Risk Premium

By now Zero Hedge readers know that there is no better contrarian signal in the world than Goldman's Tom Stolper: in fact it is well known his "predictions" are a gift from god (no pun intended ) because without fail the opposite of what he predicts happens - see here. 100% of the time. Which is why, following up on our previous post identifying the record short interest in the EUR and the possibility for CME shennanigans any second now, it was only logical that Stolper would come out, warning of further downside to the EURUSD (despite having a 1.45 target). To wit: "With considerable downside risk in the short term, within our regular 3-month forecasting horizon, the key questions are about the speed and magnitude of the initial sell-off. If we had to publish forecasts on a 1- and 2-month horizon, we could see EUR/$ reach 1.20. In other words, we expect the EUR/$ sell-off to continue for now as risk premia have to rise initially." In yet other words, if there is a clearer signal to go tactically long the EURUSD we do not know what it may be. We would set the initial target at 1.30 on the pair.

"What we have on our hands is a good old fashioned quagmire" is how Morgan Stanley's Mike Wilson sets up his surprisingly non-sheep-like perspective on the troubles that US equity investors may be about to face. Expanding on MS's bearish strategic (fundamental) forecast, that we discussed earlier in the week, Wilson combines the 'liquidity vs negative-real-rate' thesis (that the Fed's liquidity is perhaps no longer 'good' for stocks) with his own views on ECRI's weakness (very 2008-like in relation to ECO surprises), household debt deleveraging (more and longer), how much QE3 is already priced in and what will its effect be when it comes (less and less positive in nominal and real terms), investor sentiment (very bullish), long-term technicals (weak breadth), and short-term earnings expectations (deteriorating and weighted to 'weak' financials to end with the pragmatic realist perspective that perhaps 'the gig is up'.

Fitch joins the Hungary "junking" parade, which centers around the country's former unwillingness to yield to the banking cartel regarding its central bank, which as of today is no longer the case: "The downgrade of Hungary's ratings reflects further deterioration in the country's fiscal and external financing environment and growth outlook, caused in part by further unorthodox economic policies which are undermining investor confidence and complicating the agreement of a new IMF/EU deal."

The issue of Germany and its approach to ameliorating the overleveraged balance sheets of its southern neighbors will dictate the direction of sovereign spreads in 2012. The direction of sovereign spreads will also determine the direction of risk premium spreads in the leveraged finance markets— both bonds and loans. Defaults in the leveraged finance market will and should be an afterthought to the systemic risk factors inherent in sovereign and next-of-kin bank credit spreads. Therefore, forecasting default rates should take a backseat to a better understanding of German Kultur and thought that will shape the euro-zone sovereign finance structure in 2012 and beyond. The most recent European Union summit highlighted that we are left with some of the same issues that confronted the great empires prior to World War I—the battle between “English liberalism with its emphasis on individual freedom and self-determination and Prussian socialism with its emphasis on order and authority.”

One of the reports making the rounds today is a previously little-known academic presentation by Princeton University economist Hyun Song Shin, given in November, titled "Global Banking Glut and Loan Risk Premium" whose conclusion as recently reported by the Washington Post is that "European banks have played a much bigger role in the U.S. economy than has been generally thought — and could do a lot more damage than expected as they pull back." Apparently the fact that in an age of peak globalization where every bank's assets are every other banks liabilities and so forth in what is an infinite daisy chain of counterparty exposure, something we have been warning about for years, it is news that the US is not immune to Europe's banks crashing and burning. The same Europe which as Bridgewater described yesterday as follows: "You've got insolvent banks supporting insolvent sovereigns and insolvent sovereigns supporting insolvent banks." In other words, trillions (about $3 trillion to be exact) in exposure to Europe hangs in the balance on the insolvency continent's perpetuation of a ponzi by a set of insolvent nations, backstopping their insolvent banks. If this is not enough reason to buy XLF nothing is. Yet while CNBC's surprise at this finding is to be expected, one person whom we did not expect to be caught offguard by this was one of the only economists out there worth listening to: Ken Rogoff. Here is what he said: "Shin’s paper has orders of magnitude that I didn’t know"...Rogoff said it’s hard to calculate the impact that the unfolding European banking crisis could have on the United States. “If we saw a meltdown, it’s hard to be too hyperbolic about how grave the effects would be” he said. Actually not that hard - complete collapse sounds about right. Which is why the central banks will never let Europe fail - first they will print, then they will print, and lastly they will print some more. But we all knew that. Although the take home is the finally the talking heads who claim that financial decoupling is here will shut up once and for all.

Buried deep in the 137 pages of Fixed Income 2012 Outlook, Deutsche's bond group looks at the implications of an extremely flat US Treasury Curve and implicitly low bond risk premium. Based on 5Y5Y rates relative to long-term growth and inflation expectations, tail inflation risks, and estimates of supply/demand shocks, the current bond risk premium are at levels that were witnessed ahead of the bond market sell-off of 1994, at the peak of the bond market conundrum of 2004-2006 and around QE announcements. This 100bps or so of 2s10s 'flatness' relative to real short rates and expected deficits also corroborates this risk premium. So what does this tell us? The extremely low risk premium fully captures QE expectations. Empirically, they find USD19bn of new QE tends to reduce real rates by 1bps and based on this and a model of fundamentals and risk aversion parameters, they find that Twist was fully priced in last September and since then the current dislocation suggests another full QE2-style package of about $800bn is already priced into the market (ex MBS reinvestment). We just hope the market is not disappointed.

Goldman has just started selling European bank stocks to its clients, whom it is telling to buy European bank stocks. Said otherwise, the stolpering of clients gullible enough to do what Goldman says and not does, has recommenced. Our advice, as always, do what Goldman's flow desk is doing as it begins to unload inventory of bank stocks. Translation: run from European bank exposure.

Japan will reward investors who buy reconstruction bonds with half an ounce of gold, an added incentive that could boost the return by nearly six times according to Japanese Finance Minister Jun Azumi. Individual investors who purchase more than 10 million yen ($129,000) in the debt with a 0.05 percent return and keep it for three years will receive a gold commemorative coin weighing 15.6 grams (0.55 ounces), the Finance Ministry said in Tokyo today, worth about $948 based on current prices for the precious metal. The offer suggests the return could be boosted to 89,000 yen should gold prices remain at current levels, more than the approximate 15,000 yen one would receive from the bond. The coupon on conventional three-year retail government debt to be sold on Jan. 16 is 0.18 percent. 10 year debt remains near multi record lows of 1%. Silver coins weighing 31.1 grams issued as 1,000 yen currency will be distributed to those who own more than 1 million yen of the bonds, the government said. The coins will be offered for debt going on sale in March. All investors receive a thank-you note from the minister, who showed his to reporters in Tokyo today as proof of his purchase.  Chief Cabinet Secretary Osamu Fujimura also bought the bonds, Azumi said, without saying how much.  This is a sign that the Japanese government like governments internationally is very concerned that they will not be able to sell their government debt.

Just as Europe seems destined to tip into recession and the US growth miracle decouples its reality from perceived global slowdowns, the oil market steps in to balance the equation. With WTI breaking $102 and Brent over $111 this morning, driven by Iran and Syria tensions, it would seem tough for a nation exporting its way to success, that is so dependent on both domestic consumer and energy to grow 'as expected' with energy premia so high - or perhaps the justification is the energy sector will carry the S&P through the next quarter as earnings expectations are cut. Nevertheless, as Reuters points out, the risk of supply disruptions remains high.

What is certain? If you take 1350 US dollars today, you may exchange them for 1000 euros.

The much anticipated Goldman Sachs list of "Top Trades Recommendations for 2012" is out... And the squid is bearish. Which is bad news, as if there is one thing one does not want is to be aligned with Goldman's salesforce. Let's dig in.

Pimco's Greg Sharenow has released a white paper on what the Newport Beach company believes are the 4 possible outcomes should Iranian nuclear facilities be struck as increasingly more believe will happen given enough time. The conclusion is sensible enough "Whenever the global economy is in a fragile state, as it is today, geopolitical concerns such as the possibility of a strike on Iran’s nuclear facilities become much more exaggerated. Although we cannot (and will not) predict whether an attack is imminent, or even likely, our experience and research tells us that any major disruption in the supply of oil from Iran could have either subtle or profound global repercussions – especially as excess capacity is virtually exhausted and we doubt that other OPEC nations would be able to compensate for a reduction in Iranian oil production." As for those looking for numbers associated with the 4 scenarios presented by PIMCO here they are: "i) Scenario 1: Exports minimally effected. Concerns would drive initial price response; Oil could spike initially to $130 to $140 per barrel and then settle in a higher range, around $120 to $125; ii) Scenario 2: Iranian exports cut off for one month. In this case, we would expect prices could reach previous all-time highs of $145/bbl or even higher depending on issues with shipping; iii) Scenario 3: Iranian exports are lost for half a year. We think oil prices could probably rally and average $150 for the six months, with notable spikes above that level; iv) Scenario 4: Greater loss of production from around the region, either through subsequent Iranian response or due to lack of ability to move oil through Straits of Hormuz. This is the Armageddon scenario in which oil prices could soar, significantly constraining global growth. Forecasting prices in the prior scenarios is dangerous enough. So, we won’t even begin to forecast a cap or target price in this final Doomsday scenario." Needless to say, even the modest Scenario 1 is enough to collapse global economic growth by several percentage points to the point where not even coordinated global printing will do much.

Dick Comes Clean A Week After I Did Him Dirty...

Risk markets are losing their patience.  The Eurozone situation is approaching a major climax.  This is by far the most important story to follow in the coming days and weeks.  U.S. Economic data has been quite encouraging and the economy remains muddling along.  If Europe took care of business quickly, global stock markets would rally sharply.  The S&P 500 could possibly make a run at the bull market highs. Unfortunately, there is a major ongoing political crisis in the region.  There are 3 options. Still, a Eurozone blowup would undoubtably sink the U.S. recovery.  The ball's in Europe's court and they need to take action.  If they act now, it may still be on time to avert a Chinese hard-landing.  The bulls would end up as winners and risk assets would make a comeback.  It has really all come down to this binary variable in the short-term.  Government officials wanted Globalization, well they've got it.

Financial contagion in Europe is pushing already fragile global economies towards recessions, and the risk of slipping into global recession are rising significantly. Indeed, as we have warned for many months, there is a real risk of a global Depression given the scale of the debt levels in most western countries and the massive imbalances globally. A senior Chinese official, Chinese Vice Premier Wang, said yesterday that a ‘chronic’ long term global recession is certain to happen and China must focus on domestic problems. While all the focus has been on Europe in recent weeks, markets may again focus on the not inconsequential matter of the appalling US fiscal position which could see further market volatility and the dollar come under pressure again. Washington's latest fractious effort to come to grips with its mounting debt looks set to end in failure today as negotiators look set to announce they have failed to reach a deal. The Congressional ‘supercommittee ‘charged with cutting the US government's crushing $15 trillion debt looks set to admit failure which should support gold. SPDR Gold Trust, the world's largest gold-backed exchange-traded fund, reported a rise of 3.631 tons from a day earlier to 1,293.088 tons in its holdings, the highest in more than three months. The ETF witnessed an inflow of 24.422 tons last week, the biggest one-week rise in holdings since mid-August. Commerzbank say they expect to see gold trading at $1,800/oz by the end of the year. Barclays says it is sticking with a fairly bullish call for gold and says it sees the price at $1,875/oz in Q4, according to Reuters. Deutsche Bank say they expect periods of risk aversion to remain through 2012 and their strongest conviction trade remains long precious metals and specifically gold, according to Reuters.