Behold The Fed’s Takeover Of The Bond Market

Friday, August 17th, 2012

The must see time lapse video below courtesy of Stone McCarthy shows the distribution across the entire curve of the US marketable debt, as it was held by either the Fed, or the private sector over the past three unconventional monetary policy programs: starting in 2003 and concluding yesterday. In one short minute, this clip demonstrates very vividly how the Fed effectively took over the US bond market.

Some things to note:

• The reason why the Fed no longer holds any debt with a maturity under ~3 years is because of the “ZIRP through late-2014″ language which means there is no point for the Fed to hold that debt. For all intents and purposes it is the equivalent of cash. Debt maturing between now and 2014 amounts to just under $5 trillion.  Which means the Fed only has about $5.5 trillion in marketable debt with a maturity over 3 years to work with, and already owns about a third of it. It also means that as all the Fed’s holdings in the under 3 year category are sold, Twist will have to be extended, and with it the ZIRP language to beyond 3 years – most likely 5 or so.
• What is very visible is how the Fed had no choice but to expand its SOMA limit holdings per CUSIP from 35% to 70%. Soon, once the Fed owns 70% of every longer-dated Cusip, it will have no choice but to again extend the maximum permitted holdings, this time to 100% as it gradually become theentire market.

If after watching this clip anyone still believes that the biggest bond market in the world resembles anything even close to fair and efficient or which would have clearing prices anywhere near to where they transact now, they may want to double down on the FaceBook IPO allocation now.

Initial marketable debt distribution by holders starting back in2003 when the first Fed monetary policy started:

And most recent.

Tags: 3 Years, Cusip, Debt Distribution, Distribution Curve, First Fed, Intents And Purposes, Ipo, Marketable Debt, Maturity, Maximum, Mccarthy, Monetary Policy, Private Sector, Reason, Soma, Takeover, Time Lapse Video, Trillion, Us Bond Market, Zirp
Posted in Markets | Comments Off

Secular Outlook: Implications for Investors

Monday, July 30th, 2012

by William R. Benz, PIMCO

• For investors, the biggest challenge now is moving from a world of normal distributions, with expected occurrences around the mean, to one of bi-modal distributions where more extreme scenarios prevail.
• Key institutions, including governments and central banks, were previously stabilising forces but are now helping to accelerate underlying, destabilising trends in the global economy and financial markets.
• In this environment, investors need to invest for outcomes rather than simply for beta and diversification.

Perhaps the most important tradition at PIMCO is our annual Secular Forum in May. Since I joined 26 years ago and participated in my first forum with 16 other investment professionals, our forums have become much bigger and much more global. More than 300 of us descended on Newport Beach or tuned in via video in our most recent round. But the tradition continues, as does the intensity and excitement, with the output of our forum – our three- to five-year secular outlook – forming the cornerstone of both our longer-term investment strategy and our business positioning.

Mohamed El-Erian, our CEO and co-CIO, in his Secular Outlook commentary “Policy Confusions & Inflection Points,” summarized three themes that we expect to play out over the next few years: continued policy and political confusion, overly incremental public and private sector responses and, therefore, greater potential for inflection points. Mohamed also discussed the key investment implications of our outlook, noting that the strategies and guidelines that may have served investors in the past will likely be challenged in the context of inflection dynamics.

That point is worth revisiting and expanding upon because, in our view, investing is fundamentally changing. Previously, most investors simply aimed to beat their benchmarks and diversify among assets to mitigate risk. But today, as we face unusual uncertainty in the global economy and the financial markets, extreme events are not only possible but increasingly likely, and in this environment, we believe investors need to define their objectives and choose strategies that target specific outcomes.

Investors’ biggest challenge

The world is facing a number of very significant challenges for which there are no easy solutions. The eurozone faces high debt levels, a lack of structural growth and pressure to get the policy mix right to avoid contagion. The U.S. is suffering slow growth, high debt, a looming fiscal cliff and political polarisation. While enjoying higher relative growth, China and the developing world are also slowing and making difficult transitions from export-led to consumer-driven ‘emerged’ economies. And globally, a lack of policy coordination, increased income inequality and the growing use of social networks as communication tools also present long-term challenges.

Uncertainty is one common theme, and another is the potential for more extreme outcomes, good or bad. The eurozone, for instance, has to either find a path toward fiscal union or create a mechanism for orderly exit, with very little room to manoeuvre in between. Likewise, the U.S. needs to find a way to resolve its fiscal issues or face the consequences of a further downgrade and eventual loss of reserve currency status.

For investors, then, the biggest challenge is not continued volatility; that’s almost a given. The challenge is moving from a world of normal distributions, with expected occurrences around the mean, to one of bi-modal distributions where more extreme scenarios prevail.

Key institutions: once stabilisers, now accelerants

In the old normal, key institutions acted as stabilisers: They generally behaved in a counter-cyclical fashion to help enforce reversion to the mean. For example, governments and central banks enacted policies to stimulate growth and prevent deflation during economic downturns and did the opposite in upturns. Regulators tended to de-regulate during tough times and tighten the rules during times of excess, while financial institutions decreased and increased lending as interest rates rose and fell.

Their actions, individually and collectively, helped bring economic growth and the markets back to normal, back to long-term averages, back to the mean. They weren’t necessarily coordinated, but they were generally effective and helped create the Great Moderation of steady growth, strong returns and relatively low volatility that we witnessed from the mid-to-late 1980s until the global financial crisis in 2008.

But today, these institutions are acting as accelerants. Governments in Europe, the U.S. and Japan are under pressure to pursue fiscal austerity rather than stimulate growth, exacerbating the downturn. Central banks are largely going their own way, after a well-coordinated response to the financial crisis, and in some cases, are resisting stimulative measures, which is slowing, if not preventing, the healing process. Regulators, adopting a ‘never again’ mentality, are creating blunt instruments to solve complex problems, leading to unintended consequences, particularly in the banking sector, at a time when more rather than less lending should be the recommended medicine. And banks, especially in the eurozone, have been severely impacted by their holdings of sovereign debt, which, in turn, has led to a vicious cycle of falling share prices, credit rating downgrades, asset sales, reduced lending, slowing local economies, worsening government balance sheets and ultimately, an acceleration of, rather than a counterbalance to, the crisis.

Finally, investors are also acting as accelerants. Individual investors have always been more momentum-driven but had little aggregate impact on markets in the past due to their small size, lack of timely and direct access to information and lack of coordinated activity. But as they’ve grown in size and sophistication, accessing real-time information through their defined contribution plans, global platforms, multi-national distributors, private banks and independent financial advisors, their impact has become much more pronounced. When risk sectors outperform, flows into those sectors tend to increase; when they underperform, flows tend to diminish. In both cases, underlying trends are reinforced.

What’s even more interesting is how the behaviour of institutional investors has changed. This began in 2000-01, after the technology bubble burst. The perfect storm of plunging equity markets and falling interest rates turned corporate and public pension plan surpluses into deficits and created big challenges for foundations, endowments and others seeking income and targeting specific absolute returns. The movement toward solution-based investing was born as investors began to shift toward liability-driven investing (LDI), absolute return, income seeking and other, more specific strategies. The momentum increased following Lehman’s bankruptcy and again in response to recent events in Europe. But with this shift has come a more activist (or re-activist) approach, as investors make larger and more frequent changes to overall strategy, tactical weightings, benchmarks and guidelines. Some still prefer to rebalance around their longer-term, normal policy targets, but as a group – and we see this globally across our client base – institutional investors have indeed become more active.

Governments, central banks, regulators, financial institutions and investors – each group is responding to the challenges they are facing in a logical and well-intentioned fashion. Yet in the current secular environment, we believe their actions are adding to, rather than smoothing, volatility. And instead of acting as stabilising forces, we believe they are actually helping to accelerate the underlying destabilising trends. (See figure below.)

Significant implications for investors

Global challenges combined with these market accelerants have created an environment of unusual uncertainty in which ‘muddle-through’ is a temporary state. We believe this has significant implications for investors, particularly those who are still investing simply for beta and diversification rather than for specific outcomes.

First and foremost, the new normal is here, and investors need to embrace it. We coined the phrase a few years ago to describe a multi-speed world on a bumpy journey of deleveraging, reregulation and eventual reflation. We can argue whether we’re still on the journey or we’ve arrived at the final (though still very bumpy) destination. But what’s clear is that what felt like a ‘new’ normal back then now just feels normal. Gone are the days of the Great Moderation, reversion to the mean and normal-shaped distributions, in our view; instead, continued (high) volatility, acceleration in trends and bi-modal outcomes have become the new norm. In an era when muddle-through is no longer a viable option – for Europe, the U.S. and potentially others – investors need to rethink their overall approach and brace for more extreme economic and market events.

Second, there is no free lunch. There never really was, but investors are facing even more difficult trade-offs today. If the objective is to enhance yield or upside potential through credit, high yield, emerging markets, equities or other risk sectors, the likely trade-offs in a bi-modal world are higher volatility and greater downside. If the goal instead is to own ‘safe haven’ assets for downside risk mitigation, such as U.S. Treasuries, U.K. gilts or German bunds, the trade-off is currently negative real yields. And if the need is to maximise liquidity through cash instruments, the payoff is truly negative real yields (with negative nominal yields on occasion). Even when seeking inflation protection, whether through inflation-linked bonds or hard assets – like gold, real estate and commodities – we believe the trade-offs in terms of real yields, volatility and downside risk are much less attractive in this environment.

Third, investors need to think differently with respect to allocations, benchmarks and guidelines. We’ve highlighted this in the past, but it’s even more important today. In our view, asset allocation should be risk-factor-based as bi-modal distributions and accelerants are not friendly toward traditional mean-variance methodologies, which aim to maximize returns for given levels of risk. Benchmarks should be GDP- rather than market value-weighted, particularly in fixed income space, to reduce exposure to those countries, sectors and issuers with the highest or fastest growing debt. And guidelines should be flexible, with more rather than less discretion, so as to allow managers to play both offence and defence in a bi-modal world.

Fourth, investors should be confident in their managers’ ability to understand and measure risk. Global challenges, market accelerants and unusual uncertainty put a premium on risk management. This includes understanding how the credit sensitivity of fixed income investments can affect their duration – i.e., ‘hard’ versus ‘soft’ duration – and help determine what is considered a ‘safe haven’ and what isn’t. It means performing credit analysis of sovereigns knowing they have more than just interest rate risk. It necessitates analysing the entire spectrum of the capital structure to pinpoint exact needs in terms of collateral, covenants and other forms of defence. Derivatives continue to be useful tools, but being able to identify and control counterparty risk is increasingly important. And leverage, while appropriate in certain circumstances, needs to be well understood. Bottom line: we believe in developing multiple risk measures and stress testing often.

Finally, investors need to develop specific objectives and invest for outcomes rather than simply for beta and diversification. Many investors traditionally started with risk/return targets and used historical mean-variance analysis as a framework to determine asset allocations across multiple asset classes, with benchmarks for each asset class and sub-category, and then found managers that aimed to provide returns above their benchmarks. In the days of normal-shaped distributions and reversion to the mean, this was a widely accepted strategy: Long-term realised returns and volatility came in largely as expected, and further diversification – across asset classes, within asset classes and across different managers and styles – helped to smooth short-term swings. It was a beta-driven strategy, aided by diversification. But the world has changed, and we believe investors need to deepen their understanding of their objectives and invest for outcomes.

Setting objectives and investing for outcomes

Every investor has a unique set of needs and circumstances that should form the basis for setting investment objectives. Yet it’s important to consider the secular context as well, particularly given the challenges and trade-offs we’re likely to face:

• Prolonged period of low real yields on high-quality assets, with negative real yields on traditional ‘safe havens’
• Increased potential for low and even negative real returns
• Continued high volatility with increased likelihood of bi-modal outcomes
• Eventual, though uneven, inflation pressures

Income-oriented investors should consider emphasizing high-quality fixed income spread sectors, such as covered bonds, mortgage- and asset-backed securities, investment grade credit and, depending on risk tolerance, upper-tier emerging market and high yield issues and higher dividend-paying equities.

Investors with specific return objectives should consider focusing more on absolute return strategies, ranging from unlevered LIBOR-plus approaches – essentially seeking to outperform cash – to alternative strategies, depending on their risk/return targets and liquidity needs. Credit, emerging markets, equities and other asset classes can also play roles, individually or grouped into a multi-asset approach, as long as risk factors and exposures are well understood and investors consider ways to potentially limit downside risk under more extreme ‘left tail’ scenarios.

Investors concerned with volatility and ‘fat tail’ events should consider risk-mitigating strategies. If investors want to defend against downside, potential strategies would include positions in hard-duration, ‘safe-haven’ assets, explicit tail-risk hedges or a combination. Investors focused on liabilities may want a liability-matching or LDI program. Alternatively, if the goal is to maximise liquidity, cash and short-term strategies would likely play a significant role.

Lastly, for investors worried about reflation, the suggested focus is on potential inflation hedges, such as inflation-linked bonds, commodities and real estate.

In truth, many investors will likely want to employ more than one approach – income with an inflation-hedging component, absolute return with tail-risk hedges, LDI programs that include a combination of derivative-based overlays with LIBOR-plus strategies on the underlying collateral, or any of these with a cash buffer that can be used for liquidity or to invest tactically if the opportunity arises. And this makes sense. In our view, as long as investors focus on their objectives and their targeted outcomes, rather than fall into the old ‘invest for beta and diversification’ trap, they can navigate a world of secular challenges, accelerants and unusual uncertainty.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Covered bonds are generally affected by changing interest rates and credit spread; there is no guarantee that covered bonds will be free from counterparty default. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. Absolute return portfolios may not necessarily fully participate in strong (positive) market rallies. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Dividends are not guaranteed and are subject to change and/or elimination. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
LIBOR (London Interbank Offered Rate) is the rate banks charge each other for short-term Eurodollar loans. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

©2012, PIMCO.

Tags: Benchmarks, Central Banks, Confusions, Cornerstone, Diversification, Financial Markets, First Forum, Global Economy, Inflection Points, Investment Implications, Investment Professionals, Investment Strategy, Mohamed, Newport Beach, Normal Distributions, Occurrences, PIMCO, Political Confusion, Private Sector, Term Investment
Posted in Markets | Comments Off

How The ECB Is Turning Spain Into Greece

Friday, April 13th, 2012

As Spanish CDS surge and bonds shrug off the very recent gloss of a ‘successful’ Italian debt auction, the sad reality we pointed out this morning is the increasing dependence between Spanish banks, the sovereign’s ability to borrow, and the ECB. As ING rates strategist Padhraic Garvey notes this morning, the bulk of the LTRO2 proceeds were taken down by Italian (26%) and Spanish (36% of the total) and the latter is even more dramatic given the considerably smaller size of Spanish banking assets relative to Italy. The hollowing out of the Spanish banking system, via encumbrance (ECB liquidity now accounts for 8.6% of all Spanish banking assets), is a very high number – on par with Greek, Irish, and Portuguese levels around 10% where their systems are now fully dependent on the ECB for the viability of their banks. His bottom line, Spain is not looking good here and while plenty of chatter focuses on the ECB’s ability to use its SMP (whose longer-term effectiveness is reduced due to scale at EUR214bn representing just 3% of Eurozone GDP), consider what happened in Greece! The ECB did not take a Greek haircut and so the greater the amount of Greek debt the ECB bought, the greater the eventual haircut the private sector was forced to take. By definition, every Spanish bond that the ECB buys in its SMP program increases the default risk that private sector holders are left with. Only outright QE, a promise not to default and a willingness to expand the ECBs balance sheet with ownership of the entire stock of Spanish debt if necessary (in the extreme) would be enough to cause a material positive effect from ECB intervention but it is clear from the massive compression in German yields (and weakness in Spain) that the market remains nervous amid an ongoing preference for core. Of course the cycle of crisis, as BNP noted, from crisis to complacency is becoming more chaotic and less sustainable.

ECB dilemma / Bank liquidity

Latest central bank data (which comes out with a lag) shows that the 2nd 3yr LTRO was dominated by Spanish and Italian banks. Specifically we estimate that Spanish banks took down 36% and Italian banks took down 26% of the total. The larger takedown of Spanish banks here is significant as the size of its banking assets are lower than those of Italy, hence in proportional terms Spanish banks have shown the greatest need for 3yr LTRO cash.

On an on-going basis Spanish banks now take down some 316bn of ECB liquidity, which represents 8.6% of its banking assets. This is a very high number. By way of comparison Greek, Irish and Portuguese banks take down some 10% to 12% of their banking assets in ECB liquidity, and these systems are basically fully dependent on the ECB for the viability of their banks. Spanish banks are not far behind on this metric. The next worst are Italian banks with the liquidity takedown of 6.5% of their banking assets.

Bottom line, Spain is not looking good here. There has also been a warning shot aimed at Ireland from the ECB’s Asmussen, who asserts that the current amount of liquidity support extended by the ECB and through ELA (additional liquidity support through the Irish Central Bank) “needs to be substantially reduced over time”. He also warns that Ireland should be very careful on any deviation from the original promissory notes agreement, suggesting that any restructuring here should be preceded by reduced bank reliance on emergency liquidity assistance.

At the other extreme, Dutch banks take down a mere 0.4% of their banking assets in ECB liquidity, and latest data show German banks taking liquidity to the equivalent of 0.6% of their assets. We estimate that German banks took down 8% of the 2nd LTRO while the Dutch take down was significantly small. The French need for ECB liquidity is higher, with total ECB takedown running at 147bn, which represents 1.7% of its banking assets, and we estimate that French banks took down 12% of the 2nd 3yr LTRO.

In the past three weeks there has been evidence that the beneficial effects of the two 3yr LTROs are largely behind us, with spreads under widening pressure again. In the meantime there has been no evidence of ECB bond buying through its SMP program. While the SMP may be resumed and would have a positive impact, it could ultimately risk making things worse. Why? Consider what happened in Greece. The ECB did not take a Greek haircut. So greater is the amount of Greek bonds that the ECB bought, the greater was the size of the private sector haircut required in order to get to the 120% medium-term debt/GDP target.

A baseline assumption is that the same could happen in the future i.e. if there had to be, say a Spanish, restructuring (albeit unlikely) at some point in the future that the ECB would not share in the pain. By definition then, every Spanish bond that the ECB buys in its SMP program increases the default risk that private sector holders are left with. The SMP program has survived the Greek default event because the ECB did not take a haircut, but that action in itself has impaired the effectiveness of the SMP. Only outright QE, a promise not to default and a willingness to expand the ECBs balance sheet with ownership of the entire stock of Spanish debt if necessary (in the extreme) would be enough to cause a material positive effect from ECB intervention.

A more positive gloss has taken hold in the past few days, coinciding with Italy getting paper into the market yesterday amid a strong convergence theme for peripheral spreads to core. However, the fact that 2yr Schatz trade close to a single digit and that the 5yr area is trading so rich to the curve tells us that this market remains very nervous amid an ongoing preference for core.

Tags: Balance Sheet, Bank Liquidity, Banking System, Complacency, Default Risk, Dependence, Dilemma, ECB, Gloss, Haircut, Private Sector, Qe, Sad Reality, Smp Program, Spanish Banks, Spanish Cds, Strategist, Term Effectiveness, Viability, Willingness
Posted in Markets | Comments Off

€300 Billion of “Firewall” Money up in Smoke (Tchir)

Monday, April 2nd, 2012

by Peter Tchir, TF Market Advisors

Last week’s firewall headlines devolved into a “mine is bigger than yours” argument, as official headlines touted the highest possible number, and any reasonable analysis showed that the available money had only increased from €300 billion to €500 billion.  Far less than the official headlines and any analysis of how the EU cobbles together €500 billion leaves serious doubts about it ever being achieved (Spain and Italy are expected to contribute 30% of that amount, which doesn’t make sense since they are potential users of the firewall).  See here for a more detailed analysis of the “unused” firewall money and where it comes from.

What hasn’t been discussed much, is how useful is the firewall?  What did the €300 billion already spent accomplish?

At best, the firewall helps the markets, but does little for the real economy, and at worst, it hurts the economy by avoiding hard decisions and shifts risks and costs from the private sector who made the original bad decisions, to the taxpayers.

Greece, Portugal, and Ireland received €300 billion of firewall money or commitments already.  What has that done?

Greece defaulted on its private sector debt.  The new Greek private sector debt trades at 20% of face value, a level that is lower than the old Greek bonds ever go to – think about that – the New “restructured” Greek debt, trades at lower prices than the old debt ever did – hardly the sign of a good restructuring.  The economy is in shambles and has done nothing but deteriorate while the “firewall” was put in place.  The firewall in Greece did nothing to help the Greek economy, delaying the inevitable default made the economy worse, and Greece still has the same amount of debt outstanding (in part because the taxpayers have recapitalized the banks), so now they just owe that money to different (more powerful) entities so their bargaining position is even weaker.  A sad state of affairs and not a ringing endorsement of why anyone would want “firewall” money.

Portugal has not yet defaulted on its debt, but while accepting firewall money, they have also been busy at work letting the governments guarantee bonds issued by banks, so the banks can stay alive.  Just like in Greece, the first restructuring will leave Portuguese debt burden unchanged, it will just replace who they owe it to, and force the taxpayers into capitalizing the banks that have now completely developed a parasitic relationship with the country.  While Portuguese bonds benefitted substantially from LTRO and more promises that no PSI in Portugal would occur, both the 5 year and 10 year bonds have been weak the past few days, and still trade at prices 70 and 60 respectively, that indicate that restructuring is still to come.  The main hope for those bond investors is that somehow, they get paid out and the public sector takes the risk – as sad as that seems for taxpayers, it doesn’t seem impossible that that is what the EU would decide to do.

Of all the countries that have received “firewall” or “bailout” money so far, Ireland seems the closest to turning the corner.  The 10 year bond yields less than 7% and there is real talk about improvement in the Irish economy.  Having said that, they are already re-negotiating their payment schedule for their bank recapitalizations.  Yes, Ireland had actually been relatively okay until they threw taxpayer money at the banks without realizing what a deep dark hole they had gotten themselves into.  In all 3 of these countries, it is the state support for banks that is making the crisis worse, or in the case of Ireland, sparked the crisis.  The other issue with Ireland is that it is the smallest of the 3 countries that have needed help.  With only €121 billion of “official” government debt (all the guaranteed debt, hidden derivative debt, commitments of support, etc., are not readily available), it is much smaller than even Portugal with €171 “official” government debt.  One of our themes has been that smaller markets are easier to manipulate and the central bankers and politicians can hide problems longer there since the capital they are willing to throw at covering up the problems is disproportionately large.  I’m not saying that is happening in Ireland, but I would also be careful about reading too much into their bond yields, as the size of the market makes it much easier to manipulate.

So of the €300 billion spent already to “firewall” or contain Europe, it is hard to see what has been achieved.  Greece’s default, and bank recapitalization caused Greece to demand more firewall money.  As Portugal seems destined to head down the same path, they too will need more money and will take a solid bit out of that remaining €500 billion, when they convert bank losses into taxpayer loans.  Ireland seems most likely to be able to avoid needing more money, yet, having said that, they are re-negotiating terms of their existing bailout.  Hardly a successful use of €300 billion (not including IMF money).

The politicians will argue that they bought time.  That they have “saved” the banking sector.  That is the best they can come up with, that by delaying they made the default in Greece less problematic, and that by saving the banks, they make the future better.  I have argued all along that a default would not be catastrophic – the politicians didn’t do it when I first suggested – May 2010, but once they did allow the default to occur, it was far less painful than they would have led you to expect.  I have argued that keeping dead banks alive does little for future growth, while making the problems bigger.  I’m not the only one to say that, but I think Yalman Onaran’s “Zombie Banks” does a great job showing that time and again, the desire of politicians to delay the recognition of problems, particularly for banks, means the final tab for society will be much higher. The examples of this happening time and again are frightening (and recent), yet here we are trying to implement the same flawed policies.

How would the firewall work if Spain needed money?

It is great to talk about the “firewall” and just how big it is, but what happens if Spain starts to deteriorate.  The likely scenario would be that Spanish bond yields start climbing.  Let’s say that the 5 year bond gets to 5.0% and the 10 year gets to 5.75%.  They are currently at 4.1% and 5.33% so this move would represent a serious shift in concern, but still be nowhere close to the worst levels seen in November (or pre LTRO – maybe Europe should switch from calling this 2012 AD, to 1 ALTRO?).

The first line of defense would be some ECB Secondary Market Programme (SMP) purchases.  The ECB would go into the market to buy bonds.  Given the problems the ECB’s holdings of Greek bonds caused (full payment and separate laws), the EU may choose to use EFSF or ESM money to buy the bonds.  These entities are set up to work with the ECB, to buy bonds in the secondary market.  With all that has gone on, I believe that the ECB will direct the purchases, but won’t use their own balance sheet.  So any purchases will subtract from the remaining firewall.  It also means that Spain will be guaranteeing some portion of the money being spent to buy Spanish bonds.  For small size, say €20 billion or less, Spain will probably not opt to “step out”.  With all the overcollateralization built into the guarantees, versus funded amount, there will be political pressure for Spain to remain part of the bailout team, in spite of the ludicrously circular nature of that.  The argument will be that “secondary market purchases” are temporary, etc.   The market will buy into that at first.

So the Doika (EFSF & ESM) will buy bonds.  Initially this will scare the “speculators” who are short, and encourage the “investors” who will buy some bonds to participate in the potential short squeeze rally.  The fact that many of the “speculators” are the same hedge funds that become “investors” will be ignored.  We will see a rapid improvement in yields as dealers won’t fight the Doika, and fast money may even try to jump on the band wagon.  The rally will likely be short lived, and not too dramatic, as LTRO has already been priced in, and shorts aren’t as prevalent in the past, and this round of weakness has been caused by fast money being caught long and overestimating the longevity of LTRO, rather than a “bear raid” on the country.

So let’s say after the SMP, Spanish yields drift back to 4.50% for the 5 year, and 5.25% for the 10 year.  What has been accomplished?  What was actually done for Spain?

Did Spanish borrowing costs decline?  No.  The price of secondary market debt doesn’t affect Spain’s current budget.  Spain is obligated to pay the coupons agreed to when bonds are issued, the secondary market does not affect existing interest payments that Spain is due to make.  It might help control the cost of Spain’s new issues, but the country is already issuing almost 70% of their debt with maturities of 2015 or less, so keeping long term yields artificially low doesn’t have much of an impact there either.  Then why do it?

In theory, all borrowing in Spain will be benchmarked against sovereign debt.  So banks who borrow money for 5 years will pay a spread to 5 year Spanish yields.  Companies that borrow will also pay a spread over the 5 year sovereign rate.  So in theory controlling the 5 year sovereign rate affects all Spanish companies that borrow money for 5 years.  The same thing goes for the 10 year yields.  That is great in theory because typically banks and countries are creating new debt every day at a faster pace than the country is creating debt, so you effectively “leverage” the SMP money, because keeping the sovereign debt yields low, means all the companies in the country can borrow at a lower yield.  That might work in a “normal” environment, but we have moved so far past “normal” that it is laughable to believe this transmission works.  It obviously didn’t work in Greece, and hasn’t worked in Portugal, so why ignore that?  In Spain (and Italy) banks have become addicted to ECB funding.  They have grown addicted to issuing bonds to themselves, getting a guarantee from the country, and then taking those bonds to the central bank to get money.  They aren’t consistently issuing bonds to the public where the benchmark sovereign yield matters.  More than that, they have shifted their borrowing to ever shorter maturities.  The banks are borrowing more and more short term and they are definitely NOT lending money long term.  They are lending to companies long term, if at all.  The whole lending dynamic in the countries has broken down, so assuming traditional monetary policies work in this environment is just flawed.

So, other than calming the markets, at least temporarily, barely anything is done for the country, the banks, or the companies in Spain.

It might keep the cost of “hispabonds” down.  These are bonds that would be issued by regions, but come with a government guarantee.  On the other hand, these bonds might be the worst idea yet to come out of Spain.  All the existing ways of hiding debt – off-market derivatives, verbal guarantees, private side-letter guarantees, commitments to EFSF/ESM where not all commitments are used, have the benefit of being difficult to find, or to convince people that they have a real impact on the creditworthiness of the nation itself.  Hispabonds will attract attention to the fact that Spain is really issuing these bonds because the regions are in worse shape than the country.  It will be hard to convince people otherwise, as these bonds will be right out there in the open where anyone can see them.  Once the “guarantees don’t count” mantra has been breached, the potential floodgates of concern open up.  How big is Spain debt, really?  Not the “official” number, which is attractive, but the real debtload?  It is high, and growing quickly, and likely unsustainable.

But anyways, what is that would cause SMP to fail to hold.  Bad economic data?  Ever increasing unemployemt?  Failure to implement austerity?  Civil unrest?  Failure of a caja? Hispabonds?  Revelations of secret debt?  The list of potential catalysts is large.  All it takes is for one thing, and the market that is still positioned long can resume its sell-off quickly.  Remember, post LTRO, the banks are about as long as they can get and have to post collateral on mark to market losses on bonds they posted as LTRO collateral.  Foreign banks will remain reluctant to extend capital, since Greece showed that restructurings are based on what is politically expedient, and not what the rule of law was at the time you bought your bonds.

This weakness causes bonds to spike higher again, this time reaching 5.5% for the 5 year and 6% for the 10 year.  We see higher yields and a flatter curve as the market, caught long, realizes the last effort by the fire brigade failed to be sustainable.  Nervousness is creeping into the market.

This is likely where the politicians make things worse rather than better.  Some will start trotting out the “leveraged” EFSF/ESM concept.  A non-starter, that may spark a brief rally by the naïve who think it can work, only to be followed by more selling pressure as markets get nervous that Europe is heading back to the clueless stage.  The ECB will confirm that  no new LTRO is planned – since yields aren’t really that bad, and they too can see that LTRO is a double edged sword.  Renewed calls for austerity and dissention in Germany will add further concern.  People like myself, will legitimately show just how much debt Spain is obligated to pay, and now more investors will start to pay attention.  They will see that the guarantees are real.  By this time another €50 billion in firewall money will likely have been spent (€20-30 billion on Spanish SMP and some to Portugal and Italy as Spain isn’t deteriorating in a vacuum).  Rumors of law changes will abound.  Rumors that Spain is preparing to default on non-Spanish held Spanish bonds will occur.  There will be denials, but prudent foreign investors will be very fearful of getting involved in a deteriorating situation.

Long before the firewall money is spent, the outcome will come down to the ECB, France, and Germany.

What does the fire brigade do here?  It really is tricky.  At this stage, how do you stop the decline?  Buying more Spanish bonds and Italian bonds?  That will help, but not like the prior round, because now “speculators” who have been eyeing the horrific balance sheets of the caja’s, the regions, and the countries, will find ways to be short.  Spanish sovereign bonds may respond to more Troika purchases, but CDS will remain well bid.  Spanish bank and corporate debt that is beyond the maturity of LTRO will be attacked, not so much as a spread to sovereign bet, but one that sovereign yields will eventually spike.  The regions will become desperate for Hispabonds at exactly the time the market won’t buy them.  Although I believe Spanish yields will be worse than Italian yields at this stage, the Italian bond market will also be under pressure.  Guilt by association if nothing else, but sadly it is more than just guilt by association, in spite of recent progress, Italy has a lot of problems of its own, none of which is helped by increasing problems in Spain – the correlation is real.

What happens if Spain “steps out”?  If Spain decides it needs significant money to bail-out its cajas, regions, banks, and itself, then they will have to step-out.  That greatly increases the burden on Germany, France, and Italy.  Will they have the political will to take over Spain’s commitments?  Remember, even ESM is only partially paid in capital, so ESM and EFSF will be issuing guaranteed bonds into a market, that is experiencing growing concern with Spain and Italy.  Asides from the political will, does Italy have the economic capacity to step up its commitments if Spain “steps out”?  Does Spain “stepping out” create real risk that Italy too has to “step out”, leaving virtually the entire firewall up to Germany and France?  I think it does.  It is hard to see plausible scenarios where Italy can honor its commitments without getting dragged down.  They might not need to tap the firewall, but they may no longer be able to support it.

At this stage, all eyes will turn to the IMF and the ECB.  I continue to believe that the IMF is the most constrained.  Partly, their money is coming from reluctant donors, and partly because they do seem to do the most unbiased critical analysis of the situation (I’m sure what they discuss internally is far more morbid, than the already dire predictions they occasionally leak for public consumption).  So it comes down to the ECB.  The ECB will likely treat ESM as a bank or find some other way to fund programs so that these bizarre entities don’t have to rely on real markets for money.  Why ever rely on real markets for risk assessment and pricing when you have the power to print and sustain economically unviable positions far longer than anyone ever thought?

This will be the key.  It will once again fall to the ECB to come up with programs that “fix” things.  Or at least give the can another good kick.  Can they?  The ECB will have to print.  For the first time, it will become clear to everyone that if Germany and France can’t sustain the EFSF/ESM, then they can’t contain the ECB’s potential risk either.  The commitment of France and Germany to the ECB is joint and several, as opposed to the EFSF/ESM where each has exposure that is capped.  That risk will start to scare some sensible people.  Politicians will likely bring out the “if we don’t help them, we all die, scenario” but the reality, as throughout the entire crisis, will be that “helping” them ensure you all die down the road, rather than having just some serious injuries now.  Also, there will be a growing number of people, who may finally be listened to, that effectively argue that restructuring now, taking the losses and restarting with a sustainable system is the way to go.  They will only have to point to Greece and Portugal to make their point, and they will be able to clearly demonstrate that Spain’s roll in the bailout of those countries, only hurt Spain.  Too much of the bailout money goes to banks and insurance companies and not enough goes to fixing sovereign debt problems, or killing the banks that need to be killed so that others can survive.  Yes, we hear the trickle down argument, that hurting bank share prices, or the portfolios of insurance companies hurts the little guy, but after 5 years of trying that in the U.S. and Europe, maybe it is time to test the theory.  Most banks will not default if they have to take big hits on sovereign debt.

I for one, would like to see a much different approach to dealing with the crisis then has occurred so far, but in any case, this is where we likely get.  It will all come down to the ECB, with the backing of France and Germany deciding to go all in, or PSI (default) on a large scale.  But in either case, the €500 billion of unallocated money is just a myth and this problem will hit a critical point long before much more money is drawn down.

Copyright © TF Market Advisors

Tags: Bad Decisions, Banks, Commitments, Doubts, Entities, Face Value, Greece, Greek Bonds, Greek Economy, Hard Decisions, Headlines, Leaves, Nbsp, Portugal, Private Sector, Restructuring, Shambles, Taxpayers, Tf, Trades
Posted in Markets | Comments Off

Interest Rates: The Market Has It All Wrong (Jakobsen)

Tuesday, March 27th, 2012

by Steen Jakobsen, Saxo Bank

“In general, the art of government consists in taking as much money as possible from one party of the citizens to give to the other.” – Voltaire

To say that the last four years since the financial crisis broke out in 2008 has been slightly atypical would be the understatement of the century. The central banks across the globe have reached deep into their toolbox  - first by lowering interest rates to zero or effectively to zero, and then grasping at “unconventional measures” that are aimed at keeping rates low at the long end of the curve as well by buying up most of the bonds issued by their own governments’ treasuries. Decades ago, the latter would have been called a Ponzi scheme, but in today’s world the measures are sold as the “only alternative”. Voltaire saw it coming.

Traditionally, the central banks have only controlled the part of the yield curve from overnight and out to perhaps one year. But the severe drop in equities in 2008/2009 and the huge fiscal imbalances created from the biggest fiscal stimulus in history created a need for securing “orderly business” through ample liquidity at low rates. That was followed up with a PR blitz from central bank and policy makers, who told us: Trust us – we’ve got everything under control. Sure you do! Since then, we continue to the migration from one bubble to the next, and now we are in a debt trap in which governments and banks remains thinly capitalized and have no access to further credit unless the central bank is willing.

The world governments and commercial banks now take so much of the “credit cake” that the private sector is only left with crumbs. The private sector, which is traditionally the risk-taking and profitable side of the economy, has been cut off from its oxygen, credit – the macro side of the economy has overwhelmed the micro. This is a terrible mistake. All enterprising individuals and companies should want maximum flexibility and access to capital and risk, instead they are cut off, overtaxed and overregulated.

In 2012 we have so far seen a gradual normalization of interest rates coming off extreme lows. The move this month has been dramatic relative to the recent past and has lead to the talk of changing growth fundamentals and the possibility that the economy (mainly the US) has turned the corner. We were constructive on the US back in Q4-2011 as we saw that the consensus projections of expected future growth were too low (Remember the “double dip” talk?) Now fast forward to Q1-2012 and the market is, in our view, too quick in projecting that the recent “stabilization” will blossom into long-term growth. It’s too early, if anything our forward looking indicators are showing signs of a possible slow down, so we believe that the US will still outperform in 2012, but only because everywhere else will fare much worse.

This leaves us with the conundrum of the latest sharp rise in interest rates: Has the interest cycled bottomed? Is this the new “new normal” or is it simply a dose of mean-reversion? The governments and weak banks and over-indebted companies need very low interest rates to continue to carry and roll their gigantic debt loads, so the this interest rate question is vital as the future path of rates will have a massive impact on future growth and the investment climate.

With that in mind, we offer three scenarios and our perceived odds of their probability:

- Even lower interest rates/more unconventional measures going forward (Consensus: 60%, but we think far less likely) – based on infinite monetary expansion. This is the reflation trade. This is option favored by politicians as it is off balance sheet and “off accountability” for them as the central banks continue to bail out the sovereign and other large debt holders with the printing press. Since they pull the levers, this is seen as the most likely scenario and if you look at charts, it’s also very appealing in terms of the continuity: ever lower interest rates in downward channel as seen above. But shouldn’t the market recognize that central banks only go unconventional when the there is systemic panic and crashing markets? Particularly given the gross imbalances they have already introduced? Besides, now that they have force fed so much liquidity into the system, they have actually helped to remove the tail risks that lead to such outcomes in the first place.

- Lower in a channel but all-time low in place (Consensus: 30%, but our preferred scenario) – rates have visited a long-term low as “unconventional measures” will need to be slowly unwound. The biggest policy mistake historically has always been for central banks to stay too easy for too long. The politicians are clearly getting “gun shy” in the face of the monetary bazooka of “unconventional measures”. Another show-stopper could the law of stock versus flow. The policy makers have printed in excess of 3 trillion US dollars globally to keep the financial market and governments afloat. This means that to have an additional impact the net new issuance of money needs to be much bigger in nominal terms and as the debt load swells, every incremental unit of debt sparks an ever diminishing return on growth. The printing presses slowing from here would have profound implications as we discuss below.

- Crisis 2.0 (Consensus: 10%) - This is our old theme – which is that market participants will lose faith in the government and its ability to repay its debts. To some extent we have had already had a Crisis 2.0 in Club Med Euro Zone peripherals, but it has yet to pass on to the core Euro Zone economies like Germany and France, much less the UK, US, and Japan. This is the least likely scenario, but if we break the upper bound of the channel in the chart above, it could touch off a whole new paradigm in which fiat money is no longer seen as sustainable.

If we are right and the market’s belief that “the next bailout always awaits in case” is wrong, then the move away from unconventional measures, i.e., infinite money printing, is a major game changer. The banks and government are dependent on the false sense of security low interest rates creates. The latest move in interest rates is actually tiny in the historical perspective. Were we to see an expansion in the volatility to the high-end of the present long-term trading range – from 3.00% to 4.75%, for example, it would have a dramatic impact on debt crisis.

Across Europe and the US, homeowners remain under pressure. A move in rates of any reasonable size would put millions more even further under water on their home equity. That is the negative impact of a debt trap, the inability to create any economic environment that allows us to extract ourselves from the pain of the debt service – just look at Japan. The stock- and house market topped in 1989 – now 22+ years later the stock market is 75% below its peak. Too negative to apply to the rest of the world? Probably, but a long life in trading has taught me a few long-term facts. One: everything mean-reverts – What goes up must come down. (Think stock market, house prices, state intervention, excess of all kinds.) and more importantly – Two: we never learn any from history

Safe travels,

Steen

Tags: Central Banks, Commercial Banks, Debt Trap, Enterprising Individuals, Financial Crisis, Fiscal Imbalances, Fiscal Stimulus, interest rates, liquidity, Oxygen, Ponzi Scheme, Pr Blitz, Private Sector, Saxo Bank, Steen, Treasuries, Understatement, Voltaire, World Governments, Yield Curve
Posted in Markets | Comments Off

Many Questions Around the Second Greek Bailout Remain Unanswered

Tuesday, February 21st, 2012

Think this time around finally the Greek deal is done? Think again. OpenEurope lists the “many” questions still surrounding the second Greek bailout that remain unanswered. We would add that this is hardly an exhaustive list, and believe the key question, to put it simply, is a CAC is a MAC? Because if the answer is yes, the deal is off.

From OpenEurope

Many questions around the second Greek bailout remain unanswered

We finally have an agreement on the second Greek bailout…in principle. It only took eight months. If you’re of the belief that a disorderly Greek default would have triggered Armageddon, the deal that was agreed (as ever ‘agreed’ is used loosely) by Euro finance ministers in the early hours of this morning is broadly good news.

Unfortunately, it is once again hopelessly optimistic and contains numerous gaps and unanswered questions which could still bring down the whole deal. This is nowhere outlined better than the damning leaked debt sustainability analysis (see here for full doc).

Below we outline a few key issues (not exhaustive by any means, there are many more) and give our take on how they could play out.

Greater losses for private sector bondholders: Reports suggest the Greek government was sent back to the negotiating table with bondholders at least four times during last night’s meeting. Nominal write downs for bond holders now top 53.5% (or around 74% net present value). The leaked Greek debt sustainability analysis (DSA) assumes a participation rate of 95%.

Open Europe take: 95%, really? We weren’t convinced the previous threshold of 90% with a lower write down would be reached and that was while potential ECB participation was still on the table. Although this target may have been agreed with the lead negotiators for the private sector, it is far from a cohesive group, diminishing the value of the agreement. It will be interesting to see how bondholders respond to the plan but we think that hold outs could well be more than 5%.

Greek ‘prior actions’: The deal includes a list of requirements which Greece must meet in the next week to get final approval for the bailout. These include: passing a supplementary budget with €3.3bn in cuts this year, cuts to minimum wage, increase labour market flexibility and reforms opening up numerous professions to greater competition.

Open Europe take: The now infamous €325m in cuts still needs to be specified. The huge adjustments to labour markets and protected professions mark a cultural shift in Greece – pushing these through will not be painless and could result in further riots.

Fundamental tensions in objectives of the programme: The DSA notes that the prospect achieving a return to competitiveness while also reducing debt is very small – the massive austerity could induce a further recession.

Open Europe take: As we have noted all along the assumption that Greece can impose massive levels of austerity and then return to growth in the next two years is a big leap and almost inherently contradictory. We’d also note that the cuts in expenditure in Greece are larger than have been attempted anywhere in recent memory (successful or failed). Likely to be substantial slippages in the austerity programme while the growth programme remains almost non-existent, essentially closing the book on Greek debt sustainability.

Further favourable treatment for the ECB: ECB and national central banks avoid taking losses on their holdings of Greek bonds but promise to redistribute ‘profits’ from these holdings so that they can be used in Greece.

Open Europe take: See our previous post for a full discussion of this issue. Markets still don’t seem too worried by suddenly being subordinated by central banks in Europe – they should be. This raises questions of the basic premise that all bonds are treated the same, based on who issued them not who holds them. As we’ve noted before, the whole concept of ‘profits’ is misleading, while any distribution would happen anyway – this is not a commitment from central banks but a further fiscal commitment by the eurozone (should really be included in total bailout funding).

Greece may not be able to return to the market even after three years: The DSA points out that any new debt issue will essentially be junior to existing debt, hampering the chances of Greece issuing new debt in 2014/2015.

Open Europe take: This point isn’t too clear but given that the eurozone, IMF and ECB will own such a larger percentage of Greek debt in 2014 any new private sector debt will be massively subordinated and at risk of taking losses if anything goes wrong with the Greek programme. Additionally after the restructuring the remaining private sector debt will be governed under English law and will have the EFSF sweetener – further subordinating any new debt issued to the market. Why would anyone want to purchase Greek debt in this situation (especially given the other concerns above)?

EFSF funding requirements: The EFSF will have to raise €70.5bn ahead of the bond swap – €30bn in sweeteners for the private sector, €5.5bn to pay off interest and €35bn to provide Greek banks with assets to use to gain liquidity from the ECB.

Open Europe take: We’ve already questioned whether raising these funds so quickly can be done and whether the approval from national parliaments will be forthcoming. Even if it is the €35bn is said to fall outside of the €130bn meaning it is expected to be returned swiftly – given the uncertainty over how long banks will need these assets (as long as Greece as declared as in selective default by the rating agencies) this may be a generous assumption.

There is also no talk of the money to recapitalise banks. This is a risky strategy given that Greek banks’ main source of capital (government bonds) will have just been wiped out significantly. The needs were previously specified at €23bn, although reports now suggest they could top €50bn. It’s not clear where this money will come from or when it will be raised. The bond restructuring will be like dancing through a minefield for Greek banks.

We’re still trawling through the responses, analysis and documents to come out of the meeting – meaning there are likely to be plenty more questions and uncertainties to come.

The one thing that is clear is that even if this bailout is ‘successful’, it will set Greece up for a decade of painful austerity and low growth leading to social unrest, while the eurozone will have to provide on-going transfers to help it keep its head above water.

Sorry to be killjoys but as Dutch Finance Minister Jan Kees de Jager put it, the deal isn’t “something to cheer about”.

Tags: Armageddon, Bailout, Bond Holders, Bondholders, Cac, Cohesive Group, Debt Sustainability Analysis, Dsa, Eight Months, Finance Ministers, Gaps, Greek Government, Least Four Times, Negotiators, Net Present Value, Open Europe, Participation Rate, Private Sector, Target, Unanswered Questions
Posted in Markets | Comments Off

“The system will hold together…” (Saut)

Tuesday, February 14th, 2012

“The system will hold together…”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

February 13, 2012

“The system will hold together” is a line spoken by Maxwell Emory (played by Hume Cronyn) in the 1981 movie “Rollover.” The film centers on a plot whereby Mr. Emory, who is the chairman of First New York Bank, is secretly moving “the Arabs’” money out of U.S. dollars and into gold using a mysterious bank account numbered 21214. When the plot is discovered, gold prices soar, the stock market crashes, and Maxwell Emory puts a bullet through his head. I couldn’t help reflecting on that movie last week as rumors swirled that the Greek government may not be given the €133 billion loan needed to meet its long-term debt roll-over in March. If so, a Greek default becomes almost a certainty, and time is running out. Indeed, it will take a rather long time for all the authorities and lawyers to complete the paperwork. For example, EU officials, the ECB, the IMF, Germany, the Greek government, et all must sign off on the agreement and history suggests somewhere along the line difficulties will surface. Meanwhile, the Greek unions are rioting (again), punctuated by this statement from Yannis Panagopoulous, head of the largest private-sector Greek Union, “What is taking place is not a negotiation, it is blackmail!” The entire situation is reminiscent of a dog chasing its tail; the budget deficit hovers around 8% – 9% because Greece’s economy is collapsing. With the Greek elections looming in April the situation could quickly deteriorate into a sauvequi peut. So I shall say it again, as I have said for over a year, “Greece is going to default because the numbers just do not pencil. Whether it is in March 2012, or March 2013, is unknowable; but, Greece will default, hoisting the question – who’s next?”

Last week the equity markets revisited the Greek tragedy, and the “who’s next,” questions by recording their first down week this year. The result left the D-J Industrials (INDU/12801.23) down 0.47%, while the S&P Small Cap 600 Index (SML/453.00) surrendered 2.28%. In fact, of all the indices I follow only the NASDAQ 100 (NDX/2547.32) was higher on the week with a 0.72% gain. To readers of my missives this should have come as no surprise, for as scribed in last week’s strategy letter:

“That said, I turned more cautious a few weeks ago because stocks had become very overbought (read: too much bullishness) in the short-term, and most of the market’s internal energy had been expended in the upside dash from the October ‘lows’ into the recent mid-January ‘highs.’ The only question I posed was, ‘Is this going to be a sideways correction, or are we going to get more of a pullback?’ Whatever the pattern, I continued to suggest it would be a mistake to get too bearish. So far, it has been pretty much a sideways affair with the S&P 500 only 17 points above where it was when the Buying Stampede ended on January 25th. Still, the SPX is two standard deviations above its 50-day moving average (DMA) and consequently very overbought (again). Likewise, the McClellan Oscillator is back into overbought territory, many of the indices I follow are up against their respective downtrend lines as seen by connecting their May 2011 highs with their July highs, none of my short-term indicators are bullish, near-term performance following upside ‘gaps’ like last Friday’s (2/3/12) on the better than expected employment numbers typically has been poor, and there is the potential for a double-top in the DJIA, which would be negated with a close above 13250.”

To update those comments for last week’s action it should be noted the McClellan Oscillator has fallen from its overbought condition to a more neutral position, but not as of yet oversold. Additionally, there is a divergence in the McClellan Oscillator such that the stock market’s breadth is declining even on “up” days. In the past this has foretold corrections. As for the S&P 500 (SPX/1342.64), it remains about two standard deviations above its 50-DMA. The downtrend lines, at least so far, seem to have contained the rally, as can be seen in the chart of the Russell 2000 on page 3 of this report. Further, the INDU broke to a new reaction high (above the May 2011 high) last week, but the D-J Transportation Index (TRAN/5254.14) did not better its respective reaction high. That is a Dow Theory upside non-confirmation; while I don’t expect it to be a serious occurrence, it is another reason to expect a pullback in the averages. Then there are the sentiment indicators that look pretty stretched, with the AAII ratio of bulls and bears soaring to 74, while the Rydex Bull/Bear ratio is almost at a new all-time high. Of course that overly bullish sentiment “foots” with the recent complacent reaction low of 16.10 in the Volatility Index (VIX/20.79) as in the near-term sentiment is too bullish. Simultaneously, “smart money” – that would be commercial hedge traders – are short $7.4 billion of various indices (INDU, NDX, RUT) as of last Tuesday, which was up from the previous week’s $2.7 billion. That’s a weekly increase of $4.7 billion for one of the largest weekly jumps I have ever seen and it is the highest such “short” position since 2002.

So what do I expect? Well, I have maintained that the “emotional peak” occurred on January 10, 2012 with the start of an upbeat earnings season, which was a pretty good call. Subsequently, I suggested the “price peak” was registered on January 26th at 1333.47 for the SPX. That was not such a good call since the SPX traded up to a closing high of 1351.95 on February 9th. Still, as of last Friday’s close, the SPX is only about 10 points above what I had deemed to be the “price peak”; and despite all the huffing and puffing, I don’t see where a whole lot of money has been made since January 26th. Now typically what should happen from here is for stocks to suffer a bit of more weakness and then make another attempt at the recent highs around 1354. That attempt should fail, leading to a more substantial correction of between 5% – 8%. Whatever the outcome, I do not expect a serious correction anytime in the near future.

The implications are that things are likely going to get a little less fun for investors for a while with the major averages transitioning from a steep price rise to more of a sideways to downward pricing structure. This does not mean you can’t make money. On the upside, my algorithms show that our fundamental analysts’ Strong Buy ratings on 7.6%-yielding CenturyLink (CTL/$38.02) and non-yielding Whiting Petroleum (WLL/$50.89) are setting up for a potential upside breakout. Meanwhile, our analyst’s Underperform rating on ViaSat (VSAT/$45.22) is being confirmed by my algorithms to the downside.

Another strategy would be to “scale buy” fundamentally strong dividend-paying stocks. To that point, our friends at Bespoke Investment Group recently screened the S&P 500 looking for stocks that yield 2.5% (or more) and have raised their dividends every year for at least 10 years. Bespoke further refined the list to companies whose earnings in the year ahead are expected to be double their respective “payout ratio” of the last 12 months. Bespoke goes on to write:

“Of the 500 stocks in the S&P 500, and the 72 stocks that have raised their dividends for ten straight years, only twenty stocks ultimately fit the added criteria of yielding more than 2.5% and have a payout that is less than half of their expected earnings. Although these ‘chicken stocks’ will most likely not be on the list of top performing stocks at the end of 2012, they do provide stable and relatively safe dividends, providing a good starting point for investors ready to dip their feet in the water.”

Names from said list that are favorably rated by our fundamental analysts include: Abbott Labs (ABT/$55.11/Outperform); AFLAC (AFL/$48.33/Outperform); Chevron (CVX/$105.28/Strong Buy); McDonald’s (MCD/$99.72/Outperform); and Norfolk Southern (NSC/$71.53/Strong Buy). Bespoke’s entire list can be retrieved from our Research Liaison desk.

The call for this week: There was another “dog barking in the night” (reference my Sherlock Holmes report of 1/30/12) when two perma bears recently turned bullish. The bears in question are David Rosenberg and Nouriel Roubini. When the ultimate “bears” finally capitulate, well you can draw your own conclusion. That said, it is normal for a market in an uptrend to experience some profit-taking around previous peaks like those in May (1370.58) and July (1356.48) of last year, especially given all of the aforementioned metrics. Accordingly, last week’s intraday high of 1354.32 was likely a short-term trading top, but don’t get bearish because all of my work suggests stocks will be higher by year-end.

Click here to enlarge

Tags: Arabs, Budget Deficit, Chief Investment Strategist, Emory, Film Centers, Fir, Gold Prices, Greek Elections, Greek Government, Greek Tragedy, Greek Union, Hume Cronyn, Imf, jeffrey saut, Maxwell, Negotiation, Paperwork, Private Sector, Raymond James, Stock Market Crashes, Term Debt
Posted in Markets | Comments Off

Caterpillar (CAT) Smashes Earnings Expectations

Thursday, January 26th, 2012

As mentioned quite a few times, despite the broad index movement, this rally has truly been concentrated on cyclical groups since the turn of the year.  Perhaps no company represents cyclical more than Caterpillar (CAT), certainly within the industrial space.  As you can see from the chart below the stock took off at the turn of the year and simply has not looked back despite a bevy of secondary indicators indicating extreme levels of overbought.  There is a relentless asset allocation trade going on here, which seemingly is ignoring traditional levels of excess in this group of stocks.

On a fundamental basis the company continues to stand as one of the best purveyors of the ultimate global multinational with all the benefits of tax rate arbitrage, global labor arbitrage, emerging growth spending (government and private sector), etc.  The company yet again smashed estimates ($2.32 v $1.73) on very impressive 35% sales growth (inclusive of the Bucyrus acquisition).  Guidance for 2012 was also raised.  CAT continues to hit on all cylinders.

• U.S.-based Caterpillar reported net income of $1.55 billion, or $2.32 per share, up from $968 million, or $1.47 per share, in the same quarter last year.  Revenue increased 35% to $17.24 billion.  Analysts polled by FactSet expected a profit of $1.76 per share on $15.95 billion.
• Caterpillar expects a 2012 profit of $9.25 per share and $68 billion to $72 billion in revenue. Analysts expect a profit of $9.07 per share on $66.99 billion in revenue.

Disclosure Notice

Any securities mentioned on this page are not held by the author in his personal portfolio. Securities mentioned may or may not be held by the author in the mutual fund he manages, the Paladin Long Short Fund (PALFX). For a list of the aforementioned fund’s holdings at the end of the prior quarter, visit the Paladin Funds website at http://www.paladinfunds.com/holdings/blog

Tags: Acquisition Guidance, Arbitrage, Asset Allocation, Bevy, Caterpillar Cat, Disclosure Notice, Emerging Growth, Extreme Levels, Fundamental Basis, Index Movement, Industrial Space, Mutual Fund, Net Income, Personal Portfolio, Portfolio Securities, Private Sector, Purveyors, Smashes, Stand As One, Tax Rate
Posted in Markets | Comments Off

December Government Reported Employment Increases 200,000. Unemployment Rate 8.5%

Friday, January 6th, 2012

As always the overreaction to a number that is revised substantially is a bit humorous but here is what the government is reporting on first revision for December:

+200,000 (v 155,000 expected)

Private sector +212,000; public sector -12,000

Unemployment rate down to 8.5% (vs 8.7% last month)

U-6 (broader unemployment) 15.2% v 15.6%

Workforce again dropped (which is largely why the unemployment rate is dropping) – labor force participation down to 64% – new readers if the labor force participation rate was “normalized” we’d be seeing the unemployment rate 2% higher than it is now.

Hourly earnings +0.2% versus flat last month.  Workweek up to 34.4 vs 34.3 hours – these 2 points are good.

Full report here.

Disclosure Notice

Any securities mentioned on this page are not held by the author in his personal portfolio. Securities mentioned may or may not be held by the author in the mutual fund he manages, the Paladin Long Short Fund (PALFX). For a list of the aforementioned fund’s holdings at the end of the prior quarter, visit the Paladin Funds website at http://www.paladinfunds.com/holdings/blog

Tags: Disclosure Notice, Employment Rate, Force Participation Rate, Government Employment, Hourly Earnings, Labor Force Participation, Labor Force Participation Rate, Mutual Fund, Overreaction, Personal Portfolio, Portfolio Securities, Private Sector, Public Sector, Unemployment Rate, Workforce, Workweek
Posted in Markets | Comments Off

Calculating the Impact of the Keystone Pipeline

Tuesday, December 27th, 2011

Global markets have been tough in 2011 but I look forward to a strong 2012. To kick the year off, we’ve scheduled a special webcast with John Mauldin and our investment team to discuss our outlook for the coming year.

Make sure to register and add it to your calendar.

Mauldin is a wizard when it comes to markets and his annual outlook pieces are a perennial “must read” for global investors. His Thoughts from the Frontline e-newsletter is also distributed weekly to more than 1 million readers.

In this week’s edition, Mauldin shared his thoughts regarding the Keystone Pipeline that I thought you might find interesting. He begins with a short discussion from his book, Endgame, on the budget balance struggle that countries face when the private sector is deleveraging, and continues with a candid commentary on America’s dependence on energy and the impact of the proposed pipeline:

The desire of every country is to somehow grow its way out of the current mess. And indeed that is the time-honored way for a country to heal itself. But let’s look at yet another equation to show why that might not be possible this time. It is yet another case of people wanting to believe six impossible things before breakfast.

Let’s divide a country’s economy into three sections: private, government, and exports. If you play with the variables a little bit you find that you get the following equation. Keep in mind that this is an accounting identity, not a theory. If it is wrong, then five centuries of double-entry bookkeeping must also be wrong.

Domestic Private Sector Financial Balance + Governmental Fiscal Balance – the Current Account Balance (or Trade Deficit/Surplus) = 0

(By Domestic Private Sector Financial Balance we mean the net balance of businesses and consumers. Are they borrowing money or paying down debt? Government Fiscal Balance is the same: is the government borrowing or paying down debt? And the Current Account Balance is the trade deficit or surplus.)

The implications are simple. The three items have to add up to zero. That means you cannot have surpluses in both the private and government sectors and run a trade deficit. You have to have a trade surplus.

Thus the problem of Greece, with its massive trade deficit and huge fiscal deficit. They have no choices but default or depression.

The U.S. has two main sources of its trade deficit: energy and China, in roughly equal proportions. If we reduce our energy dependence, we can get the trade deficit below 2% of GDP.

The China problem is not simply one of reducing our trade deficit with China, as much of what China makes and sells to the U.S. is sourced in countries outside of China. While the final manufacture is perhaps in China, the bits and pieces come from other parts of Asia. The true cost of a product from China is less than 20% actual Chinese value added. An example is the Apple iPhone, which is assembled in China but whose most costly components come from elsewhere in Asia. Direct Chinese costs are less than 4%, but the entire amount is “attributed” to China in calculating the trade deficit.

The real problem is the demand in the U.S. for cheaper goods. If the U.S. were to pass a tariff on Chinese-manufactured goods, then production and buying would shift to other countries without the tariffs. Markets look for the lowest-price source. For a tariff to be truly effective, it would have to be on the product and not the source country. And the only way to do that is to start a trade war. That is typically not a good way to promote free markets and general prosperity. Think Smoot-Hawley in the 1930s.

On the other hand, the U.S. can do something about its energy dependence. We are blessed with abundant energy, if we simply exploit it in a responsible manner. And doing so would directly create hundreds of thousands of jobs, many of them quite high-paying, and many more hundreds of thousands of jobs servicing those employed and their companies.

Which brings us to the rather strange case of the Keystone XL Pipeline project. For non-U.S. readers, this is to be a 1,700-mile pipeline designed to connect Canada’s oil production in the province of Alberta with the U.S. Gulf Coast. The various government agencies of the current U.S. administration approved the project, after exhaustive environmental impact analyses. President Obama overruled his subordinates, postponing a decision until 2013, after the next election. Even though labor unions (normally thought of as Democratic and Obama allies) actively supported the project (as it means lots of jobs), various environmental lobbies were against it, and Obama apparently gave into them. (That is not just my opinion, but widely assumed, even by Democratic supporters.)

This issue has raised a few questions from international readers, wanting to know why so many people (the large majority of US voters, if polls are right) are seemingly willing to hurt the environment simply for the purpose of transporting oil. Wouldn’t a new pipeline create a whole new host of environmental dangers? What were we thinking?

As it turns out, a new pipeline is not all that radical. If you drive in the U.S., you cannot go ANYWHERE for any length to time without crossing dozens of pipelines that already exist, especially in the corridor where they want to build the Keystone XL pipeline.

Let’s look at two maps. The first is a map of natural gas pipelines in the U.S. To say it looks worse than your grandmother’s varicose veins is no exaggeration. It is hard to find a state that does not have a natural gas pipeline. Without them the U.S. would simply come to a grinding halt. (The source for this map is a governmental agency, the U.S. Energy Information Administration.)

The next map is just the major oil pipelines. If you were to add in all the small (8-inch or less) lines connecting minor oil fields, you could not distinguish between the lines in certain areas, as we will see in the third chart.

This next chart I throw in because it also shows the rather extensive pipeline system in Canada. This chart combines commodity pipelines of all kinds. The point is that we have the technology to build pipelines safely and in an environmentally reasonable way. When was the last time you heard of a serious pipeline disaster, or even a small one? Yes, the BP oil rig certainly comes to mind, but that was human error and not the fault of technology. Just as the large majority of airplane accidents are pilot error, you do everything you can to minimize the impact, and require safety procedures. But people screw up every now and then.

This is not to dismiss the problems and environmental concerns of drilling for petroleum products, or mining for various minerals. There needs to be strict controls on all such activities, with real penalties. You can see from the maps that my home state of Texas has a lot of pipelines and wells. The problems with pollution in the early development phase here in Texas were well-known. Now there is a very aggressive and popular regimen of control of drilling and transportation of oil and gas. We have to live next to the wells and pipelines. No one wants their water or land destroyed.

Now, let’s circle back to the Keystone Pipeline. We started this section with a reference to trade deficits. And this is Canadian oil, not U.S. oil. So it does not help our trade deficit directly, although a large portion of U.S. dollars that go to Canada come back to the U.S. Canada is far and away our largest trading partner and major energy supplier.

The problem is that the opposition is mainly of the “I don’t like any carbon-based energy” variety. Whether it is coal or oil or natural gas, it is not as “clean” as solar or wind.

The problem is that solar and wind simply cannot produce enough energy without huge government subsidies, at least with current technology (although that will change over time). In the meantime, if we want to balance our budget in the U.S. (and we must!), we are going to have to become energy independent as one part of the solution. In the short term (10-15-20 years), that means carbon-based energy. If we can produce our energy in the U.S., and we can, then why not create the jobs here rather than elsewhere, if jobs are our #1 political concern, as they seem to be, according to the polls? Further, in the short term, as Mexican production is falling rather fast, we are going to need that Canadian oil if prices are not going to rise.

(Note: in my book, I actually call for a slowly rising energy tax on gasoline usage, to be solely used for rebuilding our decaying infrastructure, so I am not against higher prices per se. I just want the reason for higher energy costs not to be shortages. But that’s another story for another day.)

In the “payroll tax cut” bill that will be passed in a few days here in the U.S., Congress will require the President to make a decision by the end of February on whether to allow the Keystone project. I hope they do pass it, and I hope he does decide to allow it.

But let’s not think that this one more pipeline is going to destroy the environment of the U.S. It might create competition for some U.S. producers, but if you can’t live with competition then you’re in the wrong country.

The U.S. is in a very deep hole. We need to stop digging and start figuring out a way to climb out. The world is sadly going to see what happens when Europe has to resolve its current crisis, one way or another, and what that will mean for world GDP growth. Then, I am afraid, Japan will be the next crisis in waiting.

The world can ill afford for the U.S. to be the third major economy to implode. The world is far too connected to shrug off such problems.

Register for Outlook 2012 Webcast

Follow the event on Twitter #Outlook2012

Tags: Account Balance, Borrowing Money, Budget Balance, Candid Commentary, Current Account, Debt Government, Double Entry Bookkeeping, Endgame, Financial Balance, Fiscal Balance, Global Investors, Global Markets, Investment Team, John Mauldin, Keystone, Pipeline, Private Government, Private Sector, Six Impossible Things, Trade Deficit
Posted in Markets | Comments Off