Price Action

The better tone in risk markets is largely being driven by encouraging economic data from the US and Europe, which as a result saw Bunds trade in negative territory. Of note, ECB’s Liikanen has said that inflation is not a particular concern in Europe, adding that the ECB has never said that there is an interest rate floor. On the other hand, Gilts are being supported by comments from BoE’s Fisher, as well as less than impressive GDP report. Nevertheless, EUR/USD took out touted barrier at the 1.3400 level earlier in the session, while USD/JPY is trading in close proximity to an intraday option expiry at 80.60.

I am staggered at how easily the concepts of Democracy and the Rule of Law – two of the pillars of the modern world – have been brushed aside in the interests of political expediency. This is not just a eurozone phenomenon but of course the removal of elected governments and the instalment of "insider" technocrats who simply serve the interests of the elite has become a specialisation in Europe. Many will think this kind of development is not a big deal and is instead may be what is needed. Personally I am absolutely certain that the kind of totalitarianism being pushed on us by our leaders will – if allowed to persist and fester – end with consequences which are way beyond anything the printing presses of our central banks could ever hope to contain. Communism failed badly. Why then are we arguably trying to resurrect a version of it, particularly in Europe? Are the banks so powerful that we are all beholden to them and the biggest nonsense of all – that defaults should never happen (unless said defaults are trivial or largely meaningless)?...– So, in terms of markets, be warned. My personal recommendation is to sit in Gold and non-financial high quality corporate credit and blue-chip big cap non-financial global equities. Bond and Currency markets are now so rigged by policy makers that I have no meaningful insights to offer, other than my bubble fears...The end of the bubble will be sign posted by either monetary anarchy creating major real economy inflation or by a deflationary credit collapse (if they run out of pumping "mandates"). The end game is incredibly binary in my view, but in between it is pretty much a random walk. Either way, "bonds are toast" in any secular timeframe (due either to huge inflationary pressures, or due to a deflationary credit collapse), which in turn means that asset bubbles in risky assets will get crushed on a secular basis.

Sprott strategist John Embry has never been a fan of the existing financial system. Today, he makes that once again quite clear in this interview with Egon von Grayerz' Matterhorn Asset Management in which he says: "I think that the current financial system, as we know it, will be totally destroyed, probably sooner rather than later. The next system will require gold backing to have any legitimacy. This has happened many times in history." Needless to say, he proceeds to explain why a monetary system based on gold, one in which one, gasp, lives according to one's means, is better. Logically, he also explains why the status quo, whose insolvent welfare world has nearly a third of a quadrillion in the form of unfunded future liabilities, will never let this happen. Much more inside.

A certain flavor of econometric model dominates conventional portfolio management and financial analysis. This model can be paraphrased thusly: seasonally adjusted economic data such as the unemployment rate and financially derived data such as forward earnings and price-earnings ratios are reliable guides to future economic growth and future stock prices....If this model is so accurate and reliable, why did it fail so completely in 2008 when a visibly imploding debt-bubble brought down the entire global economy and crashed stock valuations? Of the tens of thousands of fund managers and financial analysts who made their living off various iterations of this econometric model, how many correctly called the implosion in the economy and stock prices? How many articles in Barrons, BusinessWeek, The Economist or the Wall Street Journal correctly predicted the rollover of stocks and how low they would fall? Of the tens of thousands of managers and analysts, perhaps a few dozen got it right (and that is a guess--it may have been more like a handful). In any event, the number who got it right using any econometric model was statistical noise, i.e. random flecks of accuracy. The entire econometric model of relying on P-E ratios, forward earnings, the unemployment rate, etc. to predict future economic trends and future stock valuations was proven catastrophically inadequate. The problem is these models are detached from the actual drivers of growth and stock valuations.

In contrast with better news from macro data, the negotiations about the next Greek package intensified and this will likely remain the key focus in the upcoming week. On one hand, the present value reduction in a PSI has still not been formally agreed. On the other, the Greek Government still has to commit to more reforms in order for the Troika to agree to a new program. A key deadline for this commitment is on Monday at 11am local time in Athens. Eurogroup President Juncker has talked openly about the possibility of a default on Saturday in the German weekly Der Spiegel. Beyond the ongoing focus on Greece, the week sees a relatively heavy concentration in central bank meetings, including the RBA, ECB, BOE, Poland, Indonesia and a few others. On the data side, the focus is likely on the December IP numbers due in a number of countries, including in some key Eurozone countries (Germany, Italy, France).

While Europe's financial services sector equity prices have retraced almost half of their May11 to Oct11 losses as we are told incessantly not to underestimate the impact of the LTRO, Morgan Stanley points out the other side of the balance sheet will continue to sag. While short-term liquidity (at least EUR-based liquidity as USD FX Swap lines are back at record highs this week) may have seen some of its risk culled, the real tail risk of the 'Great Deleveraging' has only just begun. As MS notes, we may have avoided a credit crunch but European banks could delever between EUR1.5 and EUR2 Trillion over the next 18 months as the unwind is far from over. History suggests that over a longer time-frame, around five to six years - the deleveraging could reach EUR4.5 Trillion assuming zero deposit growth and the LTRO will slow but not stop the process. As we discussed last night, this deleveraging will inevitably lead to continued contraction in European lending to the real economy (no matter how much liquidity is force-fed to the banking system) which will most explicitly impact Southern and Peripheral Europe and the Emerging Markets of Central and Eastern Europe. In the meantime, we assume the Central Banks of the world will do the only thing they know, print and funnel liquidity to these increasingly zombified financial institutions; and while Dicky Fisher was calming us all down this evening on our QE3 expectations (given Gold and Silver's recent price action), it seems perhaps even the Fed is getting nervous at just how little surprise factor they have left given such a ravenously hungry deleveraging and insatiable need to maintain the market/economy's nominally positive appearances.

Did the first (of many) European LTRO buy just one month of marginal improvement? According to a compilation of analyst views by Bloomberg, who looked at today's mixed Spanish auction results when the country sold €4.56 billion of three-, four- and five-year government bonds, the easy money may have been made. Because while average yields fell for all three lines at the auctions, maintaining the trend at Spanish debt sales so far this year, it was the internals that showed weakness and could indicate that the marginal benefit from the first LTRO is now ending, even as the real task - the longer-dated bonds 10 years and great - still have to see much if any carry trade benefit at auction. Lastly, anyone hoping for a full carry flush from the European banks has to give up all hope: ECB announced its deposit facility usage rose to €486.4 billion, up €14 billion overnight. And with that we now know what the LTRO half-life is.

While Silver had a better week than Gold (+5.4% vs 4.3%), Gold managed its biggest gain in three months as the Fed's QE-ness seemed to separate the precious metals from other asset classes. Oil underperformed relative to the USD's weakness (-2% on the week in DXY) managing only a 1.3% gain (and ending below $100). Silver and Gold have no managed four weeks in a row of gains as the latter has more than retraced half of the all-time high sell-off range. With 5 minutes to go, NYSE volume was -32% from yesterday, by the close of the cash markets it was only down 2.5% leaving the week -10% from last week (so 32% of the day's NYSE volume was done in the last 1.3% of the day). In credit, HYG underperformed stocks, HY credit stayed synced with stocks and IG outperformed (touching 100bps as we closed). Treasuries ended the day (and week) at their low yields with 5s to 10s all lower by around 14bps on the week and 30Y rallying to -4bps on the week by the close. FX markets were a little odd as EURUSD squeezed higher and higher all day (largely ignored until a late ramp) by stocks as JPY's strength kept EURJPY (carry driver) relatively flat. EURUSD ended at 1.3227 (up around 300pips on the week) at its highest in 7 weeks as CFTC net shorts rose once again to new record highs at 171k. Broadly speaking risk assets and ES (the e-mini S&P 500 futures contract) have been highly correlated all week. This afternoon saw CONTEXT pull ES higher (mainly on EURJPY strength, and Oil stability versus TSY/Curve compression) but after the cash market close, ES limped back down to its VWAP to end its worst-performing week of the year (+0.15%) though not down (which we are sure would scare investors away) as stocks handily underperformed credit on the week as high beta starts to unwind.

"Reach for yield" is a phrase that never gets old, does it? Whether it's the "why hold Treasuries when a stock has a great dividend?" or "if this bond yields 3% then why not grab the 7% yield bond - it's a bond, right?" argument, we constantly struggle with the 100% focus on return (yield not capital appreciation) and almost complete lack of comprehension of risk - loss of capital (or why the yield/risk premium is high). Arguing over high-yield valuations is at once a focus on idiosyncrasies (covenants, cash-flow, etc.), and technicals (flow-based demand and supply), as well as systemic and macro cycles, which play an increasingly critical part. Up until very recently, high yield bonds (based on our framework) offered considerably more upside (if you had a bullish bias) than stocks and indeed they outperformed (with HYG - the high-yield bond ETF - apparently soaking up more and more of that demand and outperformance as its shares outstanding surged). With stocks and high-yield credit now 'close' to each other in value, we note Barclay's excellent note today on both the seasonals (December/January are always big months for high yield excess return) and the low-rate, low-yield implications (negative convexity challenges) the asset-class faces going forward. The high-beta (asymmetric) nature of high-yield credit to systemic macro shocks, combined with the seasonality-downdraft and callability-drag suggests if you need to reach for yield then there will better entry points later in the year (for the surviving credits).

Not sure what to make of a market that traded relatively poorly on strong apple earnings but managed to rip higher on a relatively neutral fed statement.

Markets have become far less volatile than last year, but many investors remain focused on the Credit Markets for signs and cues as to the next move.  With so many people looking to moves in credit markets and trying to determine how successful an auction has been, we thought it would make sense to go through some examples of how credit trades.  At one extreme you have a real market like for the E-mini S&P futures.  That trades from Sunday at 6pm EST until Friday at 4:15 EST.  It is virtually continuous and at any given time you can see the bids and offers of the entire market.  Then you have credit trading, which has almost nothing in common with ES futures and their incredible liquidity and transparency.

I am going to say that the bull trend in the Dollar is "definitely" over.

A peek into the 60's manipulation and why the CFTC is a joke.

So it looks like we should get an announcement sometime today about the proposed Greek PSI deal.  Yes, proposed, not finalized.  Asides from the obvious fact that there will be limited or no documentation for the deal, we still have no clue who has agreed to what. As far as we can tell, no one has given the IIF negotiators any binding power. We think this will be a relatively small portion of bondholders and then the real game begins. If the terms of the deal being leaked are true, it will be extremely interesting to see what other countries do. Why should Portugal or Hungary bother with painful steps to reduce debt when the alternative is spend more, reduce debt via restructuring, and get lower rates on that reduced debt?

When it comes to attempts at predicting the future, it often appears that the most desirable outcome by everyone involved (particularly those from the status quo, which means financial institutions and media) is that of the "muddle through" which is some mythical condition in which nothing really happens, the global economy neither grows, nor implodes, and it broadly one of little excitement and volatility. While we fail to see how one can call the unprecedented market vol of the past 6 months anything even remotely resembling a muddle through, the recent quiet in the stock market, punctuated by a relentless low volume melt up has once again set market participants' minds at ease that in the absence of 30> VIX days, things may be back to "Goldilocks" days and the muddle through is once again within reach. So while the default fallback was assumed by most to be virtually assured, nobody had actually tried to map out the various outcome possibilities for the global economy. Until today, when Morgan Stanley's most recent addition, former Fed member Vince Reinhart, better known for proposing the Fed's selling of Treasury Puts to the market as a means of keeping rates at bay, together with Adam Parker, have put together a 3x3 matrix charting out the intersections between the US and European economic outcomes. Here is how Parker and Reinhart see the possibility of a global goldilocks outcome, and specifically those who position themselves with expectations of this being the default outcome: "A “muddle through” positioning is potentially dangerous: Our main message is that the muddle-through scenario might be the most plausible alternative, but its joint occurrence in the US and Europe is less likely than the result of a coin toss. Uncertainty is bad for multiples." Specifically - it is 37% (with roughly 3 significant digits of precision). That said, as was reported here early in the year, Morgan Stanley is one of the very few banks which expects an actual market decline in 2012, so bear that in mind as you read the following matrix-based analysis. Because at the end of the day everyone has an agenda.