Archive - Jun 2012

With any and every European leader talking unilaterally (and only one worth listening to, given the market's reactions), we ask and answer what should investors expect from the forthcoming EU Summit and what are the investment implications? Morgan Stanley's Arnaud Mares offers a succinct analysis of the three key axes being debated around the 'banking union' premise: a European Deposit Guarantee Scheme (DGS); a Common rule book and European level bank supervisor; and a federal resolution regime (and, in some proposals, a federal recapitalisation vehicle). The base-case view is that the current set of EU banking union proposals, whilst directionally helpful, are too long-term or too timid to address the 'crisis' with supervision stratified and insufficiently federal leading investment implications of little meaningful relief in  Eurozone banking and sovereign credit markets. Recent comments from European ministers suggest that the path to federalized Banking Union will be far from an easy one, given the tightly interconnected federal debate.

There is a certain irony to the fact that John Taylor, he of the infamous 'Taylor Rule' policy tool, conjures Hayek and the need for policy-makers to base decisions on 'rules' as opposed to the whim of short-termist solutions and band-aids. In an excellent discussion starting from Hayek and the foundations of Austrian economics 'rules-based-policy', Santelli and Taylor opine that 'policy must be more predictable' as fiscal cliffs, monetary uncertainty, and policy confusion weighs on both sentiment and businesses willingness (or ability) to make plans. Critically, they point out the dilemma that the short-cuts to solve immediate problems are in and of themselves unpredictable and so a longer-term rules-based strategy - which empirically has led to re-election (which may come as a surprise to many who see palliatives as populist vote-buying) - is a far better solution both politically and economically. The two go on to discuss the inability (or unwillingness) to enforce existing legislation (as opposed to new regulatory pressures) and the Hakeyian suggestion that those in power feel the need to do something different (or 'fine-tune') as opposed to enforce and continue strong rules-based policy which leads to short-term 'confusing' interventions.

Hours ago, in addition to making Cypriot sovereign bonds no longer eligible as collateral at the ECB, the European Central Bank also announced something that received less attention, namely that its balance sheet rose by €31 billion in the past week (due to an increase in the MRO) to a new all time record high of €3.058 trillion. In other words, even as the Fed's balance sheet continues to be flat, or is even modestly declining, the ECB continues to pick up the monetary slack with all new fiat ending up to benefit the US capital markets. Now as frequent readers know, this latest shift in the relative size of the two critical CB balance sheets also means something else: that the fair value of thje EURUSD implied purely on balance sheet correlation, a relationship that historically worked perfectly, yet in recent months has broken down due to the market's conviction that more QE is coming any minute now, is now just above 1.16, or just shy of 900 pips lower from here.

Classical Hendry moments.

With Operation Twist being extended for another 6 months, forcing Primary Dealers to buy up all the short-end bonds from the Fed, the last thing the Dealer community needed at today's 2 Year bond auction was to be stuck holding the bag. Which is precisely what happened: the Treasury sold $35 billion in fresh 2 year paper as the first auction of this week's trio of bond issuance, at a yield of 0.313%, the highest since March even if in line with the When Issued, and a Bid To Cover of 3.62, the lowest since February. But the key internal indicator was the distribution between the Primary Dealer take down and everyone else: at 60.4% of the entire offering or $21 billion, going to Dealers, this was the highest notional having to be stuffed in the channels of the Primary Dealer repo market since December 2011. Naturally, the offset, Direct and Indirect takedown, was quite low, with Indirect bidders holding just 31.69% of the auction, or the lowest since December as well. Unless the PDs can offload the bonds quickly and effectively, this means they are stuck with another product for $21 billion which will generate returns far lower than ROI and ROE breakevens, and force them to take even more risks with whatever other capital they have lying around courtesy of US depositors.

In a world desperate for any positive news, today's borderline idiotic rumor du jour, of course after Monti's gambit blew up in his face literally in minutes, comes from Germany where interested parties leaked that Germany is considering changing the seniority status of the ESM, obviously to ameloirate subordination concerns of Spanish and soon, Italian, bonds. To wit, the headline machine has focused on this part of the recent Reuters report: "A leading ally of German Chancellor Merkel told a closed-door meeting of her conservatives on Tuesday that euro zone governments were discussing removing the preferred creditor status of the bloc's new permanent rescue fund, sources told Reuters." What is very conveniently missed out is what actually matters: "Neither Merkel nor Finance Minister Wolfgang Schaeuble spoke out in favour of such a move at the meeting, the sources said, leaving it unclear whether the idea had the firm backing of the German government." And whatever Merkel (and Schauble, of course), wants Merkel (and Schauble, of course) gets. Because both of them realize that investing €500 billion of what will in the end be purely German cash as more and more countries move from ESM guarantors to ESM recipients, in addition to the hundreds of billions in sunk TARGET2 costs, amount to a number increasingly roughly the same size as German GDP, as we explained last July. Also, as we explained last July, lots of angry Germans are getting angrier by the day.

“Pessimism has become tiresome, so optimism is gaining a foothold”

Between macro-economic 'religious' experiences, regulatory uncertainty, and legislative gyrations, the world appears to be a very different place now than before 2008. It seems that from the 'Lehman' moment (some might call it an 'epiphany' moment), and later the US downgrade, markets realized that the impossible was possible and while every long-only manager will try to convince you that nothing has changed, these four charts (via Barclays) will go a long way to proving that everything has changed. Whether it is policy uncertainty, the frequency of 'fat-tailed' events, market illiquidity, or the domination of correlated 'macro' risk over idiosyncratic diversification; trading (or investing) has profoundly changed since 2008.

Update: According to subsequent press reports, Monty has denied he threatened to resign. i.e., Monti just blinked. So now it is up to Merkel who will either have a very short life, or Monti will have to come up with a different professional suicide gambit.

Just when we thought the European drama couldn't get any more poignant following Merkel's statement earlier which boils down to "No eurobonds or death", here comes Italy's unelected PM and former Goldmanite, Mario Monti, threatening that the beggar will pull the trigger on his own political career if he is not allowed to be a chooser. From Il Giornale: "If the Chancellor does not give up I will tell you that I resign because if things do not change are not able to bring Italy out of the abyss", he suggested relying on the bogeyman of the crisis that would bring Italy under attack of speculators. On the other hand, Merkel knows all too well that the fall of Rome would mean the collapse of the definitive ' euros by prospects that would put the shivers even in Berlin." So one hand for Merkel Eurobonds are a matter of life or death, while an elected technocrat with no leverage at all, threatens to quit. Our money is on the German.

There are roughly 19 million vacant dwellings in the U.S., of which around 4 million are second homes and a million or two are on the market. Let's stipulate that several million more are in areas with very low demand (i.e. few want to live there year-round). Let's also stipulate that several million more are in the "shadow inventory" of homes that are neither on the market nor even officially in the foreclosure pipeline, i.e. zombie homes. Even if you account for 9 million of these homes, that still leaves 10 million vacant dwellings in the U.S. which could be occupied. That means 1 in 12 of all dwellings are vacant. Even if you discount this by half, that still leaves 5 million vacant dwellings that could be occupied. Given that the total rental market is 40 million households, that constitutes a very large inventory of supply that remains untapped. Lastly, it is important to note that the ratio of residents to dwellings is rather low in the U.S., with millions of single-person households and large homes occupied by one or two people. The potential pool of existing homeowners who could enter the "informal" rental market by offering bedrooms, basements and even enclosed garages for rent is extremely large, and that is a difficult-to-count "shadow" inventory of potential rentals.

For. The. Win.

GERMANY'S MERKEL SAYS EUROPE WILL NOT HAVE SHARED LIABILITY FOR DEBT AS LONG AS SHE LIVES

Socialism better have a Plan B.

If there is one bank report that Obama wishes is absolutely wrong it is the following note from Deutsche Bank's Jim Reid (definitely not part of the bank's laughable Trinity Of Perma Bull consisting of Bianco, Chadha and, of course, La Vorgna) who, looking at the timing of business cycles, makes the following ominous, for both the economy and Obama's reelection chances, prediction: "If this US cycle is of completely average length as seen using the last 158 years of history (33 cycles) then the next recession should start by the end of August." The only saving grace for the president: since the advent of centrally-planned markets, nothing is as it used to be, and the business cycle no longer exists ("JP Morgan Finds Obama, And US Central Planning, Has Broken The Economic "Virtuous Cycle""). Still, maybe, this is the one last trace of free capital markets that the Fed has (so far) been unable to totally destroy. We are confident it will get right on it.

Spanish 10Y spreads are now over 50bps wider on the week and the yield pushing back over 6.8% as its spread spikes 10-15bps on rumors of a Moody's downgrade to 'Junk'. The IBEX dropped 0.5% rapidly, now down almost 5% on the week. Italy is catching the cold and is blowing wider in credit and lower in stocks as financials are leading the plunge in both nations.

In a little under two minutes, Stratfor provides a succinct primer on 'France'. Its natural (ocean, river, and mountain) geographic 'barrier' borders, its major agricultural industry, and significant social cohesion. But, there is one weakness - the North European Plain - which remains France's main challenge - safe-guarding its north-European border, on the path of a historic invasion route. The most critical existential threat to France has come from its Eastern neighbor Germany and after three significant wars from 1871 to 1945, France attempted to 'contain' Germany largely through economic and political union. The most recent economic and political crisis (and the growing schism between Hollande and Merkel) suggest France's containment-strategy may be in question.

While Europe is dominating headlines this week, UBS' Art Cashin suggests "mark your calendar and cross your fingers" as he notes the disproportionate prevalence of events that occur in September. Focusing on The Economist's Greg Ip's recent post on a possible seasonal pattern in banking crises, via this recent Reinhart & Rogoff extension paper by Laeven and Valencia, he notes: "The frequency with which the world goes to hell in September seems hardly random." Unfortunately the authors provide no explanation for this beyond observing, "An interesting pattern emerges: banking crises tend to start in the second half of the year, with large September and December effects." Ip and Cashin offer some thoughts on why this is so historically, and more importantly why this time is no different, as the avuncular Art concludes with: "try to enjoy your summer".