Archive - Oct 12, 2011

Last Thursday we observed the first "reverse" POMO event, in which the Fed sold $8.9 billion in sub 1 year bonds... on $242 billion of submitted bids, or a grotesque 27.4 Bid To Cover (aka Submitted to Accepted) ratio, for bonds that yield several basis point of interest, leading us to speculate that the only reason for this epic surge in buying interest is due to a levered ability to capture a taxpayer funded bid-ask spread courtesy of Primary Dealer BWIC-like collusion. A few minutes ago Ben Bernanke has commenced the second such bond sale as part of Operation Twist, this time selling bonds maturing between 03/31/2013 - 10/15/2013. So if indeed Operation Twist is nothing than a POMO-facilitated conduit to fund the Primary Dealers bond trading desks with precious, precious year end bonuses, what should we expect? Well, the most recent regular Treasury auction of 2 Year notes saw a Dealer Bid To Cover of 5.4 ($95.7 billion Bids tendered on $17.8 billion allotted). Assuming the same incremental efficiency pick up as seen last Thursday of 4.3x difference between the S/A ratio and the regular BTC, we would hope to see nothing short of 23.2 Submitted to Accepted ratio in today's POMO when it closes 30 minutes from now. It would also validate our theory from over a year ago, that no matter how it is structured, QE, Twist, or what have you, is merely a collusive way for Primary Dealers to extract a pound of flesh from US taxpayers via the Fed guaranteed bid-ask spread... With Bernanke's blessings of course.

The Final Draft of the Volcker Rule was published for comment at the end of September. Even skipping our traditional rant about government bureaucracy, it is a document over 200 pages long, in which the word “exemption” occurs on no less than 100 pages (it is used 426 times in total). At a quick glance, each section starts with a fairly draconian statement. Then each subsection waters down the bold initial statement with exemption after exemption. As we began the daunting task of trying to make sense of these rules and what they might mean in practice, it became clear there was little point in rushing to do the work. Why is working through this doc largely pointless? Because it is unlikely to ever be implemented in anything that resembles the current form. The rules are meant to be in a final form by July 21, 2012. Assuming that deadline is met, the banks then have 2 years to conform with the provisions and can petition the board for up to 3 additional 1-year extensions. Which brings us to July 21, 2014 at the earliest, and possibly July, 2017.

I do not toss around the idea of a market crash lightly. If you've been following me long enough, you know that only in very rare instances do I issue a cautionary Alert (I've only issued four since my website launched in 2008), and I am generally not given to hyperbole. Let's be clear: I'm not issuing an Alert at this time. But I am concerned that a materially adverse disruption to the financial markets is increasingly likely in the near future. Perhaps a definition will be helpful as we begin. A 'market crash' is an event where there are no bids to meet a wall of selling. The actual amount of the percentage decline is less important to note than the amount of chaos, or loss of control, that a given market experiences. Some like to say that a market downdraft requires a decline of 10%, or maybe even 15% or 20% (or more), in order to qualify as a 'crash.' For me, the key factor is not so much the amount of the decline, but the pace of the decline. With perhaps a quadrillion US dollars of hyper-interconnected derivatives outstanding -- that's the notional value, but who really knows what the real number is? -- an orderly market is essential for knowing whether or not the counterparty to one's trade is solvent. During periods of intense price swings in the market, such things are simply not knowable, and spawn the fear and paralysis that really define a market crash.

Remember the country that started it all yet was "so small nobody should worry about it." Well, it turns out its size was juuuuust right, and while the Eurozone is now fighting contagion fires everywhere up to and including the heart of the core (thank you most-bailed-out-by-the-Fed-bank Dexia), Greece still has yet to see any benefits whatsoever from all the so called bailouts, including the 5 previous tranches from the US taxpayer funded IMF. Well, it appears Greece has effectively shut down, after the country's Finance Ministry - the nerve center coordinating not only the country's economy but its continued bailout requests, has announced the start of a 9 day strike beginning October 17. May as well call it indefinite, and may as well put a fork in it.

Is anyone surprised?

The market was looking forward to Barroso's disclosure of more details of just what the Euro bank recap plan would look like. The answer: a complete dud.

• Barroso says fully coordinated approach to European bank recapitalisation should be based on reassessment by supervisors of capital needs
• Barroso says supervisors should use temporarily significant higher capital ratio of highest quality capital
• Barroso says if government support is not available recapitalisation should be funded by a loan from the EFSF
• Barroso says banks should first use private sources of capital, then government support if necessary
• Barroso says sixth tranche of aid for Greece must be disbursed
• Barroso says pending recapitalisation, these banks should be prevented from paying out dividends or bonuses
• Barroso says the EU should agree on second financing package for Greece with adequate public and private financing
• Barroso says launch of European stability mechanism must be accelerated to mid-2012 and mid-2013
• Barroso says calls for integrated governance system combining ESM and EU budget rules

With the market now responding almost exclusively to political developments (in a bizarro way of course: US-China trade war is bad for the USD, hence good for stocks), fundamentals long forgotten, and as a result HFT algos now moving primarily to FX trading (just read the following story about a Reuters data feed break causing a currency spike), focusing on politics, especially with both the US and China having fired the first trade war shots, will be unfortunately increasingly more important. Thus, here is what to expect out of our (and by our we naturally mean Wall Street's) "best and brightest" representatives today.

Only the most drunk on hopium (and Absinthe) among us can harbor any doubt that the eurozone, and hence the common monetary union currency the zEURq.bb, can survive without a dramatic change in the current European monetary (and fiscal) structure and an unprecedented overhaul to the status quo. But it can be done: after all there are numerous case studies across history, when various fiat monetary unions either succeeded or failed. Ironically, according to a just released report by UBS' monetary expert Stephane Deo (which we will discuss more later), three of the better such examples ironically can be traced to none other than the good old United States, which, and this may come as a surprise to some of our readers, had several failed monetary union regimes in the past before it finally arrived on the current stable (relatively speaking) "dollar" solution. So here, courtesy of UBS, are the lessons that Europe can hopefully learn (once again) from America's bitter experience in this matter. Because the alternative to success is failure (more on that shortly), and as UBS notes, "The economic and political consequences of a monetary union break up are also so severe as to deter all but the most determined – or to deter all but those already suffering extraordinary economic distress (occasioned by war or by depression)." So without further ado...

All you need to read.

Chaos theory states than in complex systems, a butterfly flapping its wings in Japan can cause tornadoes in California. Whether or not that is true, a Banker in Belgium buying Greek bonds can impact the lives of factory workers in Germany. Europe continues to head down the path of making the system more complex than ever and ensuring that no bad lending, investing, or borrowing decision is ever punished.

Short squeeze moving to Shanghai?

The Slovak Parliament rejected the EFSF ratification bill late yesterday, which spurred risk-aversion overnight and in early European trade. However, in a stark reversal of fortunes, market sentiment changed following news that a new bill could be introduced in the Slovak Parliament as soon as this afternoon. Also, markets took positively comments from Chancellor Merkel who said that the EFSF changes will get full approval before the EU summit on the 23rd October, as well as a much lower than anticipated USD-allotment in the ECB's 3-month USD-operation, which waned some concerns surrounding the Eurozone banks' funding. Strength in equities weighed upon Bunds, whereas the Eurozone 10-year government bond yield spreads with respect to Bunds narrowed across the board. Bunds came under further pressure following a "technically uncovered" 30-year bond auction from Germany. Elsewhere, moving into the North American open, WTI and Brent crude futures ventured in positive territory as risk-appetite gathered pace and the USD-Index weakened... Moving into the North American open, markets look ahead to minutes from the FOMC meeting of 20th-21st September, together with the API inventories report. Any comments pertaining to the EFSF ratification in Slovakia will also be keenly watched. In terms of fixed-income, USD 21bln 10-year Note auction, allied with Fed's Outright Treasury Coupon sales in the maturity range of Mar'13-Oct'13, with a sale target of USD 8-9bln are scheduled for later in the session.

• Senate Passes Measure on China’s Weak Yuan (Bloomberg)
• Meet the next "axis of evil" - Beijing and Moscow to put $1bn each in fund (FT)
• Berlusconi’s future in balance (FT)
• Juncker lists 10 steps to stem euro zone crisis (Reuters)
• Paulson & Co warns of asset redemptions (FT)
• Pimco’s Balls Says Merkel-Sarkozy Plan Isn’t Signal to Buy European Debt (Bloomberg)
• EU banks face higher capital thresholds (FT)
• Europe Must Do More to Resolve Crisis: Geithner (Bloomberg)

We are confident the spinmasters will spin the first major domino in the muni crisis as bullish: after all it "removes uncertainty." Bloomberg reports that "The city of Harrisburg, Pennsylvania, facing a state takeover of its finances, filed for bankruptcy protection following a vote by the City Council, according to a lawyer for the council.Mark D. Schwartz, a Bryn Mawr, Pennsylvania-based lawyer and a former public finance banker for Prudential Financial Inc., said he filed the documents by fax to a federal bankruptcy court last night. The filing couldn’t be confirmed with the U.S. Bankruptcy Court in Harrisburg.The state capital of 49,500 faces a debt burden five times its general-fund budget because of an overhaul and expansion of a trash-to-energy incinerator that doesn’t generate enough revenue. “This was a last resort,’’ Schwartz said in an interview after the council voted 4-3 to seek bankruptcy protection. “They’re at their wits’ end.’’While bankruptcy would mean the loss of state aid under a law passed in June, it would be preferable to a proposed recovery plan, said Councilwoman Susan Brown-Wilson." Well, at least Jefferson County will not have the dubious legacy of being the first muni to push everyone else over. And now that the precedent has been set (yes, Virginia, it can be done) watch as tens if not hundreds of other cash-strapped towns, cities, localities and other entities follow suit promptly to quite promptly.