Volatility

Since the spike in VIX in October of last year, short-dated volatility (and correlation) has dropped significantly, but the vol term-structure has steepened, and long-dated volatility remains stubbornly high. Goldman Sachs updates their volatility debt cycle thesis today and so far we are following the typical cycle post-volatility-spike - realized vols drop, short-term implied vols drop, term structure steepens, long-term vols drop - leaving them focused on both the implications of the current low levels of short-term vol and the high-levels of long-term vol. In brief, short-term volatility reflects very closely the current macro environment (GDP growth, ISM, high-yield, and Goldman's models) but longer-dated volatility trades significantly worse. The volatility (variance swaps) market is expecting realized volatility to be very high over the next 5-10 years - the only time this has happened was during The Great Depression. Professionals remain anxiously aware that the global debt super-cycle has ended and that we face deleveraging and deflationary pressures for years to come, short-dated vol will continue to ebb and flow with each band-aid and risk flare but investors deep-down know that the 'big one' remains around the corner. Although markets are in a healthy state at the moment it would only take a relatively mild cross-wind to expose the problems again and vol markets reflect this despite what the mainstream media's view of the fear index tells us.

The Treasury complex is seeing yields (and curves) compress dramatically today. With 5Y at all-time low yields and 30Y rallying the most in three months, the divergence between stocks and bonds appears ever more glaring. 30Y (which just went positive YTD in price) has traded around the 3% yield mark for much of the last 4 months (around 120bps lower than its average in Q2 2011 - pre-US downgrade) and most notably curve movements (as the short-end becomes more and more anchored to zero) have been dramatic. 2s10s30s is now at almost four-year lows and the last four times we saw equities diverge (up) from bonds' sense of reality, it has been stocks that have awoken. Back of the envelope, 2s10s30s suggests that the S&P should trade around 1100 (as we test 1300 in cash today).

You've just crossed over...

German individual investors are gobbling up Greek sovereign bonds!

Festive Friday fun:

• FITCH TAKES RATING ACTIONS ON SIX EUROZONE SOVEREIGNS
• ITALY LT IDR CUT TO A- FROM A+ BY FITCH
• SPAIN ST IDR DOWNGRADED TO F1 FROM F1+ BY FITCH
• IRELAND L-T IDR AFFIRMED BY FITCH; OUTLOOK NEGATIVE
• BELGIUM LT IDR CUT TO AA FROM AA+ BY FITCH
• SLOVENIA LT IDR CUT TO A FROM AA- BY FITCH
• CYPRUS LT IDR CUT TO BBB- FROM BBB BY FITCH, OUTLOOK NEGATIVE

And some sheer brilliance from Fitch:

• In Fitch's opinion, the eurozone crisis will only be resolved as and when there is broad economic recovery.

And just as EUR shorts were starting to sweat bullets. Naturally no downgrade of France. French Fitch won't downgrade France. In other news, Fitch's Italian office is about to be sacked by an errant roving vandal tribe (or so the local Police will claim).

With everything from stocks and bonds to 'roo bellies rising as one trade, it may be a good time to ask: what's priced into the market's uptrend? We say "bad news is priced in" when negative news is well-known and the market has absorbed that information via the repricing process. When the market has absorbed all the "good news," then we say the market is "priced to perfection:" that is, the market has not just priced in good news, it has priced in the expectation of further good news. Markets that are priced to perfection are fiendishly sensitive to unexpected bad news that disrupts the expectation of continuing positive news. So what have global markets priced into this uptrend across virtually all markets? 

EU stock futures have come off the initial lows at the open today following news that EU’s Rehn expects a PSI conclusion to be reached over the weekend, however this news comes amid the IIF’s offer to private bondholders of a 70% haircut. Further Greek PSI talks are expected later in the session following a meeting between IIF’s Dallara and Greek PM Papademos in Athens at 1630GMT. Euribor 3-month rate fixing continues to decline, however the pace at which the rates are falling is slowing, showing a fall of 0.005% compared with a 0.013% fall at this time last week. The slowing speed of decline has prompted hesitancy in financial markets, pushing the Euribor strip downwards. Further evidence of this impact comes from Portuguese bond yields, which today hit record Euro area highs. Spanish and Italian spreads have tightened this morning following market talk that the ECB were buying Spanish debt through the SMP in the belly of the curve. The Italian BOT auction this morning came in well-received following strong domestic demand, with 6-month yields falling from previous auctions.

• Greek Debt Wrangle May Pull Default Trigger (Bloomberg)
• Italy Sells Maximum EU11 Billion of Bills (Bloomberg)
• Romney Demands Gingrich Apology on Immigration (Bloomberg)
• China’s Residential Prices Need to Decline 30%, Lawmaker Says (Bloomberg)
• EU Red-Flags 'Volcker' (WSJ)
• EU Official Sees Bailout-Fund Boost (WSJ)
• EU Delays Bank Bond Writedown Plans Until Fiscal Crisis Abates (Bloomberg)
• Germany Poised to Woo U.K. With Transaction Tax Alternative (Bloomberg)
• Ahmadinejad: Iran Ready to Renew Nuclear Talks (Bloomberg)
• Monti Takes On Italian Bureaucracy in Latest Policy Push to Revamp Economy (Bloomberg)

He said, “Rising commodity prices, uncertainty in the Middle East, the spreading European debt crisis, increased frequency of “extreme weather events” and U.S. fiscal issues are “persistent” problems that will continue to spur market volatility and sway asset prices in the global economy. This is great news for gold. Goldman Sachs noted in a report on Jan. 13th that futures will advance to $1,940 an ounce in 12 months.  Morgan Stanley forecasts the yellow metal will climb to a record of $2,175 by 2013, said analysts Peter Richardson and Joel Crane in their research report.

Even as Goldman's economists have been bashing the Fed for not proceeding with a full blown LSAP QE, and have been warning repeatedly that the economy is due for a significant leg lower, here is Goldman once again doing all it can to trade (i.e. dump) its own inventory first and foremost, with a just released trade reco which in our opinion marks a market top far better than any squiggle on a DeMark chart. From Goldman: "We are recommending long positions in the Russell 2000 with a target of 860 (c+8%) and a stop of 765 (c-3%), marked relative to today’s open." As a reminder, for every client who is buying from Goldman, Goldman is selling. That is all.

And so the volatility continues: initial claims go from 402K to an upward revised 356K, to 377K, on expectations of 370K. The swings in this data series are getting as big as those in the stock market on those rare occasions when reality sets in. The miss is in line with the Fed perceived weakness in the economy. Continuing claims also missed coming at 3554K up from an upward revised 3466K, higher than expectations of 3500K. A whopping 146K dropped out of extended claims: in fact, in the past year the unemployed collecting post 6 month benefits either EUCs or Extended Benefits have plunged from 4.6 million to 3.4 million. As for last week's massive drop of nearly 50K initial claims, we learn that somehow it was New York to thank for this, with 27.7K less claims than the week before due to "Fewer layoffs in the transportation, educational, and construction industries." How about layoffs in the financial services industry, and also how much do those jobs pay vs "transportation, educational and construction" jobs?  What however does not justify the Fed's ZIRP through 2015 or so, is the Durable Goods number which came at 3.0%, on expectations of 2.0%, down from an upward revised 4.3%. The bulk of this was in airplane orders thanks to Boeing as noted previously. However what was surprising is that Durable Goods ex transportation came in at a blistering 2.1% on Exp of 0.9%, and Capital Goods Orders ex Non-Def and Aircraft which rose 2.9% on expectations of 1.0%. However since the Fed has made it clear it will boost its balance sheet, and as of today the implied increase is over $800 billion, at the smallest whiff of trouble, the risk bubble is in full on mode as bad news is good news, and good news is better news.

For a new investor in gold and silver, here is the most lucid piece of advice I can offer. Identifying severe undervaluation points in gold and silver, buying gold and silver assets during these times, and not worrying about interim short-term volatility, even if the immediate volatility is downward, is much more likely to impact your accumulation of wealth in a positive manner than trying to perfectly time market tops and bottoms in the highly manipulated gold and silver game.

Our discussions (here, here, and here) of the dispersion of deleveraging efforts across developed nations, from the McKinsey report last week, raised a number of questions on the timeliness of the deflationary deleveraging process. David Rosenberg, of Gluskin Sheff, notes that the multi-decade debt boom will take years to mean revert and agrees with our views that we are still in the early stages of the global deleveraging cycle. He adds that while many believe last year's extreme volatility was an aberration, he wonders if in fact the opposite is true and that what we saw in 2009-2010 - a double in the S&P 500 from the low to nearby high - was the aberration and market's demands for more and more QE/easing becomes the volatility-inducing swings of dysphoric reality mixed with euphoric money printing salvation. In his words, perhaps the entire three years of angst turned to euphoria turned to angst (and back to euphoria in the first three weeks of 2012?) is the new normal. After all we had angst from 1929 to 1932 then ebullience from 1933 to 1936 and then back to despair in 1937-1938. Without the central banks of the world constantly teasing markets with more and more liquidity, the new baseline normal is dramatically lower than many believe and as such the former's impacts will need to be greater and greater to maintain the mirage of the old normal.

While Paulson's star was finally setting in 2011, that of mega macro fund Brevan Howard was rising, and has been rising for years by never posting a negative return since 2003. The $34.2 billion fund, now about double the size of John Paulson's, returned 12.12% in a year marked by abysmal hedge fund performance. But how did it make money? Simple - by taking advantage of the same permabullish market myopia that marked the beginning of 2011, and that has gripped the market once again. "The Fund’s large gains during the third quarter were due predominantly to pressing the thematic view that markets were ignoring clear signs of economic slowdown and were not correctly pricing the probability of central bank accommodation, particularly the reversal of the ECB rate hikes in April and July." Not to mention the €800 billion ECB liquidity accommodation that started in July and has continued since. So yes: those betting again that the market correction is overdue, will once again be proven right Why? Because "we are about to witness an unprecedented policy move. In the US, Eurozone and UK, fiscal austerity is being prescribed as the cure following the bursting of the credit bubble and to overcome the malaise following a balance-sheet recession. Unfortunately, there is no historical example of when this approach has been successful." As for looking into the future, "we continue to believe that markets remain at risk of  substantial dislocation."

Despite German and French Manufacturing and Services PMI data outperforming expectations, European equity indices are trading down at the mid-point of the European session on extended concerns over the still-not-settled Greek PSI agreement.  Further downward pressure on German markets came from Siemens’ earnings report earlier this morning, with the company missing their revenue targets and foreseeing a difficult economic environment for them in Q2 of this year. In UK news, despite an unexpected fall in government spending, UK debt has topped the GBP 1tln mark for the first time.