Archive - Sep 11, 2012 - Story

Three months ago, the Muslim Bortherhood supported, US-endorsed and recommended candidate, Mohammed Mursi won the Egyptian presidential election. Fast forward to today, when we learn from Al Jazeera that the grateful Egyptian population has decided to conduct a little Arab Spring repeat rehearsal in the fall, as Egyptian protesters scaled the walls of the U.S. embassy in Cairo on Tuesday and some pulled down the American flag during a protest over what they said was a film being produced in the United States that was insulting to the Prophet Mohammad, witnesses said.

I have often identified Keynesian economists and the Federal Reserve as cargo cults. After the U.S. won World War II in the Pacific Theater, its forces left huge stockpiles of goods behind on remote South Pacific islands because it wasn’t worth taking it all back to America. After the Americans left, some islanders, nostalgic for the seemingly endless fleet of ships loaded with technological goodies, started Cargo Cults that believed magical rituals and incantations would bring the ships of “free” wealth back. Some mimicked technology by painting radio dials on rocks and using the phantom radio to “call back” the “free wealth” ships. The Keynesians are like deluded members of a Cargo Cult. They ignore the reality of debt, rising interest payments and the resulting debt-serfdom in their belief that money spent indiscriminately on friction, fraud, speculation and malinvestment will magically call back the fleet of rapid growth. To the Keynesian, a Bridge to Nowhere is equally worthy of borrowed money as a high-tech factory. They are unable to distinguish between sterile sand and fertilizer, and unable to grasp the fact that ever-rising debt leaves America a nation of wealthy banks and increasingly impoverished debt-serfs.

There was a time when the short end of the curve was not very loved, as all bonds 3 years and shorter were sold by none other than the Fed. Today, that is no longer the case, driven primarily by ever louder whispers that because the Fed is very much limited in its long-dated purchases as we first calculated last Friday, it may give up on sterilization entirely (since nobody really knows what the Fed will do, but 101% of traders are now certain it will do something), and proceed to monetize all maturities as all Stock considerations are thrown away, and everyone focuses solely on the Flow. Sure enough, the $32 billion 3 year auction just priced at the second lowest yield ever of 0.337%, with only the Sept 2011 yield of 0.334% lower. This was well inside the WI yield of 0.34% at 1 pm. Offsetting the yield "disappointment" was the spike in the Bid To Cover which rose from 3.51 to 3.936, the highest ever. Finally, looking at the internals, for the first time November, Dealers took down less than half of the auction, or 49.8%, with 36.8% going to Indirects, and 13.4% to the PIMCOs of the world, and other Direct bidders such as China. Of course, if there is disappointment on Thursday, and if Dealers have no choice but to keep buying the short-end as a result of the continuation of Twist, as sterilization continues, expect to see some disappointed buyers of today's auction, which incidentally together with the rest of this week's issuance will bring total US debt to a new record of just over $16.07 trillion, and rising very rapidly.

We have already discussed what is priced into FX markets with regard QE3 - and as Barclays notes, we also saw a similar gain in momentum into QE1 and QE2 (only to fade post the announcement). Mortgage traders see a sizable QE3 more than priced in, which is especially notable given the consensus forming around the NEW LSAP being centered on the MBS market. Of course, global markets are imbibing more than just the hope of the Fed's extreme policy actions but the ESM ratification as well as handicapping ECB's OMT conditionality (and European growth expectations). Having said all that, it is worthwhile to get a sense of just what happened among the major risk asset classes into and beyond the prior QE (and Twist) announcements, and just what these markets have been doing in the lead-up to this much-anticipated announcement. It seems that no matter where one looks, as one wise old mortgage derivative trader put it "the rumor has been bought."

The official release, just issued by HM Treasury, is below. The unofficial one is as follows: "The successful candidate must have proficiency with the CTRL and P buttons. Must sound confident and sophisticated when talking in circles while saying nothing. Must be malleable to financial sector suggestions. All other considerations secondary."

Last week we discussed what the expectations were for Draghi's OMT - approximately EUR250bn - which coincidentally provided cover for the rest of the year (conditionally) for the entire new issuance of the European Union. Based on EURUSD's recent exuberance - something we saw ahead of QE1 and QE2 - the market is now more than primed for some serious USD debasement. The current EURUSD of 1.2850 implies a Fed-to-ECB balance sheet ratio around 1.11x. If we assume the ECB wil not have to fire its conditional bazooka (of which is priced in 100% likelihood of EUR250bn), then the Fed is expected to conjure a monetization scheme of around USD580bn - anything less would be a disappointment to the market. However, if we assume the ECB will be doing it's bond-buying monetization thing  - as per the equity market's expectations - then the Fed will need to come to the table with a bag of swag around USD850bn in order to debase the USD just enough to regain some hope. It seems like the market has priced in a great deal of monetary policy exuberance  - especially considering how 'confident' consumers appear to be.

To all who miss the highly volatile days of August 2011, when as a result of the congressional deadlock on the debt ceiling, and the S&P downgrade of the US, the DJIA swung by 400 points every day for 4 days in a row just to get Congress to come to the "compromise" exposed in painful detail by Bob Woodward a few days ago, fear not: they are coming back, and with a vengeance. Because while last year only the debt ceiling was under discussion, now we get the double whammy of the debt ceiling and the Fiscal cliff. And just so the suspense meter is pushed off the charts early, and the performance gets maximum billing for theatrics if not execution, House Speaker John Boehner has just said he's not confident Congress can reach a budget deal and avoid a downgrading of the U.S. debt rating. Let us paraphrase: there will be no deal until the 11th hour, 59th minute, 59th second, and 999th millisecond, at which point the market will plunge and get Congress to do what it always does: Wall Street's bidding, which now and always, is a smooth and seamless continuation of the status quo.

Just in case there wasn't enough excitement and fury directed at Swiss bank account holders, which continue to dominate the presidential election "debate" above such mundane topics as the economy, or, say, reality, here comes the IRS, which as we noted yesterday collected $192 billion less than the government spent in the month of August alone, and have awarded Bradely Birkenfeld, a former UBS employee who in 2008 pleaded guilty to conspiracy to defraud the United States and was sentenced in 2009 to 40 months in prison, but received preferential whistleblower status after a prior arrangement to expose numerous Americans with Swiss bank accounts, has just been awarded $104 million.

The Second Great Depression officially started in December 2007. The NBER tells us that the recession that started at the same time ended some time in the summer of 2009. The Second Great Depression continues. The chart below shows the cumulative increase in Americans receiving foodstamps and disability benefits since December 2007 on the positive Y-Axis, and the jobs lost on the negative Y-axis. No additional explanation is necessary.

Gallup's US economic confidence index surged 11 points last week (more than the 10 points when Bin Laden was killed) and has reached levels comparable to the pre-crisis highs from January 2008. As Gallup notes, it appears that the spark for the dramatic rise in Americans' economic confidence last week was the Democratic National Convention. A review of Gallup's nightly tracking results shows that the index was consistently near or below -25 each night in late August and early September, but then sharply improved on Sept. 4, the first night of the convention, to -18. Confidence then held at or near -18 through Sunday, despite the dismal August unemployment report Friday morning showing continued weak jobs growth. More specifically, the convention appears to have given Democrats and, to a lesser degree, independents, fresh optimism about the economy. We can only assume that the cognitive dissonance of the hope-holding believers-in-change will not carry through to real economic growth or all those other 'hopers' - the 'this-time-QE-is-different' crowd - will be sadly disappointed.

"...the only smiles you see in Wall Street are on the photocopied photos of the missing that family and friends have taped to walls, mailboxes and lampposts. It may take a long time for smiles to naturally return to Wall Street. It may take a long while to find those criminals who took our smiles and our friends. But, we will have patience. As our President said – "We will not tire. We will not falter. We will not fail!"

Despite the exuberance in Spanish equity and bond markets (which in the US managed to create a quadruple-dip bounce), home prices just can't get a break in the troubled bailout-less nation. According to TINSA, the general home price in Spain fell 11.6% YoY, and has recent reaccelerated with a 2.8% drop sequentially as hope for a third-time's-the-charm bounce now faded for the forelorn real estate market. The Mediterranean Coast suffered the most, -14.7% YoY (and are down a cumulative 39.5% from the highs). Overall, Spanish house prices are down a cumulative 32.4% from the December 2007 highs (back to 2003 levels). This re-acceleration of the downturn in home prices is hardly what the Dreme is made of as bank balance sheets come under further pressure; deposit outflows will simply not stop until there is underlying improvement in bank collateral, i.e. mortgages and housing values; and so in effect, all this news indicates is that bank balance sheets are even more impaired than previously believed (tourniquet or amputation?).

In a sad case of deja vu all over again, the over-reliance on 'shaky' collateral and concentration of risk is building once more - this time in the $648 trillion derivatives market. New Clearing House rules (a la Dodd-Frank) mean derivatives counterparties are required to pledge high quality collateral with the clearing houses (or exchanges) in a more formalized manner to cover potential losses. However, the safety bid combined with Central Banks monetization of every sovereign risk asset onto their balance sheet has reduced the amount of quality collateral available; this scarcity of quality collateral creates liquidity problems. The dealers, ever willing to create fee-based business, have created a repo-like program to meet the needs of the desperate derivative counterparties - to enable them to transform lower-quality collateral into high quality collateral - which can then be posted to the clearing house or exchange. This collateral transformation, while meeting a need, runs the risk of concentrating illiquid low quality assets on bank balance sheets. In essence the next blow up risk is the eureka moment when all banks are forced to look at the cross-posted collateral. Last time it was the 'fair-value' of housing, now it is the 'fair-value' of 'transformed' collateral that is pledged at par and is really worth nickels on the dollar - "The dealers look after their own interests, and they won’t necessarily look after the systemic risks that are associated with this."

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13 months ago, in the aftermath of the debt ceiling fiasco, which we now know was a last minute compromise achieved almost entirely thanks to the market plunging to 2011 lows, S&P had the guts to downgrade the US. Moody's did not. Now, it is Moody's turn to fire up the threat cannon with a release in which it says that should the inevitable come to pass, i.e. should congressional negotiations not "lead to specific policies that produce a stabilization and then downward trend in the ratio of federal debt to GDP over the medium term" then "Moody's would expect to lower the rating, probably to Aa1" or a one notch cut. Moody's also warns that should a repeat of last year's debt ceiling fiasco occur, it will also most likely cut the US. Of course, that the US/GDP has risen by about 8% since the last August fiasco has now been apparently forgotten by both S&P and Moodys. Sadly, continued deterioration in the US credit profile is inevitable, as every single aspect of modern day lives that is "better than its was 4 years ago" has been borrowed from the future. More importantly, with the S&P at multi year highs courtesy of Bernanke using monetary policy to replace the need for fiscal policy, Congress will see no need to act, and Moody's warning will be completely ignored. This will continue until it no longer can.