Monetary Policy

European corporate and financial credit markets are opening weak this morning - ignoring the exuberance in overnight ES futures (11,000 contracts in seconds on rumor of China for 10pt jump?) which is also leaking back rapidly to VWAP (even as European equity markets continue to levitate). Financials especially are now beyond yesterday's wides with subordinated spreads the underperformer for now. This extends from our comments yesterday that were picked up on CNBC with regard to the 'stigma-trade' in LTRO-encumbered banks (which is widening further this morning) as well as broad divergence between stocks and credit. Concerns over Ireland's fiscal consolidation plans balanced with a very slight beat on German GDP (though still negative) are seeing EURUSD leak back off its best levels of the night after it bounced off 1.31 in late US trading (on Samaras rumors then extended by this China chatter). Gold and Silver are pushing higher while Copper and Oil are stable for now (though notably up from yesterday's European close). European sovereigns are quiet for now while US Treasuries are slightly better bid.

ZeroHedge’s post on the apparent breakdown of Okun’s “Law” highlights the ongoing tragicomedy of how the science of central economic planning eventually confounds, and then consumes itself. Economics is, after all, a social “science”, an elaborate study of human beings and, most importantly, human interactions. Robert Okun, for his part, merely observed in 1962 that when “output” (whatever statistical measure is en vogue) rises by 3%, the unemployment rate seems to fall by 1%. For some reason, economics assumes that if it is true in the past, it will be true forever, so it was written into the canon of orthodox economic practice. Economics has inferred causation into that relationship, giving it a layer of permanence that may not be warranted. Econometrics has always had this inherent flaw. The science of modern economics makes assumptions based on certain data, and then extrapolates them as if these assumptions will always and everywhere be valid. There is this non-trivial postulation that correlation equals causation. In the case of Okun’s Law, it seems fully logical that there might be causation since it makes intuitive sense – more economic activity should probably lead to more jobs, and vice versa. But to assume a two-variable approach to something that should be far more complex is more than just dangerous, it is unscientific. In fact, Okun’s Law has already been adjusted somewhat, most famously by Ben Bernanke and Andrew Abel in their 1991 book. It was upgraded to a 2% change in output corresponding with a 1% inverse change in unemployment. Apparently with the economic “success” of that period, Okun needed a re-calibration.

You know there is a reason why Europe just came crawling with an advance handout looking for US assistance: Moody's just went apeshit on Europe.

• Austria: outlook on Aaa rating changed to negative
• France: outlook on Aaa rating changed to negative
• Italy: downgraded to A3 from A2, negative outlook
• Malta: downgraded to A3 from A2, negative outlook
• Portugal: downgraded to Ba3 from Ba2, negative outlook
• Slovakia: downgraded to A2 from A1, negative outlook
• Slovenia: downgraded to A2 from A1, negative outlook
• Spain: downgraded to A3 from A1, negative outlook
• United Kingdom: outlook on Aaa rating changed to negative

In other news, we wouldn't want to be the company that insured Moody's Milan offices.

Stocks advanced today after Greek lawmakers finally approved a new austerity package aimed at averting a default. As a result, it now looks like that the country will get the next bailout tranche and avoid failing to meet debt redemptions in March. The draft legislation published by the Greek government showed that the EFSF may provide EUR 35bln to help Greece buy back bonds held by euro-area central banks as collateral, while Greek finance minister said that EUR 70bln in bonds are to be issued in the swap and Greece needs to make debt swap offer by Friday Feb 17th at the latest. Credit metrics such as Euribor and Euribor/OIS spreads continued to improve, which in turn supported financial sector. Looking elsewhere, comments from Iranian President Ahmadinejad over the weekend who said that Iran will soon reveal "very big new achievements" in its controversial nuclear programme, together with comments from China’s Wen who said the country will begin to fine tune its economic policies in the Q1 of this year supported both Brent and WTI crude prices today. Going forward, there are no major macro-economic releases this afternoon, but both the BoE and the Fed are due to conduct another round of Asset Purchases.

Heading into the North American open, EU equity indices are trading lower following reports that Eurozone Finance Ministers have dismissed as incomplete a budget presented to them by the Greek party leaders. In addition to that, EU lawmakers have warned Greece of more intensive involvement in the Greek economy to improve tax collection and accelerate the sale of state-owned assets. The Greek Finance Minister Venizelos said that Greece must make a “final, strategic” decision Greek membership in the Eurozone over the next six days as it decides on new austerity and reform measures or faces leaving the single currency. However, according to sources, German finance minister told MPs, Greek reform plans would bring debt to 136% of GDP by 2020, instead of targeted 120%. So it remains to be seen as to whether Greece will be able to meet the looming redemptions in March. Of note, analysts at Fitch said that the ongoing Greece talks stating that the country must secure an agreement to cut its debt burden in the next few days to prevent a “disorderly” default.

• Eurozone dismisses Greek budget deal (FT)
• Germany Says Greece Missing Debt Targets in Aid Rebuff (Bloomberg)
• Germans concerned over Draghi liquidity offer (FT)
• Azumi Says Japan Won’t Be Shy About Unilateral Intervention (Bloomberg)
• Schaeuble Signals Germany Is Flexible on Revising Terms of Portuguese Aid (Bloomberg) - food euphemism for "next on the bailout wagon"
• Venizelos Tells Greek Lawmakers to Back Budget Cuts or Risk Exiting Euro (Bloomberg)
• Putin May Dissolve Ruling Party After Vote (Bloomberg)
• HK Bubble pops? Hong Kong Sells Tuen Mun Site to Kerry for HK$2.7 Billion, Government Says (Bloomberg)
• Gross Buys Treasuries as Buffett Says Bonds Are ‘Dangerous’ (Bloomberg)

This is the weirdest “bubble” I have seen. 

While a lot of the just completed Draghi press conference was mostly fluff, the one notable exception was the announcement that the European central bank would "approve eligibility criteria for additional credit claims" (see below). While purposefully vague on the topic, Draghi noted that the step is one of onboarding even more risk: "Sure, it's going to be more risky. Does that mean that we take more risk? Yes, it means we take more risk. Does it mean this risk is being unmanaged? No, it is being managed. And it's being - it's going to be managed very well because really there will be a strong overcollateralization for the additional credit claims. The conditions will be very stringent." While it remains to be seen just how stringent the conditions will be, but a bigger question is what is the total pool of eligible claims that can be used to flood the ECB in exchange for freshly printed cash. For that we go to Goldman whose Jernej Omahen a month ago calculated the impact of the expanded collateral pool which was formally confirmed today. To wit: "Scarcity of collateral was becoming an evident problem for a large number of banks, especially smaller and medium sized. In our view, the ECB’s collateral pool expansion was therefore a critical decision. Select corporate loans – which form over >€7 tn, or >30% of total balance sheets – will now be admissible for refinancing operations, through national central banks. Criteria on eligibility have yet to be determined – we are therefore not able to quantify the actual expansion of collateral pool at this stage. That said, the €7 tn starting points suggests it will be significant." In other words, and this is excluding anything to do with the LTRO, the ECB just greenlighted a potential expansion to its balance sheet all the way up to €7 trillion. Will banks use this capacity to convert "trash to cash" - why of course they will, and this goes to the very heart of the biggest problem with Europe: the fact that there are virtually no money good assets left as collateral, which requires the implicit rehypothecation of bank "assets" back to the ECB, to procure cash, to pay out cash on liabilities. How much will they do - we don't know yet. We will find out very soon. What we do know is that the ECB's €2.7 trillion balance sheet is about to expand dramatically, pushing the European central bank even further into bad bank status. And this is excluding the upcoming new usage of the Discount Window known as the LTRO in three weeks. Trade accordingly.

Mario Draghi has just begun his press conference in a more upbeat tone than recent months. EURUSD is limping back from its last try at 1.33 but only modestly as he sees inflation risks 'broadly balanced' and reminds us all of the 'transitory' nature of his temporary non-standard measures, as Bloomberg notes. The main thing is that the ECB is once again easing collateral demands and will now accept credit claims. This simply proves that Europe is running out of any money good assets to pledge to the ECB as "collateral." Before the European (and thus global) ponzi is over, the central banks will accept Mars bars wrappers as collateral at 100 cents on the freshly printed dollar/euro.

As expected.

He's in the process of ruining the country. 

But, but, but...

• ECB NOT YET DECIDED ON WHETHER TO CONTRIBUTE TO GREEK DEBT RESTRUCTURING - EURO ZONE SOURCES

The V-Fib pattern formerly known as the EURUSD not happy.

Mohamed El-Erian, CEO and co-chief investment officer of bond fund giant PIMCO, said investors should be underweight equities while favoring "selected commodities" such as gold and oil, given the fragile global economy and geopolitical risks. Over the long term gold will reward investors who own gold as part of a diversified portfolio. Trying to time purchases and market movements is not recommended – especially for inexperienced investors.  New research from Credit Suisse and London Business School entitled ‘The Credit Suisse Global Investment Returns Yearbook 2012’ continues to be analysed by market participants. The 2012 Yearbook investigates data from 1900 to 2011 and looks at how best to protect against inflation and deflation, and how currency exposure should be steered. The chief findings are that bonds do well in deflation and benefit from currency hedging, and equities are not a perfect inflation hedge, but benefit from international diversification.  The report shows that gold offers a timely inflation hedge and long term holders of gold should expect a positive correlation to inflation – gold is one of only two assets since 1900 to have positive sensitivity to inflation (of 0.26). Only inflation-linked bonds had more - 1.00, as expected. By contrast, when inflation rises 10%, bond returns have fallen an average 7.4%; Treasuries fell 6.2%, and equities lost 5.2%. Property fell by between 3.3% and 2%. Importantly, gold managed to increase its value across both extreme inflationary and deflationary scenarios. The academics from LBS analysed 2,128 individual years in 19 major countries (1900-2011), finding gold rose 12.2% in the most deflationary years - when average deflation was 26%.

The problem with printing money and promising to do so for years ahead of time is that the negative consequences of inflation only happen after a delay. As a result, it's difficult to know if a policy has gone too far until years down the road at times. Unfortunately, if confidence in the dollar is lost, the consequences cannot be easily reversed. One problem for the Fed itself is that it holds long-term securities that will lose value if rates rise. The federal government faces an even more serious problem when interest rates rise, as higher rates on its debt mean greater interest payments to service. Due to this federal-government debt burden, the Fed has an incentive to keep rates low, even if the long-term result is higher inflation. However, for now the Fed's statement suggests it sees inflation as "subdued," so it's putting those concerns aside for now.

Since the start of the year, global markets have been apparently buoyed by the understanding that Draghi's shift of the ECB to lender-of-last-and-first-resort via the LTRO has removed a significant tail on the risk spectrum with regard to Euro-banks and slowed the potential for contagious transmission of any further sovereign stress. In fact the rally started earlier on the backs of improved perceptions of US growth (decoupling), better tone in global PMIs, and potential for easing in China and the EMs but it does seem that for now the ECB's liquidity spigot rules markets as even in the face of Greek uncertainty, as George Magnus of UBS notes, 'financial markets are most likely to defer to the ECB's monetary policy largesse' as a solution. Both Magnus and his firm's banking team, however, are unequivocal in their view that the next LTRO will unlikely be the last (how many temporary exceptions are still in place around the world?) and as we noted earlier this morning, banks' managements may indeed not be so quick to gorge on the pipe of freshly collateralized loans this time (as markets will eventually reprice a bank that holds huge size carry trades at an inappropriate risk-weighting) leaving the stigma of LTRO borrowing (for carry trades, substitution for private-sector funding, or buying liquidity insurance) as a mark of differentiable concern as opposed to a rising tide lifts all boats as valuations reach extremes relative to 'broken' business models, falling deposits, and declining earnings power.

They expect a EUR300bn take up of the next LTRO, somewhat larger than the previous EUR200bn add-on - but not hugely so - as the banks face a far different picture (in terms of carry profitability) and yet-to-be-proven transmission to real-economy credit-creation that will make any efforts at a fiscal compact harder and harder to implement as its self-defeating austerity leave debtor countries out in the cold. The critical point is that unless the market believes there will be an endless number of future LTROs, covering the very forward-looking private funding markets for banks, then macro- and event-risk will reappear and volatility will flare.