Shadow Capitalism

Market Commentary by Naufal Sanaullah

Naufal Sanaullah China hikes while German IP misses and gas price pressures
naufalsanaullah@gmail.com
www.shadowcapitalism.com
weigh on US ABC Consumer Comfort Index
Another positive day for risk today, although volumes in equity were low across the board. The
PBoC finally hiked its benchmark lending and deposit rates by 25bps to 606bps and 300bps,
respectively. With CPI at 4.6% and January CPI rumored to have breached the 6% level, just about
everyone was expecting a benchmark rates hike. The very tight interbank funding conditions
before the Chinese New Year (with SHIBOR surging at a pace unseen since the 2007 liquidity
crunch) likely was responsible for the delay of the expected hike to after the New Year. With a hike
discounted and real yields still in very negative territory, I expected a fade of any initially bearish
reaction, which is what the market provided today.

The S&P rallied 0.45% today, extending its rally since Egypt lows. As per McLellan Oscillators and
other short-term trading OB/OS indicators, the market is still far from extremely overbought
territory. And with the AAII Sentiment Survey’s Bull/Bear ratio still below 2.0, sentiment is still far
from extreme.

February 9, 2011 |1
The labor market has been consistently pointed to by bears as defense for their theses, but there
are definitely constructive signals from leading indicators that suggest the cyclical recovery in the
labor market may be underway, and perhaps underacknowledged due to the structural
employment issues that may be masking or distorting much of the recovery.

Both initial claims and wage & salary disbursements are seeing some serious divergences from the
headline unemployment rate, suggesting the headline rate may be on its way down soon, although
as I mentioned the structural employment concerns remain and should keep jobless rates elevated
beyond the implied cyclical levels. Still, this continues to strengthen the argument for US equities.
As I’ve stated many times, the biggest risks to US stocks are in higher interest rates, implications of
rising food & energy prices, and the continued drag on housing.

February 9, 2011 |2
US yields continue to breakout as economic data improves and auction performance remains poor.
After a 62% PD takedown in today’s 3yr auction, the 10yr yield surged to close about 70bps rich
from pre-auction levels. Tomorrow’s $24b 10yr auction should provide more context to current
demand for issuance.

The chart below of 10yr yields remains very bearish US govys, after last week’s breakout. The
pattern suggests a move back to and above the significant 400bps level. With inflation rising and a
still much-too-large output gap for the Fed to be hiking this year, I expect yields continue higher
from here, particularly in the long-end of the curve. 2011 could shape up to be a rangebound year
in rates on the whole, given EM shock risks providing potential bids for Tsys, but I continue to be
bullish on curve steepeners and believe that the “new normal” of rates is here.

The Australian Dollar has been trading sideways since last week’s economic outlook upgrade by
the RBA, but is sitting at the resistance level of its current triangle while approaching its apex
concurrently. Liquidity is ample globally and risk continues to be bid, so I am more inclined to
expect a breakout than failure in the next few trading sessions. Above 1.02, AUDUSD should take
off, with the pattern implying a 600-650 pip surge, although I am a bit skeptical of a rally of that
magnitude. Still, despite my fundamental concerns and bearishness regarding Australia’s property
sector, I will definitely be chasing AUD higher if it breaks out.

February 9, 2011 |3
December German IP came in at a -1.5% MoM print vs +0.2% expected and a revised -0.6% prior,
with snowy weather getting the blame from Germany’s economic minister. However, EURUSD
shook off the news and extended its rally since the 1.35 pivot to 150 pips. With rising US yields and
bullish positioning in EURUSD approaching fall 2009 & fall 2010 highs, I will be looking for a
technical entry to short EURUSD soon. For now, however, it remains in an uptrend and there are
no bearish signals I see.

The real action in European FX is coming from the Scandinavian currencies, with their ties to crude
prices and their very hawkish CBs. NOK (Norwegian Krone) is a particular favorite of mine, with OIS
forwards discounting 73bps in Norges Bank hiking this year, up 15bps from just last week. I’m short
some euros and sterling against Krone.

February 9, 2011 |4
Wheat prices rallied another 2.45% today, on the back of more concerns regarding the Chinese
crop, which has been affected by drought. As per Jack H Barnes (whose writing and analysis I highly
recommend):

The 8 primary Providences reported to be experiencing the worse of the drought currently
affects 80% of the Chinese total wheat production. The drought has directly affected 35%
of the wheat crop in this area so far. The wheat has not received the typical rain, or the
later snow that is needed to keep it insulated from the extreme cold temperatures of
winter.

China, as the world’s largest producer of wheat, has few locations it can turn to in a time
of crisis to purchases enough volume to meet their own internal needs, if a harvest fails.
The destruction of the Russian wheat harvest via fires last fall and the flooding of the
Australian wheat harvest in January have cut the number of nations that could provide
China with emergency food down to one.

Politics will be picking up on this fact sooner rather than later. Watch for the US / China
trade imbalance to shrink significantly in the coming months as US buys less Chinese,
while they are forced to buy rapidly more expensive commodities in the US.

Switching back to the US economy, I continue to see the US in a releveraging period, with non-
revolving credit still rising and revolving credit seeing its first monthly increase last month since
summer 2008. The real issue, in my opinion, is from rising inflationary pressures. As the US
releverages and becomes more sensitive to cyclical fluctuations, it becomes increasingly fragile in
the face of surging gas prices. As such, especially given the interest rate environment we are in, I
consider the US in a period reminiscent of 2006-2007.

Morgan Stanley was out today with a great chart showing how short-end carry is discounting some
significant hiking from the Fed in the coming 18-24 months. As MS states, if “the Fed keeps policy
rates lower for longer, then risk premiums will shift further out along the curve, keeping back-end
rates historically much higher than front-end rates.” I agree with this analysis, and I see the steep
curve discounting rising inflationary and sovereign credit risk premia, with the back-end steepening
against the front-end further as the Fed’s dovishness increases risk premia in the long bond.

Tomorrow brings Japanese consumer confidence, trade data from Germany & UK, and Australian
employment figures.

February 9, 2011 |5
 Trades
OPEN
Long /ZW | 690.00 | stop 675.30 | +27.75%
Long /ZC | 550.00 | stop 541.90 | +23.09%
Long /CT | 150.00 | stop 138.50 | +16.67%
Long OIH | 140.65 | stop 135.00 | +10.20%
Long MXIM | 25.02 | stop 24.45 | +3.55%
Short ACOR | 28.90 | stop 30.60 | +21.73%
Long ERJ | 30.10 | stop 28.90 | +15.38%
Long TDY | 45.05 | stop 44.85 | +10.28%
Short ECH | 73.40 | stop 76.10 | +4.62%
Long TITN | 21.30 | stop 20.45 | +26.38%
Short AUD/NOK | 5.885 | stop 5.915 | +45 pips
Short CREE | 65.45 | stop 66.60 | +20.28%
Long WBS | 21.05 | stop 20.05 | +12.35%
Long HANS | 54.05 | stop 52.15 | +3.00%
Long /ZR | 14.64 | stop 14.20 | +11.07%
Long CNP | 15.85 | stop 15.60 | +2.46%
Long NE | 37.65 | stop 36.50 | +0.53%
Long RELL | 12.80 | stop 12.35 | +3.13%
Long MCP | 44.28 | stop 39.95 | +25.11%
Long REE | 12.50 | stop 11.55 | +20.16%
Long CAB | 23.40 | stop 22.75 | +16.07%
Long TSLA | 23.95 | stop 22.05 | +2.25%
Long /CL | 86.30 | stop 83.80 | +1.33%
Long UA | 57.55 | stop 51.55 | +16.40%
Long MEE | 55.55 | stop 51.00 | +14.18%
Long IAG | 19.55 | stop 18.50 | +8.54%
Long EDZ | 21.83 | stop 20.20 | -2.66%
Long UGL | 61.90 | stop 59.00 | +4.73%
Long SLW | 31.40 | stop 28.80 | +12.01%
Long CRR | 114.33 | stop 105.00 | +3.86%
Short FCX | 56.05 | stop 57.80 | +0.37%
Long DNR | 21.60 | stop 20.10 | -2.78%
Long MAC | 49.01 | stop 47.65 | -0.57%
Long A | 44.34 | stop 40.00 | -0.38%
Long PCLN | 440.72 | stop 423.00 | +0.46%
Long WLL | 126.04 | stop 120.00 | -0.69%
Long AUDC | 7.98 | stop 7.25 | -3.13%
CLOSED
Short AIG | 53.15 | cover 42.40 | +20.23%
Short KBH | 15.03 | cover 14.55 | +3.19%
Long NVDA | 25.45 | sell 24.35 | -4.32%
NEW
Short EUR/NOK | 7.858 | stop 7.900
Short GBP/NOK | 9.300 | stop 9.365
Long IMAX | 27.70 | stop 26.00
Long TOL | 28.90 | stop 20.00
Long VECO | 47.60 | stop 42.50
Long SHZ | 6.85 | stop 6.00
Long CTSH | 76.83 | stop 72.50
If you would like to subscribe to Shadow Capitalism Daily Market Commentary,
please email me at naufalsanaullah@gmail.com to be added to the mailing list.
DISCLAIMER: Nothing contained anywhere in this commentary, including
analysis and trade ideas, constitutes or should be construed as investing or
financial advice, suggestion, or recommendation. Please consult a financial
professional and do due diligence before engaging in any purchase or sale of
securities.

Long CNQ | 43.65 | stop 42.55 | +0.85%

Long MOO | 56.35 | stop 55.15 | +1.05%
Long SOHU | 80.04 | stop 73.00 | +6.24%
Long CLF | 88.15 | stop 83.95 | +2.27%
Long CF | 140.60 | stop 136.05 | +4.17%
Long SINA | 87.55 | stop 77.50 | +3.68%
Long BIDU | 118.30 | stop 113.00 | +1.30%
Long MSFT | 27.90 | stop 26.95 | +1.36%
Long TYO | 46.70 | stop 45.00 | +5.85%
Long CZI | 15.12 | stop 14.50 | +1.39%
Long AMRN | 8.85 | stop 7.65 | -1.69%
Long HBAN | 7.49 | stop 7.30 | -1.20%
Long DECK | 79.92 | stop 77.00 | +5.00%
Long LULU | 75.15 | stop 71.45 | +7.64%
Long CMG | 240.67 | stop 232.40 | +2.70%
February 9, 2011 |6