DL | davianletter.

com

Monday, May 10, 2010

Macro Note
Rumors were flying Thursday as equity markets plunged roughly 9% before

TDL Research | Macro Note

rebounding, eventually closing down 3.5%. One being that a trader from Citi made
an erroneous trade in E-Mini S&P futures by entering incorrect order size by typing a
B for billion rather than M for million. This doesn’t make sense for a number of
reasons. In addition, it doesn’t explain the various equity issues that showed prints
Philip Dunham of zero or a penny to others that showed prints of 100,000. Rather spending time
philip.dunham@davianletter.com dissecting why it doesn’t make sense, I will just note that NADAQ, NYSE and the
(985)789-5445 ECN’s announced they would be busting trades that meet a certain criteria and CME
Group released a statement saying,

“Upon review of yesterday's trading activity in CME Group markets, we

In Focus:
A “Flash Crash”? Probably not.
EU & IMF agree on €750bil bailout
ECB will intervene in public and private debt
markets
Federal Reserve opens Swap Lines with
Major Central Banks
BoJ intervenes Friday morning in Asia.
Q1 GDP increased by 3.2%
Unemployment rate up to 9.9% from 9.7% in
March despite increase in NFP
have concluded that we did not experience technology or systems issues
associated with trading activity between 1:00 and 2:00 p.m. CST.
Additionally, it does not appear that CME Group clearing firms or customers
experienced any significant technological failures or trading errors during
this timeframe.
Finally, CME Clearing participants have not experienced any difficulties as a
result of market events yesterday and all clearing members remain in good
standing having met all financial obligations to the CME Clearing House.”
As of Sunday, origins of anomalies in P&G are being traced to a broker in
Chicago. A chart of USD/JPY and P&G is on page 8 showing that selloff in USD/JPY
was almost over before selling in P&G started. While a case to be made that high
frequency trading systems exacerbated yesterday’s market plunge, looking to
computer glitches, etc. is obscuring what is in plain sight.
The most notable moves on Thursday, in my mind were in Eurodollars and
USD/JPY (Charts on next page). It is unlikely that a computer glitch in U.S. equity
markets caused FX markets to move like they did. Thanks to Ed Bradford for
bringing swap spreads to my attention and Professor Pinch for highlighting LIBOR-
EURIBOR spreads.

The first, most obvious source of concern is the Euro Zone/Greece debt
crisis. Thursday was the European Central Bank’s first meeting since the EU and IMF
extended a €110bil emergency loan to Greece. In addition, the ECB suspended its
minimum credit rating threshold in collateral eligibility requirements to allow (now
downgraded) Greek Government bonds to be posted as collateral for ECB funding.
This is similar to some of the actions by the U.S. Federal reserve during the subprime crisis. This however does not solve the
problem of potential for future default by Greece. The net result was further losses in Euro.

I was particularly struck by ECB President Jean-Claude Trichet’s apparent lack of concern for the problem faced by the Euro
Zone during Thursday’s ECB press conference, only reiterating that “Greece will not default”. The terms of the EU/IMF require
Greece to narrow its budget shortfall from 13.6% of GDP to 7.6% in 2011, to 2.6% in 2014. This approaches extremely optimistic
given the fact that Government Expenditure was 50.4% and revenue was 36.9% of Greece’s GDP as of 2009 (Source – Eurostat).

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DL | davianletter.com

Monday, May 10, 2010

USD/JPY - Daily
To narrow its deficit to 7.6% in
2011, Greece would have to reduce total
expenditure by 11% from 2009 levels
assuming revenue is unchanged, which in
itself is unlikely (2010 total expenditure is
presumable higher, but most recent
Eurostat GFS data is only to 2009). As I am
writing this, the EU has agreed on a loan
package worth €750bil, €440 of which will
be backed by EU governments and €250bil
will come from the IMF as well as an
additional €60bil expansion of the balance
of payments facility that was used to aid
Latvia and other non-EU countries in 2008.
The ECB also said it would intervene in
public and private secondary debt markets.

On our side of the Atlantic, the Fed

opened swap lines with the ECB, Swiss
National Bank, and Banks of England,
Canada, and Japan. The Fed press release
cited re-emergence of strains in short term
U.S. Dollar funding. Immediate market
reaction should be USD selloff.
Source - eSignal
The BoJ also intervened Thursday Front Month Eurodollar Futures - Daily
evening (Friday morning in Asia), offering
emergency funding of ¥2trillion. The BoJ
has made it clear it will defend the ¥87.00-
88.00 level in USD/JPY. We have been
positive on USD/JPY from 89.00 in January
based on medium term expectation of
higher U.S. interest rates. While 88.00 is
significant support, the sharp rebound and
generally high FX volatility has us stepping
back after Thursday’s move while USD/JPY
is between 90.00-93.00 because we cannot
rule out a move lower in the near term.

Source - eSignal

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DL | davianletter.com
The focus, at least from U.S. based investors was on
U.S. equities. After a 77% rally from March 2009 lows to April
2010 highs in the S&P 500, equities were due for a correction.
With a combination of fundamental and technical factors
supporting our thesis, we think equities are oversold in the
immediate term, but have lower to go as we move into
summer.
The rally from March 2009 to March 2010 saw
relatively low volume. This is indicative of lack of
participation. On average, 1million shares per week were
E-Mini S&P 500 Futures (Weekly)
Monday, May 10, 2010
traded in SPY and 10 million contracts in E-Mini S&P 500
futures. In addition, sell volume was relatively higher than
buy volume. Last week’s volume was roughly a third higher
than average volume over last year’s rally.
1200 in the S&P 500 was support pre-Lehman/AIG.
We expect this to be relatively strong resistance going
forward.
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DL | davianletter.com

In addition to technical factors
pointing to limited upside for U.S. equities,
fundamentals may be topping out. While
we can’t argue that growth has been on an
upward trajectory and there are no obvious
negatives in the data yet, we are concerned
G.19 revolving credit fell by an annualized rate Monday, May 10, 2010
of -8.4% in February, if unemployment remains
elevated, growth may not be sustainable without additional government stimulus.
GDP Annualized % Change Real & Nominal
12.0

about the sustainability of growth going 10.0

forward. Also worth noting is that
8.0
traditional, trend based economic
forecasting inherently misses turning points 6.0
in data.
4.0

The First estimate of Q1 2010 GDP 2.0

showed the U.S. grew by an annualized rate
0.0
of 3.2% in real terms, 4.1% in nominal
terms. This was slightly below consensus -2.0

expectations of 3.2%. Looking at the -4.0

components, Q1 growth was relatively
-6.0
solid. Real personal consumption
expenditures increased by 3.6% compared -8.0
with a rate of 1.6% for Q4 2009. Federal
consumption and investment increased
1.4% compared to no change in Q4 2009 Nominal GDP QoQ % Change Real GDP QoQ % Change

while State and local expenditure decreased Source – BEA, TDL Research
-3.8%. Real private inventories added U.S Non-Farm Payrolls (MoM Change) (LHS) & U.S. Unemployment Rate (RHS)
1.57% to headline GDP compared to 3.79% 400 12.0
in the prior quarter. Real final sales 200
increased 1.6%, slightly slower than 1.7% in 10.0
0
Q4 2009.
-200
8.0
Non-Farm Payrolls increased by -400
seasonally adjusted 290k in April while the
-600
unemployment rate ticked up from 9.7% in 6.0
-800
March to 9.9%. The uptick in the
unemployment rate was due to previously -1000
4.0
discouraged workers re-entering the labor -1200
force increasing the labor force by 805k. -1400 2.0

Two of the primary concerns for -1600

the U.S. economy in the wake of the -1800 0.0

subprime crisis have been whether the

recovery is sustainable without government
stimulus and if final demand would begin to NFP Net Change Unemployment Rate
pick up after the boost from inventory
Source – BLS, TDL Research
adjustment begins to fade. As of now, final
sales look relatively resilient. However,
with real disposable personal income
unchanged in Q1 and the savings rate falling
to 2.7% in March (3.1% for Q1 as a whole)
together with contracting consumer credit.

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DL | davianletter.com

Comparison to Japanese Monday, May 10, 2010

equities post property Nikkei 225 (LHS) & S&P 500 (RHS) 1984-2010 (Monthly)

bubble
45000 1800

40000 1600
Since the state of the U.S. economy must be
35000 1400
considered within the context of the real
estate bubble and subsequent subprime 30000 1200
crisis and its fallout, it is worth looking at
Japanese equities in the wake of Japan’s 25000 1000

late 1980’s property bubble.

20000 800

The Nikkei 225 fell nearly 60%

15000 600
from its peak in December 1989 to summer
of 1992. The S&P 500 fell nearly 50% from 10000 400
October 2007 to March 2009.
5000 200

The major difference between the

0 0
two crises was the policy response.
Primarily the U.S. Federal Reserve’s liquidity
facilities and asset purchases. While the
Nikkei 225 S&P 500
Fed’s response helped stop the collapse in
asset prices. Given the U.S. dependence on Source – eSignal, TDL Research
credit expansion from 2003-2006, we can’t Nikkei 225 (LHS) & S&P 500 (RHS)
help be question where growth will come 45000 1800

from if credit availability continues to

40000 1600
contract. Nikkei 225 December 1987 Peak
S&P 500 October 2007 Peak
35000 1400
We are not arguing that U.S.
equities will follow the same path as
30000 1200
Japanese equities, but the trajectory is
worth thinking about. 25000 1000

20000 800

15000 600

10000 400

5000 200

0 0
-7 17 41 65 89 113 137 161 185 209 233

Nikkei 225 S&P 500

Source – eSignal, TDL Research

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DL | davianletter.com

FX – USD/CAD Monday, May 10, 2010

USD/CAD Daily
At its most recent meeting on April 20, the 1.35
BoC struck a mildly positive tone, noting
“stronger near-term global growth” and 1.3
“very strong housing activity in Canada”.
1.25
On the other side of the coin, the BoC
acknowledged Canadian dollar strength, 1.2
weak relative Canadian productivity and
weak U.S. demand as drags on growth. 1.15

1.1
That said, we do not think the BoC is overly
concerned with Canadian dollar strength 1.05
(yet). Continuing with its relatively hawkish
tone, the BoC is focused on inflation and its 1
target band of 1 to 3 percent. Based on the
0.95
Boc’s outlook for slightly firmer inflation
near term, and the diminished need for
extraordinary monetary stimulus, we expect
the target overnight rate to be raised 25
USD/CAD
basis points to 0.50%. Unless Canadian
growth surprises well above expectations, Source – eSignal, TDL Research
we do not expect this to be the beginning of USDX 30 Day Historical Volatility
a rapid tightening cycle.
0.14
Given this outlook, we would look for short
entry points in the 1.0400-1.0600 range 0.12
with an expected move below parity.
However, all bets are off if USD/CAD cannot 0.1
pierce 1.0200 support.
0.08

0.06

0.04

0.02

30 Day Historical Volatility

Source - eSignal, TDL Research

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DL | davianletter.com

IR – US Treasuries Monday, May 10, 2010

U.S. Treasury Yields – 2 Year, 10 Year & 2-10 Spread

Treasury yields fell across the curve after 3.5 4.5
peaking at the beginning of April. Prices
4
surged last Thursday along with the U.S. 3
equity selloff and escalation of the 3.5
EuroZone crisis. This flattened the curve 2.5
substantially, bringing the 2-10 spread to 3

March levels around 2.66. After the €750bil 2 2.5

EU/IMF bailout, the bid for treasuries
should ease off. We think that bond prices 1.5 2

are peaking (if they have not already) but 1.5

we would be cautious not to rush into short 1

positions. 1

0.5
0.5
This week, the Treasury will
auction 3yr($38bil), 10yr($24bil) and 0 0
30yr($16bil) notes Tuesday, Wednesday
and Thursday respectively.

2-10 Spread 2 Year 10 Year

Source – Federal Reserve, TDL Research

U.S. Treasury Yield Curve

4.5

3.5

2.5

1.5

0.5

0
Fed 1 Month 3 Month 6 month 1 Year 2 Year 3 Year 5 Year 7 Year 10 Year 20 Year 30 Year
Funds

2010-02-01 2010-03-01 2010-05-03 2010-05-06

Source – Federal Reserve, TDL Research

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DL | davianletter.com

Monday, May 10, 2010

Most of USD/JPY selloff was over before P&G selloff started pointing to strains in U.S. dollar short term funding markets as the
source of Thursday’s selloff rather than unusual selling in P&G as the source.

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DL | davianletter.com

Disclaimer Monday, May 10, 2010

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