China

I missed this article, after not paying attention to Caijing's website over the weekend.

China's state-owned enterprises may unilaterally terminate commodities contracts as they try to cut massive losses from financial derivatives, an industry source told Caijing on August 28.

According to the source, China's State-owned Assets Supervision and Administration Commission (SASAC) has sent notice to six foreign financial institutions informing them that several state-owned enterprise will reserve the right to default on commodities contracts signed with those institutions.

This is of great significance in terms of investment bank earnings in their OTC trades in Hong Kong. It also raises a question as to how well counterparties have "netted" these OTC trades in the underlying commodities.

Foreign brokerages usually work through their Hong Kong operations to sign over-the-counter derivative hedging contracts, according to an investment banker whose firm is involved in the business. Hong Kong and Singapore usually serve as venues for arbitration over such transactions.

Most investment banks may "just swallow" any losses arising from canceled contracts, the executive said, adding that any losses are usually made up for with compensating trades.

Investment banks "just earn less" from such transactions, he said.

But any such move would be a major blow to investment banks which service massive commodities hedging operations for Chinese SOEs on the international market, said the executive.

Regardless of potential losses for participating firms, this is a worrying sign for the transparency and security of doing business in China.

Goldman Sachs

I have learnt with no small degree of pain that you have to be really sure should ever get on the other side of a trade with Goldman Sachs. And this just in:

China stocks remain “a bright spot” among global equities because of the nation’s strong growth potential, Goldman Sachs Group Inc. said.

Goldman Sachs set its targets for the Hang Seng China Enterprises Index at 16,800 and CSI 300 Index at 4,300 for end- 2010, according to a research note today.

“We think the market concerns about a near-term ‘exit strategy’ appear premature as the government remains pro-growth and real interest rates are still near the historical highs,” Thomas Deng and Kinger Lau, analysts at Goldman Sachs, wrote in a research note today.

Feeling Japanese

Continuing with the Japanese flavour of this morning's posting, here is some Bank of America research:

S&P 500 in a Secular Bear Market - Comparison with Japan Nikkei

I think that this assumes a "lost decade" for the US. More on this later.

The Nikkei is now negative for the day.

The Melt Up

As I type this entry the Nikkei is going bonkers, up over 2% on an election result that most thought was priced in. Clearly overturning a 50 year political dynasty has led to more euphoria than expected over the weekend and this is feeding through into today's trading. The bid in Japanese equities is an obvious disconnect between record unemployment and Yen strength. Expensive exports mixed with growing unemployment and deflation; equities rally! Nevermind.

The Summer rally, a melt up, is another momentum squeeze driven more by the fear of missing the boat than fundementals. The fact that the good ship Vasa might be in a spot of trouble is neither here nor there.

However, managing a portfolio leaves little time for hand-wringing, and one must work with the facts as they lie. Thus, when the macro picture breaks down, it might be time for some select and nimble micro trading.

Back to the macro picture for a dose of reality. Here's a sobering chart for residents of Florida from Calculatedrisk:

When things stop making sense

There has been a distinct lack of the normal correlation in markets over the last few days and, in some instances (bonds), a few weeks.

For as long as this rally has been going, the "risk-on" trade has been long equities, commodities, associated FX (AUD, CAD etc.), and EMFX. We had a simple pattern - if equities were up, the dollar was under pressure and commodities would rally. Bonds suffered as a result, whilst facing their own QE headwinds. This matrix was driven by "green shoots", the infamous second derivative (things are getting worse but at a lesser rate), and China.

The above moves have been matched by a steady decrease in the VIX, too.

I'm not going to go into the fundamentals of these price movements, I have a severe enough concussion already from banging my head against that wall. Rather I'd like to take a look at how this "risk-on" theme is falling apart.

The first port of call is the often derided, often lauded Baltic Dry Index. It has been written off as irrelevant as many times as it has been used to bolster a side of the commodity debate. The BRY has had a strong correlation with Australian dollar strength, it is one of the reasons why I have never written it off. The price of the raw materials exported from Australia are closely linked to shipping rates.



The divergence of late is quite striking, is it not?

The other divergence has been the fate of emerging market currencies and the S&P 500.



Since the beginning of July the SPX is up about 12%, whilst the BRL is up against the USD by just under 8%. More importantly, the BRL is off in the last three weeks from its highs, whilst the SPX has made a new year high. It is as a similar story for the AUD, which has not surpassed its early August high.



The other odd thing lately has been the strength of US Treasurys. Despite calls for the end of the bond market, bids have stubbornly remained for the 10 year. Despite the Fed signaling the end of the "this is not QE" bond buying program, the 10 year yield hasn't shot north of 4% as many had predicted. The strong correlation between equities and bond yields so far this year would suggest that one or the other has to give. Either bonds or equities are overpriced. Draw your own conclusions.



These breakdowns might well be a product of August malaise, and perhaps they will resume their correlations in September when everyone is back at work. For the moment, it is worth thinking about.