Archive - Sep 2012 - Story

If yesterday it was the Middle East's turn to escalate, today it is the Far East, aka Pacific Rim, where China and Japan both remind the world nothing has been fixed in the diplomatic snafu between the two countries over a barren rock in the East China Sea. First, it was China, which on the front page of the biggest daily Xinhua, over the weekend, demanded that Japan immediately stop infringing upon its "territorial sovereignty. To wit: "China asked Japan to immediately stop all acts that harm China's territorial sovereignty, Foreign Ministry spokesman Hong Lei said late Saturday, after some Japanese landed on the Diaoyu Islands. Hong said the Japanese landed on the Diaoyu Islands Friday evening with the excuse of preventing Taiwanese activists from landing on the islets. "It is a severe infringement upon China's territorial sovereignty, and the Chinese government has lodged solemn representations and strong protests to the Japanese side," Hong said in a statement." Other headlines make it quite clear that it is in China's interest to stir populist anger at Japan instead of seeking an amicable resolution. What, however, was the most important article in today's Pacific Rim press is this one which has nothing to do with Japan, and everything to do with China's expanding zone of influence: "China's top security official on Saturday made a surprise visit to Afghanistan, the first time in 46 years that a Chinese leader set his foot on the soil of this landlocked Asian country."

Large, centrally-directed systems are inherently fragile. Think of the human body; a spontaneous, unexpected blow to the head can kill an otherwise healthy creature; all the healthy cells and tissue in the legs, arms, torso and so forth killed through dependency on the brain’s functionality. Interdependent systems are only ever as strong as their weakest critical link, and very often a critical link can fail through nothing more than bad luck. Yet the human body does not exist in isolation. Humans as a species are a decentralised network. Each individual may be in himself or herself a fragile, interdependent system, but the wider network of humanity is a robust independent system. One group of humans may die in an avalanche or drown at sea, but their death does not affect the survival of the wider population. The human genome has survived plagues, volcanoes, hurricanes, asteroid impacts and so on through its decentralisation.

It seems you can't turn your back on the Middle East for more than a few minutes without something going bump in the desert. Sure enough, a few shorts hours after we reported that the leader of Iran's Revolutionary Guards is certain war with Israel is coming, here comes Iran again with the stunning admission that none other than German industrial conglomerate, and occasional maker of nuclear power plants, Siemens was reponsible for "implanting tiny explosives inside equipment the Islamic Republic purchased for its disputed nuclear program. Prominent lawmaker Alaeddin Boroujerdi said Iranian security experts discovered the explosives and removed them before detonation, adding that authorities believe the booby-trapped equipment was sold to derail uranium enrichment efforts. "The equipment was supposed to explode after being put to work, in order to dismantle all our systems," he said. "But the wisdom of our experts thwarted the enemy conspiracy." Expert wisdom aside, what is stunning is not the ongoing attempts by everyone and the kitchen sink to terminally corrupt the Iranian nuclear power plant: after Stuxnet one would expect nothing less than every form of conventional and "new normal" espionage thrown into the pot to cripple the only peaceful argument Iran would have for demanding nuclear power, which by implication would mean that all ongoing nuclear pursuits are geared solely toward aggressive, military goals, of the type that demand immediate military retaliation by the democratic superpowers. No, what is stunning is the implicit admission that Germany's, and Europe's, largest electrical engineering company, has been not only quietly transacting with none other than world peace (as portrayed by the MSM) enemy #1, Iran, but instrumental in its nuclear program.

If anyone thought the bad blood between Germany and the rest of the insolvent proletariat, aka the part of the Eurozone which is out of money (most of it), and which has been now confirmed will be supporting Obama (one wonders what the quid for that particular quo is, although we are certain we will find out as soon as December), complete collapse of the Greek neo-vassal state of the globalist agenda notwithstanding, had gone away, here comes former ECB chief economist Juergen Stark to dispel such illusions. In an interview with Austrian Die Presse, the former banker said what everyone without a PhD understands quite well: "The break came in 2010. Until then everything went well..."Then the ECB began to take on a new role, to fall into panic.... Together with other central banks, the ECB is flooding the market, posing the question not only about how the ECB will get its money back, but also how the excess liquidity created can be absorbed globally. "It can't be solved by pressing a button. If the global economy stabilises, the potential for inflation has grown enormously... It gave in to outside pressure ... pressure from outside Europe" Why, whichever bank headquartered at 200 West, NY, NY might he be referring to?

According to Mario Draghi, OMT, or Outright Monetary Transactions, is a program of conditional bond buying targeted at specific countries to restore the perception of the euro's irreversibility and stability, and repair a broken monetary policy transmission mechanism.  Once launched, OMT has no ex ante limits, it is within the ECB's price stability mandate, and it can be halted or interrupted based on achievement of its objectives or non-compliance with conditions imposed upon the targeted national government. We would posit that OMT is much more than what the party line states.  Here are some alternative interpretations for your consideration.  We challenge you to refute the logic of any of them.

Let’s review the tricks the central banks & governments have available to beat back any financial challenges presented by the debt reaper.

• Money tool # 1 = deficit spending. For years, the G7 countries have believed that spending more than you make, will create jobs and prosperity. To measure the success of this strategy, we invite you to hang out in Spain, Greece or Italy.
• Money tool # 2 = cut interest rates to 0%. All the really smart people in the World know that lower interest rates encourage people and companies to borrow more money and spend this money. To measure the success of this strategy, we invite you to hang out at the US Federal Reserve and help them count the $1.5 trillion in excess money held by the big banks.
• Money tool # 3 = when all else fails print money. Everyone knows by now the reason the Great Depression was great was because no one had the idea to print money to kick start the economy. To measure the success of this strategy, we definitely do not invite you to visit Japan. The Japanese have been printing money for over 10 years and that hasn’t shaken their economy from its funk one bit.

As we enter the always dangerous months of September and October, central bankers and governments just can’t get their heads around the fact that their cherished money tools are not shaking the World. Never one to quit, someone somewhere muttered “we must do something” – and something they did.

The seemingly inexorable rise of corporate bond ETFs (most specifically HYG and JNK is the high-yield market, and LQD in investment grade) have been discussed at length here as both a 'new' factor in the underlying bond market's technicals (flow) as well as their correlated impact on equity and volatility markets. Goldman Sachs' credit team delve deep into the impact of these relatively new (and rapidly growing) structures with their greater transparency but considerably higher sensitivities and conclude that not only are they here to stay but the consequences of ETF-inclusion (dramatic outperformance bias relative to non-ETF bonds) are deepening the liquidity divide (and relative-value) of what is already a somewhat sparsely-traded market. Our concern is that, as the divide grows (and liquidity is concentrated in ETF bonds), given the crowding tendency we have witnessed, (even with call constraints at extremes thanks to low interest rates), this is yet another crowded 'hot potato' trade hanging like a sword of Damocles over our markets (courtesy of Bernanke's repression).

There is a common problem underlying the economic troubles of Europe, Japan, and the US: the symbiotic relationship between politicians who heed narrow interests and the growth of a financial sector that has become increasingly opaque (Igan and Mishra 2011). Bailouts have encouraged reckless behaviour in the financial sector, which builds up further risks – and will lead to another round of shocks, collapses, and bailouts. This is what Simon Johnson and Peter Boone have called the ‘doomsday cycle’. The continuing crisis in the Eurozone merely buys time for Japan and the US. Investors are seeking refuge in these two countries only because the dangers are most imminent in the Eurozone. Will these countries take this time to fix their underlying fiscal and financial problems? That seems unlikely. The nature of ‘irresponsible growth’ is different in each country and region – but it is similarly unsustainable and it is still growing. There are more crises to come and they are likely to be worse than the last one.

Two weeks ago, when summarizing the state of the US vs China escalating patent war (for now manifesting itself in the courtroom brawl between Apple and Samsung, but soon to drag many more comparable companies down in drawn out litigation), we observed that while AAPL may have the upper hand, iPhone 5 map fiasco notwithstanding, that "the Chinese politburo can one day decide to pull FoxConn's operational license, in the process bankrupting AAPL overnight" if China really wanted to turn the tables. Obviously, this was the "thought experimental" MAD outcome which leads to loses for everyone involved: both Apple and China (where Apple's contract manufacturer FoxConn employs over 1 million workers). There is one other alternative: that FoxConn, by now having reverse engineered the peak of Apple's brilliance (whose latest evolutionary step was "lighter" and "longer", which anyone could have come up with), decides to brave it alone, and instead of being a contract manufacturer, to simply slap on a FoxConn sticker, a la Acer and ASUS, and sell all Apple-equivalent products at 50% off while collecting all the revenue. Impossible, you say, Apple would never allow it? It is already happening, first in high-growth Brazil, where FoxConn is now launching its own stores.

After the financial debacle caused by a thieving and uncontrolled Thug-elite (banksters, Wall Street, moneyed interests), helped in part by a society ready to be courted by its very own ugly greed, this time in real estate, one would think the electorate would have economics as the prime, if not the sole focus when casting a ballot in this next presidential election.  And that would entail castigating politicians, or parties, who could be justly blamed for such debacle and for embracing globalization without a viable plan for those Americans who would be left behind without living-wage jobs; while rewarding politicians, or parties, who offer a reasonable way out, not just of the present mess we are in, but of the impending uglier mess which looms in the horizon.  But that would be taxing reality in a nation which has failed to charge Wall Street criminals, for the most part Republicans; in a nation where Bill Clinton, the godfather of American globalization, continues to be held in high esteem by a clueless Democrat party.

When it comes to diving trends in the Fed's take over of the Treasury market, there are those who haven't got the faintest clue about what is going on, such as Paul Krugman, who naively looks (as Bernanke expects all economists to) at the simple total notional of securities held by the Fed and concludes that the Fed is not doing anything to adjust fixed income risk-preference, and then there are those who grasp that when it comes to defining risk exposure in the bond market, and therefore in equities, all that matters is duration, expressed in terms of ten-year equivalents. Sadly, this is a data set that not every CTRL-V major or Nobel prize winner (in order of insight) can grab from the St. Louis Fed - it is however available to those who know where to look. And as the chart below shows, even as the Fed's balance sheet has remained flat in notional terms, its Ten Year equivalent exposure has soared, rising by 50% during Operation Twist alone, from $900 billion to $1.313 trillion. What this means in practical terms, as Stone McCarthy summarizes, is that the Fed now owns 27.05% of the entire inventory in outstanding ten-year equivalents. This leaves less than 75% of the market in private hands.

Peak career risk. That's how one can summarize what the hedge fund community, long used to "nimbly" outperforming the market populated by slow, dumb money managers and getting paid 7+ digit bonuses, is feeling right now. The last time we looked at relative hedge fund performance, because let's face it: indexing is a polite word for underperforming and anyone who says otherwise is rather clueless about the asset management industry in which the only thing that matters is always outperforming everyone else, only 89% of hedge funds were underperforming the S&P500 through mid-August. A month later, this number is now up to 92% as of September 14. A month later, this number is now up to 92% as of September 14.

Inversely this means that only 8% of hedge funds are outperforming the market with just 3 months left in the year.

Even as the popular ADHD affliction is preoccupied with who paid what taxes, and whether this poll shows that guy on top or this one, until tomorrow when they flip providing even more meaningless chitchat opportunities, everyone appears to have once again lost sight of the big picture, which is that two US ships continue full steam ahead toward Iran, namely the CVN-74 Stennis aircraft carrier which has crossed the Pacific ocean and is now a week away from its target, and the LHA 5 Peleliu big deck amphibious warfare ship, where they will join two other aircraft carriers and the LHD 7 Iwo Jima as summarized by the graphic below. Why is US naval presence in the Gulf soaring to a concentration not seen since the last Gulf war? The head of the Iran revolutionary guard may have an idea. From Reuters: Israel will eventually go beyond threats and will attack Iran, the commander of Iran's Revolutionary Guards was quoted as saying on Saturday. "A war will occur, but it's not clear where or when it will be," Jafari was quoted as saying on Saturday. "Israel seeks war with us, but it's not clear when the war will occur."

We believe an unsustainable new global financial architecture that arose in response to the US and European financial crises has replaced an older, more sustainable, architecture. The old architecture was crystallized in Washington- and IMF-inspired policy responses to the numerous sovereign defaults, banking system failures, and currency collapses. Most importantly, the previous architecture recognized limits on fiscal and central bank balance sheets. The new architecture attempts to 'back', perhaps unconsciously, the entire liability side of the global financial system. This framing is consistent with a purely political—institutional stylized—fact that it is nearly impossible to penetrate the US political parties if the message is that there are limits to their power…or that their power requires great effort and sacrifice. This is why Keynesians (at least US ones) who argue there are no limits to a fiscal balance sheet are so popular with Democrats, and why monetarists (at least US ones) who argue there are no limits to a central bank balance sheet are popular with (a decreasing number of) Republicans. Party on! Again, nobody chooses hard-currency regimes – they are forced on non-credible policymakers. Let me put it more positively. If politicians want the power of fiat money, let alone the global reserve currency, they need to behave differently than they have - or the consequences for Gold are extraordinary.

There was a time when the market led, and the economy followed. That's when the market was still a discounting mechanism, a long, long time ago. Then came a time when the clueless market, after every illusion it held about a Dow 36,000 future was shattered, would respond with a slight, millisecond delay to every flashing red economic "surprise" headline and thanks to HFTs exaggerate the momentum of the move spectacularly, leading to delirium-inducing volatility, and even further confusion. But what we have now, under the final advent of the central planner New Normal, when the economy is clearly going one way (the wrong one), while the S&P is dogedly chasing the opposite direction and completely ignoring any and all downside macro surprises, is something never seen before. One thing is certain: the gaping maw of the alligator: the red and the blue arrows will converge, and sooner or later the convergence will not be in the direction that the central printer, and his Liberty 33 henchmen, request.