Discount Window

While in principle central banks around the world can talk up the market to infinity or until the last short has covered without ever committing to any action (obviously at some point long before that reality will take over and the fact that revenues and earnings are collapsing as stock prices are soaring will finally be grasped by every marginal buyer, but that is irrelevant for this thought experiment) the reality is that absent more unsterilized reserves entering the cash starved banking system, whose earnings absent such accounting gimmicks as loan loss reserve release and DVA, are the worst they have been in years, the banks will wither and die. Recall that the $1.6 trillion or so in excess reserves are currently used by banks mostly as window dressing to cover up capital deficiencies masked in the form of asset purchases, subsequently repoed out. Which is why central banks would certainly prefer to just talk the talk (ref: Draghi et al), private banks demand that they actually walk the walk, and the sooner the better. One such bank, which has the largest legacy liabilities and non-performing loans courtesy of its idiotic purchase of that epic housing scam factory Countrywide, is Bank of America. Which is why it is not at all surprising that just that bank has come out with a report titled "Shipwrecked" in which it says that not only will (or maybe should is the right word) launch QE3 immediately, but the QE will be bigger than expected, but as warned elsewhere, will be "much less effective than QE1/QE2, both in terms of boosting risky assets and stimulating the economy."

"This market isn't real. The two percent on the ten-year, the ninety basis points on the five-year, thirty basis points on a one-year – those are medicated, pegged rates created by the Fed and which fast-money traders trade against as long as they are confident the Fed can keep the whole market rigged. Nobody in their right mind wants to own the ten-year bond at a two percent interest rate. But they're doing it because they can borrow overnight money for free, ten basis points, put it on repo, collect 190 basis points a spread, and laugh all the way to the bank. And they will keep laughing all the way to the bank on Wall Street until they lose confidence in the Fed's ability to keep the yield curve pegged where it is today. If the bond ever starts falling in price, they unwind the carry trade. Then you get a message, "Do not pass go." Sell your bonds, unwind your overnight debt, your repo positions. And the system then begins to contract... The Fed has destroyed the money market. It has destroyed the capital markets. They have something that you can see on the screen called an "interest rate." That isn't a market price of money or a market price of five-year debt capital. That is an administered price that the Fed has set and that every trader watches by the minute to make sure that he's still in a positive spread. And you can't have capitalism if the capital markets are dead, if the capital markets are simply a branch office – branch casino – of the central bank. That's essentially what we have today."

Just like last time around when stocks were plunging with no knight in shining armor in sight, until the Fed's faithful mouthpiece-cum-scribe Jon Hilsenrath showed up with a report, subsequently disproven, that more QE is coming minutes before the market close on July 6, so today stocks appeared poised for a precipice until some time after 3 pm it was leaked that none other than Hilseranth once again appeared, at precisely 3:55 pm, with more of the same. Ironically, the market only saw the word Hilsenrath in the headline, and ignored the rest. The irony is that this time around the Fed's scribbler said nothing that we did not know, namely that the Fed can do something in August, or it may do something in September, or it may do nothing, none of which is actually news.

Libor is not a market determined interest rate, rather it is a trimmed mean from a survey of banks participating in a survey conducted on behalf of the British Bankers Association (BBA). There are a number of problems inherent in the survey-based Libor calculation. Chairman Bernanke was asked in testimony several times yesterday whether Libor should be dropped as a benchmark interest rate. His answer was Libor should be repaired or some market determined interest rate should be embraced as an alternative. He offered up 2 market-determined replacement possibilities for Libor: (1) Repo Rates; and (2) OIS rates. Both are market determined interest rates, but neither in our minds captures the essence of what Libor is supposed to measure. Stone & McCarthy's preference for a Libor alternative would simply be the eurodollar rate.

As Messers Frank and Paul take on the Bernank this morning, we reflect on the four easing options that the illustrious fed-head laid out in a statement-of-the-obvious that still managed to get the algos ripping. As Goldman notes, his prepared remarks were terse (and lacking in 'easing options' discussion) - cautious on his outlook, concerned at Europe, and fearful of the 'fiscal cliff' - but his response in the Q&A were a little more revealing as he laid out his choices: asset purchases, discount window lending programs, changes in communication about the likely path of rates or the Fed balance sheet, or a cut in the interest rate on excess reserves. We discuss each below but note, just as Goldman believes, that while we think that a modest easing step is a strong possibility at the August or September meeting, we suspect that a large move is more likely to come after the election or in early 2013 (and not before), barring a very rapid further deterioration in the already-cautious near term Fed economic outlook (which we assume implicitly brings the threat of deflation).

"A week after Bernanke spoke last year we saw the highs for H2 2012 (1345) before moving aggressively lower into the low 1100s through August- October as Europe’s problems intensified and the US debt ceiling problems came to a head. One year on and the biggest H2 risks are probably similar. US data is weakening, Europe’s problems could easily come to a head again and the fiscal cliff could become a major issue, albeit slightly later in the year. We also now have a China slowdown to contend with. So the parallels are there."

Just under two years ago, when we mocked then Morgan Stanley's analyst Jim Caron's call for a surge in long-dated yields on the back of an improvement in the economy (not something more realistic like the Fed losing all control of the TSY curve), we penned "Visualizing The Past Of The Treasury Yield Curve, And Deconstructing The Great Confusion Surrounding Its Future" in which we said that contrary to pervasive expectations of a bull steepener, the treasury curve would continue flattening more and more, until the whole thing would become one big pancake. Today, we have decided to revisit that post: in short - Jim Caron was fired by Morgan Stanley as head of rates following 3 consecutive years of bad calls starting in 2009 (only to be rehired in June as a Portfolio Manager... oops), while our view that sooner or later the 2s30s will be 0 bps is over one third complete.

Despite BoE's Tucker telling us this morning that there is no need to look at any other market but LIBOR, it appears the world has moved on from this debacle of indication of anything. As we pointed out here, the 'stability' of LIBOR given everything going on around it is incredulous (whether due to the ECB's crappy-collateral standards-based MROs or the Fed's FX swap lines - since unsecured interbank financing is now a relic of the pre-crisis 'trust' era). Furthermore, as we discussed yesterday, the machinations of the LIBOR market and calculations (which Peter Tchir delves deeply into below) suggest that this not the act of a lone assassin suggesting quite simply that complaining or suing Barclays is redundant - any Libor-related suits (from the public or the government/regulators) must sue all the submitters or it misses the critical facts of the manipulation.

With a few hours until BoE's Paul Tucker takes the stand, the venerable institution has finally acquiesced to the Freedom of Information Act request from British MP John Mann and released all copies of emails and transcripts of telephone conversations between Tucker and Bob Diamond between 10/1/08 and 11/30/08. The emails make for some fascinating reading when one considers the sources of the conversation. The thrust of the discussion is Tucker's concern at UK Libor rates being considerably higher than US - especially as US rates were dropping; Tucker's 'shock' at the cost of funding for Barclays' government-guaranteed debt; and finally the explanation/admission for why the BoE's liquidity hosepipe was not fixing the solvency problem in British banks - a lack of eligible collateral. Smoking gun maybe; nail in the coffin of independent Central Banks for sure; hangings in the streets - we are not so sure.

The Fed does everything it can to keep LIBOR low. The Fed cannot affect LIBOR directly, but in general LIBOR trades in line with Fed Funds.  You can see that historically as Fed Funds was changed, LIBOR responded appropriately. That all started to break down in 2007 and re-ignited in the late summer of 2008 and peaked after Lehman and AIG. The Fed was blatantly clear that it wanted borrowing costs to go down.  They had the obvious tool of reducing Fed Funds to virtually zero, but when LIBOR didn't follow, the Fed took further action. The Fed has done a lot and trying to control LIBOR as a key borrowing rate is one of the things they have worked on, both directly and indirectly.

In honor of the FDIC releasing the living wills for banks, we thought we’d offer up a shorter version that the banks could use. You're welcome.

What would the weekend be without at least one rumor that Europe is on the verge of fixing everything, or failing that, planning for a master fix, OR failing that, planning for a master plan to fix everything. Sure enough, we just got the latter, which considering nobody really believes anything out of Europe anymore, especially not something that has not been signed, stamped and approved by Merkel herself, is rather ballsy. Nonetheless, one can't blame them for trying: "The chiefs of four European institutions are in the process of creating a master plan for the euro zone, the daily Die Welt reports Saturday, in an advance release of an article to be published Sunday. Suggestions targeting a fiscal, banking, and political union, as well as structural reforms, are being worked out..." Less than credible sources report that Spiderman towels (which are now trading at negative repo rates) and cross-rehypothecated kitchen sinks are also key components of all future "master plans" which sadly are absolutely meaningless since the signature of Europe's paymaster - the Bundesrepublik - is as usual lacking. Which is why, "the plan may well mean that the euro zone adopts measures not immediately accepted by the whole of the European Union, the article adds." So... European sub-union? Hardly strange is that just as this latest desperate attempt at distraction from the complete chaos in Europe (which will only find a resolution once XO crosses 1000 as we and Citi suggested two weeks ago and when the world is truly on the verge of the abyss), none other than George Soros has just started a 3-month countdown to European the European D(oom)-Day.

Today the ECB is expected to do absolutely nothing, although many have their hopes up that at the post announcement press conference Mario Draghi may possibly hint at some more easing (with what collateral we wonder, and with what Germany) to bring some spring into the step of a continent that has milked $1.3 trillion in 3 year repo/discount window borrowings for all their worth and then some. And instead if the ECB cuts its rate below the psychological barrier of 1% today, or at any time over the next several months, it will make Hugh Hendry once again that much richer. Recall as of November: "He’s made bets that he says will deliver a 40-to-1 return if the ECB cuts rates below 1% next year." Below is a full rundown of what to expect, and not to expected, from the former Goldmanite, now head of the central bank for the world's biggest economic region.

At least that is the bogey according to JPMorgan's Pawan Wadhwa, who in a note announced that the ECB may resume SMP purchases if the 10 year hits 6.5% (as in a few hours), much to the chagrin of Germany, which was foosed into believing LTRO 1+2 would mean no more SMP purchases. More importantly, since the 6.50% barrier will be taken down with impunity in days if not hours, and the SMP has proven time and again to be powerless to prevent mass selling, the next big bogey is 7.50% at which the ECB will likely announce another 3-year Discount Window bazooka, pardon, LTRO. What JPM does not say is that with the halflife of each successive LTRO getting cut in half, LTRO 4 will be needed in June, LTRO 5 in July, LTRO 6 in July, LTRO 7 in July and so on. Most importantly, now that banks, who are desperate for some cash infusion from either the Fed or the ECB, know what the critical threshold bogey for action is, they will be sure to facilitate the ECB's life, and send Spanish 10 Years plunging to at least 7.50% and demand Draghi play ball, again. In other words: now that the market knows what the consensus is to get more European QE, it will promptly do it. After all the LTRO was never for the benefit of the countries: it was always and only to benefit Europe's insolvent banks. If that means "Greecing" Spain in the process, so be it.

And like that, Europe is broken again. Following a spate of negative European data (what else is there), including a miss in German industrial production as well as a miss in UK manufacturing output, all eyes are again on Spain, especially those of the bond vigilantes, who have sold off the sovereign European bond market, sending the Spanish-Bund spread to over 400 bps for the first time since December 2011. The main reason today: a Goldman report saying Spain will unlikely meet its 2012 and 2013 budget targets, as well as JPM Chief Economist David Mackie saying Spanish government "missteps" have raised questions about its credibility, making investors reluctant to purchase Spanish debt. Stress has returned to periphery, if it broadened into bank funding markets more LTROs would be forthcoming; if that “failed to hold yields at an appropriate level” Spain may need assistance from the EFSF/ESM and the IMF. Euro area unlikely to return to stability in sovereigns without some burden sharing; nominal growth likely to stay below borrowing costs, making fiscal targets “all but impossible to achieve”. UBS piles in saying Spanish banking stresses still haven't been addressed. Finally, a big red flag is that market liquidity is once again starting to disappear, and as Peter Tchir points out, Main is now being quoted with 3/4 bps bid/ask spread, all the way up to 1 bps spread. In other words, as we have been warning for weeks, the period of fake LTRO-induced calm is over, and the market is demanding more central planner liquid heroin. The question becomes whether Europe has even more worthless collateral in exchange for which the ECB will continue handing out discount window money in sterilized sheep's clothing. Yet nowhere is the resumption in risk flaring more evident than in the Swiss Franc, where the EURCHF all of a sudden broke through the critical 1.20 SNB floor, which was set back in September 2011, the day gold was trading at its all time high. Said otherwise, everyone is once again scrambling for safety. And since they can't get it in the CHF, it is only a matter of time, before gold resumes its ascent as the paper currency alternative that sent it to its all time highs late last summer.