Bank of Canada to cut interest rates?

I notice that December BAX futures are pricing in a rate decrease by the Bank of Canada to 0.5 to 0.75%:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 11 AU 0.000 0.000 98.880 0.000 0
+ 11 SE 98.890 98.895 98.895 0.000 23059
+ 11 OC 0.000 0.000 98.865 0.000 0
+ 11 DE 99.140 99.150 99.150 0.000 50455
+ 12 MR 99.140 99.160 99.170 -0.020 32592
+ 12 JN 99.140 99.150 99.170 -0.030 17723
+ 12 SE 99.110 99.120 99.140 -0.040 6277
+ 12 DE 99.050 99.070 99.090 -0.020 1582

Indeed, the only people making any money out of the marketplace right now are those that have been holding onto long-term government bonds, an instrument that almost everybody stated couldn’t go lower in yield.

Highest volitility of the year

The VIX index (S&P 500 options implied volatility) has officially reached the highest of the year, at 40.96%:

This is still lower than the 48.2% seen during the depths of the early 2010 crisis involving Greek soverign debt. If this issue is worse than the one last year then my 40-45 VIX prediction should be elevated.

(Subsequent Update: 46.80… this can only be described as a slow-velocity market crash.)

Payment for liquidity – anatomy of a margin call

When you go to a bank and ask for their rates on 1-year GICs, you usually get two responses – the rate for the cashable GIC and the rate for a locked-in GIC. You will receive a larger rate if you are willing to commit your money for a longer time period, at the penalty of having no interest if you want early access to your cash. The rate differences can be considered a payment for liquidity.

In the stock markets today, people are paying heavily for liquidity.

As an example, one of my top holdings, Rogers Sugar (TSX: RSI), tanked in trading because somebody needed liquidity, fast:

At 9:56 (eastern), the bid/ask was already being pushed down. It was at bid/ask 4.90/4.92 and then somebody wanted to get rid of about 100,000 shares quickly. In the span of five seconds, they took down the asking price 44 cents to $4.50 and then in the course of ten seconds there were 58,190 shares traded between 4.46 and 4.90. The bulk of the trade was done at the price of $4.50 where 35,400 shares changed hands.

This is the type of trading activity that occurs when somebody is undergoing a margin liquidation. They are paying a 40 cent per share premium for the privilege of wanting cash right now.

Generally speaking if you were on the opposite ends of these types of liqudiations you will receive a very, very good price. However, the window of opportunity you actually have to react to such liquidations is very, very tiny – you had about 1 second to hit somebody’s ask at 4.50 before somebody else picked it up. This is why computer trading is so prevalent in the marketplace – they are out there looking for such prospects.

When the market needs liquidity it does not matter what the fair value of the underlying security is – it will go at whatever price others want to pay for it. This can be much lower than the existing market value or what would be a rational valuation for the underlying company.

The week ahead

This upcoming week in the markets is probably going to be the most interesting since March 2009 when the S&P 500 hit the famous “666” mark.

As I write this, the S&P futures are down 1.9%, gold is up a whopping US$59/Oz and oil is down $2.85. There is clearly a large amount of panic being baked in the marketplace. The cause is being attributed to the S&P downgrade of the US soverign debt but this is the trigger, not the cause. There are a lot more macroeconomic problems going on in the world that have attributed for this market meltdown while everybody tries to rush for liquidity.

August volatility futures were sleepy until they exploded in the past week:

I had earlier said that the market panic is likely to be over when it has reached 30-35, but I am now of the mindset that the volatility can get higher before the market has seen capitulation – I’m guessing now around 40-45.

Even when there is capitulation, the bears will likely not be done yet – part of dealing with market downtrends is that there will be significant periods of time (one or two weeks) where you will see sharp market rallies and people with cash on the sidelines will be stepping over themselves to get back into the marketplace. These will simply be more moments to lose money. As long as there are columnists and people on the television that are willing to say that this volatility presents a good time to purchase stocks, I do not believe this downtrend is over – it has just started.

What is incredibly contrary to the market action is the fact that corporate profits appear to be at incredibly reasonable levels compared to prevailing interest rates provided by “safe” (ahem) government bonds. It could be the case the market is predicting that such profits are going to evaporate in the near future or that such profits simply do not matter and liquidity is what is being traded, rather than equities in companies with solid fundamentals.

Investors must be able to be nimble on their transactions and try to buy when supply is at its highest, while selling when the demand has almost peaked. Selling in downturns or buying in uptrends will result in very sloppy executions.

This is reminding me of two other situations in the past. One was in the year 2000, when the Nasdaq went from 5,000 in March and crashed all the way down to about 3,000, only to climb back up to 4000 again in August before crashing to its ultimate low of about 1100 in October 2002. There was one day (April 4, 2000) where the Nasdaq went from 4283 down to 3649 intraday (a 15% drop), only to recover to 4148 at the end of trading (a 14% recovery). This was the most volatile day of trading I had ever experienced and was an omen that there were bad things coming down the pipeline.

Last Thursday was all down, but if my hunch is correct, we are going to see a lot of volatility this week, so be prepared to ride those ups and downs like a professional ocean surfer. Monday is going to start down, but the rallies and downturns are going to be as sharp as a razor blade.

That said, so many people think that the markets will tank on Monday that I would venture they main indices (S&P 500, TSX) will end the day up.

Anecdotal measures of inflation

The Nomad Lawyer (Paul Lukacs) notes the following in his web posting:

When I visited Hong Kong in December 2010, the cost of one Mrs. Fields cookie was 11 Hong Kong dollars (US$1.43).

In early spring, the price rose to 11.5 Hong Kong dollars (US$1.49).

This week, the price rose to 12 Hong Kong dollars (US$1.56).

That’s a lot for a small cookie.

Applying some Canadian grade 11 math, the compounded annualized rate for the 8 months of price change is the following:

exp(ln(1+[{1.56 – 1.43} / 1.43]) / [8/12]) = 13.94%

Ouch!

I find these anecdotal measures of inflation to be more realistic than government-released statistics. Although the US Dollar has depreciated about 7% against the world basket of currencies, increases in sugar and flour prices (derived from wheat) have also skyrocketed.

Inflation, whether the US government reports it in its statistics or not, will be the only politically practical way the they can ever pay off its mammoth debt. There are too many entrenched interests to allow other options at present. The result is the currency depreciating, which will increase commodity prices (as they are US dollar-linked). This depreciation also highly affects the competitiveness of Canadian exports to the USA, but also gives net importers (such as most consumers) higher purchasing power – most cross-border shoppers know this.

My own personal anecdotal explorations of inflation are usually at the supermarket. I notice a jug of homogenized milk (albeit protected by the BC Dairy Board in the province I live in) is about $4.50 for 4 litres. Bread costs are creeping up at around the $2.70-$2.80 level for a 680 gram loaf (although you can still find cheaper options). Coffee has skyrocketed on a per pound basis. I also notice those concentrate juice mixes in the freezer section have been downsized in volume but still sell for roughly the same price. There are signs of inflation everywhere similar to Mrs. Fields Cookies that was noticed by the Nomad Lawyer.