Ever since late March, we have said that the only realistic resolution to the Fiscal Cliff standoff (and the just as relevant latest and greatest debt ceiling hike due weeks from today as well), driven by a congress that has hit peak party-line polarity and which the recent election loss only made even more acute, would be a market mandated "resolution" (read sell off) whose only purpose is to crack the gridlock as representatives are flooded with phonecalls from angry constituents who now, and always, will be far more concerned about the value of their 401(k) than any ideological split. By that we mean an identical replica of what happened in the summer of 2011 when the market had to tumble 17% before the debt ceiling "compromise" was finally reached. This also explains why with just 6 weeks of trading in 2012 left, Goldman still forecasts a slide to its 2012 year end target (which it has kept constant since late 2011) of 1250. So while a resolution will almost certainly come, it will not be until the very last moment. As GS summarizes, "Bush income tax cuts was not resolved until December 17th, 2010. Last year’s decision to extend payroll tax cuts was not finalized until December 23rd, 2011. The current challenge is significantly more complex. Divergent views on tax policy, defense spending, and entitlements need to be resolved in a short lame-duck session of Congress." And while the market may or may not jump after there is an actual resolution, don't expect any real buying ahead of a compromise, as any uptick in the DJIA (the Beltway has still not heard of the S&P500 apparently) will immediately lessen the impetus for a deal. In fact, if the following chart from Goldman is correct, and if we are indeed to relive a replay of the summer of 2011, watch out below, especially since true wholesale liquidation across the hedge fund space has yet to occur.
Much is being made of the compression in Spanish bond spreads this week - the largest 3-day drop since Draghi's 'dream' speech. Four critical things come to mind: 1) increasing amounts of Spanish sovereign debt is now held by domestic banks, making the market less liquid (and far less transparent as any indication of 'reality'); 2) the ban on naked CDS (and Draghi's put) has created a hedging vacuum with CDS spreads collapsing and exposure slumping (technically dragging bond risk down); 3) Lower spreads reflexively mean lower probability of Rajoy saying "Si" - which is what is helping spreads compress (leaving event-risk high - as indicated by the outperformance of our legal arb trade); and perhaps most importantly 4) Recency bias is incredible - we have seen 100-plus percent rises in Spanish risk followed by 35-plus percent retracements a number of times and the current level of Spain risk is still above LTRO-inspired crisis levels. So let's not get all excited quite yet eh?
As overseas deposits continue to flood from the periphery (e.g. Italy -15.4% YoY in Aug), yet another European Summit is about to begin delivering headline after headline of baffle-'em-with-bullshit comments. As the market switches from rallying on conditional OMT-backed bailouts (that are not needed according to Rajoy and De Guindos), now it is rallying on a precautionary line of credit (with no apparent conditionality) that Katainen also adds is not needed because Spain doesn't need a bailout. It seems that a 'half pregnant' bailout for Spain is all that it takes as 10Y Spanish spreads dropped below 400bps for the first time in six months and while IBEX is lagging the sovereign's performance for now, it is also having a great week (up over 5%). Thanks to Moody's apparently gutless contingent investment-grade-but-on-the-verge-of-needing-a-sovereign-bailout decision, more rotation from foreign real money to domestic real money and fast money is slapping Spanish credit tighter in a hurry (5Y CDS 278bps and 10Y yield under 5.5%). Now if someone would just explain how any of this has solved the underlying insolvency issues, we'll be more than happy to play along.
This is the stuff that would never be aired in the US mainstream media, at least before a POTUS election!
IMF Cuts Global Growth, Warns Central Banks, Whose Capital Is An "Arbitrary Number", Is Only Game In TownSubmitted by Tyler Durden on 10/08/2012 18:05 -0400
"The recovery continues but it has weakened" is how the IMF sums up their 250-page compendium of rather sullen reading for most hope-and-dreamers. The esteemed establishment led by the tall, dark, and handsome know-nothing Lagarde (as evidenced by her stroppiness after being asked a question she didn't like in the Eurogroup PR) has cut global growth expectations for advanced economics from 2.0% to only 1.5%. Quite sadly, they see two forces pulling growth down in advanced economies: fiscal consolidation and a still-weak financial system; and only one main force pulling growth up is accommodative monetary policy. Central banks continue not only to maintain very low policy rates, but also to experiment with programs aimed at decreasing rates in particular markets, at helping particular categories of borrowers, or at helping financial intermediation in general. A general feeling of uncertainty weighs on global sentiment. Of note: the IMF finds that "Risks for a Serious Global Slowdown Are Alarmingly High...The probability of global growth falling below 2 percent in 2013––which would be consistent with recession in advanced economies and a serious slowdown in emerging market and developing economies––has risen to about 17 percent, up from about 4 percent in April 2012 and 10 percent (for the one-year-ahead forecast) during the very uncertain setting of the September 2011 WEO. For 2013, the GPM estimates suggest that recession probabilities are about 15 percent in the United States, above 25 percent in Japan, and above 80 percent in the euro area." And yet probably the most defining line of the entire report (that we have found so far) is the following: "Central bank capital is, in many ways, an arbitrary number." And there you have it, straight from the IMF.
Usually on semi-US holidays such as today, when bonds are closed but equities left to the whims of vacuum tubes, equities do their mysterious ramp and never look back. So far today, however, this has failed to happen with futures at lows, driven by a noticeably weak EURUSD, which has traded down nearly 100 pips from the Friday late day ramp close, currently at 1.2940. It is unclear what has spooked the Euro so far, although all signs point to, as they did 2 months ago, the Spanish lack of willingness to throw in the towel and demand a bailout, thus easing conditions for everyone else if not for Spain PM Rajoy. Today's main event will be European finance ministers meeting in Luxembourg to discuss the recent Spanish economic transformation efforts as well as an attempt to accelerate banking cooperation and implement a banking regulator - something which is needed for the ESM to monetize bank debt, and something which Germany has been firmly against from day one. Additionally, a day ahead of Merkel's visit to German (where she will be protected by 6-7,000 cops), the ministers are likely to make a positive statement on Greece’s progress toward austerity targets, according to European viceroy Olli Rehn said. In other overnight news, German Industrial Production saw a -0.5% decline, which was modestly better than the -0.6% expected. Over in Asia, China reopened from its 1 week Golden Week hibernation with the SHCOMP down -0.56% to 20.76.42 following a small bounce in the China HSBC Services PMI to 54.3 from 52 in August, and with average house prices rising for a 4th month in a row, and even more repo operations by the PBOC, the result is that the market's ungrounded hopium for an immediate PBOC liquidity injection was taken away pushing regional markets lower.
To those familiar with Algebra, we suggest that the Ponzi scheme we live in is actually an overdetermined system, because there is no solution that will simultaneously cover all the financial and non-financial imbalances of practically any currency zone on the planet. Precisely this limitation is the driver of the many growing confrontations we see: In the Middle East, in the South China Sea, in Europe and soon too, in North America. That these tensions further develop into full-fledged war is not a tail risk. The tail risk is indeed the reverse: The tail risk is that these confrontations do not further develop into wars, given the overdetermination of the system! We have noticed of late that there’s a debate on whether or not the US dollar zone will end in hyperinflation and whether or not the world can again embrace the gold standard. The fact that we are still in the early chapters of this story does not allow us to state that hyperinflation is only a tail risk. The tail risk is (again) the reverse: That all the steps central banks took since 2008 won’t lead to spiraling quasi-fiscal deficits.
In a sad case of deja vu all over again, the over-reliance on 'shaky' collateral and concentration of risk is building once more - this time in the $648 trillion derivatives market. New Clearing House rules (a la Dodd-Frank) mean derivatives counterparties are required to pledge high quality collateral with the clearing houses (or exchanges) in a more formalized manner to cover potential losses. However, the safety bid combined with Central Banks monetization of every sovereign risk asset onto their balance sheet has reduced the amount of quality collateral available; this scarcity of quality collateral creates liquidity problems. The dealers, ever willing to create fee-based business, have created a repo-like program to meet the needs of the desperate derivative counterparties - to enable them to transform lower-quality collateral into high quality collateral - which can then be posted to the clearing house or exchange. This collateral transformation, while meeting a need, runs the risk of concentrating illiquid low quality assets on bank balance sheets. In essence the next blow up risk is the eureka moment when all banks are forced to look at the cross-posted collateral. Last time it was the 'fair-value' of housing, now it is the 'fair-value' of 'transformed' collateral that is pledged at par and is really worth nickels on the dollar - "The dealers look after their own interests, and they won’t necessarily look after the systemic risks that are associated with this."
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!
XAU/EUR Exchange Rate Daily - (Bloomberg)
Gold at €1,355/oz, just 2.5% from the record high of €1,390/oz, is a sign of a continuing lack of trust in the euro and in Draghi’s stewardship at the ECB.
It ain't safe no more???
The slings and arrows of outrageous EUR positioning remain key to figuring out where next in this on-again-off-again currency. The last six weeks or so have seen a dramatic regime shift from smooth transitions from risk-on to risk-off to more staccato-like jumps and trends as the world hangs on every rumor and flashing red headline. We note three things that may be critical to understand where we go next: 1) EURUSD has entirely recoupled with its EUR-USD 'swap-spread' implied fair-value - removing the 'chaos premium' in the pair, and providing less room for upside without broad-market agreement; 2) EURUSD has decidedly lagged the very impressive rally in European sovereign risk (suggesting the latter may be a little over-exuberant); and 3) Despite every talking head telling you about 'all the EUR bears', both Commitment of Traders and Citi's FX positioning indicator have shifted notably more positive - with the latter, as Steve Englander notes, beginning to show significant EUR longs. Now that an active segment of the market actually seems long EUR and associated currencies, the 'good news' bar is a lot higher, and the impact of bad news will be more readily visible.
As European markets have rallied - just like in the US - forward earnings estimates have inched down, leading to a significant multiple (eurhopia) re-rating. As we noted last week, this multiple expansion is dramatically 'rich' compared to sovereign risk changes and is now at the top-end of the euro-zone crisis range. Meanwhile, sentiment has become palpably positive - put/call ratios near lows (highs in complacency; and at the same time European cash equity trading volumes have plunged to 12-year lows (with no high-priced AAPL to 'defend' this with); while fundamentally earnings momentum among cyclical stocks has continued to deteriorate since May 2012. But apart from that, it's all good...
Gold’s remonetisation in the international financial and monetary system continues. LCH.Clearnet, the world's leading independent clearing house, said yesterday that it will accept gold as collateral for margin cover purposes starting in just one week - next Tuesday August 28th. LCH.Clearnet is a clearing house for major international exchanges and platforms, as well as a range of OTC markets. As recently as 9 months ago, figures showed that they clear approximately 50% of the $348 trillion global interest rate swap market and are the second largest clearer of bonds and repos in the world. In addition, they clear a broad range of asset classes including commodities, securities, exchange traded derivatives, CDS, energy and freight. The development follows the same significant policy change from CME Clearing Europe, the London-based clearinghouse of CME Group Inc. (CME), announced last Friday that it planned to accept gold bullion as collateral for margin requirements on over-the-counter commodities derivatives. It is interesting that both CME and now LCH.Clearnet Group have both decided to allow use of gold as collateral next Tuesday - August 28th. It suggests that there were high level discussions between the world’s leading clearing houses and they both decided to enact the measures next Tuesday. It is likely that they are concerned about ‘event’ risk, systemic and monetary risk and about a Lehman Brothers style crisis enveloping the massive, opaque and unregulated shadow banking system.
It is hard to find fiscal situations that are worse than Japan's. The gross government debt/GDP ratio, at more than 200%, is the worst among the major developed economies. Yet yields on Japanese government bonds (JGBs) have not only been among the lowest, they have also been stable, even during the recent deterioration during the European debt crisis. This apparent contravention of the laws of economics is both an enigma for foreign investors and the reason for them to expect fiscal collapse as a result of a sharp rise in selling pressure in the JGB market. As Goldman notes, the European debt crisis has led to an increase in market sensitivity to sovereign risk in general and questions remain on when to expect the tensions in the JGB market and the fiscal deficit to reach a breaking point in Japan. In the following 14 charts, we explore the sustainability of fiscal deficit financing in Japan and Goldman addresses the JGB puzzles.