Rising gold lease rates and the front-end backwardation

Gold lease rates have risen dramatically this year. In fact on the short end, lease rates are now higher than US dollar interest rates - which is quite unusual.

Source: KITCO (click to enlarge)

Part of the reason for rising lease rates this year is an increase in hedging activity ahead of the Fed's series of decisions on QE3. Investors, mining firms, banks, etc. who are long gold are selling gold forward contracts as a hedge against their positions. The providers of these forwards (usually dealers) hedge themselves in the physical market by borrowing gold for a fixed period and shorting it into the spot market. A forward contract provider thus becomes long a gold forward in the derivatives market (via forward they bought from a client) and short a gold forward in the cash market (via a combination of lease and a physical short) - thus fully hedged. The demand to borrow physical gold in order to short it is forcing lease rates higher.

One interpretation of this trend from an economic perspective is that gold lease rates to some extent mirror global real rates - if one thinks of gold as an international "inflation-free" currency (h/t Ed Grebeck). Gold lease rates move higher due to expectations of rising real rates. That to some extent explains why gold lease rates were negative last year.

The combination of much higher lease rates and low short-term dollar rates has created an unusual gold forward curve. Here is what the COMEX gold futures curve looks like now. The curve is quite flat in the front and even inverted in the first two months.

Note that the futures curve begins to rise in the first half of 2015, around the time of the Fed's first expected rate hike. The inversion in the front end (Aug-Sep backwardation) is highly unusual for gold (would only happen when lease rates exceed short-term dollar interest rates.) In fact this has not happened over a 4-week period at any time during the past 30 years - until now.

Source: JPMorgan

As long as hedging activity stays strong, demand to borrow physical gold will keep lease rates elevated. In the intermediate term this is probably a positive for spot gold prices because if the hedging activity slows, dealers will be covering their spot short positions and not rolling into new ones.

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Are mortgage rates impacting construction? A couple of signals from the markets

Here are three charts to consider:

1. Mortgage rates this month -

Source: MND

2. Lumber futures prices this month -

September lumber futures (source: Barchart)

Is this telling us something about expectations for housing starts this month?

3. For those who think the above two charts are a coincidence, here is a signal from the equity markets comparing homebuilder shares with the S&P500 over the past 3 months.

Homebuilders index vs. the S&P500 total return (Source: Ycharts)

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India, Brazil should thank Bernanke for their currency woes

India and Brazil are struggling to regain control of their currencies as both the rupee and the real touch new lows (all-time record for the rupee). It is remarkable how violent the corrections have been in just the past 3 months:

Green = rupees per dollar; Blue = real per dollar 

For those who don't watch these currencies on a daily basis, these sell-offs seem to happen in spurts - almost at random. But there is a pattern here, particularly in the past few months. Investors are dumping these currencies during periods of higher expectations of the Fed's slowing its securities purchase program. The evidence for the pattern is in the correlation between these exchange rates and the US treasury yields. Since Bernanke's first comments on slowing the securities program, currency weakness consistently corresponds to higher US yields resulting from sharper taper expectations (see post).

Brazil

India

The prospects of higher long-term interest rates resulting from the Fed's taper is forcing investors out of emerging markets - and these two nations are feeling the brunt of this "rotation". To be sure, we have no way of knowing if this would have still occurred if the Fed had not initiated QE3 a year ago. But the severity and the speed of these corrections would suggest that this is one of those unintended consequences of applying and then trying to exit an aggressive monetary stimulus program within highly interconnected capital markets, operating in a global economy. This has not been a part of the FOMC's forecast...

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Weaker earnings will result in higher corporate default rates; "zombie companies" yet to be hit

Credit Suisse is ringing alarm bells on corporate earnings - both in the US and Europe. The Wal-Mart negative earnings surprise last week for example could be signaling a slower earnings trajectory for other firms.

What CS is particularly focused on is not necessarily the stock market valuations in the US and Europe (which is a separate problem), but corporate default rates instead. So far default rates have been extraordinary low - around the levels seen during 2005-2007 "bubble" years.

US HY issuers default rate (source: JPM)

Increasing numbers of middle market firms are having difficulties growing revenue or even losing money and yet obtaining all sorts of financing (see post). The current earnings situation is simply not consistent with the current level of default rates.

CS: - ... the current levels of companies losing money on both sides of the Atlantic is rising. This is not yet a phenomenon in the largest companies – which is why Wal-Mart might be very important – more, it is a problem in the medium-capitalisation range. But it would normally be associated with a very much higher high-yield default rate and therefore much tighter financing conditions of which all markets, not just credit markets, would have to take notice.

Source: CS

As the percentage of money-losing firms rises, corporate default rates should follow. The chart below compares the two trends: "Current profit performance is consistent with a default rate of 6%, not
the current 2.8% in the US …"

US firms only (source: CS; slightly modified/simplified)

That is why Q3 earnings results will be vital. If the rise in the number of firms with poor or negative earnings continues, default rates are sure to pick up. And the catalyst could be the sudden spike in interest rates we've had - which has the potential to squeeze corporate margins.

CS: - So we have a strong suspicion that the medicine applied to the financial sector has suppressed corporate defaults (the thematic “zombie companies” argument.) Raising the awful possibility that we may be only part-way through a current default event dating all the way back to 2008/9, with the other foot to fall as we all realize that the new normal has to involve some sort of positive interest rate.

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Further fiscal drag poses risks to the US economy

One of the reasons for the slow US recovery has been weaker than usual government spending. The weakness started with fiscal consolidation at the state and local level, driven by sharp declines in tax revenues. The negative impact on the economy is now more pronounced at the federal level. In previous recoveries government expenditures provided cushion to the economy, while in this recovery the net impact of government activity creates a drag. Of course the recent tax increases have not been helpful either.

Source: DB

The most direct impact is visible in the number of government jobs - the impact on the private sector that services the government is of course quite large as well. The chart below shows the decline in government payrolls over time (not seasonally adjusted).

Source: US Department of Labor

While government payrolls continue to fall, the decline has been slowing - mostly due to the stabilization in state and local employment. Federal jobs however are another story.

Given the fiscal drag resulting from an already weak (relatively) federal spending, the US economy is highly vulnerable to a negative outcome of the upcoming debt ceiling/budget fight. And while tightening federal spending is absolutely vital, a disruption at this juncture could prove to be costly.

BNY Mellon: - The upcoming showdown between Republicans and Democrats of Capitol Hill over both the 2014 federal budget and the national debt ceiling is shaping up to be a battle royal in Washington...”

In fact the "showdown" has already started. Some Republicans have threatened to shut down the federal government (by withholding funding) if the administration does not compromise on the Affordable Care Act. Yesterday the Obama administration fired back (see video below). While nobody thinks the situation will turn as ugly as it did in 2011, a major budget disruption (beyond the sequester) could create a serious setback for the US economy. And in this tepid recovery there is little else that could cushion this potential increase in "fiscal drag".

What's particularly concerning however is that after having developed a "tolerance" to repeated budget fights, the public seems to have completely lost interest in the topic.

Google Trends for phrase "federal budget" (US-based searches only)

Enjoy!

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Mortgage refinance boom ending

While there is still some debate about the degree to which higher rates are impacting housing demand (see post), there is no question about the drop off in refinancing activity. The refinance applications index is down 60% from a year ago. The (poorly designed) chart below from MND shows the refinance index and the 30y mortgage rates.

Source: Mortgage News Daily

Perhaps an even better indicator of refinance activity is the frequency of US Google search for the phrase "mortgage refinance" (chart below), which is consistent with the applications index.

Google Trends US search for "mortgage refinance"

This slowdown is negatively impacting profitability in the banking sector and even generating layoffs. Moreover, economists are forecasting refinancing activity to shrink further in the next few quarters. The refi gravy train is coming to a stop.

The Denver Post: - Higher interest rates are strangling the mortgage-refinancing market, eroding the industry's profits and forcing job cuts.

"The refinancing volume has significantly dropped off," said Jim Hunter, president of the board of directors at the Colorado Mortgage Lenders Association. "It is putting pricing pressure into the market."

Wells Fargo announced Aug. 7 that it would let go of 763 loan-processing workers nationally, including 118 in Colorado, because of the slowdown in mortgage activity.

A day later, Chase Mortgage Banking said it would eliminate 150 positions in Colorado, effectively moving its mortgage-processing operations out of state.
...

Refinances, which were 83 percent of all mortgage activity in mid-December, are down to 63 percent. Economists at the MBA estimate they could decline to a third of the total by the third quarter of 2014 .

All of that means less business for lenders. Quarterly mortgage-origination volumes were running between $471 billion and $511 billion over the past four quarters. That volume could drop to $247 billion by the fourth quarter, the MBA forecasts.

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China's "flash rally" will further erode confidence in domestic markets

China's stock market has experienced another setback to its credibility when Everbright Securities' trading error caused China's version of "flash crash". It was actually a "flash rally" generated by the brokerage firm's massive buy orders (someone "fat-fingered" an extra zero or two). The firm was trading with its proprietary account.

The Shanghai Composite intraday (source:Yahoo/finance)

Bloomberg: - “When the proprietary operation of the strategic investment department of Everbright Securities used its independent arbitrage system, it encountered a problem,” Everbright said in its statement to the Shanghai stock exchange last week. All other operations are normal, China’s fifth-largest brokerage by market value said.

Given the capitalization of the nation's companies, China's stock market is relatively thinly traded, making it more vulnerable to large orders. Sadly, anecdotal evidence suggests that retail investors often get "picked off" by trading programs managed by brokerage firms running "strategic investment departments" (which of course is not unique to China). It is no wonder that the percentage of dormant retail accounts has been rising for years (see post). This latest incident will further erode retail investors' confidence in the nation's domestic markets.

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Treasuries increasingly drive stock market performance

In recent months the US equity markets have become increasingly sensitive to movements in treasury yields.

BMO Capital Markets: - U.S. equity markets stumbled this week, with the S&P 500 sliding 2.1% and the Dow now skidding almost 4% from the record close set earlier this month. Most of the damage came on Thursday alongside a host of factors including disappointing July industrial production, downbeat corporate news from some Dow heavies and, perversely, a drop in jobless claims to the lowest level since 2007. The latter helped stoke expectations that Fed tapering is fast approaching, and pushed the 10-year Treasury yield above 2.8% for the first time in more than two years. Indeed, while not a big fan of the whole ‘good news is bad news’ refrain, it’s hard to ignore the recent inability of the equity market to absorb upward moves in bond yields.

In fact the correlation between the S&P500 and the 10yr treasury yield hit a new post-recession low (higher yields driving stock prices lower).

Not surprisingly, it was the high-dividend shares that have been most impacted by rising rates (higher rates decrease the present value of future dividends). After an impressive performance this spring, high dividend shares now lag the S&P500 by over 3% for the year (on average).

Source: Ycharts

Furthermore, if rates continue to rise, higher cost of borrowing will ultimately begin to eat into earnings - and will be immediately reflected in stock prices. At this stage the stock market in the US (and to some extent globally) is taking its lead from treasuries.

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