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What we are seeing in the commodity complex is the drip, drip, drip of orderly liquidation. Commodity funds are losing assets and/or being shut down. Tourists who ventured into commodities to protect against macro fears that didn’t materialize have started to sell. And the sell-side commodity hype machine is now behind us. This is why commodities have stayed so oversold for so long with high negative sentiment readings, yet still go down pretty much every day.

When performance is dragging, less experienced traders often lock in profits on their winners and double down on laggards. The pros, however, prune their losers, and pros are the big holders of commodities. Hence, the drip, drip, drip. (NB: liquidations usually start with drip, drip, drip and end with flush.)

How far does the unwind have to go? These things are always hard to say with precision. But what we do know is that the commodity unwind should be a function of the size of the build-up—plus a reverse-bubble psychological dynamic once the selling gets going. Rapid rate of change influences emotion much more than level.

Since I believe the buildup was significant, with a good portion of it predating QE, I expect the unwind to be large and sustained. But, ultimately, every investor/trader has to come to his/her own determination of how big the unwind will be.

Do you think the US has put crisis behind it? This is really the only question you have to consider when you look at the above chart of gold since 2000.

What we have been seeing is that silver and gold are developing an increasingly negative correlation with the S&P. And it is in the precious metals where most of the tourist dollars reside. So hedging your equity longs with silver and gold—though it has worked very well for the past few months—will become more painful to hold onto in countertrend days, and possibly brutal in a selloff (both your longs and shorts may well move against you). It you have a cast-iron stomach, you should be fine. The reality is, however, that most of us don’t—and hanging on to a winning trend is the single hardest skill to learn in investing. A better hedge will help you do that.

Enter copper. During the speculative run on commodities, there was a lot of broad allocation to the asset class as well. This means copper (and to a lesser extent oil) will correlate in part to precious metals, and in part to the S&P, since, as an industrial metal it is more sensitive to growth. The bottom line: copper right now makes for a better macro hedge than silver or gold.

The point of this is that if you have been suffering from being underinvested and you are looking for a way to add stock risk to your book, a really solid way to do it that minimizes the risk of being the goat in two months’ time is to buy the stock you like based on your process, and hedge the beta out by shorting copper. It sensitivity to growth should make it go down on down equity days, but on up days it should lag—or even outright decline—based on the drip, drip, drip of the commodity unwind.

Here’s the chart of copper of the same time horizon, FWIW:

Apple and GDX, the ETF for gold mining stocks have very little in common–or so it would seem. One is a major technology stock, the other, a leveraged play on precious metals. Apple has tangible value, which at some price point will matter; Precious metals have whatever value we assign to them–the ultimate greater fool trade.

But the chart below shows a striking similarity. Both have been highly correlated to the downside in an overall up market.

Why? A tale of two bubbles. Both were the objects of excessive enthusiasm. This enthusiasm is now unwinding. My guess is that AAPL is close to finding a bottom. Precious metals–where there is no tangible anchor–look set to go much, much further.

The other interesting observation is the evolution of the rolling correlation between AAPL and the SPX. One thing to watch for is this correlation picking back up–implying the idiosyncratic component of the AAPL unwind is mostly behind us.

This was originally written for a blog over at the CFR. The framework is still useful today, IMO. At least you can compare it to how things have kind of turned out. Here is the link to the original.

The Dollar: It’s an Overhang, not a Hangover

By Mark Dow 
July 6, 2009

Few things are more confounding to economists and traders as forecasting currencies. However, as I have come to realize, the approach each group takes is very different. Economists are never wrong, only early; traders are often wrong, but never in doubt. Economists look at interest rate differentials, growth differentials, current account positions, and other fundamental factors. It doesn’t always help much, but it is a defensible place to start. Traders, on the other hand, cognizant or not, focus not on the fundamentals, but on the “fundamental story”. These stories typically emerge to fit recent price action and are then coupled with what economists refer to as stylized facts. Unlike facts, stylized facts are not stubborn things. Some stories turn out to be true, others false, but whether they are true or not the most powerful ones share two characteristics: they are easy to explain and intuitively appealing. And once a good story takes root it can be very difficult to dislodge it—irrespective of how untrue it may be.

“Stories” that drive the dollar abound. They are usually easy to explain and intuitively appealing. Most of them turn out to be wrong. Excessively low interest rates in 2003, the Fed “printing money” today, large current account deficits, increasing budget deficits, Chinese concerns, all of these are given ample airtime. In short, the core story we have been hearing is that the dollar is now suffering a hangover from the fiscal, monetary and external account binge it has been on in recent years.

How well does this hangover story hold up? Not well.

First, dollar weakness has not been as dramatic as the story that has accompanied it. The only big decline came in 2007 (red arrow in the chart below) when the world was in massive risk seeking mode, loading up on carry, reaching for yield, constructing CDOs and CDO-squareds, and using the dollar as a funding currency. Much of this decline was unwound over the past year as the world began to deleverage. In fact, the dollar is right about at the same level as it was when Lehman went bankrupt.

Second, much of the story centers on the Fed’s expansion of base money. This is wrong on many counts. To begin with, the Fed is not printing as much as you might be led to think from listening to financial commentators on TV. Base money (here) has been flat lining since early this year (total liabilities are in the leftmost column). Moreover, the money multiplier has continued to decline, as credit is destroyed and the private sector delevers. (I think many commentators end up confusing base money with the broader money supply, but there is no need to get into this now). In addition, when the expansion of base money was truly rapid, from September to December of last year, the dollar was getting stronger. Why? Because that’s when the demand for dollars was strongest. Memories of Econ 101 and quotes from Milton Friedman have encouraged an excessive focus on the supply of money, when the real driver has been the sharp changes in demand. As funding pressures in the financial system eased, the dollar started to decline again. It is not a coincidence that the DXY (dollar index) made a high in early March when the S&P made its lows. Lastly, there is an article in this week’s Economist, pointing out how the ECB has been as expansionary as the Fed, but have been lower profile about it. But I haven’t heard any talk about the debasing of the Euro. In sum, sexy though the story might be, I don’t think the “Fed-is-printing-money-like-Zimbabwe” theme is really driving anything but the psycology of a few.

What about the current account deficit? No one home there either. As soon as the deleveraging accelerated, the US current account took a sharp turn northward. In the chart below I use the trade balance, which comes out monthly, as a proxy to capture the rate of change.

Ultimately, the current account story is much more a credit story than an FX story, in my view. And it is fixing itself without much help from the exchange rate. In fact, as you can see above, the increase in the trade deficit coincided pretty well and pretty monotonically with the great credit bubble in the US. So it shouldn’t surprise us that the decline in credit reverses it. (This also has implications for the need for foreign purchases of Treasuries, which has been cited as another concern.)

Fine. If these stories are wrong, does that mean I am bullish the dollar? The answer is no.

The dollar has an overhang problem.

For the past 60 years the dollar has been the only game in town. It was the lubricant for financial and trade globalization, the undisputed store of value in the international monetary system and the primary medium of exchange/unit of account for commerce. The world held more dollars, and the world transacted more often in dollars. Demand outside the U.S. for dollars grew rapidly for many, many years. For monetary balance inside the U.S. to be maintained, the Fed had to provide these dollars; otherwise interest rates at home would have been much higher.

Fast forward to today. The world has undergone a radical transformation. Abstracting from the current global recession, most countries across the world are in much better economic shape than was the case 15 years ago, and their currencies are more stable and increasingly more freely convertible. People trust their own currencies more, as well as the currencies of other countries. Dollar holders — central banks, sovereign wealth funds, international corporations and individuals alike — realize they have accumulated too many dollars over the years. Holding such a high percentage of one’s precautionary balances in dollars no longer makes sense in today’s world. Not because the dollar is bad per se, but because there are so many opportunities to diversify safely.

Mexicans no longer have to keep as many dollars under the mattress. Brazilian companies no longer need to keep a war chest of dollars hidden in the Cayman Islands in order to ensure access to imported inputs. Sovereign wealth funds have realized that it is neither wise nor prudent to keep so much of its stock of wealth in one currency. Investment management firms are starting to offer more non-dollar share classes for their products. And Italians, Poles, and Turks — peoples closely linked in one way or another to the euro — are thinking less and less in dollars (it is amazing that they still do at all).

The transactional demand for dollars is also declining. This too puts downward pressure on the dollar. In countries like Brazil and India, hotel bills used to be presented in dollars. Not any more. Cabs in emerging economies used to prefer payment in dollars. Now it’s not worth the hassle. Many countries that historically quoted real estate prices in dollars are doing so less and less. Bilateral trade, on an ad hoc basis, is ever more frequently eschewing the dollar for other currencies.

With the demand for dollars structurally falling, the dollar should face headwinds until currency stockpiles have adjusted and a new equilibrium is found. With some 70 percent of dollars in circulation held outside of the US, unwinding this overhang may take a long time. This doesn’t mean we can’t have vicious countertrend rallies in the dollar. Every time risk aversion gets intense enough, the dollar tends to do exactly this. But it does suggest that you can expect the dollar to be undervalued relative to any intertemporal, goods market concept of its underlying value for quite some time.

Commodities as a group have been underperforming equities for about six months now. The correlation between the two groups has been grinding lower. Even more important, I think the underperformance of commodities—and by extension emerging markets—will persist for some time.

Hang on. If the backdrop is improving growth expectations and continued, if not increased, global central bank base money expansion, why have they underperformed and why should it continue? Here’s my answer.

Misunderstanding Monetary Policy

This is going to sound bad so I’m just going to say it: Most investors and commentators have a deeply flawed understanding of monetary policy. Very few have any direct experience in this complex issue area. Many equate printing money with the money supply. They think changes in base money drive currencies. Most haven’t internalized that the money supply in a modern monetary system is endogenous (i.e. created by banks and risk appetite, not the central bank).

It is for these reasons people feared inflation, higher Treasury yields and a collapse in the dollar in response to the Fed’s exceptional measures. Remember stagflation? Me neither. None of these things happened.

People are now catching on to this. The percentage of investors who now think the Fed balance sheet will provoke a new crisis or that the ONLY possible solution to the US debt is inflating it away has shrunk considerably. This reduces the demand for hard assets.

Pavlov’s Oil

Many may have forgotten by now that the first massive wave in commodities was in 2007-2008, back before we knew what QE was. The story then was China and the Emerging Markets were rapidly plugging into the grid, set to consume our finite reserves with their vertiginous growth trajectories.

Subsequent boomlets in commodity prices, the ones that came post-crisis, were linked mainly to monetary stimuli and the flight into hard assets.

Together, this imprinting led us to reach for emerging markets and commodities any time we had a risk-on phase. In this last phase people have again reached for commodities and emerging markets to express their bullishness, but I’m suggesting this time they are setting themselves up for disappointment.

The first reason is that the emerging markets have downshifted their rate of growth. Some even have their own processes of credit digestion to contend with. Moreover, before the downshift we feared EM could grow to the sky, leaving many of us guessing at how intense the competition for scarce resources would become. We now have a better handle on “how high is high”.

Second, we have been coming around to a better understanding of monetary policy. We now increasingly get that the effects of monetary policy will be largely psychological and transitory until the deleveraging process approaches completion. At least, I hope we do. Otherwise, the fall in commodity prices will be deeper and the pain trade will last longer.

These developments will, eventually, reprogram our reaction function. The days where we’d say, as someone else recently put it, “it’s going to be a risk-on day, let’s buy 200m AUD”, are likely to fade further and further into the recesses of our memories.

Beware the Hype Machine

When the sell-side makes “a thing” out of an asset class, there is usually considerable downside and unwind at some point ahead. The length and depth of the downside is typically a pretty clean function of the length and breadth of the hype. And in 2011 commodities became a thing.

Sell-side firms were sending team after team of analysts and strategists to explain exotic commodity trades, often to hedge fund managers who had no experience in them. Buy-side firms started to scramble to build their own teams and launch new strategies. John Paulson was still in hero mode and he was buying gold, thus giving cover to others’ hubris. And, of course, the gold ads on television were busy shifting into a higher gear. I could just close my eyes at night and hear the sound of central banks printing money.

The apex came in the spring 2011, a month or two before the final parabolic burst in silver. The Morgan Stanley commodity specialist came in to visit with his 8-man team. When he recommended, as his best idea, a pairs trade “long rhodium and short molybdenum” (really, I’m not kidding), I knew that the time for shorting precious metals would be soon upon us.

The bottom line: the speculative demand for commodities is likely to become less robust over time, and the growth rate of emerging markets more modest and definable. We are in the midst of the process of pricing these factors in. And the good news is the decline in commodity prices need not presage a collapse in global growth if it is mostly a function of a slow unwind of past excesses and the market’s previous monetary miscalibration.

A friend of mine from London (a currency-oriented macro guy) with whom I regularly exchange ideas asked me my views this morning. I’ve posted my side of these exchanges before. Here’s the latest:

I think the story with gold/silver is the same one we’ve been discussing since May 2011. The fever peaked (with the parabolic silver spike), and now we realize that (1) monetary easing isn’t as powerful as the markets had been thinking and (2) all the “tail-risk reasons” for owning gold and silver are melting away. And it is still a crowded trade amongst the macro tourist crowd that hate US monetary policy, but, when you read what they write, clearly haven’t understood it (e.g. inflation, higher yields, US-is-Greece, pick your variant). Think Einhorn, Loeb, Paulsen, Dalio (though Dalio’s not a tourist), etc.

In short, the monetary tables are now turned: it’s not Bernanke who needs an exit strategy, it’s them.

The framework I finally got around to laying out in June last year goes through things factor by factor. It seems as relevant now as it was then—at least to me.

More broadly, I am bullish, structurally. Growth will be mediocre, with scope for upward surprise only in the US—and even this would be modest. Plus in the US we have to slog through a fair amount more of fiscal drag. Growth everywhere else is not great, and in Europe it’s downright terrible. There is not enough lipstick in the whole Sephora chain for the PIIGS, and I expect more downside surprises—both with respect to depth and duration, but at least the surprises should now be of a lesser magnitude.

We will likely have risk hiccups out of the Old World, but the end game there (re-memberfication of the euro—I know, not a word) will be further out in time and only after years of economic contraction bring radical political alternatives more solidly into the mainstream. For now these forces are still dancing around the fringes.

But, for the medium term, I think low-ish but steady global growth is good for equities. Notice below how the amplitude of the surprise index swings post-crisis has been contracting. Textbook disaster myopia. Bottom line: People will need to take risk. Multiples should expand. Dividends are still a draw. Cash hurts.

I have been long equities (admittedly a little slow in jumping back on after getting off end-December) and short gold and silver. I haven’t needed to trade much. I took down equity risk on Friday for the first time in a while. I don’t like what I see in the European indices of late and if gold and silver accelerate further to the downside (which is my base case) the old correlation to equities would likely come back, dragging equities down along with the shiny stuff.

The equity market is loaded enough with “late purchases” that it wouldn’t take a huge story to generate a shakeout. A hard fall in precious metals could catalyze such a story. What would that story be? It really doesn’t matter much; we market participants always reverse engineer something plausible whenever we see sharp price action.

I am holding core long positions, now partially hedged with European “stuff”—in addition to the precious metal shorts. I hope we get a selloff in the next month or so, so that I can increase equity exposure. I suspect I am not alone in this, which of course complicates my odds of being right. If the selloff in precious metals accelerates too much I will probably trim some futures and sell some puts against a good part of the rest. But sooner or later—who knows when?—we are going to get a whoosh-type selloff in precious metals for the reasons outlined in my framework, so it’s very unlikely that I would take my exposure to zero. In my dream sequence, I am hoping that the market will let me keep my long equities, short precious metals positioning for the bulk of this year if not longer.

Late in January I was worried about having been too cautious since end-December yet too late to the party to add risk. I posted some charts showing that the odds were decent that the shift afoot was structural in nature, unlike the stop and go markets of the past two years. These charts made me more confident to go with the flow. Here is an update of those charts. And, sadly for the Policy Bears, the song remains the same.

The 2s-10s steepener trend looks robust, not tired. A great sign for risk taking.

EURAUD and EURCHF are signs of financial normalization. Don’t worry that AUD is considered a growth currency (more on this below), the bigger signal is that people are crawling out of their bunkers.

Mortgage rates (above) look set to go higher. Wait. Isn’t this bad for housing and therefore for the overall US recovery?

Answer: no, for two reasons. One, from a financial point of view it shows investors are moving out the risk spectrum. And two, price hasn’t been holding buyers back. Down payments, job security, and tighter lending standard have. Levels are still plenty low enough for solid borrowers who can make the down payment to buy.

If indeed this is the structural shift in risk taking that it appears to be, it will be more about normalizing financial risk appetite than a rapid acceleration in growth—either here in the US or globally. This means the reflexive reach for commodities and commodity proxies (e.g. AUD) that has accompanied every risk impulse for the past five years may come a cropper this time—particularly since we have seen behind the Great Monetary Curtain and realize the machine is being run by mortals (i.e. The broader money supply is endogenous, and is driven by risk appetite and not money printing).

The portfolio implication for the investor? Structurally long equities, hedged with structural commodity shorts.

Four charts tell a powerful story of where we are. They all say “It’s Structural this time”. Safe Haven Exodus.

Yes, I know a correction could happen at any time. I myself got caught out jumping off the train a little too early back in late December. But longer-term, if you do the impossible and look out over the news cycle, these four charts below tell us a structural shift in risk allocation is afoot. The Policy Bears, the Central Planning Truthers, are either getting tapped on the shoulder or rounded up to be executed. How fitting: Death by stocks.

I am not talking about short- and medium-term positions, the kinds that get picked up in sentiment surveys and overbought/oversold oscillators. I am referring to the structural hedges big, slower-to-move strategic investors have had on to protect against the next macro crash. These massive structural trades—and make no mistake, they are measured by the ‘yard’—appear to be in a fairly early phase of unwinding.

 

Above is the yield spread between the 2yr and 10yr UST yields, charted on a weekly basis back 5yrs. Moving higher is referred to as curve steepening, and is associated positively with growth expectations and risk taking. If you think about where this spread was in 2011 and how much better we feel about today’s economy and financial landscape, this spread could easily get back to well north of 200bps.

Another structural Safe Haven position has been to be short EURCHF. In size. Long CHF and short EUR. The reasoning is clear. Europe bad, Switzerland safe. I don’t think Europe is anywhere near out of the woods, but between the LTRO and the OMT, they have “merely” a growth problem now—or, at least for the next year or two. Rightly or wrongly, people are assigning a higher probability to Europe muddling through, causing the macro monsters to unwind the flight-to-Zurich trade.

 

A first cousin of the EURCHF position is short EURAUD. Again, the logic is clear. Europe has no growth prospects and risked imminent financial meltdown. AUD, on the other hand, lives where the growth is, with a commodity kicker/China play thrown in. It has also trended for a long time, suggesting that a lot of trend following CTAs and hedgies have been riding it. The chart here two, suggests this trade too is now in the early phases of getting unwound.

 

Lastly, a more exotic version of these Safe Haven positions is Short TRYZAR. This, too is unwinding. This trade is trickier because there are idiosyncratic moving parts in both countries, especially South Africa. But it does reflect global normalization from crisis mode coupled with modest growth. It also suggests, as do the 2s10s steepener and long EURAUD, that commodities will not bounce back as forcefully as they have in the past few years on bouts of risk appetite.

 

But I should finish by being clear about my views: Don’t confuse me with a growth bull. Both the developed and developing economies have “digestive” issues they need to grind through, and economic expectations have improved to the point that when fiscal drag in the US starts kicking harder there will be room for disappointment. But the incipient unwind of these positions is nonetheless a strong long-term positive. It tells us a broader investing audience is, in deed and not just in word, coming around to realizing the next financial calamity, the Lehman II, that lurking “Other shoe”, is just not on the horizon.

On December 16th I posted some trading views, in which I referenced the economic surprise index Citigroup publishes for the US. Here it is, from that date, below:

And here is the update from today:

Remember, a positive reading of the Index suggests that economic releases have been, on balance, beating consensus. So a lower positive number means less positive surprise. It doesn’t mean negative surprise until it crosses zero.

We’re approaching zero pretty fast.

The debate about the impact on US treasury yields from the Federal Reserve’s LSAP programs—often referred to as Quantitative Easing—is raging into its fourth year. In fact, now that the time series are getting long enough for more robust number crunching, I suspect academics are going to really start diving in and begin the writing of history.

Practitioners, however—both policy makers and those of us who have money on the line—don’t have the luxury of time. We are entering a critical phase right now. Why? Household leverage has been the prime impediment to a normal functioning of monetary policy. And it is now starting to get down to a point where monetary policy will start gaining traction. Not a lot of traction, because these processes are slow, but any traction at all means the days of the dreaded liquidity trap are numbered.

So we are now going to have think harder, and in more practical terms, about the counterfactual: where would UST rates be without the exceptional monetary stimuli the Fed hath wrought.

There are two basic camps in this debate, and from where I sit, neither side has it quite right.

One camp says the Fed’s massive purchases of USTs and agency mortgages have artificially lowered rates a lot. Looking at UST yields and spreads throughout the fixed income complex gives them sticker shock. Some fixed income managers are even mad. They fear that this is inducing a misallocation of resources, incenting higher government spending than would otherwise be the case, is hurting savers, and might constitute a new bubble. Many in this camp fear high inflation will follow. Their prediction for when the Fed stops buying? Pain—pain in markets, pain in the economy, and pain in the budget, stemming from the higher UST rates they assume will follow.

This camp comprises much of the professional fixed income asset management crowd, the majority of sell-side strategists, a fair number of economists (e.g. the recent op-ed by Marty Feldstein in the WSJ), and virtually all of the Policy Bears (think, for example ZeroHedge or CNBC’s Ric Santelli).

The second camp claims it is all about expectations, not physical purchases, and that QEs have actually raised UST yields relative to where they would otherwise be. Joe Wiesenthal over at Business Insider was perhaps the first to propagate this view. Others, like Matt O’Brien at the Atlantic and Matt Yglesias at Slate, have more recently laid out the same basic case: looser monetary policy from central bank bond buying raises, rather than lowers, rates because the indirect effect through expectations on future nominal GDP growth is greater than the countervailing pressures from bond purchases.

This camp comprises an increasing number of sharp-eyed financial/economic journalists, some of the more nuanced fixed income veterans, most salt water economists, and a lot of equity managers (who always seem to be on the lookout for a bullish story).

This view is always buttressed by some version of the very convincing chart shown below, in this instance lifted from Matt O’Brien:

 

In it, one can see very clearly that when the physical purchases of USTs and mortgages were taking place bond prices were indeed going down and yields higher.

Conversely, the moves higher in price and lower in yield happened when the Fed “wasn’t in the market”.

The rationale is simple: the Fed tended to hint at or announce QE programs when the economy and markets appeared to be weakening sharply. The chart shows that even though we were in the throes of a deep in a liquidity trap, the psychological effect of Fed support was strong enough to snap us out of slide into self-reinforcing pessimism and move us away from nastier equilibria.

Okay, that was easy. So, case closed? QE means higher rates, right?

Not so fast. Look more closely at the chart.

The idea behind large scale asset purchases, of course, is that they are supposed to drive down interest rates and facilitate the healing of bloated private sector balance sheets, in our case, in the household and financial sectors. This, in turn, would lead ultimately to a resumption of lending, once the lenders and borrowers have worked themselves back into stronger financial positions.

The theoretical debate has taken for granted that LSAPs lowers rates, and instead focused on the channel through which the purchases would achieve this. Thinking about these channels is important.

First, there is the “Flow” channel. Some academics and most markets participants have been inclined to believe that LSAPs lower rates through a flow effect, that is, through the physical purchases. The intuition here is powerful: sharply increased demand means higher prices, lower yields.

On the other hand, many academics and policy makers—including the bulk of the Fed—believe rates are lowered through a stock effect. That is, asset purchases reduce the available stock of assets, and so, for a given view, the clearing price will be higher (and the yield lower) than otherwise would have been the case. The implication is that this affects, over time, the level of yields, even if the oscillations in yields are driven by other factors, such as economic expectations.

Now, let’s go back and look at the chart again. You will see what technicians call “lower highs and lower lows”. And it’s important to note that this pattern was taking place against the backdrop of an improving economy which would normally push UST yields higher.

This to me means two important things: one, LSAPs have almost certainly over time lowered the clearing rate for UST yields—even though the impulse correlation, driven by economic expectations, has worked in the short-term in the opposite direction.

The second observation is that the “expectations effect” was of lesser amplitude with each Fed announcement, again, against the backdrop of an improving economy. In fact, after QE3, there was virtually no bump at all. This is because sentiment surrounding monetary policy has done a 180 over the past two/three years. Because the shifts in expectations were not subsequently validated by fundamentals, market participants progressively came to view effects from Fed policy as psychological and ephemeral. It went from ‘very hard’ two years ago to make the case that QE wouldn’t be inflationary to ‘fairly easy’ today. Most everyone by now has wrapped their head around the notion of “liquidity trap”.

Two conclusions can be drawn from this. One, the end of LSAPs will matter for yield levels—even if the Fed decides not to sell any of its holdings and let their book run off. So, if you think it is entirely about economic expectations you are likely to underestimate the magnitude of yield “normalization”.

Two, many investors and analysts have settled into the notion that we are in a liquidity trap, and that monetary policy here is largely “pushing on a string”. While this is still for the most part the current environment, it is finally, slowly, starting to change. Monetary policy can be very, very powerful when the soil is fertile. This is not the time to become complacent about the impotence of monetary policy. That time has passed. It may not be tomorrow, but the efficacy of monetary policy has now become, as the economists might say, a positive function of time.

The only asset that can embarrass you faster and more brutally than silver (and to a lesser extent, gold) is natural gas, the nitroglycerin of futures trading. With that firmly in mind, and in light of the recent price action, here are my current thoughts:

My fundamental views about silver and gold are, gulp, on record here and more recently here. What has changed recently is that the impulse correlations of precious metals to stocks, the US dollar, and bond yields, which have been steadily declining for a long time, have now flipped signs.

Despite all the talk about safe haven status in recent years, PMs have had a strong positive correlation with stocks and risky assets more generally. Their correlation with the dollar, of course, has been strongly negative. Less intuitively, the impulse correlation of PMs to treasury yields has been positive, even though low levels of yield (more precisely, real rates) is an important driver of higher PM prices.

These correlations have flipped in the last few days in a way that is apparent to everyone. The decline in gold and silver in the face of a strong bid to risky assets will now likely force people to reconsider their investment hypothesis for holding them. Big events and correlations that change signs often do. Specifically, a lot of big macro tourists hold large PM positions, and what I believe we are seeing is some of them starting to hit the bid. It is also possible that some of them are also facing redemptions, since those clinging hardest to their PM positions are also those most likely to have been working under the wrong economic assumptions and underperforming all year. So, the year-end dynamic may be exacerbating the pressure we are currently seeing

On the technical side, though I am not, ahem, a master technician, it is apparent that gold and silver yesterday broke medium-term trend lines. But I actually don’t think that is unusually significant. As I said before, PMs are notoriously tricky to trade on a short-term basis. I’m sure even the best technicians have great war stories about being fooled by gold and silver. What I think is hugely significant is the 1600 level on gold (Feb 2013 contract). If it breaks below that level I think the warning flare goes up for everyone to see. Gold has rebounded from strong corrections before and may well rebound from this one. But I have a strong sense that if we get below 1600, it will matter in a way it hasn’t in many years, and all (gold) bets will be (taken) off.