Archive - May 2012

Just when we thought the president didn't have any tricks left up his pre-election sleeve on the anniversary of Osama's death announcement, here he comes and surprises everyone with what has just been disclosed as a secret visit to Afghanistan, where in a televised statement at 7:30 pm Eastern, the president will announce a strategic partnership with president Karzai, and where he will designate Afghanistan a major non-Nato ally - the "first such designation of the Obama presidency."

Hard landing, soft landing, civil unrest, dominant economic superpower – the forecasts flow freely regarding China. The fact that good data is hard to come by regarding China does not seem to inhibit many outside observers. In this piece I will look at China through the lens of economic structure, Chinese history and culture—concepts which a number of observers often overlook. My general conclusion is that Chinese GDP growth rates are about to undergo a gradual but nevertheless perceptible decline. But I now believe a hard landing crash is unlikely, assuming that Europe does not totally disintegrate and the US does not roll over into a full scale recession.

The 20-day realized volatility of the S&P 500 ETF (SPY) has more than doubled in the last two months from a low near 7% to the current level over 15%. At the same time, implied vol (akin to VIX) has dropped 2-3vols during that period and almost 5 vols in the last two weeks - nearing its multi-year lows once again. For the first time this year though, 3-month-implied volatility is trading below realized 20-day volatility and while they are apples-to-oranges to some extent (forward-looking vs historical), the 'cheapness' of volatility may well be enough to encourage hedgers back in - especially on a day when stocks pop unexpectedly. What is more worrisome though is almost exact replica that implied- and realized-vol are following when compared to last year in the run-up to the big mid-summer swoon as complacency is back it seems.

Two weeks ago, when commenting on the (first of many) nationalizations of energy companies (yes, the collateral shortage we have been discussing over the past year is particularly in effect when it comes to energy assets, although one does not need superficially complicated theories to explain it), in this case of Spanish YPF assets in Argentina we said "How soon until any and every government follows suit in a world in which excess liquidity sloshing around makes expropriation of vital energy producing assets a key prerogative? And how long until the resultant (accelerating) collapse in faith of the monetary system, leads government to declare "monetary self-sufficiency" and confiscate everything that is not nailed down. In exchange for worthless pieces of paper of course. Just to make it "fair"." The answer: two weeks. As of a few hours ago, Bolivia has followed in Argentina's footsteps and has just announced it is nationalizing yet another Spanish company's domestic assets, in this case Red Electrica.

Much has been made of the apparent lack of demand for credit as well as apparent supply (especially well-collateralized and credit-worthy credit) during a period when the banks have been mouth-to-a-fire-hose gorged on money. Small businesses, as UBS notes, have been at the center of this debate - as the engine of the economy, politicians have been vociferous in the face of banks ignoring their suggestions to lend. This initial credit crunch, however, has led to a structural change among small businesses which may have a much larger slowing-impact on OECD growth than is currently understood. Small businesses horded cash and reduced their reliance on bank loans after the crisis as the fear of the credit crunch remains front-and-center (and therefore crushed a key transmission mechanism of monetary policy). This drop in demand is driven by the hidden credit crunch - a structural shift to more just-in-time inventory management regime. This in turn reduces the inventory:sales ratio (which is exactly what we have seen in an unusual divergence from large business and appearing like a structural decline). The worrying aspect of this, and indeed the other credit crunch is that the inventory management regime-change among small businesses exaggerate anaemic growth since restocking has traditionally helped to drive economic growth above trend in a recovery phase. As UBS' Paul Donovan concludes, "the traditional concept of inventory restocking may be a great deal more lacklustre in the current environment."

History shows that freedom is almost always the price that societies pay to maintain the status quo and keep their rulers in power. When the system finally collapses under its own weight, though, things can go from bad to worse as the people cry out for CHANGE. The French, for example, traded an absolute monarch in Louis XVI for an absolute dictator in Robespierre. Similarly, the Russians traded the empire of ‘Bloody’ Tsar Nicholas II for the Red Terror of Soviet Russia. As the Russian Marxist revolutionary Leon Trotsky said in 1937, “The old principle of ‘who does not work shall not eat’ has been replaced by a new one– who does not obey shall not eat.”

Two words: Screw that.

In late February and early March, gas prices were all the rage with every media outlet quoting them ad nauseum until European distresses reclaimed the headlines and suddenly, gas prices became irrelevant once again in the minds of the politicians and media - despite only a very modest drop from their near-record highs. Retail gas prices have indeed fallen for the last three weeks and some have heralded this 13c drop as the second-coming of tax-rebates for consumers in the US. However, in the last few weeks, Crude oil prices have rallied somewhat smartly from under $101 to over $106 this morning (back to one-month highs). RBOB (wholesale gasoline) prices have also - in the last few days - started to push higher with their 'normal' few-week lag. Given the historical precedent, we would expect to see retail gasoline prices stabilize and turn up once again within the next week or two - just in time for the winter-warmth effects to wear off on the macro-economy and the summer driving season to begin - burning an ever-bigger hole in the household's pocket.

When we last discussed what now appears certain to be a TBAC announcement tomorrow that Floating Rate Treasurys are about to be launched by the US during the Treasury, we cautioned, using an analysis by the IMF's Singh, that "the US Treasury may be telegraphing to the world that it, or far more importantly, the TBAC, is quietly preparing for a surge in interest rates." We then continued that "What is also obvious is that if the TBAC is quietly shifting the market into preparation mode for "a steady (or rocky) rise in rates from near zero to a "neutral" fed funds rate of 400 bps and a "normal" 5 percent yield on 2 year U.S. Treasuries" as the IMF warns, then all hell is about to break loose in stocks, as by now everyone is aware that without the Fed liquidity, and not just liquidity, but "flow" or constant injection of liquidity, as opposed to merely "stock", VIX will explode, equities will implode, and all hell would break loose. It is not yet certain if the TBAC will proceed with implementing FRNs. Although, since the proposal came from the TBAC, read Goldman and JPM, and what Goldman and JPM want, they get, it is almost certain that in about a month, concurrent with the next quarterly refunding, America will slowly but surely proceed with adopting Floaters." Judging by the amount of press coverage this topic has received in the past week, the advent of FRNs is now a given. What is unclear is why: our take is that this is simply a move to make Treasurys more palatable to investors, simply to avoid capital losses when rates finally resume their inevitable surge higher. The flipside of course, is that the guaranteed coupon payments in a rising rate environment means that more cash will leave the Treasury to cover interest. It is this corollary to increasing demand that has made the "father" of Treasury floaters warn on Bloomberg that now is the worst possible time to being sales of FRN Treasurys.

When we talk about Europe today in an economic context, we really mean the Eurozone, whose seventeen members are the core of Europe and share a common currency, the euro. The euro first came into existence thirteen years ago, on January 1, 1999, replacing national currencies for eleven states; Greece joined two years later. In theory, the idea of a common currency for European nations with common borders is logical, and it was Canadian economist Robert Mundell's work on optimum currency areas that provided much of the theoretical cover. However, the concept was flawed from the start.

"We're on the road to economic stagnation" is how the Dallas fed describes the status quo as Too-Big-To-Fail (TBTF) is forcing the US economy to suffer from the perpetuation of perverse incentives. We want to get back on the path to prosperity and they note that there are some things monetary policy can't fix (well we know that already) but in this case they demand an end to the TBTF paradigm now. In an excellent presentation of the costs and benefits of ending TBTF (defined rather tongue-in-cheekily: The unwillingness of a government entity to abruptly close an insolvent company and force its creditors to sustain sizable losses due to the company’s size, complexity, interconnectedness and general significance within the financial system), the ignorance of the process of creative destruction is critical as they note that a sick (or failed) bank cannot lend: "Undercapitalized banks gum up the working of the interdependent moving parts of the monetary policy engine". Dismissing the Dodd-Frank Act as a distraction that doesn't buttress market discipline, they summarize their guiding principles as: End banking oligopoly power; punish failure quickly; and change the do-or-die (M.A.D.) decision-making paradigm; ending with the threat promise suggestion that Restructuring isn't so radical, firms do it all the time.

I am ill aware of anything... Moe Greenspan

Forget 'irrational exuberance', forget 'deregulation of derivatives', Big Al is back and this time he seems to have forgotten any- and every-thing we has ever said. It was only a year ago that Greenspan told CNBC "I am ill-aware of anything that really worked. Not only QE2 but QE1" and yet today the mumbling-'maestro' pronounces, via Bloomberg:

• *GREENSPAN SAYS EQUITY STIMULUS IS HELPING TO DRIVE ECONOMY
• *GREENSPAN SAYS EQUITY STIMULUS IS UNDERESTIMATED
• *GREENSPAN SAYS EQUITY IS COLLATERAL OF FINANCIAL SYSTEM

So it sounds like Alan has joined Ben in the parade of 'the-market-is-the-economy' thinkers as now the critical action of all the greatest minds in our economic policy-makers are convinced that debasement manufacturing a rising equity market (by whatever means necessary) is key (and nothing else!).

Collateral matters when it comes to assessing the value of the debt. If a bank lists the mortgages in its "assets" column at full value even though the underlying collateral (the houses) has lost much of their value, then the bank is grossly over-estimating the value and security of the mortgage. The bank's "assets" are based on phantom collateral. Take away $1 in collateral and you impair $4, $10, $20 or even $30 of debt. Recall that the vast majority of real estate equity and financial wealth is owned by the top 20%, with the majority of that concentrated in the top 5%. That means the bottom 80% own little collateral to leverage into debt. How about leveraging income into more debt? Since the top 10% receive almost 50% of the income, and most of the bottom 90%'s income goes to non-discretionary spending and taxes, then only the top 10% have discretionary income that can be leveraged into more debt.

Since nobody else is trading anything today, we wanted to show readers, courtesy of Nanex, just how it is that the only market participants in the past year, that would be robots of course, traded the ISM number. Pay particular attention how the size book in the E-Mini contract virtually disappeared two minutes ahead of the number as everyone shut down and was merely awaiting the headline at which point everyone who trade in the same direction.