".
The problem is that this pinball game may be harder to restart than in the past. Instead of the ‘restart’ scenario, we may be witnessing a classic ‘Tilt’. Forget the most recent CPI statistics which are alarming policymakers at just 4.3% year over year. Ignore the silly GDP statistics which actually show our economy growing, albeit slowly. Estimates of the unpublished M3 numbers run anywhere from 15-20% per year. Commodity production rates have not kept up with the production rate of paper dollars. This is inflation, and the consequences of such inflation are higher prices. Don’t bother looking beyond $100 crude oil, $950 gold, $5 corn, $20 wheat, $13 beans, $2500 cocoa, $1.60 coffee, etc. Everything else is irrelevant. There are only so many plasma TV’s and computer RAM that a person can buy.
Combine the current inflationary spiral with the ongoing commercial credit debacle and the up and coming consumer credit calamity, and you have all the makings of an economic implosion. The recent opening of the new Term Auction Facility (TAF) between European and North American central banks is nothing but a glory hole for elitist corporatists, hoping to hide their bad debts from one another. Imagine - the banks are so petrified to show their balance statements to each other that a new anonymous discount window needed to be designed to encourage lending between them.
While Roosevelt’s New Deal in the 1930’s was to combat deflation, this bizzaro 21st Century policy action could be aptly described as ‘The Raw Deal’ - we know from history that this practice can lead to significantly higher interest rates and a much weaker economy.
So how can we take advantage of this scenario unfolding, one that we believe will lead, in the short run, to the following:
a) Lower short-term rates
b) Higher long-term rates
c) Weaker economy
Lower short-term rates
With the idea that the Fed could come in this year and continue to blast short term rates lower, and with what appears to be little risk of any rate hikes before year’s end, we like the long side of December Eurodollars (EDZ8). We are looking for the market to move to 98.00 and possibly to 98.28, over the course of the next several months. This would imply a 1.5-2% Fed Funds rate come December 2008. Watch the equity markets in particular to force the Fed’s hand into further rate cuts.
Daily Eurodollar chart here -- image.exct.net
Higher long-term rates
Last week, for the first time since late 2004, we saw 10 year note and 30 year bond prices reach nominal parity. Both TYH8 and USH8 hit 116, respectively. We think this is the beginning of a major trend towards a steepening yield curve, where the long bonds weaken dramatically relative to the notes. We prefer using a futures spread, in a straight 1 by 1 trade, buying 10-year notes and selling 30-year bonds. Our 12 month target for this trade is about 5 handles over (about $6,000 per spread from where we are right now). With the margin for this spread relatively low at just about $1,000 / spread, and looking to risk about $2,000 per spread, we view it as a good risk/reward play. Margins are always subject to change.
Weekly Notes/Bonds chart here -- image.exct.net
Weaker Economy
I have been a stock market bear since 2000. While the markets did turn around in 2003 and make nominal record highs in 2007, you can’t ignore the fact that if you price US equities in anything other than US Dollars, we are in a major bear market. We have been advising our clients to buy gold and sell equities, with the opinion that there will come a time, in the next 5-10 years, that you may be able to nominally buy the Dow with the dollar equivalent of one ounce of gold. Think gold $5,000 / oz and Dow 5,000. Such a scenario could mark the end of the equity bear run and the end of the commodity bull run. In the immediate term, being aware that recent monetary stimulus has done nothing to prop up equities, we think stocks could fall into the summer. We advise buying June 1170-1320 put spreads for about 35 points. Be aware that a bounce in the ES up to 1420 area over the next few weeks should be viewed as a selling opportunity.
Weekly US Equities chart here -- image.exct.net
About the Author
Drew Klein is Principal of Greenrush Capital Management LLC, an introducing brokerage outside of Los Angeles, California. Drew has been a member of the National Futures Association in good standing since 2001 and has worked for some of the largest options firms on the West Coast.
Greenrush specializes in managed accounts, full-service retail brokerage, and self-directed trading for the more sophisticated client. Drew is the editor of Greenrush Capital Research, which is available on a subscription basis but is complimentary to all clients trading with Greenrush Capital.
Drew is Series 3 and Series 30 licensed, and is a member of the Sigma Chi Fraternity, an organization whose trader hall-of-fame includes the legendary Larry Williams and Ed Seykota.
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