Saturday, March 26, 2011

Pimco and Bill Gross Sell US Treasuries

The $237 billion Pimco Total Return Fund is the world's biggest bond mutual fund. It is run by one of the most influential persons in the bond market – Bill Gross.

So when Mr. Gross speaks, people usually listen. And recently, he has spoken volumes – both in his words and in his actions.

In his March investment outlook for shareholders, Mr. Gross said Pimco estimated that the Federal Reserve had been buying 70 per cent of annualized issuance of US Treasuries since its QE2 (quantitative easing/ money printing) program began. Mr. Gross last year aired his views on QE2, likening it to a Ponzi scheme.

In his latest statement, Mr. Gross said he was worried about, at the least, a temporary void in demand for US Treasuries once QE2 is scheduled to end in June. If he is correct about demand for US Treasuries drying up, the yields for these bonds will rise and the prices will fall. This will hurt anyone holding Treasuries in their portfolio.

So Mr. Gross has taken action to protect his shareholders. His Pimco Total Return Fund has cut its holdings of US government-related debt to zero for the first time since early 2008.

After this move, the fund holds approximately 23 per cent in cash. The remainder is invested in US mortgage bonds, corporate bonds, high yield bonds and emerging market debt.

Pimco is hardly alone in its thoughts about the US government debt market. Investors have recently poured $500 million of new money into exchange traded funds that will profit when US yields rise. Examples of such funds include the ProShares Short 20+ Year Treasury ETF and the ProShares Short 7-10 Year Treasury ETF.

The Fed vs a Lousy Economy

The decision to sell Treasuries in the Total Return Fund was based on the direction of Federal Reserve policies. But another key factor in determining the direction of interest rates will be the pace of the US recovery.

Mr. Gross actually is rather a lonely voice in the bond market. Most bond investors are very gloomy about the US economy and argue that rates will stay low for a very long time.

One argument countering the case for a jump in interest rates is the concern about the impact on consumers of the sharp rise in oil and other commodity prices.

Higher food and oil prices, the argument goes, will drag on the economy rather than stoke broader inflation. The argument is that higher commodity prices act as a tax on US consumers, slowing the economy.

Another factor dragging on the US economy is the fact that many US states with large deficits are under pressure to cut spending and raise revenues.

In addition, the US still has many homeowners stuck in negative equity positions after sharp falls in property prices. And the sharpest private sector deleveraging since the Great Depression continues to go on.

All of these negative factors, the gloomsters say, are working against the massive flood of monetary stimulus that the Federal Reserve has unleashed.

A Pertinent Question

The Federal Reserve has indeed unleashed a tsunami of money. It has been buying about $100 billion of bonds a month through its QE2 program. Since last November, it has accumulated $419 billion of government debt. That takes the Fed's current total Treasury holdings to $1.23 trillion.

By the time QE2 ends in June, the Fed will have bought approximately $800 billion of Treasuries, pushing its total holdings to $1.6 trillion!

So Mr. Gross' question about who steps in to fill the gap when QE2 ends is therefore a very pertinent question. But is it the right question?

Probably not. Why? Because when QE2 ends, it is highly likely there will be a QE3 and a QE ad infinitum. Rumors of QE3 sent the stock market higher this past week.

Continued easy monetary policies from the Federal Reserve will actually have very little to do with the state of the US economy, but with the health of US financial institutions.

Most major US financial institutions are loaded to the gills with US government bonds. And they are either not hedged at all or poorly hedged against a rise in US interest rates.

Therefore any cutoff of Fed purchases of US Treasuries is most unlikely. The Fed does not want a replay of the 1994 devastation in the bond market. Not with so many US financial institutions still on shaky ground.

Bottom line - the monetary floodgates will stay wide open.

Saturday, March 19, 2011

Japan and Wall Street

A lot has happened in the past week, with the epicenter of events being in Japan. Japan, as everyone knows, has suffered a three-pronged disaster - earthquake, tsunami and a nuclear crisis.

Our beat is Wall Street and the financial markets, so the focus will be on that aspect of this terrible tragedy.

Wall Street's reaction to the events in Japan? It can best summed up in the words of CNBC's Larry Kudlow: "Be grateful the human toll is much more than the economic toll from Japan quake!"

To be fair to Mr. Kudlow, he most likely misspoke. But it does sum up the feelings of most on Wall Street to the events in Japan.

And unfortunately, it sums up the lack of morals and ethics on the part of most of the big players on the Street.

Japanese Yen

There was a great example of this the past week in the currency markets.

Anyone who knows anything about economics realizes that Japan will have to rebuild the part of the country devastated by these disasters.

In order to do that, Japanese institutions and companies will be forced to repatriate funds from overseas. In other words, the Japanese will have to covert overseas holdings into yen, which then can be spent in Japan to begin reconstruction.

So what did the Wall Street vultures do? They immediately bought as many yen as they could, driving the price sharply higher.

In effect, they were frontrunning the Japanese. They knew that the Japanese would be forced to buy the yen at much higher prices, bringing Wall Street a riproaring profit on their yen positions.

In fact, the yen reached such a point that Japanese exporters would no longer be competitive, adding another problem into a country that has had enough of them.

So the major economic powers, including the United States, were forced to intervene in the currency market. They sold a bumch of yen, forcing the price back down for now.

This, of course, cost billions of dollars. Once again, we see the US government shelling out money to make up for Wall Street greed.

Isn't it enough that the Federal Reserve is spending $4 billion a day to prop up the stock market?

And is it any wonder then that the stock market rallied the last two days of this past week? And why Wall Street is loathed in other parts of the globe?

Saturday, March 12, 2011

Is Silicon Valley Losing Its Edge?

The lifeblood of technology innovation in the United States over the past half-century has been a steady flow of venture capital dollars. This made both the United States and Silicon Valley's entrepreneurs the envy of others around the globe.

That picture, however, is changing rapidly. Last year, only $12.3 billion of new money found its way into venture capital funds. This is less than half the level of two years earlier. With a retreat from private equity underway, many American start-up financiers are predicting a historic contraction in their industry.

One reason for this is that US venture capitalists have begun to hunt elsewhere for big ideas. Many US venture capital firms have been looking increasingly to China to invest in areas such as clean technology. VantagePoint, one of the biggest Silicon Valley investors in this field, last year launched a $100 million fund for emerging clean technology in China. This made it one of the largest investment vehicles of its kind.

Some venture capital firms are doing so because the legislative environment at home is not as conducive to backing local companies. But there are other reasons.

American Innovation

So the question has to be asked – why China and not the United States? A closer look is warranted.

When Facebook was accorded a $50 billion valuation in private financing in January, it looked like business as usual in Silicon Valley.

To some industry veterans, however, eye-catching successes such as the social networking site provide little indication of the underlying trend in the country's underlying technological competitiveness.

If anything, the success of companies like Facebook may be masking a deeper malaise that threatens the American system of innovation.

John Seely Brown is the former head of the Palo Alto Research Center for Xerox. This center was once one of the Valley's most renowned corporate research and development laboratories.

Mr. Brown believes that drawn by the quick profit of high-flying internet and social networking firms, US technology investors have lost interest in the more serious work needed to sustain a lead in some of the world's most advanced industries. He said, “We've lost the will for patient investment.”

American Psyche Bruised

In the popular psyche, American technological leadership seems almost innate. It is seen as the product of an ingenuity, a sense of risk-taking and a hunger for the new that could only have taken root in a country as democratic, socially mobile and close to its pioneer roots as the United States.

But that is just a quaint notion. Michael Moritz, one of Silicon Valley's leading venture capitalists, said that the belief that American individuality and creativity somehow assure future leadership is “a clear exposition of the arrogance of empire.” He added that today “the need to succeed is far greater in the emerging markets.”

Nor is there any inherent US resource advantage, as information and talent flow freely. “We're not smarter than they are,” says Bill Watkins, another Silicon Valley veteran.

Let's look at what has happened over the past few decades. The United States suffered the loss of electronics manufacturing to Asia, which began in the 1980s. Then there is the shift of information technology services to India, which has been the story of the past decade.

And in entirely new markets such as green technology, the center of gravity has been moving to Asia. The aforementioned Mr. Watkins is the chief executive of Bridgelux – a company at the forefront of the promising new LED industry. His company makes low-power lighting using light emitting diodes.

He warns that promising new industries like his continue to quickly slip away to Asia: “We [the US] invented LEDs but we're losing the business to Asia, and it's the same with solar.” Yes, just ask First Solar about increased competition from China.

Now today, the R&D and design work that goes into many areas of electronics manufacturing – bringing with it high-paying jobs – has also been moving elsewhere. For instance, Applied Materials startled many last year when it announced that its chief technology officer would move to China to be closer to the company's manufacturing facilities.

There is a close tie between design and manufacturing of products that characterize the evolution of new technologies. Developing prototypes and manufacturing processes becomes harder when the design and manufacturing of products takes place half a world apart. As a result, the US is losing, as Mr. Seely Brown says, “the capabilities to build serious, complex stuff.”

Possible Solutions

The solution to such a long-term problem that the United States and Silicon Valley face is not easy or simple. Many things need to be done. Here are just a few ideas.

First, the US educational system needs to upgraded, with an emphasis on science. The nation is simply not graduating enough science, engineering and technology students to feed the national demand for such skills and to keep the country ahead in the global technology race.

Second, the US government needs to decide it is “open for business” and willing to compete in the global marketplace for factories and jobs. Technology companies say that costs are higher here in the US, mainly because of the lack of incentives or tax credits that are available to US corporations in most other countries.

Third, change the focus for Silicon Valley. The nation needs its emphasis to be on the key industries of the future, such as green energy, that will produce lots of jobs. We don't need a million Facebooks and other companies related to leisure-time activities. We need some genius to develop an alternative to oil, not develop a new app for the App store for Apple.

And the United States needs to begin implementing changes immediately.

Saturday, March 5, 2011

Why Libya Is Important to Oil Prices

As most investors are well aware, oil prices have surged as turmoil in Libya has risen. Increased violence in that North African nation has knocked out at least half the country's production of 1.6 million barrels a day of oil.

Lower output from Libya's oil fields comes at an inconvenient time for global economies.

The world's thirst for oil is especially strong right now in diesel and other distillates. According to JPMorgan, these distillates will account for more than half the world's demand growth in oil this year. An important fact to keep in mind is the fact that it takes more of heavier oils to produce diesel than it does light crude oil from Libya.

In addition, environmental regulations globally are clamping down on fuels with high sulfur content to combat air pollution. For example, Europe this year limited sulfur content in fuels for some machinery and on inland waterways. And in 2012, Europe will expand the restrictions to trains too.

Similar trends are taking place in the United States. The US Department of Energy just sold 2 million barrels of high-sulfur heating oil from a strategic reserve. It will soon be bidding for the same amount of low-sulfur oil this summer, further stoking demand for sweet crudes, such as come from Libya.

Libya's Oil

Stock markets rallied earlier this week as Saudi Arabia announced that it would make up for any shortfall in Libyan oil production. But the solution is not that easy – people who bought stocks on that news really don't understand the oil market.

Yes, it's true that Libya produces only 1.6 million of the globe's 87 million barrels of oil a day. However, it produces some of the most coveted and highest quality light, sweet crude oil on the planet. Its crude is easily refined into gasoline and diesel. It is also lower in sulfur, making it cleaner to burn.

Libya's crude oil stream includes Es Sider, whose light density and low sulfur content makes it desirable. Even more desirable is the oil from the huge El Sharara oil field in Libya run by Spain's Repsol. This oil is a mere 0.07 per cent sulfur!

Saudi Arabia is the de facto custodian of OPEC's 4.7 billion barrels a day of effective spare capacity. However, Saudi crude oil overall is not of the same quality as Libya's.

Most of the country's production is classified as medium crude oil. Arab Light, the leading Saudi oil by volume, is a relatively high 1.8 per cent sulfur and heavier. This makes it more difficult to refine into light products such as diesel and other fuels.

The Future for Oil Prices

The take away for investors is that the Saudis have adequate spare supplies to replace Libya's lost production. But the quality of the oil is mostly inferior. You can't just substitute one barrel of Saudi oil for one barrel of Libyan oil. For example, it takes three barrels of Saudi oil to make as much diesel as Libyan oil.

This means oil companies will have to do more than just replace lost production barrel for barrel. Ideally, they will also need to find new sources of light, sweet crude oil.

Other regions of the globe producing high-quality crude oil include Nigeria, Angola, Algeria, the North Sea and the region surrounding the Caspian Sea. Most of these regions aren't exactly politically stable either.

One definite trend that will continue for the foreseeable future is that the bidding for high grades of crude oil by oil companies will further raise prices for the kinds of high-quality crudes that underpin benchmark oil futures contracts. It most likely will also reduce fuel output from refineries unable to afford the higher prices.

As mentioned earlier, this is happening at precisely the time when demand for low-sulfur oil is increasing. This has raised fears of a repeat of 2008, when oil prices moved above $145 a barrel.

Two factors though may prevent oil from reaching those lofty levels, at least for now.

The first is that since 2008 refiners have invested hugely in turning barrels of heavy oil into light products. Global refinery distillation capacity is also up 3.3 million barrels per day since 2008 to 92.5 million barrels a day.

Oil inventories in developed countries are also higher than levels were in December 2007. In the United States, the 727 million barrel strategic oil reserve contains 293 million barrels that are low in sulfur.

However, due to the spreading unrest in North Africa and the Middle East, oil prices will not move back to $75 a barrel anytime soon. The turmoil is particularly unsettling in Bahrain, because of its proximity to Saudi Arabia and the presence of a major US Naval base there.