Archive - Jun 2012

Just as Patton surveyed Rommel's battlefield of Panzers and assumed he knew his plan (since he had 'read the book'), so UBS' Art Cashin reminds us that traders trust implicitly that Bernanke is an assumed tactical genius - capable of deploying his monetary troops at will and in a perfectly timed manner. This trust (and hope) is based on Bernanke's early speeches and one in particular - “Deflation: Making Sure 'It' Doesn’t Happen Here” (here). It was delivered back at the National Economists Club in November 2002 (Before Bernanke became Fed Chair). As Wall Street ponders what form or format the next level of quantitative easing might take, Cashin is taking time off from the fermentation committee to sift through the speech, looking for clues to the next Fed move. The primary complication is the turmoil in the European banking system. That may force Mr. B to include things like currency swap facilities in any new comprehensive easing effort. While QEx is certainly coming, we remain highly cognizant of the reflexive market reaction to any 'decent' dip as hope remaining too alive-and-well that the Bernanke-Put strike is considerably higher than it is in reality.

With 5 days to go until we have a rerun of the Greek election, which most likely will result in another hung jury parliament (and we are being metaphoric here) as we expected before even the first election, here once again is reminder of the complete Greek decision tree that is set to unfold once again starting Sunday night. The one thing we can definitively say: this is one tree that money definitely not grow on. Or olives.

What are capital controls? Simply, capital controls are policies which restrict the free flow of capital into, out of, through, and within a nation’s borders. They can take a variety of forms, including:

• Setting a fixed amount for bank withdrawals, or suspending them altogether
• Forcing citizens or banks to hold government debt
• Curtailing or suspending international bank transfers
• Curtailing or suspending foreign exchange transactions
• Criminalizing the purchase and ownership of precious metals
• Fixing an official exchange rate and criminalizing market-based transactions

Establishing capital controls is one of the worst forms of theft that a government can impose. It traps people’s hard earned savings and their future income within a nation’s borders. This trapped pool of capital allows the government to transfer wealth from the people to their own coffers through excessive taxation or rampant inflation… both of which soon follow.

Overnight, Pimco's flagship Total Return Fund posted its monthly update, with several notable highlights. First, total holdings in the fund rose to a record $260.7 billion, a $2 billion increase over April. Next, following months of consecutive reduction in the firm's Treasury holdings, the TRF reported its first TSY increase, rising from 31% to 35%, a modest number historically, but definitely a change in trend. It also appears that Gross has had his fill of MBS, which as we all know too well by know, is how he plans on frontrunning the Fed's next QE episode. At 52%, it was just a modest decline from the April 53%, and in dollar terms the $136 billion in holdings, is only the second highest ever. Still, it is notable that instead of continuing to load up on MBS, Gross is now "diversifying" into Treasurys. All other asset classes were relatively flat, with margin cash increasing slightly from -18% to -21%, or short $55 billion. Finally, the most interest data point has nothing to do with the portfolio structure, but the duration of holdings: the effective duration rose for the first time since October 2011, increasing from 4.61% to 4.81%. Is Gross finally taking a peek from underneath his shell and going to the long-end?

Incentivize debt, and you end up relying on debt as a sustitute for productivity and income. Increase debt, and there's not enough income left for productive investments that might boost income. Incentivize debt via making interest tax deductible, and you create a self-reinforcing feedback of a rising share of declining income being devoted to interest payments. With demand and borrowing both suppressed by debt-serfdom, demand for housing, goods and services declines. Borrowing more to consume simply speeds the cycle of rising interest and falling net incomes. Incentivize debt and you create multiple overlapping death spirals. We are seeing the death-spirals play out in a fractal manner, from households to nations to entire regions. High debt levels lead to high interest payments which lead to low investment and savings rates which lead to lower productivity which leads to stagnation of income, consumption and investment: in other words, a death spiral.

..... The entire bond curve through the 5 year point is now negative (for the first time ever). At this rate, courtesy of the FX peg and the SNB's free put option, whereby EURs are converted into CHFs at a furious pace even as the facade of a collapsing Eurozone is itself crumbling, and the proceeds are use to buy Swiss bonds ever further into negative territory, we may soon have an entire bond curve trading at negative territory. Which, paradoxically, would lead to that Keynesian wet dream: the more debt Switzerland issues, the more money it would make courtesy of negative interest expense, literally, and the faster it would pay down its debt. Curiously, this may not be a bad offset to losses that the SNB is currently experiencing due to its currency peg. And some thought bizarro world was a sitcom construct.

As subordination and the inevitable cram-down of European sovereign debt becomes increasingly clear, the 'legal-arbitrage' that we were first to point out back in January in our Subordination 101 post (which worked out extremely well for Greek PSI holdouts), is beginning to be priced into Spanish debt also. As we pointed out yesterday (here and here), being long non-local-law Spanish bonds against a short in a well-matched local-law Spanish bond offers significant upside should things start to get really-ugly (as opposed to the current just-ugly) in Europe. It seems obvious to us that, arbitrage aside, bond portfolio managers should be seeking out these non-local-law bonds and swapping into them (as part of their Fiduciary duty to their investors) if their mandates force them into owning Spanish bonds. In the meantime, as is clear from the chart below (and noted that liquidity/sourcing of the non-local-law bonds is tough but that's why you pay your bond broker so much) that the 'trade' or swap is beginning to be positioned (and especially the last two days where the non-local-law bond has actually risen in price as the local-law bond has crashed).

Nobody can forget how over the weekend Spanish PM Rajoy told economy minister de Guindos to keep a stiff upper lip, and that, lest someone forget, Spain is not Uganda. Two days later nobody is laughing: Spanish bond yields just pushed to Euroarea records, Fitch just downgraded the bulk of Spanish banks, and it looks like Spain may need a second bailout before the details of the first one are even ironed out. However, one entity is not amused. Uganda. Or perhaps, is very amused, depending on one's perspective.

Lesser Of Two Evils?  There’s No Such Thing…

First of all, asserting that there is such a thing as a “lesser of two evils” is an act of naivety.  It relies on a very dangerous assumption; that one can somehow quantify which candidate is going to hurt the country less.  I’ve even read essays by people who pretend they can mathematically delineate the “more evil” of the evils!  Not surprisingly, their “logic” invariably leads them to proclaim the lesser evil to be the candidate of the party they happen to belong to.  Ignorant Republicans always see the Democrat as the greater evil, while ignorant Democrats always see the Republican as the ultimate monster. Here’s some math for you:  there are two candidates for President of the United States, one is a cannibalistic serial killer who plans to murder 20 more people with his own hands while in office.  The other is a cannibalistic serial killer who only plans to kill 19 innocents personally.  Which candidate do you support?

The correct answer is NEITHER.

European credit markets are near one-week wides, having tumbled dramatically since yesterday's open. Investment grade credit is leading the charge followed by senior financials as professional investors look for macro protection - we suspect ahead of this weekend's election. However, European equities are modestly higher from yesterday's close and remain higher than Friday's close. Credit markets had their own dead-cat-bounce at the open this morning but that has since faded significantly, so for now, as we have said again and again 'credit anticipates and equity confirms', it seems credit is seeing something a little less sanguine ahead for now. In the meantime, Spanish and Italian sovereign debt is pushing higher in yield (Spain +74bps from yesterday's open to euro-era record highs) and Swiss 2Y rates have hit a new record low at -36.6bps.

Yesterday, Reuters royally spooked the market when it announced that Europe is in all seriousness considering full blown capital controls, including border halts and ATM closures. Subsequently, various European talking heads aggressively tried to talk down this latest development. However, overnight Saxo Bank appears to have focused on the former and not the latter, and sent out an email with the following key text: "Due to the current market environment in Europe, Saxo Bank is adjusting the margin requirement for Swiss Franc (CHF)." Specifically, the margin is going from 1% to 2% on June 14, to 4% on June 21. How soon until margins become so high that they effectively act as an FX trading prohibition- i.e., an implicit "capital control", and how long until all other exchanges get the memo next?

...and after all of those fancy acronoyms (ECB, EFSF, EU, ESM, ASS, BS, etc.), Italy is essentially just one big Greece. No, I'm not oversimplifying, just look at the bank bailout bailing out the insolvent country circular arguments!

The ongoing drama and chaos across Europe has seen the rise and spread of a number of 'extremist' anti-EMU and anti-bailout parties. As JPMorgan notes, the political consequences of reform fatigue are high. Many countries have seen the emergence of nationalist parties but only France, Italy, and Greece have parties advocating EMU withdrawal (for now). This is exactly what we discussed as likely to occur and was quantified here (and here) as inevitably leading to chaos, judged empirically, when austerity has been imposed.

Spanish bond yields have leaked slowly higher all day but the very recent news from Merkel, talking on the G-20, that:

*MERKEL SAYS WRONG TIME TO DISCUSS POSSIBILITY OF EURO BONDS
*MERKEL SAYS STATES MUST GIVE UP SOME SOVEREIGNTY TO EU
*MERKEL SAYS JOINT LIABILITIES IN EUROPE REQUIRE JOINT CONTROLS
*MERKEL SAYS INVESTORS' INTEREST NOT IDENTICAL WITH EUROPE'S (Subordination?)

has pushed Spanish CDS and bonds to they highest closing levels for the year and just shy of intraday post-EU record wides. For context, these are 15 year high yields at 6.67% and while they 'feel' dramatically high, Spanish bond yields were over 12% in 1995 (but the current spread to Bunds is dramatically wider) highlighting why focusing on the spread not the yield is now critical. 5Y CDS are holding above 600bps again (record wides) and 10Y Spanish spreads (over Bunds) are at 527bps - near all-time (pre- and post-Euro) wides. The last two days have seen a dramatic surge of 38bps from Friday's close and 65bps from Monday's open as Goldman's 'long' short-dated Spanish bond bet continues to Corzine the Muppets.