EuroDollar

Following on the widely telegraphed rate cut by the Australian central bank overnight to a record low 2.75%, here comes a truly surprise move out of the Kenya Central Bank, and its Governor Njuguna Ndung'u whose central bank just showed the world how it's really done:

• KENYA CENTRAL BANK CUTS BENCHMARK RATE TO 8.50% FROM 9.50%
• KENYA CENTRAL BANK SAYS CONFIDENCE IN ECONOMY HAS INCREASED

As long as the confidence is there... Incidentally, the expectations, by those who have nothing better to do than forecast what the Kenya central bank will do, was for a mere 25 bps cut. We expect the credit carry traders out of Niarobi to scramble for yield in places like Greece, now that their cost of funding has dropped by over 10%. The good news for those doing the inverse trade, and looking to trade Kenyan Eurodollar futures, or the "Kenyo-dollar" as the case may be, is that there still is a long way to go before all time lows rate lows are taken out.

With equity valuations no longer levitating but in a different, 4th dimension altogether, and credit spreads compressing dramatically (and unreasonably)... It is in situations like these, when the crash comes, that the proverbial run for liquidity forces central banks to coordinate liquidity injections. However, something tells me that this time, the trick won’t work. Over almost a century, we have witnessed the slow and progressive destruction of the best global mechanism available to cooperate in the creation and allocation of resources. This process began with the loss of the ability to address flow imbalances (i.e. savings, trade). After the World Wars, it became clear that we had also lost the ability to address stock imbalances, and by 1971 we ensured that any price flexibility left to reset the system in the face of an adjustment would be wiped out too. From this moment, adjustments can only make way through a growing series of global systemic risk events with increasingly relevant consequences. Swaps, as a tool, will no longer be able to face the upcoming challenges. When this fact finally sets in, governments will be forced to resort directly to basic asset confiscation.

The currency wars are just beginning. It is a race to the bottom.

In the last two weeks we have pointed out that not only are equity futures traders the most net long in six years but NYSE Margin Debt is also near four year highs. Add to this the fact that VIX futures are the most net short they have ever been - crushed by an all too visible hand - and it appears that equity market participants were critically unafraid of the fiscal cliff uncertainty. What is even more concerning, at least for those who care to be modestly contrarian that is, is that the market appears to be running out of greater fools in every asset class as JPMorgan's speculative position indicator - which combines net positioning across 8 'risky' and 7'safe' assets - is at its most risk-on since just before the crash began in Q3 2007. So, for all those taking heads who expect a flood of new money, who still believe there is money on the sidelines that wants to be put to work, the fact is in the last decade we have been more speculatively positioned long only once - and that marked the top in stocks (and risk-assets everywhere).

These two charts suggest a major decline is ahead in 2013; but we are told "Don't fight the Fed," blah blah blah. Really? What did the market do after QE3 and QE4 were duly announced? It tanked. What if the Fed is out of tricks? It's not really a question; Fed Chairman Ben Bernanke said as much in his press conference. It's not clear if the Ibogaine was wearing off or just kicking in, but the Chairman had an apologetic deer-in-the-headlights look of, "Gee, we're out of tricks and I'm sorry to have to tell you what is painfully obvious to everyone who isn't stoned silly on Delusionol (tm)."

Last week Dennis Gartman, in his homonymous letter said that he was concerned about the fact that the adjusted monetary base has been falling, rather than rising, taking away the bullish case for gold on the topic of “money printing”. One must therefore remind those with this concern that the credit expansion caused by the backstop of the Fed alone is enough to inflate asset prices. This is consistent with the case we made in our last letter, that a commodity based standard is not as relevant as having a 100% reserve requirement. By the same token, if the reserve requirement is below 100%, it is not that relevant to see the expansion of the monetary base! The “printing of money” will eventually come, when EU corporations begin to default and the Fed has to “ensure there is enough US dollar liquidity”. It happened in 1931-33, in spite of the fact that the adjusted monetary base had been contracting since 1929: The US dollar was devalued from approx. $20.65/oz to approx. $34.70oz and gold was confiscated.

Since 2009, outside of the megabanks in Europe, the bulk of the rest of the financial system has been completely shut out of the unsecured financing markets. One of the workarounds to this liquidity problem was the reclamation or retention of covered bonds issued by the Eurozone banks themselves, but these are constrained by strict allocation rules. Once the bank reaches that defined upper bound, where it is already close to exhausting this route, the bank will be forced to find a further alternate means for funding its existing loan portfolio. We discussed the issuance of self-referential or ponzi bonds previously since - can you really “own” your own liabilities?  Since circular logic pervades the current realm of central banking, this is wholly unquestioned.  In reality, retained covered bonds are just the accounting gloss on direct monetization of past and existing mortgage loans. Covered bonds as collateral to the ECB is an extremely important bridge holding the shaky liquidity system together as it is now; as the shortage of 'good' collateral increases, banks that do not possess enough “good” collateral have self-selected themselves for extinction and resource re-allocation.  There is no economic argument for maintaining self-selected bad banks.  Free markets demand their extinction.  Anything short of that will result in escalating and perpetual liquidity and solvency crises until the real economy is freed from the yolk of bad banks and their dis-intermediation. There is no real wonder as to why we have exactly that right now – the intrusion of politics done in the name of economics.

We will mince no words: Mr. Draghi has opened the door to hyperinflation. There will probably not be hyperinflation because Germany would leave the Euro zone first, but the door is open and we will explain why. To avoid this outcome, assuming that in this context the Eurozone will continue to show fiscal deficits, we will also show that it is critical that the Fed does not raise interest rates. This can only be extremely bullish of precious metals and commodities in the long run. In the short-run, we will have to face the usual manipulations in the precious metals markets and everyone will seek to front run the European Central Bank, playing the sovereign yield curve and being long banks’ stocks. If in the short-run, the ECB is the lender of last resort, in the long run, it may become the borrower of first resort!

When it comes to the NEW QE, everyone has an opinion, and most seem to believe that the NEW QE will come next week, now that the US economy added "just" 96,000 people (but, but, the unemployment rate 'fell'). Certainly, and far more importantly, if the most recent FOMC minutes are any guide, the Fed shares this view. Sadly, as so often happens, most, and this includes the FOMC's various voting members, have once again made up their minds without actually evaluating the limitations posed by simple math. After all it is far easier to form an opinion, and actually think about the underlying facts later. The math, for those who actually have looked at the numbers behind the scenes, is scary (in UBS' words, not ours).

Here is the math.

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.

We can finally close the case on the massive Libor manipulation issue that we first brough to the world's attention back in January 2009 when we penned: "This Makes No Sense: Libor By Bank." As of minutes ago, Barclays is the first bank to admit it has engaged in gross manipulation of the key benchmark rate that sets the cost of capital for $350 trillion in interest-rate sensitive products. As the CFTC notes, as it produly announces an epic wristslap of $200 million for Barclays Bank: "The Order finds that Barclays attempted to manipulate and made false reports concerning two global benchmark interest rates, LIBOR and Euribor, on numerous occasions and sometimes on a daily basis over a four-year period, commencing as early as 2005." Surely this massive fine will teach them to never do it again, until tomorrow at least, when the British Banker Association once again finds 3 month USD liEbor to be... unchanged. In other news, who would have thought that the fringe "conspiracy" brigade was right all along once again.

The revaluation that is underway now is beyond the simple scope of corporate earnings valuations, going to the very core of the system itself.  Just like the equity pricing regime (and investor expectations for equity assets) needs to adjust to the twelve-year-old bear market reality, pricing within the global banking system as a whole needs to adjust to the reality that the artificial growth of the economic textbook is not replicable.  The economic truth of 2012 is that much of the science of economics, and the foundation that gives to finance and financial pricing, was a temporal anomaly befitting only those specific conditions of that bygone era.  In other words, the entire financial world needs to reset itself outside the paradigm of pre-2008.  The secular bear market in US equities is one strand of this changing landscape, perhaps the first stirring of the collapse of the activist central bank experiment. In the end, the potential selling pressure of the dollar shortage is irresistible, no matter how “cheap” stock prices are to earnings, but none of it may matter in the grander scheme of a dramatic reset to the global system.  The inability of that global system to escape this critical state, to simply move beyond crisis and function “normally” again, demonstrates conclusively, in my opinion, the foundational transformation that is still taking place well beyond the stock bear.  Everything is a locked feedback loop of negative pressures in this age, no matter how much we want to see “value” where and how it used to exist. 

Paradigm shifts are rarely orderly, but there are warning signs.

Today brings the release of the Minutes of the March 13th FOMC meeting. As Steven Englander of Citi notes today, since the tone of the Minutes reflects the breadth of opinion among FOMC members the risk is that it reads somewhat more hawkish than recent comments by Chairman Bernanke. Persistent hawkishness from other FOMC members could foster the perception that Bernanke will face greater resistance in any push to introduce additional accommodation which could have a negative impact on risk appetite and lend support to USD. This would be particularly true if mentions of possible further easing by FOMC doves are few and far between. Given that interest rate expectations have declined over the past two weeks since the series of speeches by Chairman Bernanke, there does appear to be some room for investors to price in more Fed hawkishness. As reflected in implied yields for December 2013 eurodollar futures, interest rate expectations have dropped nearly 20 bps since March 20th. However, this drop in yields only reverses part of the rise seen in the wake of the Chairman’s earlier Senate testimony and the release of the FOMC statement, so ultimately scope for a rebound should not be open ended. Coupled with the fact that Bernanke’s comments are more recent than March FOMC meeting, this convinces us that risk return in chasing any bout of USD strength upon the release is unattractive.

Not only is the large bank-GSE cartel preventing millions of Americans from refinancing, but these same cartel players are also thwarting Fed monetary policy and hurting all our economic prospects.

One of the more useful Wall Street fictions is the naive notion that big players and small-fry equity owners alike love low-volatility "melt-up" markets that slowly creep higher on low volume. The less attractive reality is that big trading desks find low-volatility "melt-up" markets useful for one thing: to sucker retail buyers and less-adept fund managers into an increasingly vulnerable market. Beyond that utility, low-volatility "melt-up" markets are of little value to big trading desks for the simple reason that there is no way to outperform in markets that lack volatility. The retail crowd may love a market that slowly gains 4% for the year, barely budging for months, but such a market is anathema to big traders. It's always useful to ask cui bono--to whose benefit? In this case, highly volatile markets don't benefit clueless retail equities owners, as they are constantly whipsawed out of "sure-thing" positions. From the big trading desk point of view, this whipsawing provides essential liquidity, as retail traders and inept fund managers trying to follow the wild swings up and down provide buyers. I have a funny feeling the "smart money" has built up a nice short position here and as a result the market is about to "unexpectedly" decline sharply. The ideal scenario for big trading desks here is a sudden decline that panics complacent retail traders and managers into selling (or leaving their stops in to get hit).