morph366

The Euro in 2012: expect more testing times

2012-01-02T10:47:00.000-08:00

The following comes from an article published here as well as on this site in February 2011 and seems just as relevant today as then

If E-bonds are a non-starter, and if the Germans are only committed to a pro-rated liability for anything that can go wrong within the Eurozone states, is it right for the CRAs to continue to rate the securities issued by any new facility as AAA? While Moody’s and S&P analysts may possibly ponder that question, the capital markets may well be moving towards another test of the issue. But again, there is a danger in thinking that they are only testing the size of the facility… more seriously they may be ultimately testing the nature of the legal guarantee behind the facility.

2 and 20 anyone?

2012-01-02T10:22:00.000-08:00

Can the technocrats save the euro?

2012-01-02T07:40:00.000-08:00

Downward adjustment to the external value of a currency has traditionally been one important policy tool which can benefit an economy which is uncompetitive and in need of a stimulus from increased exports. In addition, there should eventually be enhanced capital inflows following such an adjustment, as the risk to foreign capital investors is reduced as the exchange rate corrects to more long term sustainable levels.

The troubled economies of the Eurozone have the problem that they effectively are imprisoned within a foreign currency - the euro - since its external value is not something that can be managed down by for example the Greek, Spanish, Portuguese or Italian governments.

The problem is compounded because, even if deemed appropriate by the EZ as a whole, an adjustment down of the euro by as much as 30% - which many feel is required in order to be of benefit to the peripherals, just doesn't look feasible in a weak global economy with signs of protectionist rhetoric already, and which is likely to become even more prevalent in a year with many key elections.

There would be an extremely high hurdle to overcome for a policy initiative which might hypothetically be adopted by the ECB to engineer a gradual decline of the euro towards parity with (say) the US dollar, which is what a 30% decline would amount to.

In essence the major hurdle is that the Federal Reserve, the PBOC, other Asian central banks and even the central banks within Europe that are not part of the Eurosystem, would not condone it. Simply stated they do not want high quality goods from Germany and other efficient EZ economies becoming even more attractive as they become cheaper under such an ECB competitive devaluation initiative. This would, in the context of election flavored rhetoric, pose even more "unfair" competition for home-grown wares in global markets.

Despite the likelihood of strong tail winds behind it from FX speculators, a concerted effort to reduce the value of the euro against the other major currencies would face strong head winds from those other central banks that are focused on enhancing (or at least preserving) their own "competitiveness".

The growing realization that there may be no possibility of a gradual and technocratically "managed" solution to the current vicious circle of more austerity/ weaker economic performance/growing public deficits for the EZ peripherals, could well result in one or more of them seeing the benefit of taking a similar route to the one that Iceland has taken. The problem is, of course, that the consequences for the global banking system of a possible euro collapse would be of a completely different order of magnitude to that resulting from the collapse of the Icelandic krona.

One can only wonder at how little time and attention must have been invested in risk modelling by the architects of the Maastricht treaty and the EMU project.

Surely the pundits can't be wrong over Meredith Whitney bashing, can they?

2012-01-02T06:05:00.000-08:00

This chart can be found at M3 Financial Sense which is one of the most stimulating TA flavored blog sites that I look at.

The Supreme Currency 1999-2012

2011-12-31T09:55:00.000-08:00

Notice how the Fiat, Citroen and car with the Spanish flag behind the limousine, are having to be pushed along.

By Patrick Blower in The Daily Telegraph, December 31, 2011

Sovereign debt in 2011

2011-12-30T08:27:00.000-08:00

Excluding the usual suspects at the bottom of the table, sovereign debt outperformed, by a considerable margin, most global equity indices.

Eurosystem balance sheet heading to Euro 3 trillions

2011-12-29T09:37:00.000-08:00

Long and low and the outlook for bond price volatility

2011-12-28T08:12:00.000-08:00

When thinking about bond price volatility it might be useful to have the image of a crocodile in mind. Modified duration (MD) - where the maths is not that challenging but need not detain us here - is a measure of the approximate sensitivity of the price of a bond to a given change in interest rates - say one percent.

The highest MD is to be found with low coupon bonds with a long time left to redemption, and a mnemonic for the notion of long and low that I have found useful is the image of the crocodile.

With the yield on 10 year UST's below 2% and 30 year UST's below 3% as we close out 2011 those portfolio managers that are stuffed to the gills with the aforementioned paper had better be hoping that interest rates continue to decline since they will be getting the best bang for their bucks if rates are going down. But then again one of the last places to be should interest rates begin to climb will be in high MD bonds.

Just to elucidate further, high duration and high beta are often considered together from the perspective of asset allocation. Just as high beta small cap equities are not a good place to be during a significant stock market correction, long and low UST's might just bite the hand that's feeding them when (eventually) rates start moving higher.

How to get a job at Royal Bank of Scotland

2011-12-24T02:48:00.000-08:00

Young Paddy bought a donkey from a farmer for £100. The farmer agreed to deliver the donkey the next day.

The next day he drove up and said, 'Sorry son, but I have some bad news. The donkey's died.'

Paddy replied, 'Well then just give me my money back.'

The farmer said, 'Can't do that. I've already spent it.'

Paddy said, 'OK, then, just bring me the dead donkey.'

The farmer asked, 'What are you going to do with him?'

Paddy said, 'I'm going to raffle him off.'

The farmer said, 'You can't raffle a dead donkey!'

Paddy said, 'Sure I can. Watch me. I just won't tell anybody he's dead.'

A month later, the farmer met up with Paddy and asked, ' What happened with that dead donkey?'

Paddy said, 'I raffled him off. I sold 500 tickets at £2 each and made a profit of £898'
The farmer said, 'Didn't anyone complain?'

Paddy said, 'Just the guy who won. So I gave him his £2 back.'

Paddy now works for the Royal Bank of Scotland.

Ultra high incomes: agency/principal neglect

2011-12-23T08:30:00.000-08:00

Martin Wolf wrote an interesting piece in the FT on the growing gap between those with median incomes in both the US and UK and the super wealthy. One of the most perceptive remarks he makes is as follows:

People will disagree over why rising inequality matters and what should be done about it. I suggest it matters most, at least in the high-income countries because it both undermines hopes for any reasonable degree of equality of opportunity and cements the inequalities in power that have, in turn, allowed the preservation of a wide range of privileges, particularly in taxation.

These outcomes should matter even to those who have no concern for equality of outcome. I would add that some – perhaps a great deal – of the ultra-high incomes at the top are almost certainly the fruit of rent extraction facilitated by a breakdown in the control exercised by principals – outside investors – over their agents – corporate executives and financiers. Huge rewards then are both unjust and inefficient.

EFSF chief sounds confident about sufficient funding...doesn't he?

2011-12-17T08:41:00.000-08:00

Al Jazeera has a substantial and candid interview with Klaus Regling, the EFSF chief, which is well worth watching. I came away with the sense that, although he stated early in the interview that the facility has more than enough firepower to handle potential crises from Italy and Spain, as the questioner kept probing about the possibility of downgrades from the CRA's for the major guarantors of the EFSF, his confidence in the adequacy of the facility's funding became much less reassuring (even to himself).

Also worth referencing back to this piece here from July.

Should we be more or less comfortable that the stability facility is up to the task now? See what you think after watching Mr. Regling.

New fiscal pact for EZ

2011-12-11T05:47:00.000-08:00

Will those states within the EZ that exceed the new limits on budget deficit to GDP (apparently set at 0.5% but who knows) be able to borrow the money from Germany (or the ECB) to pay the fines?

The EMU monetary convergence myth exploded

2011-12-10T08:30:00.000-08:00

The chart below reveals more clearly than endless obtuse verbiage what is going wrong for those EZ states that are committed to using a "foreign" currency i.e. the euro.

Good news for those who like Swiss francs...there are now a lot more of them!

2011-12-10T08:07:00.000-08:00

The only major country within Europe which is neither a member of the EU or the EEA is the euro's biggest supporter.

Source The Swiss National Bank

"It means what I choose it to mean"

2011-12-10T05:42:00.000-08:00

'You don't know what you're talking about!' cried Humpty Dumpty. 'How many days are there in a year?'
'Three hundred and sixty-five,' said Alice.
'And how many birthdays have you?'
'One.'
'And if you take one from three hundred and sixty-five what remains?'
'Three hundred and sixty-four, of course.'
Humpty Dumpty looked doubtful. 'I'd rather see that done on paper,' he said.
Alice couldn't help smiling as she took out her memorandum book, and worked the sum for him:
365
1
----
364
----
Humpty Dumpty took the book and looked at it carefully. 'That seems to be done right —' he began.
'You're holding it upside down!' Alice interrupted.
'To be sure I was!' Humpty Dumpty said gaily as she turned it round for him. 'I thought it looked a little queer. As I was saying, that seems to be done right — though I haven't time to look it over thoroughly just now — and that shows that there are three hundred and sixty-four days when you might get un-birthday presents —'
'Certainly,' said Alice.
'And only one for birthday presents, you know. There's glory for you!'
'I don't know what you mean by "glory",' Alice said.
Humpty Dumpty smiled contemptuously. 'Of course you don't — till I tell you. I meant "there's a nice knock-down argument for you!"'
'But "glory" doesn't mean "a nice knock-down argument",' Alice objected.
'When I use a word,' Humpty Dumpty said, in rather a scornful tone, 'it means just what I choose it to mean — neither more nor less.'
'The question is,' said Alice, 'whether you can make words mean so many different things.'

EFSF structure: actual and simplified

2011-11-13T10:15:00.000-08:00

Hours required by US workers to buy the S&P 500

2011-11-13T05:29:00.000-08:00

Brain Dead

2011-11-13T03:06:00.000-08:00

ATTORNEY: Doctor, before you performed the autopsy, did you check for a pulse?

WITNESS: No.

ATTORNEY: Did you check for blood pressure?

WITNESS: No.

ATTORNEY: Did you check for breathing?

WITNESS: No..

ATTORNEY: So, then it is possible that the patient was alive when you began the autopsy?

WITNESS: No.

ATTORNEY: How can you be so sure, Doctor?

WITNESS: Because his brain was sitting on my desk in a jar.

ATTORNEY: I see, but could the patient have still been alive, nevertheless?

WITNESS: Yes, it is possible that he could have been alive and practicing law.

S&P 500 down 30% in real terms since 2000

2011-10-09T03:38:00.000-07:00

Eurozone Bonds perhaps, but with one less AAA guarantor?

2011-08-06T10:53:00.000-07:00

Here is a slightly modified extract from an article which appeared here in February entitled Macro Eurozone Risk: We're all in this together aren't we?

Some have suggested that the best way around the difficulties of designing a new architecture for the EFSF or its successor would be to grant the ECB the power to issue new E-bonds, but this may have the unintended consequence of highlighting the legal flaw that the current guarantees for the EFSF are several but not joint. It would also certainly require major EU treaty changes and plebiscites in many states with highly uncertain outcomes, not something favored by those anxious to solve the current Italian debt crisis in a hurry.

Interestingly one of the main critics of E- bonds is the current ECB president as this article makes clear.

BRUSSELS (MNI) - The European Central Bank maintains its position that eurobonds with a "joint and several" guarantee would not be appropriate given the present circumstances in the European economies, ECB president Jean-Claude Trichet said.

"In the ECB, as you know, we are not in favour of European bonds in which the European countries would be joint and several. We don't consider it is something that would be appropriate in the present circumstances," Trichet told the European Parliament's Economic and Monetary Affairs Committee.

Just to be totally clear and unambiguous on the matter – never something that a central banker should really do – the following direct quotations from M. Trichet are also on the record of the European Parliament:

1."We are not ourselves in favour of issuing securities, treasuries that will be joint and several," Trichet told the European Parliament.

2. "We consider it is good that each particular state, each particular treasury has its own refinancing and has its own way of being on the market."

If E-bonds are a non-starter, and if the Germans are only committed to a pro-rated liability for anything that can go wrong within the EZ states, is it right for the CRA’s to continue to rate the securities issued by any new facility as AAA? While Moody’s and S&P analysts may possibly ponder that question, the capital markets are moving towards yet another test of the issue. But again there is a danger in thinking that they are only testing the size of the facility… more seriously they are testing the nature of the legal guarantee behind the facility, or any EZ facility.

The ultimate test for any structure that the EZ might try to devise as a way of containing the threat of further contagion hinges on how the federalists can counter the strong conviction within the Bundesbank and parts of the German government that it would be prudent to step away from the forces of encroaching fiscal unification, fiscal transfers and complete financial integration of the EZ, which would result in Germany effectively providing a safety net under the whole EZ project.

The easiest way out of this impasse would seem to be for Germany to cap its obligations and future contributions to the ECB capital structure rather than leaving the bank with an open cheque as it is committed to at present, and to seek an exit from the EFSF artifice sooner rather than later.

If Germany did exit the Eurozone experiment it would reduce the number of EZ states to sixteen and the number of AAA guarantors to four. Of the other twelve "guarantor" states many, it could be argued, are either basket cases or candidates themselves for financial rescue. So exactly how the EFSF architecture - notwithstanding the over-collateralization and credit enhancement features - is supposed to provide comfort to investors in EFSF paper is left to the reader's imagination.

What is clear is that without Germany the EFSF is a paper tiger, and that brings us back, in circular fashion, exactly to the reason why it is too onerous for Germany to continue the charade that "We're all in this together aren't we ( as long as it's all pro rata )?"

Signs that are becoming part of life in Tokyo

2011-07-31T03:25:00.000-07:00

Italy's regions are microcosm of the European Union

2011-07-23T02:31:00.000-07:00

Merkel/Sarkozy lost in an Escher like maze with no exit

2011-07-21T01:42:00.001-07:00

The onslaught of headlines in this morning's media (July 21st) exclaiming that we have reached the day of reckoning for the Euro project etc. etc. suggests a rather apt metaphor which sums up the bind that EZ leaders find themselves in.

According to reports on talks that took place for most of the preceding day Angela Merkel and Nicholas Sarkozy would appear to be completely and frustratingly lost in an Escher like maze, where even trying to get back to the entry point (rediscovering EMU structural flaws at its inception) is not only historically impossible but also topographically impossible

This only goes to highlight the hubris and financial engineering mistakes made by those who conceived the idea of a single currency club and were then very lax about handing out membership cards.

To extend the metaphor even further it is as if they are literally imprisoned in a construct similar to those M C Escher drawings where, quite simply you cannot get there from here.

Larger Private Sector not good for GDP growth

2011-07-20T07:53:00.000-07:00

Chart: Penile Length Leads to Little Economic Growth

The following article is provided without comment.

DINO GRANDONI JUL 18, 2011
The opening question to most undergraduate macroeconomics courses usually is, "Why are some countries rich and others poor?" The lecturer will then probably dive into all of the usual suspects behind economic growth--natural resources, technological innovation, savings rate--without mention of perhaps the most primal of measurements: penis size.

That's right, penis size. In a study published today, the University of Helsinki's Tatu Westling points out a surprising strong correlation between a country's GDP growth rate and average penile length. As the chart above shows, countries that averaged smaller penis sizes grew at a faster rate than their larger counterparts between 1960 and 1985. Every centimeter increase in penis size accounted for a 5 to 7 percent reduction in economic growth. The study also showed that overall GDP was at its highest in countries with average-sized penises with GDP falling at the extremes of penis length.

As Westling explains in his paper, previous studies "concentrate on economic, social and political factors, these and many related treatments largely abstain from biological and/or sexual considerations. The aim of this paper is to fi ll this scholarly gap with the male organ." Interesting choice of words (the study is full of them, as you'll see below), but why should this particular, um, unit have any explanatory power? Penis size and economic growth might be related through some intermediary variable like gender equality, political stability, or population growth, Westling writes, but he seems to prefer an admittedly more Freudian explanation that goes like this: Penile length and income are both factors that contribute to an individual's level of self-esteem, and if a person has more of the former, he'll need less of the latter. Or, to put it in layman's terms, some fast-growing countries may be compensating for something. Not a particularly poor argument until you realize, as Westling acknowledges, that half the world's population don't have penises.

As Westling told the GlobalPost, he was only half-serious about the study until he saw such a strong statistical correlation. "But seriousness," he says, "does not imply that I believe in causality at this point." That seriousness doesn't always quite come through given the way some things are worded in the study. Here are some choice quotes; sometimes it's not entirely clear if the double entendres are intentional.

Taken at face value the findings suggest that the `male organ hypothesis' put forward here is quite penetrating an argument. Yet for the best of author's knowledge, male organ has not been touched in the growth literature before.

...the `small male organ' countries would gain more utility by expanding their economy than the `large male organ' countries. Actually the latter populations would simply exploit their nature-given, non-disposable groin-area endowments.
And finally...
It clearly seems that the `private sector' deserves more credit for economic development than is typically acknowledged.
Zing!

At critical times markets need disambiguation

2011-07-17T08:33:00.000-07:00

Much of the time, during non-critical phases, capital markets will embrace the ambiguities being promulgated (spun) by central bankers, policy makers, and analysts, and this provides the basic disagreements about price and value amongst traders and investors which promotes liquidity. There is no urgent demand for transparency or unequivocal clarification of systemic information. Risk appetites and complacency levels are relatively high.

But from time to time, when a disruptive event occurs or when markets have moved into a critical phase -as they are now with regard to the Eurozone crisis specifically, and to some extent with the US debt ceiling "crisis" (or melodrama) - market participants will immediately press for disambiguation on as many fronts as possible. Risk aversion moves to center stage, non-equivocation is demanded, and the fractiousness which enables liquidity, is replaced by a coherent viewpoint which results in markets becoming lopsided with a subsequent (and sudden) drop in liquidity.

The longer the demand for disambiguation goes accompanied by a failure by policy makers to be decisive and provide unambiguous answers, the greater the risk of systemic accidents and a complete collapse in liquidity. When markets reach such critical stages - and we could be getting quite close to one in the mid summer of 2011 - the more likely it will be that there are no private bids only private sellers that ultimately will be seeking out public sector bids (i.e. bailouts).

Defaulting: Keep it simple

2011-07-17T08:01:00.000-07:00

If your income is less than your expenses and you can’t borrow money, you are insolvent and should be required (not allowed!) to default.

The PBOC has a larger wallet than the BOJ

2011-07-17T07:37:00.000-07:00

With the highest debt/GDP ratio in the developed world (at well in excess of 200%) and with yields on its 10 year bonds at just a fraction over one percent there is a real enigma about the macro financial picture in Japan. In recent weeks, despite the protestations of the BOJ, including a round of intervention in the FX market, the yen has continued to strengthen against most major currencies. On July 15th, USD/JPY closed below the pivotal 80 level and during the course of the preceding week had reached back down to within less than 300 pips of the historic lows seen right after the tragic events of March 11th.

Here are just two observations on key factors that keep pushing the yen higher. Both of them reflect the activity of the People's Bank of China (PBOC)

The PBOC have at least two motives for wanting to see a strong yen:

1. China is extremely keen to diversify its holdings of FX reserves so that it is less reliant on the USD (esp if more QE is on the horizon) and the yen is a currency for which there is a deep and liquid market.

2. The higher the yen is against the US dollar and other currencies the more competitively priced will be Chinese goods, priced in RMB which is fixed against the dollar, for exporting to major consumer markets.

Despite what the BOJ may say the PBOC have a larger wallet.

Will Germany take the Mister Creosote option?

2011-07-17T03:59:00.000-07:00

In a nutshell the hard problem which has to be resolved in the Eurozone crisis can be reduced to this simple question: "Will Germany backstop the entire obligations of the EFSF, or whatever mechanism is put in its place to "assist" those EZ states that are insolvent, or not?

The head of the Bundesbank Jens Weidman was quoted recently as follows

"Nothing would destroy the motivation for solid budgetary policies faster than joint liability for (EZ) state debts" [emphasis added]

There is a huge difference between a backstop up to a limit - which for Germany at present under the current EFSF framework is approximately 27% or, to use the inimitable words from Mr Creosote, when faced with a menu of many options, choose to backstop "the lot". It comes down to the difference between a joint guarantee or a several guarantee. While Germany insists on the latter - which is the position of the German central bank chief and Angela Merkel, the legal framework of the EFSF would not provide suitably enduring underpinnings for the issuance of Eurobonds with a bulletproof AAA rating.

As others have argued there may well be contamination already within the capital structure or tranches of the CDO which is the framework of the EFSF. For Germany to agree to a joint guarantee of all of the obligations of the facility - which in effect would mean that in a worst case scenario it could end up on the hook for the lot would impair Germany's credit rating - and according to one very insightful analyst that process may currently be under way.

The existential risk for the German government - and the electorate - can be simply expressed in the analogy of a group of mountain climbers who are all inextricably linked together; if the most vulnerable was to fall it has the potential for "the lot" to fall into the abyss.

Expressed even more grotesquely it is worth remembering what happened to Mister Creosote when he elected to go for the lot.

World is drowning in supposedly risk free debt -but is AAA risk free?

2011-07-16T02:17:00.000-07:00

The chart above was shown in a very good article from FT Alphaville from July 15th written by Tracy Alloway. To cut to the chase the main point of the piece is to expose the complacent manner in which so much debt is being piled up with AAA ratings which, at least according to canonical notions in finance, is supposedly risk-free. Whether or not one can have confidence that all of this annual issuance is without risk is left for the reader to judge.

Here is an explanation of what the chart shows from Felix Salmon.

At the left-hand side of the chart we see that global issuance of triple-A bonds was more or less nonexistent back in the early '90s. All those Treasury bonds, all those agency securities from Fannie (FNMA.OB) and Freddie (FMCC.OB), all that Japanese debt — add it all up, and it still comes to essentially zero by the standards of what seems normal today. Check out the left-hand y-axis: it goes up in $1 trillion increments. And we’re not talking stock, here, we’re talking flows: this chart is issuance per year.

(It’s pretty easy to see, looking at this chart, how a company like Pimco can find itself with over $1 trillion in assets under management: that’s now just a small fraction of the bonds issued each year.)

Now zoom back, and look at the chart as a whole: it’s going up and to the right, which says two things. Firstly, the amount of debt in the world is soaring. That’s a bad thing, because debt is much more systemically dangerous than equity. And secondly, the amount of triple-A debt in the world is soaring as well. Which is a worse thing, because triple-A debt is much more systemically dangerous than most other debt.
Then look at the green line. Triple-A debt wasn’t a huge part of the bond market back in the early 90s, but for the past decade it has invariably accounted for somewhere between 50% and 60% of total global fixed income issuance. That’s possibly the most horrifying bit of all: it simply defies credulity for anybody to be asked to believe that more than half the bonds issued in any given year are essentially free of any credit risk.
Finally, look at the way that the maroon bars — structured products, basically — have given way to a scarily large purple bar at the far right of the chart. That’s sovereign debt, and it tells you all you need to know about where the next crisis is likely to come from.

In a nutshell, triple-A debt is dangerous; there’s far too much of it; its growth seems out of control; and the triple-A problem has now become a sovereign-debt problem, in a world where sovereign-debt crises are the most damaging crises of all.
All that said, there are two things worth bearing in mind which make the chart slightly less horrific. The first is that for reasons I don’t understand, the chart ends in 2009, a crisis year when sovereigns pulled out all the stops in their attempt to prevent a global Depression. We’re more than halfway into 2011 at this point, there’s no good reason why the chart couldn’t include 2010 as well. And that might show 2009 as being a bit of an aberration. Does anybody have the numbers for total triple-A bond issuance in 2010, and how much of that was sovereign?

S&P puts USA on credit watch with 50% chance of downgrade

2011-07-15T01:43:00.000-07:00

Here is the relevant text from the decision by S&P to place US debt on credit watch with negative outlook from July 14, 2011

United States of America ‘AAA/A-1+’ Ratings

Placed On CreditWatch Negative On Rising

Risk Of Policy Stalemate

Overview

Standard & Poor’s has placed its ‘AAA’ long-term and ‘A-1+’ short-term sovereign credit ratings on the United States of America on CreditWatch with negative implications.

Standard & Poor’s uses CreditWatch to indicate a substantial likelihood of it taking a rating action within the next 90 days, or in response to events presenting significant uncertainty to the creditworthiness of an issuer. Today’s CreditWatch placement signals our view that, owing to the dynamics of the political debate on the debt ceiling, there is at least a one-in-two likelihood that we could lower the long-term rating on the U.S. within the next 90 days. We have also placed our short-term rating on the U.S. on CreditWatch negative, reflecting our view that the current situation presents such significant uncertainty to the U.S. creditworthiness.

Since we revised the outlook on our ‘AAA’ long-term rating to negative from stable on April 18, 2011, the political debate about the U.S.’ fiscal stance and the related issue of the U.S. government debt ceiling has, in our view, only become more entangled. Despite months of negotiations, the two sides remain at odds on fundamental fiscal policy issues. Consequently, we believe there is an increasing risk of a substantial policy stalemate enduring beyond any near-term agreement to raise the debt ceiling.

As a consequence, we now believe that we could lower our ratings on the U.S. within three months.

We may lower the long-term rating on the U.S. by one or more notches into the ‘AA’ category in the next three months, if we conclude that Congress and the Administration have not achieved a credible solution to the rising U.S. government debt burden and are not likely to achieve one in the foreseeable future.

We still believe that the risk of a payment default on U.S. government debt obligations as a result of not raising the debt ceiling is small, though increasing. However, any default on scheduled debt service payments on the U.S.’ market debt, however brief, could lead us to revise the long-term and short-term ratings on the U.S. to ‘SD.’ Under our rating definitions, ‘SD,’ or selective default, refers to a situation where an issuer, the federal government in this case, has defaulted on some of its debt obligations, while remaining current on its other debt obligations.

We may also lower the long-term rating and affirm the short-term rating if we conclude that future adjustments to the debt ceiling are likely to be the subject of political maneuvering to the extent that questions persist about Congress’ and the Administration’s willingness and ability to timely honor the U.S.’ scheduled debt obligations.

Convergence/Divergence of Greek and German bonds

2011-07-12T08:46:00.000-07:00

So what’s the takeaway? Basically investors front-ran the inclusion of Greece into the eurozone. The trade worked. A lot of people made a lot of money as the spreads came in to Germany as expected. And on the face of it, some of the statistics such as Greek inflation numbers seemed to back up the story that the Greek economic/technocratic establishment was starting to behave in a way that would be more favorable to bond investors. (Although, as we know now, it would have been a good idea to view those stats with some skepticism.)

But in giving a quick glance to the coverage of the great convergence, it’s tough to find any indication that anybody really understood what what “convergence” really was and how it explained bond yields that low. In short, it was a trade that worked, until recently, when it stopped working.

Source

Key US Employment Metrics

2011-07-10T12:19:00.000-07:00

EFSF not funded sufficiently to deal with rescue of Italy

2011-07-10T09:49:00.000-07:00

As Reuters has reported the EFSF does not have sufficient guarantees in place to rescue Italy should that be required.

(Reuters) - The existing European rescue fund now in place is not large enough to protect Italy as it was never designed to do that, an unnamed European Central Bank source was quoted telling Die Welt newspaper on Sunday.

"The existing rescue fund in Europe is not sufficient to provide a credible defensive wall for Italy," the central bank source was quoted telling the newspaper in an advance text of an article to appear on Monday.

"It was never designed for that," the source added.

The newspaper said that the rescue fund might have to be doubled to up to 1.5 trillion euros. But it was not clear if it was the central bank source calling for the increase.

There was a sharp sell-off in Italian assets on Friday, which has increased fears that Italy, with the highest sovereign debt ratio relative to its economy in the euro zone after Greece, could be next to suffer in the crisis.

Why Italy really matters for the Eurozone

2011-07-10T07:41:00.000-07:00

As the graphic reveals the CDS market for Italian debt is particularly vulnerable and as useful background the following is excerpted from an article in the FT for July 10th.

On Friday, yields on Italian government debt – the largest bond market in Europe – hit their highest levels since October 2002. Italy is now borrowing at its biggest premium over German bunds, the benchmark for the region.

The move followed the surfacing last week of tensions between Silvio Berlusconi, prime minister, and Giulio Tremonti, Italy’s finance minister, over the country’s proposed austerity programme.

Good Graphic on System Risk from Greek default

2011-07-05T03:09:00.000-07:00

Grecian tragedy - a sideshow to the main event

2011-06-25T09:37:00.000-07:00

The following excerpt comes from a very good article written by Justin Webb who was the BBC's North American editor for eight years.

America's federal government debt is growing at $40,000 per second. It has reached $14 trillion, whatever that means. More comprehensible perhaps is this fact: the debt will soon match the entire GDP of the United States. Outside wartime, that has never happened before.

A combination of tax cuts and spending increases, coupled with the war on terror and the financial meltdown, has seen America's fiscal health evaporate.
Even the savings implied last week in the surge home of US troops from Afghanistan, count for little more than a drop - a splash, perhaps - in this ocean of debt.
The real issue is the future of America's domestic spending.

The projections are appalling: the non-partisan Congressional Budget Office thinks that by 2030 interest payments plus spending on pensions and health will take up all the government's tax income. Everything else, from education to war-fighting, will have to be borrowed for. Or cut out.

Distribution of High Net Worth Individuals

2011-06-25T08:59:00.000-07:00

Source and document here

Heads we win, tails you lose

2011-06-25T08:18:00.000-07:00

The good news for lawyers advising the ECB and EZ ministers is that they may just have figured out how to roll over Greek debt without triggering a credit event or default in the near term.

The bad news for many banks, especially those in the US and UK according to some reports (for example here), is that the CDS contracts which were supposed to insure them against any debt re-structuring may not be worth the paper that they are written on.

In the meantime they will just have to sit on deteriorating collateral, for which there are no bids. But from the bankers point of view the end game of course will be that should the whole EZ sovereign turn out as badly as many fear, it will be deemed to be another TBTF risk and the inter-generational theft wheeze will continue.

Variations on a moral hazard theme

2011-06-25T07:58:00.000-07:00

Contrast these two scenarios:

A medical doctor says that a patient has a life threatening condition and that unless the person suffering receives immediate treatment there is no chance of recovery. The patient and his/her family and friends will almost invariably make all of the necessary arrangements to bring about the changes required.

A leading central banker- the BOE's Mervyn King as reported here - says that essentially the problems with EZ peripheral debt are based on insolvency and not liquidity. That, in effect, extending new credit to an insolvent sovereign will simply add to the magnitude of the default when it occurs. But rather than listen to a prudent central banker (sorry but that is almost an oxymoron), the ECB and EZ leaders stand ready to shovel another Eu 120 billion to add on to the approximately Eu 200 billion that the ECB will have to write off when Greece fails.

Moral of the story is hazardous (excuse the play on words) to the public purse.

Euro politicians cannot fool markets

2011-06-25T03:32:00.000-07:00

The "founding fathers" of the European project and the bloated edifice of incumbents in Brussels will do their utmost to push towards greater integration...otherwise they would have to get real jobs. Politicians are quite adept at riding the apathy of their electorates and managing to fool most of the people most of the time- so who knows they just might be able to get a more federal system accepted by stealth

The one constituency that politicians are not good at mystifying are market traders and when the true extent of the shaky finances of the Euro system are revealed (useful to see BOE now insisting on greater transparency in this respect) it may well be that the integrationists will not have time to prevent an unravelling of the EZ.

Fed is in a fiscal box aka double bind

2011-06-23T10:57:00.000-07:00

This excerpt appeared here, and is included without comment

Right now, thanks in large part to Federal Reserve policy, Uncle Sam can borrow at an average cost of just 2.5 percent. The average borrowing cost over the last three decades was 5.7 percent. Our debt is now $14 trillion and scheduled to grow to $25 trillion by the end of the decade. If interest rates normalize over that period the added interest costs in 2021 alone will be $800 billion—more than 20 times the mere $37 billion in budget cuts that tore up Congress in March. It would take virtually all of the cuts in the Ryan budget just to cover that added interest, much less to start bringing down the national debt. Unfortunately, the Fed is now in a fiscal box. A normalization of interest rates would break the Treasury. Hence, a normalization of rates really can't happen—we're stuck in a world in which the Fed must keep rates artificially low in order to prevent a budget disaster.

EZ banks might die nationally or as part of a new European federation - outcomes might not be that different

2011-05-24T01:29:00.001-07:00

Having completely failed investors at the most critical time in generations by comprehensively misjudging the credit risk of CDO's and other exotic structured instruments, the three major credit ratings agencies (CRA's) now seem to be overly anxious not to be accused of being asleep at the wheel with respect to the Eurozone sovereign debt crisis.

S&P on May 23rd changed its outlook on Italian public debt from stable to negative and all of the agencies seem to be trying to differentiate between different shades of "junk" in regard to Greece's debt.

In the case of sovereign debt the CRA's might want to think of a new category somewhere between investment grade and default which would be equivalent to the need for creditors - in most cases private sector banks - to seek a bail out from their respective domestic public sectors.

Mervyn King once observed that the world's major banks are "global in life but national in death" and this is really the overwhelming issue beneath the tip of the iceberg that seems to preoccupy most commentary on the EZ debt crisis. Should there be an ultimate unravelling of the duct tape that is holding together the "solutions" that have been hatched by the ECB and the enormous contingent of the smartest from Europe's business schools, then it will be the German, French, Swedish, and UK governments - to name just a few - that will have to clean up the mess. And that clean up will - despite all attempts to conceal it with smoke and mirrors - amount to yet another transfer of mistakes made by hapless bankers to the future generations of European taxpayers.

One supposed way out of this outcome would be for the EZ to become something like a United States of Europe with a federal guarantee provision for the ECB and mechanisms for fiscal transfers. The only problem with this pathway is that electorates across the more prosperous parts of Europe are unlikely to enable their elected officials to enact such a re-structuring of the EMU.

Ironically if they don't act together then as the troubled European banks "die nationally" as aptly characterized by Mervyn King, the outcome may not be very different from having the whole mess transferred to a federal EZ balance sheet.

Selecting the new IMF head - awkward for China

2011-05-18T22:52:00.000-07:00

In a statement dated May 18th, 2011, Dominique Strauss Khan (DSK), has tendered his resignation as head of the International Monetary Fund (IMF) with immediate effect.

Just how momentous an event is this, and have the capital markets fully discounted the ramifications? Will the post WWII "convention" that the IMF should be run by a European, but also someone that is entirely acceptable to the US, which holds almost 17% of the voting shares for the bank, be continued?

The replacement process for DSK could become both contentious and disruptive to capital markets in fairly short order. The more obvious and immediate disruptions could manifest themselves in relation to the ongoing saga of the bail outs of the peripheral EZ nations. To put it more precisely the real saga and the IMF and EU's primary objective has been, in regard to its actions with Greece, Ireland and Portugal, to bail out the private banking sector within Europe where German, French and UK banks have particularly troublesome exposure to any sovereign debt re-structuring (or whatever is the current euphemism of the day) by these three countries -- and who knows what may lie ahead for Spain, Italy etc.

Longer term the selection and replacement procedure will almost certainly bring to the fore far more systemically troubling issues such as the antiquated structure of the IMF and the fact that, for example, Brazil has just 1.38% of the voting power within the IMF which is less than that for relatively tiny economies such as Belgium and the Netherlands. Even worse, the world's second largest economy, China, which has about 40% of the GDP of the US, has 3.8% of voting rights compared to the US with almost 17%.

Let's examine each of these potential disruptions, quite different in their order of magnitude, in turn:

Holding the Eurozone together

What would be the possible implications for the EZ debt crisis if the candidate to replace DSK was to come from one of the newer G20 economies and who was less familiar with the nuances of European politics, and quite possibly less beholden to sorting out the mess that the EZ finds itself in?

Many within the European banking system and political establishments are particularly concerned that the new IMF head should have a deep knowledge of the EZ financial landscape, its major players and has a demonstrable interest in "looking after" the interests of some of Europe's largest private banks - as well as some that are partly private and partly public e.g. RBS and Lloyds in the UK.

It has been claimed that Mr. Strauss Kahn showed an extraordinary skill at holding together the fragile consensus within the EU between contrasting viewpoints from the Germans (even within the fractious German coalition) and other EZ member states. Most mainstream economists, bankers and policy makers within Europe and North America would strongly argue that there would be a substantial risk in appointing someone to head the IMF without the nuanced knowledge of European politics along with the flawed structure of the EMU and its various "stabilization" facilities including the EFSF

The New York Times is one of many publications to be opining that Christine Lagarde, the current French Finance minister is a leading contender for replacing DSK:

Mr. Strauss-Kahn’s resignation now sets off the jockeying for his replacement. The French finance minister, Christine Lagarde, is considered the leading candidate to succeed Mr. Strauss-Kahn, her friend and colleague. Her straight talk has helped burnish Ms. Lagarde’s reputation as one of Europe’s most influential ambassadors in the world of international finance.

The fact that Madame Lagarde has emerged as a front runner so quickly, and that she has that quality so valued in bankers - a safe pair of hands, is perhaps a source of comfort to traders and asset allocators on the day that the current head's resignation has been announced. But there are also suggestions that her appointment may not be as effortless as it might seem. There clearly will be some awkward questions raised by numerous G20 nations that are economically punching above their weight in terms of their stature within the IMF, and these questions are likely to bring to the surface the glaring imbalances facing the IMF. In particular there is the highly anomalous condition where a small group of European nations enjoy unusually generous voting rights within the IMF than they would be entitled to in a system that was both merit based and a better reflection of 2011 rather than 1944. Just how well organized the pressure from newer and less empowered states remains to be seen, but there is one candidate that has already attracted attention as a possible rival to Mme Lagarde and who could potentially act as a "bridge" across the old order/new order divide. Again to quote from the NYT:

Her main competition, analysts say, is Kemal Dervis, a former finance minister of Turkey. Mr. Dervis is credited with rescuing the Turkish economy after it was hit by a devastating financial crisis in 2001, in part by securing a multibillion-dollar loan from the I.M.F. Before that, Mr. Dervis worked at the World Bank for 24 years.

The selection of Mr Dervis would be a bold move for the IMF but notably absent from the leading contenders is any one from the BRIC's or other fast growing Asian economies. Rather if Mme. Lagarde emerges as the preferred candidate the selection process will begin to appear very much like business as usual or to put it more pejoratively as a "stitch up". In other words, a coordinated effort by the old economies to hang on to the privileged positions granted to them more than 60 years ago. Even more ironic is the fact that many of these mature and "rich" economies are also the most indebted, topped by the US and UK which have public balance sheets that are financially embarrassing.

The world of 2011 is a very different place to that which emerged after the second world war in which the major powers created new global institutions to create the conditions for financial reconstruction and mechanisms to foster a more collaborative world order. But it was a world order that was almost exclusively cast in the mould envisaged by the five great powers at the time - the United States, Russia, France, the United Kingdom and China. These five states were provided with permanent seats on the UN Security Council - another global institution which emerged after the prolonged horror and destruction of WWII.

Interestingly the IMF took no such account of the pre-eminent roles that Russia and China would wield in the development of commerce and capital flows in the 60 plus years that have followed the establishment of the IMF.

Just two years ago the Indian foreign minister interviewed at the G20 conference in London ridiculed the notion that his country had no special status on the UN Security Council and that the old boy's network which still prevailed at that body was an anachronism which deserved no place in the 21st century.

But no matter how compelling the arguments from the newer and more dynamic economies may be to enhance their role and power within the IMF, there seems, at least at the time of writing, to be no coordinated effort by these economies to seize the initiatives provided by Mr Strauss-Kahn's dramatic departure.

TThe WSJ points this out in the following piece

It isn't clear that emerging economies are ready to agree on a single candidate. Brazil's finance minister Guido Mantega said the top IMF role shouldn't be reserved for a European. South Africa's finance minister Pravin Gordhan also forcefully argued the point. "Institutions such as the IMF must reform so that they can become credible, and to be credible they must represent the interests and fully reflect the voices of all countries, not just a few industrialized nations," Mr. Gordhan said in a statement. A candidate from a developing country, he added, "will bring a new perspective" to the IMF.

Larger and Structural Issues relating to the appointment of a new IMF Head

In fact the DSK succession highlights one of the most discordant features of our financial system which is that the world's second largest economy - with 10% of the world's GDP - has no contenders for the replacement of DSK. It also dispels the notion that the IMF has properly factored into its voting shares that the PRC commands just 3.8% of the voting shares while nations with less than half of China's GDP such as France and the UK have close to 5%. Such is the legacy of the 1944 Bretton Woods conference and the cosy club of mature economies which have effectively had their own way with the IMF for the last 60 years.

It is, of course, a complete misnomer to be calling China an emerging market as it now exceeds Japan, Germany and other major G8 economies in terms of its economic output. In fact it is only surpassed by the US which has about 25% of world GDP. Indeed the ability to hide out under the BRIC moniker and to allow cliche driven economists and policy makers to avoid confronting the issue of how to engage China to its rightful position at the very top table of global banking is likely to be one of the major consequences of the DSK succession.

There has been much posturing and rhetoric from the more accurately characterized EM economies, such as Brazil, India and Russia, about how the IMF needs to recognize, within its voting infrastructure, the increasingly vital role of their new high growth economies, but at this most opportune time for the EM's to be using their leverage to gain greater influence within the IMF, there has yet to be any coherent strategic move to advance a top level candidate who can represent their constituency.

The real vacuum seems to stem from the inability of China to want to take a leadership role in seizing the opportunity to become far more influential and engaged in the IMF's affairs. This is all the more surprising in view of the often made comments of Chinese officials that the current monetary regime, predicated on the integral role of the US dollar, is more influenced by domestic issues affecting the US economy than any stewardship of the global reserve currency as a store of value.

Last week I was a guest speaker at a conference in Beijing and had the benefit of witnessing a a 60 minute presentation from a senior representative from the PBOC. The topic of the paper delivered by the lady from the PBOC, indeed the theme of the conference, revolved around the question of the pathway towards internationalization of the RMB.

It was clear from the phraseology and content of her presentation that China sees its entry into the front line of global banking and finance as a long way off. Several times during the presentation she placed emphasis on the need for a series of small steps, and the need for gradual evolutionary change rather than any decisive and potentially disruptive steps in the manner in which the PBOC handles its interface to the freely marketed currencies and capital instruments of the rest of the world.

The current offshore market for RMB - conducted by the Hong Kong Monetary Authority - runs, relatively speaking, at miniscule levels when one contrasts it to the $4 trillion which is cash settled each day in the freely marketed currencies of the world. One gets the sense that the internationalization and accessibility to RMB denominated assets is, to quote an apt phrase, on a slow boat from China.

In conclusion it would seem that the real fall-out from the sudden exit of DSK will be to highlight the fact that China remains essentially outside the world's capital markets. For all of the talk about finding a replacement reserve currency/SDR's for the US dollar, or of winding down US dollar denominated assets, when the opportunity arises for China to become a major protagonist in carving out the future direction of the IMF, it would seem that the isolationist and disengaged modus operandi of the People's Republic will ensure that they will be passengers in terms of the way forward, rather than up front at the helm, which is where their $3 trillion of reserves would suggest they really should be.

GBP/CHF clear loser over last 4 years

2011-05-07T06:15:00.000-07:00

Measuring the relative strength of various currency pairs can be done using a separate benchmark such as determining the price of gold for each currency, and then creating an index to see how much more or less the gold price in that currency is now rather than it was priced at the base period for the index.

The method chosen to prepare the chart above is simply to contrast the current relative performance of six major currency pairs - each with the Swiss Franc as the base currency. The starting period chosen is the end of July 2007 which marked an important inflection point for most FX pairs.

The results clearly show that GBP/CHF is the weakest pair, and as of the Friday May 6th closing price, sterling is 38% less valuable against the Swiss Franc than it was at the end of July 2007.

The other results are as follows, in descending order:

JPYCHF is up by 2%
AUDCHF is more or less at par
CADCHF is down 18%
EURCHF is down 20%
USDCHF is down 30%

The strength of the yen underlines the peculiar position that the Japanese yen occupies in the FX market - both as a key component of the FX carry trade, and, less now than a few months ago, indicative of the yen's traditional relative safe haven status even vis a vis the Swiss franc

Of the key commodity currencies the Australian dollar has more or less retained its position at par value, while the Canadian dollar has performed more or less in line with the euro, as both have declined by similar amounts of approximately 20%.

The US dollar has declined by 30 % but the wooden spoon clearly goes to sterling.

Unsurprisingly, the notable under-performance of GBP/CHF, and the associated lack of purchasing power of sterling, is manifesting itself in higher domestic inflation in the UK

What is perhaps more remarkable is that yields on 10 year gilts are still relatively similar to those on 10 year bunds and 10 year UST's, indicating that global asset allocators are not demanding much of a risk premium for holding obligations in, by far, the weakest of the major currencies.

Tax Paradises and Offshore Shenanigans

2011-04-03T00:44:00.001-07:00

The author has undertaken a big task with this book. But the task is well worthy of examination as it is so vital to the shadowy infrastructure of the global financial system. To use the term that the author himself uses throughout the book - the role of "offshore" in finance - has been hugely overlooked in mainstream academic literature on finance and economics and also hardly ever mentioned in the mainstream media.

During the 2007/2008 near meltdown, analysts referred sometimes to the importance of the "shadow banking system" and too often their inability to articulate more exactly what constitutes that system left most people none the wiser as to what was involved and how critical this element is to systemic risk.

Nicholas Shaxson provides an easily digestible overview of the labyrinthine nature of the world of offshore finance and it is, as he suggests, ubiquitous. From its origins in the UK and the development of the euro markets in the 1960's (not to be confused with the EZ single currency - which came much later), he illustrates how the elaborate structures which have been put in place, have enabled wealthy individuals and corporations to avoid - more precisely, evade - massive amounts of taxes in the world's principal tax jurisdictions by concealing much of their net income in tax havens.

The dynamics of regulatory arbitrage are explained well, and as the author suggests the financial services industry and major banks have effectively captured the policy makers in the major economies and spurred them into a race to see which onshore jurisdiction can provide the most favorable cover and opacity to its corporate citizens. The thinking goes that by turning a blind eye and with a nod and a wink here and there, the most favorable climate for offshore tax planning will at least contribute some trickle down benefits to the GDP in the "host" nations. The effort is to try to maintain some concept of domicility with respect to their corporate organizations, rather than lose these entities completely to more business friendly jurisdictions.

The real issue which the author addresses in a slightly indirect manner has to do with the "ethics" of offshore. With public balance sheets in most of the G10 nations in a shambles, and growing complaints from the "little people" in those jurisdictions as to their tax burdens, it seems likely that there can only be greater sympathy with the leading edge of civil protest about the injustice of current taxation arrangements in the world's "richest" (i.e. most indebted) economies. Those who reside and work in their home countries under "normal circumstances" are being required to pay higher taxes, while many of those who, despite have all the benefits of unlimited access to selling into these markets and economic infrastructures but, as a result of numerous shenanigans and schemes designed to dodge taxes, are left essentially untaxed.

One further sentiment which is quite well explained by Shaxson is the extent to which the UK, and the City in London in particular, has been a huge beneficiary of offshore. UK bankers and businessmen were very instrumental in getting it all started in the 1950's and 60's and it was seen partly as a way of preserving Anglo Saxon influence in a post colonial era. The UK still is the preferred haven for the rich and non-domiciled, and this helps to explain why central London has some of the most expensive real estate in the world.

The central question which remains still rather shrouded after reading the book - just like the very financial structures in the treasure islands and places like Switzerland and Luxembourg - is whether there will be any progress made to shine a strong light on to this shadowy world of offshore finance. As policy makers become even more stretched to maintain some credibility to their stewardship of the public finances, the balance may tip in favor of demanding more corporate social responsibility and transparency from their corporate citizens in their accounting systems, organizational frameworks and willingness to pay their "fair share" of taxes.

Having just re-read that last sentence and weighed it against the power of the large banks who just have to drop hints that they may relocate their head offices elsewhere, and the panic induced in the domestic establishments, I somehow think that it is naive to expect that there will be any significant changes in the status quo . The only possibility would be if the citizenry of the principal onshore hosts for tax havens have epiphany moments, admittedly of a different order of magnitude, but in some ways analagous to those now being seen by the "little people" throughout the Middle East and North Africa.

But I am not holding my breath on that happening any time soon.

Treasure Islands: Tax Havens and the Men who Stole the World [Paperback]
Nicholas Shaxson (Author)

Micro-cap stocks (IWM) are behaving far more independently of macro risk than might be expected

2011-03-21T05:57:00.000-07:00

The basic proposition in this article is that there has been significant evidence (admittedly of a rather technical nature), demonstrated during recent market "difficulties", that there is considerable relative strength for the Russell 2000,the US micro-cap index, in comparison to the larger cap index the $S&P 500.

After the tumultuous conditions across most asset classes over the last week or so, there are some interesting patterns emerging which point to the fact that the micro-cap stocks are behaving far more independently of macro risk than might be expected. In fact there is evidence going back to September 2010 that suggests that there is an asymmetry in the performance of IWM and SPY (I shall use the two ETF’s IWM and SPY as surrogates for the cash indices).

One of the features of this asymmetry is that, during recent months, the beta value of IWM has been increasing when the overall market is performing well and has been decreasing when the overall equity markets are suffering from risk aversion. Based on a rolling 20 day linear regression the readings for beta (i.e. the gradient of the linear regression) were moving up towards a peak of about 1.8 during the strong upward impulse in prices during the latter part of 2010 and the first few weeks of 2011, and, during the recent price retreat, the beta value has declined sharply with a reading on Friday of just 1.14. This is not what one normally expects to see, as will be discussed below.

The chart below captures the relative price performance of three major US equity indices since September of 2010. The Russell 2000 has delivered a return of 25%, whereas the S&P 500 has returned 16% and the DJIA about 14%.

Significantly the recent sell-off has been more severe for the large cap indices than for the 2000 smallest stocks that are traded on US exchanges and which are the constituents of IWM.

A second technique to illustrate the recent decline in the correlation or co-movement of IWM and SPY is to track the correlation between the daily price changes of each index via a linear regression. The regression is based on daily changes in each index and a 20 day sampling is rolled across the complete data set for the last two years (500 data points)

The chart below shows that the square of the correlation coefficient (or R squared) for the most recent 20 day period which ended last Friday was 0.78 and, more typically over the extended period of two years, the R squared value has had an average reading of 0.86.

In essence what is being demonstrated statistically is that there has been a looser coupling of the daily movements in the two indices and that, somewhat surprisingly, this coincides with the recent volatility and sell-off in the overall market.

The next chart illustrates the degree of co-movement between SPY and the AUD/JPY cross rate which can act as a very good barometer of macro risk and which in turn can act as a driver as well as a reflection of the major shifts in asset allocation by large funds and asset managers.

The R squared value for the associated movements of SPY and AUD/JPY revealed on the chart is 0.45 which is fairly typical of the degree of correlation exhibited over the last two years. The actual 20 day rolling coefficient value for last Friday was 0.67 - in line with the typical performance between these two instruments - and also one of the most pronounced correlations between any FX pair and a major global equity index.

The manner in which these two asset classes move together is a surface manifestation of the underlying inter-dependent nature of large allocation decisions by global fund managers to both risk on/off currency plays and risk on/off equity (and commodity) plays.

The remaining chart for today’s analysis illustrates the much weaker co-movement between the micro-cap stocks (as represented by the daily changes in IWM over the last twenty trading sessions) and the daily changes in AUD/JPY.

The R squared value of just greater than 0.2, which is indicative of a coefficient of correlation of around 0.45, is not only half the value observed above for the SPY and AUD/JPY correlation, but also from an historical perspective is also considerably below the average value for the R squared value (over the last two years) which is approximately 0.5.

The conclusions that I am drawing from this hopefully not too statistically arcane approach are as follows:

1. Since the micro-cap stocks are showing less tendency to track the larger cap indices when the overall market and risk appetite are in retreat, there is evidence of a de-coupling between the larger macro risk environment and the performance of the micro caps. This is a surprising result as it indicates that when the large caps are getting beaten down the most, the propensity of fund managers to liquidate long positions in the micro caps is not taking place.

2. The large structured trades (often implemented via complex inter-market algorithms) where ongoing adjustments in large futures trades in the S&P 500, and large movements in the SPY exchange traded fund, and the FX market are very closely inter-twined, are not being seen recently in the behavior of the micro caps.

3. There has not been evidence of any liquidity panic in the US equity market despite the recent turmoil, which is largely a by-product of the almost daily injections of several billions by the Fed via its open market operations activities. In less liquid market conditions, where funds are keen not to be exposed to liquidation difficulties, there would be a tendency to avoid the smaller cap issues as they will tend to more difficult to sell when managers in general are heading for the exits.

4. One could also make the case that what is becoming evident might be a variation on the "Long tail" thesis which has been expressed in relation to new business models for mass distribution of companies like Amazon and Netflix. The key idea is that, just as with books and DVD’s, the less popular stocks are now more accessible and less dependent for their level of demand on the activities of large nodes in the market network. This also has, as a consequence, the benefit that smaller stocks will be less exposed to the rapid re-allocation shifts executed by the larger nodes (i.e. prop trading desks and quant funds) in the market network.

Seismic rumblings under Mount Fuji

2011-03-15T13:27:00.000-07:00

MAP 6.2 2011/03/15 13:31:46 35.300 138.700 10.0 EASTERN HONSHU, JAPAN

Keynes RIP

2011-03-15T13:24:00.000-07:00

To paraphrase one of the better known aphorisms of JM Keynes

If you hold an asset which is well represented on the public balance sheet for long enough you will die before it defaults.

Risk management revisited

2011-03-15T13:13:00.000-07:00

Oxymoron = risk management

Risk management

2011-03-15T13:10:00.001-07:00

The key word you do not want to hear from someone trained and respectably qualified in the practice of risk management " 'Oops"

Spiking oil, gold and a rather uncomfortable looking Fed chairman

2011-03-02T05:49:00.001-08:00

Yesterday was decidedly not a good day for the animal spirits as most risk assets spent the day spiraling downwards.

Seen below is the 240 minute chart for the e-Mini S&P 500 futures (March 2011 contract) which provides a very clear illustration of yesterday’s (and other recent) plunges, and also the chart indicates a clear barrier which will need to be overcome in coming sessions at the 1310 level.

I spent part of yesterday watching the testimony of Ben Bernanke before the Senate Banking committee. The overall impression was of someone who found the questioning at times tedious, and at other times awkward. His demeanor, at least from this writer's perspective, could best be described as uncomfortable.

He made some rather remarkable comments in response to what, from time to time, were some very good questions put to him by members of the committee. One of my favorites was when he stated that he did not think it would be a good idea for the US to default on its debts when he was asked about the consequences of not raising the debt ceiling...that was rather reassuring!

The central theme of his remarks, and he came back to the point several times, was that the efficacy of QE2 should be judged primarily on its demonstrated ability to lift equity prices and thus avoid asset deflation. Given that the S&P 500 has doubled in the last two years he would seem to have been vindicated. However, as a side effect (not an entirely unintended consequence) of QE and ZIRP, it has to be clearly acknowledged that the US dollar is particularly weak at present in a global economy where rising commodity prices are ensuring that many nations are suffering from rising inflation. And that could get much worse if the events in North Africa and the Middle East continue to push Brent Crude and WTI further into triple digit territory.

In the fullness of time it could well become manifest that Chairman Bernanke has been following an imprudent course. His belief, and the received wisdom of many mainstream economists, that the US will somehow stay immune from higher input prices, including food and energy, could well turn out to have been a momentously significant misjudgment.

Also noteworthy was his firm reassurance, when interrogated on the matter, that the Fed has not actually been monetizing the debt of the US when it keeps taking hundreds of billions of US Treasuries onto its balance sheet. Just how he was able to say that quite so blithely remains a bit worrying. His rejoinder to this allegation, expressed somewhat diffidently, was to articulate his long term plan to sterilize the present QE related accommodations by eventually selling all of this Treasury paper back to the private sector.

Even for an optimist the best that could be said of this exit strategy is to express the hope that this procedure will work out as smoothly as he seemed to be suggesting. For a realist, the preferred approach would be, if not already doing so, to begin investing in a variety of inflation hedges including ETF's which provide exposure to commodities (e.g. DBB, GLD, DBC, REMX etc.) and also, in the longer term to be considering instruments which move in the opposite direction to the prices of long term US Treasuries such as TBT, which moves up as yields move up.

As Dr. Bernanke repeatedly pointed out in his testimony, higher yields on the mountain of US debt would be very troublesome for the US public balance sheet. It will be just as troublesome for those holders of longer term UST's that either want, or have, to sell those notes and bonds in the secondary market.

Macro Eurozone risk - we’re all in this together, aren’t we?

2011-02-21T03:36:00.000-08:00

While recent events in North Africa and the Middle East, especially the current bloodshed being seen in Tripoli, are creating the potential for a regional geo-political crisis with far reaching implications for the rest of the world, the received wisdom is that there is not enough at stake for the global financial system to have to really work itself into a lather – even if the price of Brent crude is now firmly established above $100 a barrel and the propensity of citizens to take to the streets over many “injustices” seems to have reached a possible “tipping point”

The main event at the moment for the global capital markets appears to be the relentless march upwards in US equities and the macro perception that there has been a rotation out of EM and BRIC exposure into the world’s developed markets. There are some that believe that this rotation has almost run its course and that it is now time to buy the BRIC’s and EM’s again while others, including myself, are of the view that it is hard to ignore global trade imbalances coupled with the inflationary consequences of QE2 (and potentially Qn), and that these factors suggest that the hoped for rallies in China and India may not prove as resilient as some are expecting. Just to focus on the Shanghai market for one moment the 3200 level on this index has proven to be a resistance level twice over the last year and the current rebound seems to be lacking the dynamism to take out this overhead barrier.

But where could the real surprise to the global financial system come from? It could, of course, come from many places, but let me suggest that it could come about as a result of a reasonably simple concept from jurisprudence which, in essence, hinges on the difference between joint and several obligations. To be more direct about it I shall state a view which is that the euro currency bloc faces an impossible dilemma. On the one hand, over the longer term (maybe five years, maybe more) the EZ is almost certainly doomed unless the German government is willing to underwrite a bail out system which makes them joint and several guarantors for all of the debt of the Eurozone nations collectively. On the other hand, there is increasing evidence that the German electorate want no such thing. Although of a different order of magnitude, recent geo-political events suggest that politicians should think very carefully about the consequences of not listening to the concerns of their constituents.

We’re all in this together – pro rata of course!

With news on Sunday (Feb 20th) that Angela Merkel’s coalition government suffered another setback at the polls when the CDU lost a local election to the Social Democrats in the city of Hamburg, there has been a rally in Germany’s ten year bunds. Here is how the development was described by Bloomberg

German 10-year government bonds advanced after Chancellor Angela Merkel’s Christian Democratic Union lost an election in the city-state of Hamburg to the Social Democrats.
Bunds also advanced before reports that are forecast to show German manufacturing and services growth slowed this month. The election result may weaken Merkel’s position as she negotiates a comprehensive plan to contain the euro-region’s sovereign debt crisis.

This article sets out to put this apparent celebration by German bund investors about Merkel’s slow attrition in her power base, into the larger context of the current ticking time bomb which is the hopelessly irreconcilable aims of different segments of the Eurozone in trying to devise a safety mechanism for future sovereign debt crises.

Beneath the surface, and as evidenced by the Hamburg result (and even more serious problems could confront Merkel if she loses Baden Wurttemburg at the end of March), there is a new subliminal slogan that is on the loose within Germany with regard to the Eurozone – which could be stated somewhat sardonically as “we’re all in this together – (pro rata of course).” The key thesis that will be proposed is that the German position on any rescue plan, no matter how contrived and shrouded in obfuscation, is fundamentally at odds with the kind of mechanism that investors would like to see and that will allow the funding facility to prevail with continued AAA support from the principal credit ratings agencies (CRA’s). To that extent the outlook for the EZ remains highly uncertain.

The EZ malaise is rising to the fore again

The tectonic plates of crisis within the Eurozone government debt market are rumbling again as the yields on Portuguese 5 year debt now seem to have established a foothold above 7% and the 10 year yield is currently at a record high above 7.5%.

As the three dimensional graphic above shows yields on the 10 year benchmark bonds for Germany, Spain, Portugal and Italy have all been on the rise during the last several weeks. In fact, notwithstanding the small drop in yields cited at the beginning of this article resulting from the Hamburg election result, German yields have moved up by more than 75 basis points since mid October of last year.

Particularly alarming is the rate now shown on the Portuguese 10 year which has a yield at the time of writing (Feb 21st) well above 7.5% and this is considered by most analysts to be above the critical level, and as such the Portuguese government will almost certainly have to turn to the EFSF for a bail out.

Fatal flaw in EZ’s legal architecture

There is a flaw in the legal/constitutional framework that underpins the way that the Eurozone is organized and it needs to be confronted without the usual shenanigans of smoke and mirrors that give most observers a false sense that it’s just a matter of more meetings that will solve the problems besetting the EMU currency union. The difficulties that crop up each time the matter of how to deal with rescuing the troubled nations, how to re-vamp a Euro stability mechanism, whether to increase the funding commitment, or whether indeed the current SPV vehicle known as the EFSF deserves a AAA credit rating which is what has been granted to it by the major CRA’s, can be directly attributed to this flaw.

As suggested the essence of the problem lies within the legal architecture which surrounds the whole Eurozone project and specifically the EFSF (or its successors). The best way to get a handle on structural flaw is to consider the difference between a joint obligation and a several obligation. The EFSF has a several obligation on the member states that are guaranteeing the obligations of the facility, but critically, not a joint obligation.

In simple terms the best way to contrast the difference is to consider the nature of a partnership – a form of business organization which used to prevail in the professional world, including until the 1980’s in the domain of investment banking.

A firm based upon a partnership deed is bound together legally under the concept of joint and several responsibility for all of the obligations of the firm or partnership. All of the partners are each fully liable for all of the sums that the firm could be obliged to pay out in the case of a financial mishap. There is not a pro rata agreement which says that the liability of each member of the partnership is limited in any fashion – for example in proportion to that partner’s net worth or other assets. If there is a judgment against the partners, requiring the obligations to be honored, theoretically the onus for meeting those obligations could fall on just one of the partners if he or she is the only one left standing after the others may be insolvent or may have declared personal bankruptcy. Admittedly this would be a limiting case but the key idea about joint responsibility – which overrides the notion of several responsibility – is that each and every person in the partnership is liable up to the full amount of the relevant obligation.

The next strand to the story is that the EFSF does not presently provide for joint responsibility of the guarantors of the SPV and its borrowings. The manner in which the structure was established only provides for several responsibility in which the liability of each of the EZ member states is limited to their capital contributions to the ECB.

The table showing this commitment to the current EFSF facility is as follows:

Member State	Capital Commitment Euros bn	Percentage of Total
Federal Republic of Germany	119,390.07	27.1%
French Republic	89,657.45	20.4%
Italian Republic	78,784.72	17.9%
Kingdom of Spain	52,352.51	11.9%
Kingdom of the Netherlands	25,143.58	5.7%
Kingdom of Belgium	15,292.18	3.5%
Hellenic Republic	12,387.70	2.8%
Republic of Austria	12,241.43	2.8%
Portuguese Republic	11,035.38	2.5%
Republic of Finland	7,905.20	1.8%
Ireland	7,002.40	1.6%
Slovak Republic	4,371.54	1.0%
Republic of Slovenia	2,072.92	0.5%
Grand Duchy of Luxembourg	1,101.39	0.3%
Republic of Cyprus	863.09	0.2%
Republic of Malta	398.44	0.1%

Total Guarantee Commitments	440,000.00	100%

Most notable about this table is that Germany and France together provide 47.5% of the total guarantee. They are two of the six AAA credits amongst the 16 EZ States listed (Estonia became the 17th member in January 2011 but is ignored for present purposes as its “contribution” to the funding guarantee would be minimal anyway).

Also notable is the fact that Spain and Italy make up almost another 30% of the guarantee and there are grounds for believing that their ability to comply even in pro rata fashion may not be a safe assumption – especially if the size of the guarantee is increased, or more ominously if either of these two member states becomes a rescue candidate. Indeed it is one of the sad ironies of the structure that included as guarantors of the funding are several candidates for rescue including two which have already proven themselves to be junk credits – Ireland and Greece. In headline terms there are just four countries which are responsible for more than ¾ of the total obligations of the fund.

When designing the architecture of the fund the Brussels technocrats decided in effect to emulate the structure of a CDO with some features that would make the ratings agencies look benignly on the risk parameters for the SPV. Credit enhancement features, especially over-collateralization were introduced into the capitalization model. In essence the fund is over-collateralized by 20% so that the relative contributions of each guarantor are actually 20% above the available funds that the facility can borrow against.

This has the effect of reducing the scope of the facility’s funding commitment, so the effective facility has actually been estimated at about Euro 300 bn. There are ongoing discussions about increasing this funding guarantee, but these are proceeding slowly and with quite a lot of acrimonious discussion amongst key players in the negotiations.

But there is a danger in trying to analyze and parse every new press release or comment from EU officials with regard to these deliberations about the size of the new facility, as we are in danger of losing sight of the forest for the trees, or more specifically, in this case, losing sight of the imperfections of the legal architecture of the facility, and instead becoming fixated on the monetary size of the facility.

The simple question needs to be asked – how should such a structured credit instrument be rated by a ratings agency? Even though the question was answered by the CRA’s in the summer of 2010, the answer is still worth asking again as the CRA’s have been known to get things wrong in the past!

The EFSF SPV was given a AAA rating by the three big agencies and largely (wholly?) as a result of that, when the facility went into the market to raise its first tranche of funding the deal was oversubscribed with keen participation from China and Japan and the initial issue was sold with a yield, according to the EFSF's own website of 2.89%.

So it would seem that all is going well for the EFSF and that the precedent set bodes well for further issuance. But, the argument here is that this is not to be assumed in the light of the events which are currently unfolding in Germany. The unsettling question that needs to be answered by the CRA’s is whether or not further bailouts by any rescue facility should also be granted a AAA rating? Even more serious is the question whether or not the role of a guarantor such as Germany to an enlarged bailout facility could even call into question the AAA sovereign rating given to that nation. It hardly needs to be stated- in fact I already have done so here - that the Germans don’t love the euro enough to see their own AAA rating in jeopardy.

Credit Enhancement Features of the EFSF

It will be recalled that when CDO’s were issued by US investment banks they also had credit enhancement features – such as “guarantees” from outfits like AMBAC. It may be redundant to point out at this stage that far from AMBAC being able to honor its commitments made to enhance the creditworthiness of CDO’s, the company filed and declared for Chapter 11 bankruptcy in New York on November 8, 2010. There was also the not insignificant problem faced by the US Treasury when it was faced by all of the guarantees made by AIG under various swaps and instruments designed to enhance the massive issuance of CDO’s during the 2003-7 period in the US and elsewhere.

The over-collateralization feature built into the EFSF was certainly a cosmetic sweetener providing an additional buffer of capital and gave the EFSF more breathing room if things got tight. But the troubling issue with over-collateralization and the concept of several obligation which is part of the legal fabric of the EFSF, is extraordinarily similar to the problem that arose for mortgage backed securities.

Just as in the case of the CDO debacle with real estate mortgages as collateral, where the possibility that real estate all over the US could suddenly decline in a uniform fashion was seen as a statistically insignificant “outlier”, it also appears to have been assumed by the CRA’s that the chances of several sovereigns running into difficulties and suffering impaired creditworthiness at the same time is equally as remote.

Several hundred books and articles have been written on the dangers implicit in the former assumption about the non-correlatedness of declines in US real estate, and, with that in mind, many asset allocators (not enough perhaps) are now questioning the assumptions behind the latter assumption. In fact articulate protagonists of the sovereign domino theory, for example Kyle Bass from Hayman Capital Advisers, are beginning to get prime time TV slots and plenty of coverage which, in view of the gravity of the consequences of sovereign contagion, is well deserved. It would not be an exaggeration, claims Bass, to say that defaults by even one major sovereign, with its cascade of impairments to the balance sheets of the major private sector banks (well private in the sense that the shareholders are still not in the majority of cases taxpayers, even if banks’ balance sheets are underwritten by the public sector), would trigger the ultimate systemic meltdown.

I don’t like to use hyperbole to get attention for its own sake and there is a danger in overstating the risks that are actually present, but the likelihood for further disruption in the EZ government bond markets is accelerating.

Consider for example some recent events as reported by Bloomberg

The European Central Bank is being forced to print money to bolster banks in bailed-out Greece and Ireland, leaving the region’s taxpayers on the hook as the final guarantors of those nations’ debts.

Greek and Irish banks have issued at least 70 billion euros ($95 billion) of bonds to create the collateral required to get cash from the ECB, according to the International Monetary Fund and regulatory filings, a figure that may rise to 100 billion euros after Greece said Feb. 11 it may extend another 30 billion euros of guarantees to its banks.

“What you have here is micro-quantitative easing, or money printing,” said Cathal O’Leary, head of fixed-income sales at NCB Stockbrokers in Dublin. “The banks are issuing unsecured loans to themselves.”

“This is a great example of bank risk moving to national government risk, and now to ECB risk,” said Jean Dermine, professor of banking and finance at INSEAD business school in Fontainebleau, France. “The ECB is increasing the money supply and that is raising inflationary pressure. There is also credit risk, the fact that default would lead to a loss for European taxpayers.”

A big headache for Angela Merkel

The fact that the ECB is going beyond its mandate and engaging de facto in QE, despite numerous denials that it is not, is also in direct violation of the treaty ratification which established the ECB and it has lead to the resignation of Bundesbank president Axel Weber who was seen by some as an eventual successor to Jean Claude Trichet. Angela Merkel is really not to be envied for the position she occupies now with regard to this matter and probably has plenty of paracetamol nearby to help her through the coming months.

The question that really needs to be confronted by Trichet and his successor is – given that the ECB is now expanding its balance sheet and incurring obligations on behalf of the citizens of the EZ’s member states - who stands behind the debt of the ECB?

Does the principle of several liability realistically apply there? I see this as somewhat similar to the situation that the US faced with Fannie Mae and Freddie Mac in which here was not an explicit US guarantee until the whole edifice came tumbling down at which point the holders of GSE bonds needed an answer right away – are these things federally guaranteed or not? The US decided that the public safety net would be put in place to cover them and another possible trigger for a systemic meltdown was averted. The simple rule of thumb that the US government has taken since the financial crisis of 2008 has been, to return to the main motif, we’re all in this together and the debt holders will be protected by the full faith and credit of the US government.

If a truly Darwinian outcome was to befall the Eurozone and capital flight from the banks of nationals was to gravitate towards the center would Germany stand tall and agree that we’re all in this together 100% - and not just pro rata ? This is the really hard question for which the only sane answer might be that it is better for Germany to get out of this commitment sooner while the going is good, rather than later when the entanglement is so great that there is no way out.

This explains why Merkel has been talking about haircuts, why the German parliament has been talking about the fact that the changes being contemplated by a revised EU treaty calling for more fiscal integration will require a 2/3 majority in their legislature and in a more general sense a rapidly evaporating consensus amongst German policy makers that protecting the euro should be undertaken at all cost.
The Germans are effectively snookered on this issue. Unless they agree that they are totally committed to supporting the euro – with all of the nasty political consequences that would flow from that, including even the possibility for German civil unrest – then the euro’s next crisis may be its final one as, to paraphrase W.B Yeat's classic line from The Second Coming, the center may not hold.

Whatever language is put into new documents that will replace or supplement the EFSF will try to obfuscate this issue. In their own inimitable way the EZ technocrats will devise ever more arcane credit enhancement features - labyrinths of repo channels - to try to disguise the fact that this issue has not been addressed. But if the sovereign dominoes start falling, or even if enough EZ government bond buyers think they might start falling, this question will move to center stage.

Why not issue Eurozone Bonds?

Some have suggested that the best way around the difficulties of designing a new architecture for the EFSF or its successor would be to grant the ECB the power to issue new E-bonds, but as indicated above this may have the unintended consequence of highlighting the legal flaw and bringing about the more vitriolic attacks from some member states. It would also certainly require plebiscites in many states with highly uncertain outcomes, not something favored by EZ bond investors.

Interestingly one of the main critics of E- bonds is the current ECB president as this article makes clear.

BRUSSELS (MNI) - The European Central Bank maintains its position that eurobonds with a "joint and several" guarantee would not be appropriate given the present circumstances in the European economies, ECB president Jean-Claude Trichet said Monday.

"In the ECB, as you know, we are not in favour of European bonds in which the European countries would be joint and several. We don't consider it is something that would be appropriate in the present circumstances," Trichet told the European Parliament's Economic and Monetary Affairs Committee on Monday.

Just to be totally clear and unambiguous on the matter – never something that a central banker should really do – the following direct quotations from M. Trichet are also on the record of the European Parliament:

"We are not ourselves in favour of issuing securities, treasuries that will be joint and several," Trichet told the European Parliament.
"We consider it is good that each particular state, each particular treasury has its own refinancing and has its own way of being on the market."

If E-bonds are a non-starter, and if the Germans are only committed to a pro-rated liability for anything that can go wrong within the EZ states, is it right for the CRA’s to continue to rate the securities issued by any new facility as AAA? While Moody’s and S&P analysts may possibly ponder that question, the capital markets may well be moving towards another test of the issue. But again there is a danger in thinking that they are only testing the size of the facility… more seriously they may be ultimately testing the nature of the legal guarantee behind the facility.

The final word on this dilemma will go to Han Werner-Sinn, who is Professor of Economics and Public Finance at the University of Munich, President of Ifo Institute for Economic Research and Director of CES.
The influential policy adviser wrote recently as follows:

One idea being voiced in Brussels is that the Luxembourg special purpose vehicle should buy up existing debts, as the ECB is already doing. It would be even more attractive for the debtor countries if they received additional loans from the special purpose vehicle so that they could buy back their outstanding debts themselves.

This would be an opportune time since 10-year Greek and Irish bonds are now only worth about 70% of their nominal value. This would amount to a valuation adjustment (“haircut”) for private creditors – as even members of the German government are claiming – without really hurting anyone.

But this sort of magic cannot work. Taxpayers of the countries with a good credit standing would in that case be liable also for the existing debts of the affected countries. If the loans granted as a substitute are not serviced, the taxpayers would have to meet the claims of the special purpose vehicle.

Under no circumstances should Germany accept this approach. It amounts to making the debts the responsibility of the Community via eurobonds – a policy that the German federal government has strictly refused, and rightfully so. This is a cunning way of introducing eurobonds, using incorrect figures and new semantics.

I would suggest that the writer of the above has hit the nail on the head in his last paragraph. The only real question is not one regarding whether the German government would be prudent to step away from the forces of encroaching fiscal unification and complete financial integration of the EZ, which would result in the ultimate consequence that Germany could effectively end up providing a safety net under the whole EZ project, but simply when they will want to step away.

Revolutions in music and Egypt

2011-02-13T07:28:00.000-08:00

The following colorful remark from the Lefsetz Letter - suggests that the revolution in the music industry antedated the uprising in Egypt.

I would suggest before reading it that one takes a deep breath and remembers that for business analysts generally, and those engaged in "analyzing" the music industry especially, there is a tendency to take the view that nothing succeeds like excess (or hyperbolic overstatement.)

Here it is:

EGYPT:

“We were there first, music fans already revolted. They killed not only the album, but the major labels. We’re living in an era of chaos. To complain is to be Mubarak. The audience was oppressed for too long, given an opportunity to go its own way, it did. Remind me how it helped the audience to have to buy a fifteen dollar CD to hear the one track that was a hit? Now they just buy the hit on iTunes. And if they don’t do that, they don’t even bother to steal it, they just watch it on YouTube. You don’t need to own it, next year it won’t mean anything.”

Why would anyone want to buy a record company?

2011-02-13T03:05:00.000-08:00

The following brief item appeared in Music Week on February 11th.

Warner Music Group is reportedly asking bidders to submit their first offers for all or part of the company by the end of February – before the recorded music and music publishing assets of rival EMI are formally put on the market.

However, Citigroup is also moving quickly to sell off EMI and is readying the music group for sale in short order. Timing is important, as potantial bidders for the two companies would doubtlessly be affected by the presence of another music major on the market at the same time.

More than 20 parties have been reportedly shown interest in Warner so far, including Zomba founder Clive Calder and Russian investor, Leonard Blavatnik, Universal Music, Sony Music, private-equity giants KKR, Apollo and Providence Equity, and independent publishers giant Imagem.

Beneath the piece is a comment from a reader of the piece who is clearly not enamoured with the music industry from an investment perspective.
The gist of the remark is as follows:

The thing is who is the genius that would purchase a music company these days? Nobody, not even someone who can afford to waste money.

Citigroup is certainly hoping that it can find a buyer for EMI Music which it now has to sell following its much publicized falling out with Guy Hands and Terra Firma.

As another article noted - "What did Terra Firma get out of the deal? When all is said and done, it looks like Terra Firma paid a whopping 1.6 billion pounds to rent EMI for three and a half years."

After seizing control of EMI after Terra Firm was in breach of loan covenants and in no position to keep funding the company, Citigroup have written down the debt that it is owed from £3.4bn to £1.2bn - translating into a loss of £2.2bn, which in the big scheme of things is no big deal for a bank which must have written down hundreds of billions (at least) in even dodgier investments in CDO's and other exotic instruments.

At this point Citigroup's effort to emerge from its calamitous EMI venture has to rely on two possibilities.

Either it can find someone dumb enough to pay real cash (as opposed to structured notes which may or may not be worth anything in the fullness of time) for the company in an upcoming auction or it needs to find someone smart enough - who has a radically new business model for the company. In the latter case it is best to contemplate that EMI is essentially a business involved in digital rights management rather than one beholden to the traditional making of discs and antiquated A&R/marketing and accounting practices that flourished yesteryear but are totally obsolete today.

There are some early indications that Citigroup might just find itself lucky enough that an innovative group currently traveling incognito could provide a suitable exit for the bank. On the other hand the dumb money option could also be a possible exit as Guy Hands has indicated that he might have another go at acquiring the company.

As is often said, some things are so bizarre you simply cannot make them up.

How much does Germany love the euro? [ Part 2]

2011-02-12T05:20:00.000-08:00

The following news story from Reuters illustrates the difficulties ahead in persuading the German population that it is in their best interest to preserve the Eurozone.

(Reuters) - The German government may need a two-thirds majority in parliament to approve any deal on the new permanent rescue mechanism for the euro zone, meaning it will need opposition support for any compromise, Der Spiegel magazine reported on Saturday.

The report by the Bundestag's legal department underlines the challenge facing Chancellor Angela Merkel to convince the public and allies at home of a deal which will commit Germany to bankrolling future bailouts of euro zone member states.

At a summit in December European leaders agreed to set up a permanent mechanism from mid-2013 to solve sovereign debt problems. It will replace the temporary system -- a 750 billion euro emergency loan facility created by the EU and IMF in May.

As a quid pro quo for her support for the scheme, Merkel and French President Nicolas Sarkozy have put forward proposals for a "competitiveness pact" which is to be hammered out by March and has provoked strong opposition from other EU leaders.

Berlin's ability to compromise on the steps -- which seek to end wage indexation, raise retirement ages and lock debt limits into national constitutions -- may be influenced by what the government can sell to a domestic audience.

Der Spiegel said the legal opinion on the issue -- pointed to by an MP from Merkel's junior coalition partners -- found that a two-thirds majority would be required because the European Stabilisation Mechanism (ESM) would involve an extensive intrusion into the Bundestag's administrative sovereignty.

Merkel's center-right coalition would need backing from the opposition Social Democrats to obtain a two-thirds majority.

Recent indications are that many Germans are becoming disillusioned with the euro and feel that their elected representatives are not taking notice of their growing disenchantment with the EZ. For example these two excerpts come from an article at Spiegel Online:

Surveys show that many Germans are worried about the future of the euro, but the country's political parties are not taking their fears seriously. The number of grassroots initiatives against the common currency is increasing, and political observers say a Tea Party-style anti-euro movement could do well.

Unnerved by shaky, debt-ridden countries and bailout packages worth billions, the majority of Germans want the mark back. In a survey conducted in early December by the polling firm Infratest dimap, 57 percent of respondents agreed with the statement that Germany would have been better off keeping the mark than introducing the euro. Germans, it seems, are gripped once again by their historic fear of inflation: According to the Forschungsgruppe Wahlen polling institute, 82 percent of the population is worried about the stability of their currency.

Although of a different order of magnitude, recent geo-political events suggest that politicians should think again when not listening to the concerns of their constituents.

A few weeks ago I posted an article on a related theme entitled How much does Germany love the euro? which can be found here, and, it may be that under the requirement that Merkel needs a 2/3 majority for approval to provide additional support for the single currency, she just may be trying to build a bridge too far.

Will the BRICS and US decouple, or are cracks in the BRIC's a taste of things ahead?

2011-02-05T04:58:00.000-08:00

Some intriguing, and potentially unsettling, shifts have been taking place in macro asset allocation decisions over the last few weeks which have been somewhat overshadowed by the relative strength of US equity markets, and perhaps more recently obscured by developments in Egypt, Tunisia and Yemen.

The striking observation that needs to be made is that global investors are losing their appetite for the BRIC economies, indeed there are cracks in the BRIC’s which are beginning to point to a potential hard landing for such previously buoyant markets as China, Brazil and India.

First of all we need to state in simple terms the extraordinary growth that these last three economies have shown in the last several years.

Martin Wolf, the respected FT columnist included the following helpful illustration of how, despite the financial crisis of 2008, the BRIC economies have surged ahead in recent years, especially in relation to the “advanced” economies. He demonstrated this with reference to a notional GDP index for several key economies here

If one were to set GDP at 100 in 2005, it was 105 in the US in 2010, 104 in the Eurozone and 102 in Japan and the UK. But in Brazil it was 125, in India 147 and in China 169.

As Wolf remarks for policy makers in the BRIC nations there is a temptation to ask laconically “Crisis? What crisis?”

However, the cracks which are now appearing in the BRIC’s and three of the equity markets referenced in the acronym are revealing that despite, perhaps even because of the remarkable growth rates which have been seen in these super economies of the future, all is not well. Global asset allocators and other investors are exiting these markets in a hurry now and this is confirmed by data published in a report from Emerging Portfolio Data Reseach (EPFR) and which is referenced in this recent article also from the Financial Times

Investors have pulled more than $7bn from emerging market equity funds in the past week, the biggest withdrawal in more than three years….
Violence on the streets of Egypt and a jump in oil prices to more than $100 a barrel set off a wave of anxiety across developing markets.
But the fund outflows also reflected deeper unease about economic overheating in China, India, Brazil and other big emerging economies.
Emerging markets attracted record investor inflows of $95bn last year as they became a defining investment theme in the wake of the financial crisis. The latest figures have raised concern that the bull run may be about to end as investors look for value in beaten-down markets in the west.
“Since the fourth quarter, the perception of where the value lies in the equity markets has shifted pretty decisively toward the developed markets,” said Cameron Brandt, global markets analyst at EPFR, which tracks the fund movements.

However, as with most sudden rushes for the exits, there were early warning signs of a retreat in the BRIC’s and these have been evident for some time. In fact, the case will be made that the tide turned for these markets in November of last year and that two related events could be behind the shift away from the stellar performers during most of 2010. The two events are - on the one hand - the persistence of the elevation in commodity prices which has been associated with an unwillingness of, indeed need for, the BRIC monetary authorities to take measures to address troublesome inflation, particularly in food prices - and on the other hand - the decision by the US Federal Reserve to continue with its policy of QE. Somewhat counter-intuitively the US dollar also registered a multi-year low in November 2010 which adds further credence to the notion that FX traders in particular decided to sell on the rumor (of QE prolongation) and buy on the fact i.e. when Bernanke officially confirmed the QE2 program at the beginning of November.

The chart below shows the trajectory taken by the US dollar index, as reflected in the price of the exchange traded fund, UUP, over the last year.

Evident on the chart is the low seen in early November which was also accompanied by a positive technical divergence in momentum. One could argue that the last move down in early November was the final thrust by FX traders keen to set up better levels for taking long positions on all of the key dollar cross rates as the implications of further QE became the focal point in markets. Adding to the notable bounce in the dollar was also the fact that Chairman Bernanke limited himself to only $600 billion, rather than the $1 trillion or more which some had been projecting.

Even though the US dollar registered a significant low the continued appetite from investors and traders for most commodities, and the accusations by the Chinese that QE2 was in effect a deliberate debasement of the US currency and attempt to trigger inflation, added further impetus to the incipient currency war which moved to center stage in late 2010. The events in the Eurozone, with Ireland's need for a rescue operation, also deflected some attention away from the fact that the Chinese authorities were becoming more than just a little concerned about the fact that their own equity market was showing signs of fatigue. Mounting concerns about rising food prices and commodity pressures in general, in the wake of too much global liquidity - at least that is the view of the PBOC - and the possibility that this might lead to civil unrest is an alarming prospect for the second largest economy in the world, which is now responsible for 10% of global GDP. As China morphs even more into an urban economy where the acquiescence of the working classes toward rising food prices, rents and their willingness to accept evidence of blatant social inequality, cannot be taken for granted.

The chart below for the Shanghai Composite index shows that this key BRIC index topped out around 3200 in early November 2010. Since this most recent peak the index has retreated by almost 600 points, touching an intraday low of 2661 on January 25th of this year.

The decline in the Shanghai index has been, from a technical perspective, remarkably in conformity with certain key fibonacci levels. The move down from the top in November to the low seen on January 25th was almost exactly 62% of the range between the high and low values seen on the chart. The recovery back towards the 38% level will be especially critical for this index as this level is also an area of technical resistance. The 50 day moving average (exponential) has intersected with the 200 day average, and if, in fact, the index fails to maintain its recovery mode and there is a crossing of the shorter term average below the longer term average, this would actually constitute a so called death cross which, as the name suggests, is not a healthy development in technical terms.

The way in which prices develop on this index in the coming weeks will be vital to monitor as the trend line up from the lows seen in the summer of 2010 has clearly been violated, and the risk is that if the index fails to regain the levels seen in mid December a succession of lower highs would suggest that the correction has further to run.

The relatively weak performance of Chinese equities sets the backdrop for the remainder of this discussion which will focus on two other BRIC markets.

Recently I presented charts showing the negative reaction in two of the other key BRIC markets in a televised slot for Reuters Insider which can be seen here.

The first chart to consider is that for the Mumbai Sensex index which has fallen by more than 15% since reaching a high above 21,000 on November 5th (recall that this was almost exactly to the day that the US dollar index turned upwards after the QE2 ratification).

The key factors with regard to the Mumbai index are the notable failure in mid January - shown as B on the chart - for the index to reach back to its November peak - marked A on the chart. Also evident is the recent price action which has brought the index to the somewhat critical 18,000 level. The index closed on Friday (Feb 4th) just above this level which also is a 62% retracement of the entire high/low range seen on the chart.

Moving beyond the technical patterns there are undoubtedly some key concerns that are undermining the confidence of global and local investors in Indian equities. There is a real concern about the accelerating rise in food inflation which is now above 17% on an annualized basis, and this is putting increasing pressure on New Delhi to take tougher steps to keep food prices in check in India. It is worth noting that in an economy where 80% of the 1.2 billion population lives on less than $2 a day, the impact of higher prices for basic foodstuffs is far more profound than it is in a more heterogeneous market where consumers have more discretionary income.

The following comments from the Indian government which were reported recently by BBC News, highlight the risk that the Sensex index, precariously poised at 18,000, may come under further pressure as India's central bank seems destined to keep raising rates.

India’s prime minister has warned that the country’s rapid economic growth is under "serious threat" from inflation.
Manmohan Singh said getting inflation under control was a matter of urgency, raising the prospect of an eighth interest rate rise in under 12 months.
Emerging markets like India, where GDP growth is running at 8.5%, are helping to drive global economic recovery.
But Mr Singh said India’s inflation rate of 8.4% - and food price inflation of 17% - was unsustainable.
"Inflation poses a serious threat to the growth momentum. Whatever be the cause, the fact remains that inflation is something which needs to be tackled with great urgency," he said.
Analysts believe that surging food and oil prices mean that India’s central bank may have to raise interest rates before its next policy meeting, which is scheduled for 17 March.
India’s stock market has fallen this year on fears that high inflation will scare off foreign investors.

The key macro-financial question has to be asked - how likely is it that the Indian government will be able to contain the damage being done by increasing food prices simply by base rate increases in its domestic financial markets? A compelling argument can be made that global liquidity - driven mainly by easy money and ZIRP policies in many "advanced" economies - is the principal dynamic, along with weather related and geo-political unrest, behind the relentless increase in the cost of basic agricultural and industrial commodities. To imagine that the Indian government can counter these dynamics by local interest rate increases is analagous to the notion that one can tame a King Kong like gorilla by administering a mild sedative.

The final market to consider in this overview of unsettling developments in the BRIC's is Brazil. The extent of food price inflation in Brazil, according to the official government statistics, is far less alarming than the 17% figure seen in India, and is currently estimated to be around 6% on an annual basis; but there are unofficial estimates that place the figure considerably above this level.

The losses seen on the Bovespa index have so far been less than 10% but the potential exists for a further slide in this index. The inflation-targeting program established by the Brazilian government requires that above target inflation has to be held in check and this will almost certainly lead to further interest rate hikes.

The base rate in Brazil is already at 11.25%, and in a recently released central bank survey, Brazilian economists have projected a rise to 12.50% by the end of 2011.

The usefulness of fibonacci retracement targets in forecasting potential price targets and support/resistance levels is well illustrated in relation to the weekly close for Brazil’s Bovespa Index. On February 4th the index closed at 65,269 which was almost exactly the level indicated in the broadcast slot above and in my daily commentary which was published early on February 3rd and which is available here.

The thesis being proposed is that the three BRIC economies examined in this piece have all reached key retracement levels where there are two contrasting outcomes.

The more positive outcome would be that one would expect, on the assumption that asset allocators remain optimistic about the continued economic out-performance of the BRIC's in contrast to the sclerotic growth in the mature economies, that equity market rebounds are most likely. Moreover if one subscribes to the view that global de-coupling is valid, and that there is a long term macro negative correlation between the appetite for the dollar and BRIC/EM assets then one would have to remain skeptical regarding the US dollar’s appearance of forming a base at present (i.e. in early February 2011).

If on the other hand the attrition in the BRIC markets continues and risk appetite for BRIC assets is in retreat one must be tempted to reach the conclusion that there are the beginnings of a real aversion by investors to the inflation genie. Not only is it out of the bottle but fund managers may suspect that containing the damage arising from mounting agricultural and other strategic commodity prices, will be a painful affair for the BRIC's and perhaps too eventually for the "advanced" economies.

The question then becomes one of de-coupling again but under a different guise this time than that usually depicted. If the most dynamic economies of the world – where final demand is increasing more rapidly than in North America, Japan and most of Europe – are being forced to tighten monetary policy to preserve purchasing power of their currencies, and to avoid the political and social fallout of higher food costs, then for how much longer is it safe for the USA, UK and Eurozone to maintain the confidence trick that ZIRP is not a hazardous policy which will eventually lead to troubling and ubiquitous global inflation?

There are several ETF’s that enable investors to have exposure to some key emerging markets and these include EWZ, which tracks the MSCI Brazil index; INP, which tracks the MSCI India Index; IDX, which tracks the MSCI Indonesian market; ILF, a fund which tracks the Top 40 Latin American equities, and which provides exposure to Brazil as well as Mexico. These are all relatively large and liquid exchange traded funds and there are also inverse funds for taking a short position with respect to BRIC and emerging markets in general.

BZQ ProShares UltraShort MSCI Brazil
EDZ Direxion Daily Emrg Mkts Bear 3X Shares
EEV ProShares UltraShort MSCI Emerging Mkts
FXI iShares FTSE China 25 Index Fund

Watch for cracks in the brics

2011-01-30T09:07:00.000-08:00

(Reuters) - Rapidly growing BRIC emerging economies are vulnerable to external shocks as they lack adequate risk management and must synchronize fiscal and monetary policies, a survey of finance ministry officials showed.

The survey, released on Monday by consultancy Booz & Company, said the role of finance ministries have expanded far beyond their traditional fiscal mandate and they must reform so that they are not overly driven by interventions, near-term fiscal targets and benchmarking against local peers.

Booz polled more than 60 policymakers in finance ministries in the Group of 20 and other key economies, along with officials from the IMF, World Bank, European Union and OECD, academic institutions and think tanks.

Brazil, China, India and Russia -- the powerful BRIC group of emerging nations -- rebounded fast from the financial crisis, but the survey warned of shortcomings which could pose risks in the future.

"Russia is vulnerable to swings in the price of oil, Brazil to commodity prices, and India and China to global demand. China faces the additional risk of potential changes in currency policy, which could have ramifications for its trade position," Booz said in the survey.

It said these economies will face volatile swings within the economic cycle, often requiring corrective measures with high costs, unless the economic management functions within these countries are coordinated via a larger framework.

"This being the case, an overall framework for coordinated action is a priority for these economies," the survey said.

It also said BRIC and other growth economies should quantify on- and off- balance sheet risks, including commodity prices, currency fluctuations, private demand, or financial exposure -- and build them into policy decisions.

The survey said generally there was no one-size-fits-all solution for reforming today's finance ministries with overstretched objectives.

But it urged them to move away from ineffective notions such as more government interventions, focus on near-term fiscal targets, and benchmarking against regional peers.

Possible weakness for Yen crosses ahead

2010-12-19T00:45:00.000-08:00

Foreign Exposure to the PIGS

2010-12-19T00:38:00.000-08:00

The Eurozone Crisis: The Visceral and the Cerebral

2010-12-10T07:43:00.001-08:00

There may be one redeeming feature about the shambolic state of the public finances in the peripheral states that are members of the currency “club” known as the European Monetary Union (EMU), and that is that it provides a convenient distraction to global asset allocators from the similarly dire state of the balance sheets of several key states, as well as the federal government, that collectively comprise the United States.

At the time of writing the first warnings of a possible buyers’ strike for US Treasury bonds are sending a discomforting signal to Fed Chairman Bernanke that QE may not be the panacea that he had thought it would be. At the same time, it may be his good fortune, in the near term, that the troubles on the other side of the Atlantic, which seem to lurch from one financial mishap to another, will keep a bid under dollar denominated government bonds as there is even less appetite for those denominated in the second most traded global currency – the euro.

Increasingly Dysfunctional Bond Markets in the Eurozone

Perhaps not unique in this regard, given the “support” being provided to asset classes in general by many central bankers, expressly by Fed Chairman Bernanke, it is feasible to argue that there is no "real" price discovery mechanism functioning at present for EZ peripheral debt. There is a de facto buyers’ strike, and, without the purchases by the ECB under its SPM program, one can only hazard a guess as to the prices that many issues – both sovereign and private bonds and structured instruments – would be fetching were true price discovery be allowed to prevail.

Laurence Mutkin from Morgan Stanley has summarized the situation rather aptly as follows:

Peripheral government bonds…while still being government bonds in name, no longer offer the advantages of a government bond – safety, liquidity, low volatility and a negative correlation with risky assets… Hence, investors running a traditional government portfolio are exiting those markets. In short, peripheral government bonds have become an asset class in search of a new investor base.

But most recently we now need to go beyond the peripherals and look at the European core. If the problem was confined to the PIIGS nations that would be serious enough for capital markets but on December 6th yields on 10-year German bonds briefly rose above their US Treasury counterparts. That is not typical and rather disquieting. Based on historical data it turns out that US bonds had higher yields for 70 per cent of the last decade and 74 per cent of the last five years. If there is one development which could turn the PIIGS fiasco into a full blown systemic crisis it would be the occurrence of a kind of Gresham’s Law, where the “bad” debts of the EZ peripherals tarnish the creditworthiness of the core countries of Europe and specifically that of Germany.

I commented on this phenomenon in an article entitled “How much does Germany love the Euro?” which can be found here.

A problem… which will almost certainly lessen the appetite for further political/fiscal integration of the EZ is that the 10 year bund yield keeps moving higher and is approaching the yield on the equivalent UST (U.S. Treasury Bond). This remarkable phenomenon will not go down well with German policy makers or their electorates and may hasten the day when the consensus view within Germany is to return to the Deutschemark.

A poll conducted at the beginning of December by a major German TV network found that almost 60% of Germans would now like to see Germany abandon the euro and return to their much loved former currency. For the technocrats in Brussels this may well be, to use a wonderful American expression, where the rubber meets the road.

It has been observed by some that European Union officials never miss an opportunity to miss an opportunity. The events of the last few weeks which have seen the Irish government humiliated, an almost complete lack of liquidity in the private and sovereign bond markets for European issuers, and a renewed attack by short sellers on the euro accompanied by a ratcheting up of the rates chargeable under CDS and other swap agreements, have still not been adequately addressed. The EZ mess gets messier and there is, in my estimation, a strong presumption that things could spiral out of control, causing a nasty threat to the global financial system.

Is an EMU Failure Inevitable?

Just how seriously should the potential break down of the EMU and the demise or re-organization of the euro currency be taken? In the remainder of this article I shall provide reasons why I believe that the attempts to change the underlying architecture of the EMU are likely to fail. These inherent flaws in the EMU system are as much to do with the hubris and market naivete of the system’s architects as they are to do with the likely reactions – which will be visceral – when politicians seek a mandate from their constituents on a way of “fixing” the big problem with a big (but unacceptable) solution for greater “fiscal and political integration”.

Stated at its most simple level, none of the actions that have been taken by the ECB and the Eurozone states have so far remedied the problems with the peripheral states or Club O’Med states (the addition of the O’Med to Club allows the inclusion of Ireland along with the other PIGS). All that has happened to date (as of mid December) are a series of disjointed and piecemeal initiatives designed like band aids to stop the bleeding within a body or system which could well be on the verge of cardiac arrest. The so called rescue packages for Greece and Ireland have crippled those economies with even more debt, with interest burdens that are on disadvantageous terms, and for which there are two choices – either many years of financial servitude for their populations, or a process of default and re-structuring, just the mention of which sends EZ leaders into paroxysms of rage and denial.

The major flaws in the EMU and the procedural shortcomings of the EZ management system have been only too obvious since the Irish have had to air their dirty linen in full view of the world’s financial media and analysts. But even more revealing has been the extent to which the German government appears to be resolved (?), to prevail on the view that eventually there must be burden sharing or haircuts for the senior creditors of the major European banks. While this eminently sensible idea continues to be propounded by German politicians (at least most of the time they seem to have this view), the rest of the EZ and of course the Federal Reserve, Bank of England and other central banks shudder at the thought that they too would most likely be implicated in another bail out of their respective banking systems. Yet again the policy makers will be prompted to remind us that given such a systemic threat we have no choice but to bail out these TBTF banks; these are, of course, the usual suspects who never saw an opportunity to lend money (up until late 2007), especially if it came with a AAA rating from a CRA (Credit Rating Agency), that they did not like.

Are the EZ's problem Global and Systemic?

The lack of resolve on the issue of how to allow insolvent, but totally inter-connected, banks to fail within a mechanism for re-structuring all stakeholders, including the claims of senior debt holders, is now the glaring weakness of the EZ and its interface with the global banking system.

Just how inter-connected and fragile the web of EZ sovereign and private credits are can be appreciated from how the metaphors regarding the messy state of affairs are getting ever more graphical. This one from a Bloomberg article captures the flavor:

“The problem for the Irish state is that banking guarantee two years ago inextricably merged the country’s banking problems with the sovereign,” said Brian Lucey, associate professor of finance at Trinity College, Dublin. “It’s an omelette that is impossible to un-scramble at this stage.”

It also should be noted that European banks had $509 billion in claims against Ireland at the end of June according to the Bank for International Settlements.

One final indication of the repercussions of the intermingling of public and private balance sheets within the EZ, and how the first and foremost criterion for investors in any peripheral European debt should be the state of the sovereign nation’s finances, is brought out in an interesting piece from FT Alphaville. The following is taken from an article which appeared in June 2010 (after the Greek crisis but preceding the full blown Irish debacle by several weeks) and which highlights how the linkage between sovereign credits and private banking credits are so closely entangled that they effectively can not be separated.

This (grim) sovereign-bank loop is one that’s finally increasingly being picked up by markets — particularly in Spain. To wit, the rolling correlation between five-year CDS on Spanish banks (BBVA and Santander) and that on the Spanish sovereign below, from Deutsche Bank.
It’s inching towards the 100 per cent mark, implying the market is beginning to view the two sectors as one and the same.

As the graph above illustrates, even in June 2010 the correlation (as expressed by the more meaningful normalized beta values) was at or close to its maximum. For those paying attention to such extreme correlations, it should not have been a surprise when the Irish government’s 100% guarantee to its insolvent banking system effectively “bankrupted” the nation.

Deficiencies of the European Financial Stability Facility (EFSF)

The mechanism which the EZ is using to finance part of its rescue facilities (along with IMF facilities) for member states that are having difficulties (i.e. they are close to being, if not already, insolvent) is structured as an SPV. The table below shows the commitments that are required to be underwritten for this special purpose vehicle, from each of the 16 member states which use the euro currency, and these are in accordance with their capital contributions to the European Central Bank (ECB). The bottom line shows a total fund of Euros 440 billion and the key percentages are really those for Germany and France at 27% and 20% respectively.

Member State	Capital Commitment Euros bn	Percentage of Total
Federal Republic of Germany	119,390.07	27.1%
French Republic	89,657.45	20.4%
Italian Republic	78,784.72	17.9%
Kingdom of Spain	52,352.51	11.9%
Kingdom of the Netherlands	25,143.58	5.7%
Kingdom of Belgium	15,292.18	3.5%
Hellenic Republic	12,387.70	2.8%
Republic of Austria	12,241.43	2.8%
Portuguese Republic	11,035.38	2.5%
Republic of Finland	7,905.20	1.8%
Ireland	7,002.40	1.6%
Slovak Republic	4,371.54	1.0%
Republic of Slovenia	2,072.92	0.5%
Grand Duchy of Luxembourg	1,101.39	0.3%
Republic of Cyprus	863.09	0.2%
Republic of Malta	398.44	0.1%

Total Guarantee Commitments	440,000.00	100%

The EFSF legal framework is arcane and designed with “credit enhancement” features according to its prospectus, which may help to explain (although these matters often defy explanation) why the three major credit ratings agencies back in the summer of 2010 attached a AAA rating to the EFSF as an issuer. On reflection the awarding of this rating (one cannot help recall the similar ratings given to CDO sub prime creations) is remarkable given that the Greek crisis should surely have raised a question about the validity of relying on the Hellenic Republic being able to underwrite its E12 bn commitment, and the uncertainty, even back then, surrounding the financial wherewithal of states such as Ireland and Portgual, should surely have raised serious concerns for the CRA’s as to the credit worthiness of this vehicle. Nonetheless the EFSF mechanism, which would be relying on nations being bailed out to contribute to their own bail outs!, was promoted heavily by key European policy makers as providing a safety net under the EMU and designed to end speculative attacks against the euro currency.

The EFSF has a termination clause which sees the mechanism being wound up by the end of June 2013 and, from a contractual stance, the underwriters do not incur obligations which are joint and several. Both of these features should have raised further concerns to the CRA’s. Firstly to put a time limit on the need for this vehicle seems imprudently optimistic given the long term and structural nature of the deficits of the peripheral states, and also raises the question of how do lenders deal with rollover risk. Secondly, the last provision is important since it provides, at least on a strict interpretation, that the commitment of Germany to supporting the mechanism is confined to its 27% shown in the table. The problem that makes many in Germany uncomfortable, to put it bluntly, is that if most of its “partners” in this club turn out to be financial basket cases, and there is any default risk attached to the issuances of EFSF bonds, this could jeopardize the much cherished AAA rating of the German Republic.

Three states, Germany, along with France and the Netherlands, the other key AAA sovereigns at present, represent more than half of the contributions required to underwrite the EFSF bonds which are currently in the process of being issued to cover the first tranche of funds being made to Ireland.
Once one removes the contributions of the actual and potentially troubled states, that may themselves need to be bailed out by the EFSF, the table looks quite a lot different. The size of the fund has shrunk to E278 billion (in fact due to other consequences of the legal framework the original headline amount for the table above of E440 bn was always more like a 350 bn in actual usable funds) and the top three contributors, currently with AAA ratings are actually obligated to provide almost 85% of the total funding required.

Member State	Capital Commitment Euros bn	Percentage of Total
Federal Republic of Germany	119,390.07	42.9%
French Republic	89,657.45	32.2%
Kingdom of the Netherlands	25,143.58	9.0%
Kingdom of Belgium	15,292.18	5.5%
Republic of Austria	12,241.43	4.4%
Republic of Finland	7,905.20	2.8%
Slovak Republic	4,371.54	1.6%
Republic of Slovenia	2,072.92	0.7%
Grand Duchy of Luxembourg	1,101.39	0.4%
Republic of Cyprus	863.09	0.3%
Republic of Malta	398.44	0.1%
Italian Republic		0.0%
Kingdom of Spain		0.0%
Hellenic Republic		0.0%
Portuguese Republic		0.0%
Ireland		0.0%

Total Guarantee Commitments	278,437.29	100%

The limitations of the EFSF have become only too apparent to those at the sharp end of the EZ crisis i.e. the TBTF "private" sector banks and those pension funds and insurance companies that own these bonds. The challenge of valuing their existing holdings of both sovereign and private sector issues, and also contemplating purchases in the future is not for the faint hearted. More precisely the real risk is that markets are doing what they do best – and should be doing – which is to test the robustness and resolve of various pledges that are made by issuers of any security. During the peak days of the Irish rescue negotiations CDS rates blew out and the spread between the government bonds of Spain, Italy, Portugal, Greece and even Belgium reached levels never previously seen since the EMU was introduced.

During the last few days while the negotiations were taking place in Dublin, the euro broke briefly below the pivotal $1.30 level, and sovereign CDS rates kept breaking records. The magnitude of the crisis was sufficient to bring forth some dramatic utterances from alarmed EU officials including the Union’s president Herman Van Rompuy, who it is worth mentioning is not a publicly elected official but an appointee of the Brussels parliament. Mr van Rompuy was quoted in several news reports as follows:

“The European Union won’t survive if it fails to overcome a debt crisis plaguing the single currency area.”
“We’re in a survival crisis,” Van Rompuy said in a speech in Brussels hours from an assembly of euro finance ministers with Ireland and Portugal each teetering on the brink.
“We all have to work together in order to survive with the euro zone, because if we don’t survive with the euro zone we will not survive with the European Union. But I’m very confident we will overcome this.”

Since the Irish government agreed to the rescue package and during early December, the ECB has been actively buying bonds of Ireland and Portugal and this has at least “stabilized” matters to the extent that betting against these sovereigns was no longer a one way bet. The approach of the year end also means that a lot of institutions are closing their books for the year and the euro bond market is effectively closed until January. Whether this will either dissuade or encourage traders to conduct raids against the euro and cause further widening of bond spreads and CDS rates again before next year will become clearer as we head towards the end of 2010.

But the chance to articulate a deeper solution to the ongoing crisis has still not been forthcoming. Rather we have seen more of the same and what has become characteristic of the daily pronouncements from EZ leaders. The first part of their rhetoric is the constant denials of the need for any further bailouts, but this is quickly followed up by their reassurances that the EZ can cope with another bailout for (say) Portugal.

There has been an acknowledgment by key EZ officials that the EFSF is insufficiently funded, there has even been the flotation of the idea of an E-Bond which would essentially be like a US Treasury Bond but issued by an ECB which, formally at present has none of the powers of a federally constituted central bank. The ECB’s Jean Claude Trichet has also ruled out (at least for the time being) any Euro style QE, and with numerous policy makers admitting that at present there is not a structural solution to the EZ’s problem, a two day meeting on December 6/7 was convened in Brussels to try to make progress on a new architecture – the European Stability Mechanism (ESM). However, as always the meetings were inconsequential, and perhaps not so much a wasted opportunity, as a reminder that there really may be no viable solution for “fixing” the ultimately flawed currency union.

The Visceral and the Cerebral

From their inception, the EMU and EZ have been examples of overly abstruse technocratic design, and built on the kind of consensus requirements of the EU itself – which, in many respects are woefully ill prepared for governing and solving problems in a real world consisting of an heterogeneous collection of often fractious European states, with a visceral history of disharmony. In the case of the EZ this lack of “fit for purpose” is particularly acute since it highlights that the financial engineers behind the EZ framework failed to take into account fundamental features of capital markets. The shortcomings of their architectural endeavors have now been exposed to the real world where things go wrong, investors become anxious and sell in attacks of panic and moments of great illiquidity, and where politicians come under pressure from their electorates because things have not turned out the way that they said they would.

For its first eight years or so the euro was widely welcomed as it allowed the citizens of the peripheral states to borrow money far more cheaply, since they were under the umbrella of some of the most stable sovereigns (especially Germany), than they could ever have borrowed in their own currencies and having to rely on their own country’s credit profiles. But since the banking crisis of 2008, in a reminder of the slogan “It’s the economy stupid” it has to be said that there is strong anecdotal evidence that many of the EZ citizens would rather see the back of the euro currency and a return to their previous domestic currencies. Despite the obvious financial dislocations that would be created by several countries exiting the EZ, the visceral may well prevail over the cerebral in the longer term.

Essentially there is a major cognitive conflict between truly global capital markets where financial flows can cross borders without showing any passports or hindrance, when a hedge fund in London with investors from Miami or Qatar could hold the largest net long position in government paper from Indonesia, on the one hand, and the antiquated system of nation states, sovereign risk and the nature of the “guarantees” being provided for specific regions of the global economy. Financial technocrats have yet to deal with the “gap” between the world of spreadsheets and algorithms and the world where the average citizen pays little attention to finance until it begins to encroach on visceral and primordial prejudices.

During the crisis in H2, 2008 there was quite a lot of hostility expressed in the US to the notion that TARP monies could be used to benefit global banks such as Deutsche Bank –which may be domiciled in Germany but is effectively a global bank. Why did this arise? The simple but powerful answer is – when you use taxpayers’ money it is to be expected that visceral and atavistic energies will be released.

As it turns out, and following the FIA request to the Federal Reserve where it was required to release information about the recipients of emergency funding in 2008, it is now apparent that amongst the beneficiaries were major non-US domiciled banks and even some offshore hedge funds.

There has been a lot of criticism from various German and French politicians and other eurocrats that the markets have been displaying irrational behavior and “have it in for the euro”. Once again, when stripped down to the bone, these kinds of statements do not present the parties expressing them in a good light, but they need to be understood as the utterances of individuals coming from cultures which are highly competitive and which have had a troubled history.

Part of this resentment is tinged with a certain hostility (and perhaps envy) toward the pre-eminence of “Anglo Saxon finance” (whatever that means!) with London and New York clearly outranking Paris and Frankfurt as financial hubs. Again to pursue the more emotive side of this envy and anger at the Anglo Saxon axis, there is considerable antagonism expressed by many continental bankers at what they perceive as financial engineers in London and New York embodying the “Wild West” of modern finance. However, one of the hardest things for such critics to explain is how and why some of the largest purchasers of questionable structured products were banks within their own domiciles. Furthermore to accuse traders in markets as being subject to bouts of irrational behavior is like complaining that your national football team should have won the game because they played more skillfully. The height of folly and hubris of the technocratic mindset would be to imagine that these bouts of non-rational behavior can be eliminated by clever regulators and regulations.

The same kinds of strongly visceral responses are pervasive in the EZ crisis. Why should the German electorate agree to a new EZ architecture which would include, among other devices leading to more “integration”, provision for fiscal transfers, and where amongst the recipients would be Greek citizens who can retire in their early fifties on a state pension? West Germans had to extend considerable generosity to twenty million fellow countrymen/women in 1990 after the Berlin Wall was removed and the old GDR was absorbed into the new German Federation. The fiscal transfers and re-structuring based upon accepting the old East German mark at parity with the old Deutschemark, while it was portrayed (correctly) as an exciting re-unification by German leaders, for a lot of ordinary German citizens there was a lot of disgruntlement about the drop in living standards and increased taxes that were involved in the process.

To expect German voters to elect politicians who would consent to treaty changes within the EU which would allow fiscal transfers to the peripherals would be as far removed from the real world as is the belief that an enlarged EFSF or revamped ESM is going to solve the structural flaws in the EMU.

The term “uncertainty” is being used increasingly amongst practitioners in Eurobond financing and the world of structured finance. There is a lot of discussion about arcane matters such as the percentages required to trigger collective action clauses and the nature of preferred creditor status. However the continuing use of the term “uncertainty” puts me in mind of another term which has been used to describe the aftermath of the bursting of the Japanese real estate/equities bubble of the 1980’s which is “zombie”. A zombie financial system is one in which uncertainty is omnipresent as participants continue to deny that there really is a problem and try to find comfort in pretend and extend stratagems which will hopefully make insolvency problems go away.

In conclusion and to enlarge the context, for the fiscal problems of the US are not that dissimilar in many respects to those being seen in much of Europe, there is a real question mark as to how long we can all continue to kick the can down the road and believe that in the long run we will muddle through without dealing with our demons.

How much does Germany love the euro?

2010-12-06T02:55:00.000-08:00

The daily chart for EUR/USD from an Ichimoku perspective is quite revealing as it shows that the EZ currency met rejection at almost exactly the point anticipated. After peeking into the cloud and reaching the $1.34 level the rate has retreated below the cloud and, at the time of writing, is now sitting close to $1.33.

As can be seen on the chart another break below the upward sloping trendline not far below the current exchange rate would validate a five down wave interpretation and suggest that the $1.30 level is back in play.

Fundamentally there are several items that are playing into the double bind issues which confront a resolution of the severe architectural flaws of the EMU mechanism.

An interesting piece at the FT Alphaville website has pointed out that the plans to replace the EFSF, which has a built in termination date of June 30, 2013, with a new European Stability Mechanism (ESM) is facing legal/conceptual hurdles because, according to the wishes of the Germans, new debt issued from the ESM vehicle would have "preferred creditor" status and seniority over existing debt. Apart from the obvious issue that this will simply reinforce the buyers' strike (apart from the always reliable ECB that is) for existing instruments, the further problem is that by insisting on seniority for the new debt it is conceivable that default/restructuring clauses could be triggered in a variety of CDS arrangements.

Not only could there be another rush to the exits for eurobonds (as the demarcation between sovereign issues and other structured instruments is becoming increasingly blurred) but there could also be a rush to the courthouses. This is making the EU mess even messier.

The second problem, which will almost certainly lessen the appetite for further political/fiscal integration of the EZ is that the 10 year bund yield keeps moving higher and is approaching the yield on the equivalent UST. This remarkable phenomenon will not go down well with German policy makers or their electorates and may hasten the day when the consensus view within Germany is to return to the Deutschemark.

Over the weekend a poll by a major German TV network found that almost 60% of Germans would now like to see Germany abandon the euro and return to their much loved former currency. For the technocrats in Brussels this may well be, to use a wonderful American expression, where the rubber meets the road.

Bond Vigilantes and Wikileaks

2010-11-29T08:24:00.000-08:00

Q: What is the difference between the Bond Vigilantes and Wikileaks?
A: One is a shadowy transnational group dedicated to exposing the Truth at all costs and with the power to seriously embarrass governments, the other is Wikileaks.

Taken from the comments section of an article entitled "Will the euro survive?" at FT Alphaville.

No parallel between the Eurozone currency club and the federal system behind the US Dollar

2010-11-29T02:30:00.000-08:00

The Irish Independent ran a story on Sunday November 29th which is worth reading for illustrating how troubled peripheral Eurozone states can best negotiate terms for EU bailouts...just threaten default.

With French and German policymakers issuing hyperbolic (and desperate sounding) statements in support of the euro currency on Monday as the markets seem not to be overjoyed by the Irish "rescue" package, the Achilles heel of the EZ currency club is becoming all too apparent.

The major flaws in the EMU and the procedural shortcomings of the EZ management system have been only too obvious since the Irish have had to air their dirty linen in full view of the world's financial media and analysts. But even more revealing has been the extent to which the German government in particular has had to back down on the issue of bond haircuts. The lack of resolve on the issue of how to allow insolvent, but totally inter-connected, banks to fail within a mechanism for re-structuring all stakeholders, including the claims of senior debt holders, is now the glaring weakness of the EZ and its interface with the global banking system.

One could even make the case that Europe is simply in the vanguard of the eventual unraveling of the many dodgy bank balance sheets which have been subjected to a low tech shell game of financial engineering with bad assets simply being shunted through a maze of obfuscation.

The architectural flaws of the EZ currency club are almost too numerous to mention but can be framed essentially in the following question - How does one expect a "union" to survive under a common currency, which has to be supported by a central bank, when any and all of the member states are free to issue as much debt in the collective currency as they deem necessary?

While the US dollar bloc is similarly exposed to hide the salami accounting shenanigans the lack of a parallel between the EZ currency club and the USD regime which is under-written by the truly centralized Federal Reserve system is highlighted by the Irish negotiating tactic alluded to above.

Imagine the circumstances where to take just one example, say California, threatened to default on its obligations and how this would impact the US dollar. It clearly would be a distressing circumstance and likely to cause major disruption in asset markets but would it trigger a cascading of defaults on vast numbers of daisy chain obligations denominated in US dollars? California is not obviously a sovereign in the same sense that Ireland is and the defaulting by the state of Ireland would have wiped out in a second hundreds of billions of euros of loans by global banks to not only Ireland per se but all of its banks which are subject to the guarantee of a state which had just defaulted. Would the capital markets be convinced if the ECB stepped in and was prepared to guarantee all of Ireland's obligations? What about the credibility of a promise by the EFSF (an SPV which derives its AAA credit rating from the creditworthiness of all EZ states - including the so called PIIGS!) to honor all of Portgual's and Spain's liabilities?

The US Federal Reserve could much more readily and convincingly undertake to protect debt holders in the case of a unilateral default by one of the US states than the European central bank, and this is underlined by the fact that the idea of a state like California declaring its currency independence from the USA and floating a rival currency seems like a nonsense.

When all of the impossibly awkward repercussions of the EZ bailout process and the flawed architecture of the underlying EMU are fully exposed - and they surely are close to that point already - the non-survivability of the euro currency will become obvious to all.

The EZ mess is getting very messy indeed

2010-11-16T04:55:00.000-08:00

The metaphors regarding the messy state of affairs in the Eurozone are getting more graphical. This one from a Bloomberg article caught my eye

“The problem for the Irish state is that banking guarantee two years ago inextricably merged the country’s banking problems with the sovereign,” said Brian Lucey, associate professor of finance at Trinity College, Dublin. “It’s an omelette that is impossible to un-scramble at this stage.”

But just after composing this posting the following comments from the EU President were reported by Dow Jones and show that the mess is getting even messier.

The European Union won't survive if it fails to overcome a debt crisis plaguing the single currency area, the bloc's president Herman Van Rompuy said Tuesday.

"We're in a survival crisis," Van Rompuy said in a speech in Brussels hours from an assembly of euro finance ministers with Ireland and Portugal each teetering on the brink.

"We all have to work together in order to survive with the euro zone, because if we don't survive with the euro zone we will not survive with the European Union. But I'm very confident we will overcome this."

Ireland admitted Monday that it was holding talks about a rescue package of emergency aid, six months after EU nations had to rush to the rescue of Greece with a EUR110 billion bailout.

Portugal has also warned it is at "high" risk of needing financial support, unable to borrow money on open markets other than at prohibitive rates.

And just to round this out here are a couple of my own contributions to Twitter on the matters:

If EZ does crumble - the EU "center does not hold"- the EU project would, in hindsight, appear as fantastic technocratic folly built on hubris.

Apart from EZ "crisis", the failure of EU members to agree on a budget and not allow Brussels to set it, is starting to look like "constructive dismissal"

Credit depends on a socio-cultural matrix of keeping promises

2010-11-14T04:26:00.000-08:00

The current clash over monetary policy/currency debasement or manipulation, may well be a zero sum game or to cite other terminology, the US might win but it will be a Pyrrhic victory. It has even been suggested that the US policy of QE is a shrewd tactic which will reduce the burden of the national debt by enabling it to be "repaid" in dollars which have diminishing purchasing power.

There is almost certainly not a simple winner/loser dialectic at work here. There are both direct and external costs to a currency war where both sides will win some battles and lose others but the "war" will end in an economic stalemate or looking at the worst outcome, a depression culminating possibly in military conflict and/or a breakdown in the rule of law.

Some have argued that the US is being backed into a corner by China by its refusal to revalue the yuan and to encourage its consumers to save less and spend more. On the other hand China is effectively saying that their economic livelihood, including their belief that buying US Treasuries and agency debt represented a "store of value" and economic benefit, was based on a false premise that they presumed (perhaps due to misrepresentations) about US fiscal/monetary responsibility, and that this extending of credit is now being jeopardized by the monetization of US debt obligations.

At the end of the day monetary and credit systems are all about a socio-cultural matrix of shared beliefs (i.e. the Latin verb for belief is credere) and an assumption that promises made are going to be kept. Right now more of the world is having serious questions about whether the US (and many other nations) have either the intention or wherewithal to honor their financial obligations.

In that sense, and in my view in the longer term, the US especially, but other states as well, are not being shrewd but reckless.

Two key markets EUR/USD and S&P 500 ready for major moves?

2010-11-02T04:00:00.000-07:00

The 15 minute chart for the S&P 500 futures over the last 48 hours or so reveals very clearly the two points that I have made in my Daily Form column regarding this key US benchmark index. The two arrows point to the two critical levels that are prevailing at present --- and both were touched within about 4 hours of each other.

The 1193 zone is clearly the top of the recent range and a failure to penetrate that level yesterday energized traders to immediately test the lower support level at 1173 as anticipated in the Daily Form commentary yesterday.

At present the futures in European trading are around the 1187 level (approx 62% of the swing high/low visible on the chart below).

The next 24 hours will be quite critical for this index, and if I had to guess (I don’t plan to trade this way however) I would be looking for a break above 1193 with perhaps a quick run towards the April high, but I would then be wary of an abrupt reversal.

If 1165 is taken out then there could be a scramble for the exits and if 1220 is exceeded then there would be a lot of large position traders within hedge funds that would be scrambling to cover. Either way there should be substantial range expansion which would lead to greater volatility and benefit option buyers and punish option sellers.

EUR/USD has reached into the apex of a key triangular formation which will need to be resolved soon. At the time of writing the euro is poised at the top of a descending trend line through highs which is seen on the 240 minute chart below.

Retreating from the technicals for a moment the fundamental position is that the announcement from the Fed regarding QE will highlight the almost impossible agenda for Ben Bernanke. On the one hand he faces the requirement to please the Administration and the consensus view that structural unemployment in the US needs more asset purchases (fallacious reasoning perhaps, but still politically expedient), and on the other hand the US is facing mounting of pressures from EM economies that the last thing that their markets need is even more hot money seeking out higher yields in their asset markets and forcing up the value of their currencies.

Despite a lot of attempts to try to smooth over the gaping cracks by policy makers mindful of the need for diplomatic rhetoric, it is worth emphasizing the point that there is a currency war already in effect and it is likely to get considerably more fractious.

QE addiction: exonerating Chairman Bernanke

2010-10-29T07:59:00.001-07:00

It has been widely noted this week, including here and also again here, that Bill Gross is on record as describing US current monetary policy as having all of the characteristics of a Ponzi scheme. At the same time Gross also proposes that Chairman Bernanke has really no other options than to implement such a scheme, as he has run out of all other viable policy weapons.

But what about the argument that he could/should do nothing and wean the US economy off a diet of endless asset purchases? In essence the flaw in this argument is that he may not have the option of curtailing QE and, in an ironic sense, this would go a step further in exonerating the Fed Chairman.

Looked at from the perspective of the US government's finances, although the unintended consequences of QE are highly undesirable - e.g. a weaker US dollar, friction with other global trading partners, creation of asset bubbles in emerging markets, booming commodity prices etc. - the US economy is most likely now addicted to QE in the same way that happens in any Ponzi scheme.

There's an old saying that a "rolling loan gathers no loss" and if government's simply roll forward expiring debt with new debt in moderation this does not pose systemic risk. However when the magnitude of the expiring debt is so colossal, and where there is clear evidence that, were it not for the stated aim of the Fed that it is effectively backstopping the Treasury market, non US government buyers (e.g. PIMCO, pension funds, PBOC, BOJ etc) may not participate (at least not at current historically low coupon rates).

There is much talk about the Fed's exit strategy but if the Ponzi scheme is as voracious as it appears to be, due to the over-commitments of US federal debt obligations, it looks as though the Fed is trapped. Not only will it be the lender of last resort it may ultimately become the only lender. Unless the Fed continues to reassure other market players such as other sovereign buyers, banks and pension funds, that they - and this includes PIMCO as well - can turn over their inventory quickly to the Fed if the market becomes illiquid, the absence of bids will create that very same illiquidity and systemic risk.

For many private investors, and this may well include PIMCO, it is not their intention to hold a 10 year bond to maturity. Rather they wish to avail themselves of easy exit possibilities from an accommodating central banker running a public buyback program. This "easy exit" is especially true should interest rates be rising and the value of the bond is declining. Usually it is only very long term asset managers such as pension funds that are committed to such buy and hold strategies - with all of the interest rate risk and duration difficulties that comes along with such an extended holding horizon.

More typically for many private investors their typical holding period may be weeks/months where they are looking to unload the bonds at higher prices each time the Fed steps in with more QE.

If the Fed terminates QE just how easy will it be to keep the Ponzi scheme afloat?

In a nutshell, this is why Chairman Bernanke is "boxed in" and why not only Mr. Gross is turning bearish on US bonds but also so are other major holders such as the People's Bank of China.

It's now respectable to call it a Ponzi scheme

2010-10-27T08:14:00.000-07:00

Whether one calls it Quantitative Easing (QE), or one uses any other of the multitude of acronyms that have been floated since TARP, the simplest nomenclature for the financial mechanics which constitute US monetary policy is to call it what it really is - a Ponzi scheme. Reduced to its simplest the US Treasury issues bonds at which the principal buyer (or implicit guarantor that indefinitely large quantities of the bonds will always be accepted as collateral) is the Federal Reserve.

Over several years, but especially the two most recent, a number of market commentators, not within the mainstream of "reputable finance", have been gutsy enough to characterize the manner in which the public sector balance sheet has been expanded to prop up asset prices as a Ponzi scheme. But most have been marginalized or considered to be part of the loony blogosphere and dismissed by their more "respectable" and politically correct peers.

In his current commentary Bill Gross from PIMCO has finally uttered the words which give a new respectability and gravitas to this characterization. Here is the relevant section from his current commentary .

It seems that the Fed has taken Charles Ponzi one step further. Instead of simply paying for maturing debt with receipts from financial sector creditors – banks, insurance companies, surplus reserve nations and investment managers, to name the most significant – the Fed has joined the party itself. Rather than orchestrating the game from on high, it has jumped into the pond with the other swimmers. One and one-half trillion in checks were written in 2009, and trillions more lie ahead. The Fed, in effect, is telling the markets not to worry about our fiscal deficits, it will be the buyer of first and perhaps last resort. There is no need – as with Charles Ponzi – to find an increasing amount of future gullibles, they will just write the check themselves. I ask you: Has there ever been a Ponzi scheme so brazen? There has not. This one is so unique that it requires a new name. I call it a Sammy scheme, in honor of Uncle Sam and the politicians (as well as its citizens) who have brought us to this critical moment in time. It is not a Bernanke scheme, because this is his only alternative and he shares no responsibility for its origin. It is a Sammy scheme – you and I, and the politicians that we elect every two years – deserve all the blame.

The only real question is why is it only now that Mr. Gross is willing to publicly acknowledge something which he must surely have known and thought about dozens of times over a very long period? Surely it couldn't be as simple as the fact that in the same letter he predicts that the 30 year bull market in Treasuries is now over. For Mr Gorss to reach this conclusion one is left wondering just how consequential it is for capital markets that he has realized that, even with PIMCO's vast buying power, a monetary policy predicated on QE, like all Ponzi schemes, eventually requires an incommensurately large flow of money from investors to keep the scheme going.

For a graphic image of just how unsustainable this self-reflexivity eventually becomes there is the archetype known as Ouroboros which is a voracious creature that ends up devouring its own tail.

More than usual FX is driving markets

2010-10-22T04:45:00.001-07:00

Several commentators (including myself) have recently pointed out that much more than usual asset markets are being driven by price developments in the foreign exchange markets. And in trading yesterday across several FX pairs and watching the associated movements in equities, gold, oil and other commodities the broad theme was exemplified par excellence

Here are some "Big Picture" themes for a "dress down" Friday column.

1. There is an inherent bias in US monetary policy to weaken the US dollar, despite all protestations to the contrary.
2. The Chinese know this and, as George Soros has recently commented, they have sufficient reserves and enough skin in the game that they can effectively "manage" (manipulate) the FX markets to achieve their longer term goals of diversification so that they are less reliant on dollar denominated assets and at the same time secure their stake in resources/commodities to continue to grow their economy at 10% per annum.
3. The world is awash in dollar liquidity which helps to explain why US equities and bonds have marched relentlessly higher despite, especially in the case of Treasuries, the real inflation adjusted returns and expected future returns seem absurdly "underpriced" and defy explanations from "traditional finance theory".
4. Many major funds are massively short US dollars from the use of all kinds of derivatives which are tied into correlation strategies involving everything from commodity plays to yield curve arbitrage and ETF rotation plays.
5. It would not take too much evidence of a short term US dollar rally to lead to some sudden and large scale shifts in asset allocation
6. Continuing with the theme from earlier this week in this column, many global equity indices are stalling at key fibonacci levels
7. Systematic (i.e. overall market) risk is under-priced
8. Exactly how global policy makers would deal with another bout of systemic risk remains a mystery of staggering proportions.

The intraday moves on the S&P 500 are becoming more erratic which is indicative of a lot of short sellers trying to pick an intermediate term top and to a large extent the "traps" are being set in the FX market where, even if the S&P 500 shows remarkable resilience, the astute inter-market traders can reap their rewards from coordinated plays with strategic FX pairs.

1200 is still the upside target but the 1155 value registered earlier this week also represents an Achilles heel which may need to be tested again before the April highs are challenged.

To end for today ... it is vital for those large funds that are aligned with the Chinese currency management goals, and are counting on a weak dollar to sustain further gains in the S&P 500, that the ambushes based on selling the euro, aussie and sterling do not turn into a rout.

Selling England By The Pound

2010-10-21T04:01:00.000-07:00

Residents of the world’s largest onshore tax haven, or as it has been amusingly described by Ambrose Evans Pritchard, a rainy version of the Cayman Islands in the North Atlantic, are getting set for belt tightening as the government is chopping away at entitlement programs and getting rid of 500,000 public sector workers in the coming three years or so.

But the borrowing continues with record public deficits - in September alone the UK required more than £15bn to plug the gap between revenues and expenditures.

However, it is heartening to hear the political leaders talking about how "we’re all in this together", but as I commented on Twitter yesterday, there are quite a lot of MP’s that will have to clean up their own tax avoidance (evasion) shenanigans before that slogan becomes too laughable.

Anyway enough of politics and let’s take the higher ground - and in this case it looks almost certainly higher ground for $EURGBP as targets above 0.90 are now alive and well. On the contrary it is lower ground for $GBPUSD with imminent targets in the $1.5640 region. But as FX traders can attest sterling sometimes takes the long way home, and whipsaw behavior is to be expected as the whiz kids in the towers at Canary Wharf engage in their passion for "bouncy castles".

Continuing with the theme of both fibonacci retracements and Great Britain as it is sometimes referred to (especially by George W Bush as I recall), the chart for EWU shows that the MSCI UK index also faces a challenge to remain above the 62% retracement level. It has been turned back already three times so far in 2010.

One of the more novel ways that the UK government may try to dig out from its mountain of debt is by selling off "bits" from the public sector in a 2010 version of Margaret Thatcher’s privatization. Going even further back into modern UK history, and with reminiscences of Edward Heath, three day weeks and power cuts, if the government does decide to "privatize" some bridges and other bits of infrastructure, serious thought should be given to a re-issue of the classic 1973 Genesis album Selling England by the Pound.

Currency war - for China a smoke and mirrors job

2010-10-11T03:46:00.000-07:00

The following brief citation which I came across at the naked capitalism website, expresses the unusual power which China has in the world of FX as alluded to here.

Furthermore it also helps to explain why, for the US to condone Japanese currency management (or at least not to criticize it), the Chinese government can afford to take the high ground and a tough stance in the negotiation, instigated by the US Treasury secretary, about increased voting rights for BRIC nations in the IMF as discussed here

"Japanese intervention...means that Chinese authorities managed to get Japan to acquire their Dollar reserves for them. Instead of buying Dollars, China buys Yen, which in turn induce Japan to buy Dollars. This maintains the artificial capital flows to the US while allowing China to escape accusations of being a “currency manipulator.”

Congratulations to the writer of the above paragraph as it captures elegantly the essence of the back and forth on the "currency war" issue.

What currency war?

2010-10-09T11:57:00.001-07:00

The following comes from the Nasdaq website as the IMF meeting in Washington appears to be failing to agree on a resolution to address the accusations that there is a currency war

China's official Xinhua News Agency on Saturday sought to turn the table on the U.S., accusing it of being the currency manipulator and of threatening the global economic recovery. The Xinhua article, citing officials at government think tanks, pointed to the dollar's 12% fall against the euro since June and recent strength of Brazilian real, the Japanese yen, the Korean won and other currencies and the possibility of Federal Reserve Board quantitative easing measures as evidence that the U.S. purposely weakens its currency indirectly. "The U.S. not only manipulates the dollar's exchange rates, it also manipulates other countries' exchange rates," Xinhua quoted Cao Honghui, a division chief at the Chinese Academy of Social Sciences, as saying. Chinese scholars have made such accusations before whenever China's currency manipulator status is being discussed in the U.S., but this fresh accusation comes as the yuan valuation issue is at the center of attention during the IMF/World Bank meetings in Washington.

The systemic view from eight miles high

2010-10-09T08:48:00.000-07:00

ZIRP, QE and competitive devaluations all manifestations of late stage Ponzi capitalism (that’s capitalism with a public backstop, of course)

Is Mr Geithner really in a position to make such demands on China?

2010-10-09T08:08:00.000-07:00

The following "initiative" from Mr. Geithner follows on from a theme articulated earlier in the week in which the older and supposedly richer (in fact, the most indebted) economies are prepared to grant more power to the newer and less affluent (in fact, surplus economies with huge currency reserves and savings) economies in the G20 with respect to IMF voting rights.

WASHINGTON (MarketWatch) -- The United States has linked a faster rise in China's currency to a deal that would give the Asian country more sway at the International Monetary Fund. In a speech to the IMF's governing council on Saturday, Treasury Secretary Timothy Geithner said any agreement to give emerging market economies more voting power at the IMF "needs to be accompanied with more progress by countries, particularly the surplus countries, towards more market-oriented exchange rate policies and policies that will reduce reliance on exports and strengthen domestic demand." The top Chinese representative at the IMF talks, Zhou Xiaochuan, the head of China's central bank, has already rejected any link between the two issues. The U.S. has been seeking new levers to force China to let its currency rise.

Surely there is great irony in the fact that Mr. Geithner has so little leverage to exert over the PBOC and central banks of the G20 "tigers", that the reverse situation of China and the other BRIC's considering how many votes should be allotted to the US, UK, France, Spain etc, would be a much more plausible scenario.

Moreover, there is further irony in the fact that the PBOC are doing the US a massive favor at present by unloading their US dollars in exchange for yen, euros and Aussie and Canadian dollars, which has the affect of enabling the US to have the most successful stance in competitive devaluations, with the side benefit for China that the exports from Germany, Japan, Canada etc will be relatively less competitive in world markets than the yuan based manufacturing which is tied to a depreciating US dollar.

From the viewpoint of IMF realpolitik it really feels as though the tail (Mr. Geithner) is trying to wag the dog (PBOC).

China controls the world currency markets says George Soros

2010-10-09T03:53:00.001-07:00

George Soros, interviewed on the BBC Radio 4 program Today (October 9) can be heard in the clip referenced below making the rather striking assertion that the "Chinese effectively control the entire world's currency system".

Here is the audio clip and the assertion comes around 1:40 into the interview segment.

Notice how the interviewer completely fails to grasp the true significance of what Soros is alleging and moves on with the interview in a one-dimensional and prosaic manner to talk about re-valuation of the yuan against the dollar.

If Soros is right, and there is mounting evidence that he is, for example as I have discussed in this article , which can also be found here, the consequences for those running global asset allocation strategies and believing in the notion that markets, especially in FX, are price discovery mechanisms, should really be quite disruptive.

The twists and turns of Chinese currency management

2010-10-02T10:45:00.000-07:00

The following news item from Reuters on Saturday (October 2nd) shows some remarkable cunning in an era when accusations are being hurled around about currency manipulation and especially the Chinese version of it, which is multi-faceted, and includes, to the annoyance of the Japanese central bank, the enthusiasm that the PBOC has for buying the yen whenever the BOJ tries to make it cheaper. The current visit by the Chinese Premier to Greece is now providing an opportunity for further magnanimity which could result in a stronger euro, which may not be exactly what Monsieur Trichet has in mind.

(Reuters) - China offered on Saturday to buy Greek government bonds when the country returns to markets, in a show of support for the country whose debt burden pushed the euro zone into crisis and required an international bailout.

Premier Wen Jiabao made the offer at the start of a two-day visit to Greece, his first stop on a tour of Europe, and also said he wanted to boost shipping and trade ties with Athens, underscoring Beijing's use of economic strength to win friends.

"With its foreign exchange reserve, China has already bought and is holding Greek bonds and will keep a positive stance in participating and buying bonds that Greece will issue," Wen said, speaking through an interpreter.

"China will undertake a great effort to support euro zone countries and Greece to overcome the crisis."

The last quote is particularly revealing as it achieves at least three objectives for the world's second largest economy:

1. It is a recognition by the Chinese authorities that in a fragile and totally inter-connected financial system, a serious crisis for the basket case EZ economies would be especially harmful to China which has vast holdings of euros and the government bonds of the Eurozone constituent states.

2. The support of China for the sovereign credits of Greece, and quite likely the other PIIGS economies will help to further bolster the euro against the yuan. This can only be good for Chinese exporters.

3. Furthermore it could have the affect of diverting attention away from the current antagonism between Washington and Beijing over the artificially low rate of exchange between the US currency and the yuan. Ironically by supporting the Eurozone financial system, and indirectly the euro, it will become harder for the ECB and the Federal Reserve to condemn the Chinese actions, which can only be considered as making a positive contribution from the perspective of helping to avert systemic anxieties.

In the post-2008 meltdown era, the trend towards a more altruistic form of "capitalism", some would even say outright socialization of the global financial system, China appears to be taking a leadership role in recognizing its dependency on the continued solvency of its less dynamic trading partners by rewarding them with pledges of further financial support. In so doing the Chinese authorities will continue to find even more reasons to continue its policy of "currency management". Perversely policy makers in the US and Eurozone may not appreciate such altruism.

Daily Form September 30, 2010

2010-09-30T03:46:00.001-07:00

Inter-market Technical Analysis using algorithmic pattern detection

THURSDAY SEPTEMBER 30, 2010 10:42:00 GMT

Spot gold is trading at $1315 an ounce as this is being written and is on its way to a target which was mentioned in this column in October 2009 of around $1340. Meanwhile the US dollar index is at its lowest level in eight months.

I believe that the end of quarter window dressing to try and break above $1150 on the S&P 500 is causing some extremely over-stretched conditions in the FX market which is all part of the effort to provide the most supportive backdrop to further gains for equities.

Somewhat tongue in cheek I made the following comments earlier this morning from my twitter account:

My hunch is that $GBPUSD has a run at $1.60, $EURUSD at $1.38, $AUDUSD at 0.98 and then its wile coyote time-which would also not be good for $SPX.

FX market seems really stretched against the dollar and there could be a big snap back in coming days.

End of quarter window dressing is causing some real tensions in FX which seem ready to break apart -perhaps even later today

The achievement of the $1340 target on gold, which arose in connection with the inverted head and shoulders pattern which took a couple of years to develop, could mark an exhaustion point in the outright hatred of the US dollar at present. October could be interesting.

A potential double top lies in wait for $GBPUSD.

As discussed here on Tuesday and on CNBC that afternoon, $AUDUSD could be facing a key inflection point.

The S&P 500 futures are currently at 1140 and if the window dressing exercise can be sustained today it would be not be surprising to see a rally up to 1150.

Meanwhile I shall be paying close attention to any ambushes/traps that are being set in the forex arena as we exit a very profitable September and open the books for Q4.

TRADE OPPORTUNITIES/SETUPS FOR THURSDAY SEPTEMBER 30, 2010

The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions.
None of these setups should be seen as specifically opportune for the current trading session.
For a more comprehensive listing of price formations detected by our pattern recognition algorithms please visit TradeWithForm

Daily Form September 28, 2010

2010-09-28T02:30:00.001-07:00

Inter-market Technical Analysis using algorithmic pattern detection

TUESDAY SEPTEMBER 28, 2010 09:12:00 GMT

I have been invited to present charts for analysis on CNBC’s European Closing Bell this afternoon (at 16:40 London time) and will be showing, time permitting, the following three charts below. This also explains why today’s commentary takes a big picture view on material which has been covered in finer granularity in recent commentaries.

The target which is now on the agenda for the S&P 500 cash index, and could even come this week, is the 1173 intraday high from May 12th in reaction to the May 6th mishap. As also discussed here the Nasdaq 100 has already achieved the equivalent target and seems destined to head towards the April high.

If forced to express an opinion about the direction of the S&P 500 over the next 30 days (as one tends to be on a TV slot) my suggestion is that the 1170 could well be touched but, given the risks attached to other strategic targets which are outlined below (including the NDX scenario), the potential benefit of maintaining a long position in the S&P 500 beyond this 1170 level- waiting for a re-visit to 1200/20 - would not fit my risk/reward trade-off criteria.

The long term weekly chart for AUD/USD reveals that the highest weekly close on this currency pair was observed for w/e July 20th 2008, which was a pretty good ringing of the bell marking the exhaustion top of the leveraged carry trade at that time and which preceded the financial meltdown of H2, 2008. As can be seen the value registered, in terms of closing values, was 0.9727 which is only about 100 pips from where this pair has been during the last few trading sessions.

My contention is that the risk/reward ratio for being long this pair is becoming unfavorable. This is not the same as suggesting that one should be instigating a short position - yet.

The way in which I reconcile these comments with the view expressed here yesterday regarding the target of 81.80 for AUD/JPY is as follows:

1. I would not be surprised to see another run up in AUD/USD towards the 9730 level in coming sessions
2. I would not be surprised to see a weakening of the yen against the dollar towards the 86 level

The net result would be that AUD/JPY will strive to hit the 62% retracement level discussed yesterday, but, given the other conditions around this, my sense is that the 81.80 level could well be an intermediate milestone, and certainly a place to exit any long positions in AUD/JPY.

USD/JPY is drifting back to the levels around 84 where the BOJ intervened on an industrial scale during Asian trading on September 15th.

As suggested here yesterday my intuition is that the BOJ is really struggling with the Chinese central bank over this rate and I suggest that the PBOC could be moving into more politically treacherous territory as its currency management operations are antagonizing many central bankers and politicians.

I have drawn a line at the 88.50 level which I believe is a level which has to be contemplated as a possible target for the yen against the dollar if only market forces (and not currency manipulation) are allowed to express themselves.

Don't fight the Fed or the BOJ?

2010-09-26T02:47:00.000-07:00

David Tepper, founder of the multi-billion dollar hedge fund Appaloosa Management, who normally adopts a rather low profile may have discovered a new career as a broadcaster when he was interviewed on CNBC last Friday morning (24th). His manner was attention grabbing in the same way that could be said of a loose cannon, and his enthusiastically bullish outlook, which may have helped to light the fire under US markets that sustained for the rest of the day, is likely to have appealed to CNBC viewers and equity bulls alike. Moreover his reasoning was profoundly simple and seemed to have only one real underpinning - amounting to the simple notion "Don't Fight the Fed".

While it would be rash to question the judgment of someone who has a laudable track record of returns to participants in his hedge fund, there was one rather awkward issue that the CNBC anchors failed to raise with Mr. Tepper. It has to do with whether, in the longer term, US Treasuries are likely to be a buy or sell for portfolio managers.

Essentially the argument presented by Mr Tepper was that either the US economy will recover on its own accord without further QE from the Fed, or if it doesn't then the Fed has stated that they will oblige with further asset purchases (i.e. buying more Treasuries and agency securities) financed from the public balance sheet. For Mr. Tepper this can only present a benign outlook for most assets classes in the longer term.

But, surely there is a difference in the outlook for the US Treasury market depending on which of the either/or scenarios comes to pass. If the economy starts to show more signs of a robust growth, and the Fed is not required to do more QE, then one would have thought that this would not be good for Treasuries. There would be no advantage to getting ahead of the Fed now by buying more government bonds as they would no longer be net buyers of these securities. Furthermore if a more favorable dynamic begins to propel job growth and increasing GDP one would expect 2.5% yields on 10 year bonds to seem very skimpy. Needless to say, there is considerable capacity for capital losses on existing longer maturity bonds if the US economy surprises most market participants, especially the Fed, with renewed vigor.

Returning to the core notion that it is never wise to fight the Fed there seems to be an asymmetry within the capital markets with respect to whether or not it is wise to fight the BOJ.

The following comes from a BBC news item on the question of intervention by the BOJ last week to weaken their currency.

The governor of Japan's central bank has not ruled out further interventions in the currency markets in its fight to control the rising value of the yen.

Speaking at a conference in Kobe, Masaaki Shirakawa said the Bank of Japan (BOJ) was "ready to implement appropriate action" if required.

The BOJ intervened in the currency markets for the first time in six years earlier this month.

Its decision to sell large amounts of yen helped drive down the currency.

Previously the yen had reached a 15-year high against the dollar - a concern for Japan's exporters who are seeing their profits squeezed by the poor exchange rate.

Mr Shirakawa said the BOJ would closely watch the impact the strong yen is having on the economy.

"We have to pay more attention than before to the downside risk to the economy," he said.

"We are ready to implement appropriate action in a timely manner if judged necessary."

The comments came two days after the central bank was suspected of intervening in the markets for a second time, leading to a sharp fall of more than 1% in the value of the yen against the dollar.

Later the Japanese prime minister Naoto Kan said he was unaware of a second intervention by the BOJ.

Although the Japanese PM would not acknowledge it, there is a firm belief that the BOJ intervened a second time during Asian trading on Friday (24th) and yet the market sharply reversed following the selling of yen and purchase of US dollars by the BOJ, and by the end of the trading day in North America the yen was stronger against the dollar than at the time of intervention.

Perhaps the fact that the BOJ is now on record as saying that it wants a cheaper yen and yet the markets seem not to take their intention seriously, is a reflection, that unlike their deference to the Fed, traders seem quite comfortable in fighting the BOJ.
One other possibility is that the more that Japanese policy makers seem keen to reduce the rate of exchange for their currency against others, the keener is the appetite of the PBOC - the central bank of China - to buy yen for strategic reasons. The most benign of these reasons might be their desire to further diversify their holdings of foreign currency in general and as an alternative to stock piling more US Treasuries, the more problematic strategic reason would be their policy of preserving the competitiveness of the yuan vis a vis the yen and other major currencies.

To the extent that the latter policy of currency management is their predominant motivation, the BOJ and the US Treasury will find themselves increasingly well aligned in their criticism that the yuan is substantially in need of re-valuation.

Daily Form September 3, 2010

2010-09-03T03:41:00.000-07:00

Inter-market Technical Analysis using algorithmic pattern detection

FRIDAY SEPTEMBER 3, 2010 10:33:00 GMT

Friday morning’s trading in Europe remains subdued as market participants await the release of the US Labor Department’s employment related data at 08:30 Eastern time. The S&P 500 futures have made a little progress since yesterday’s New York close and are currently at 1090 which places them in a price congestion zone between 1090 and 1095.

It would appear that the current thinking is that a weak report will give cover to Bernanke for a second round of QE and that this will be "good" for equities. Rather than take a view on that kind of theorizing I would rather wait and see how markets actually react to the number today and will be watching several key instruments today. In no particular order they are spot gold, USDJPY, yields on longer term Treasuries and the financials.

The KBW Banking Index (BKX) has bounced after reaching below the February low and I have indicated on the chart where this index should face a real challenge which corresponds to the point where the downtrend line and the 200 day EMA coincide at approximately $48.

Spot Gold is quite critically poised as we head into today’s data.

We could see a sharp move up through previous highs if the promise of QE2 is not yet fully discounted in current market sentiment or if we were to see a sell off this could raise questions about a failure and lower double top pattern.

Readers may recall that last October I suggested $1350 as a technical target based on the break through an inverse head and shoulders pattern and that target still stands in the longer term. But in reviewing the current technical patterns my concern would be that a setback today could lead to some aggressive selling by some trading desks.

The FTSE index provides further evidence of the range bound/sideways action which was discussed here yesterday.

Reviewing the fibonacci grid on the chart the 5436 level, which also coincides with the bounce level following the sharp move down in early May, appears to be in need of testing in coming sessions.

In yesterday’s commentary I discussed the chart for JPY/AUD, which I also presented on CNBC’s European Closing Bell, and kept the chart deliberately simple for broadcast purposes.

I thought it would be helpful to show the full fibonacci grid and to re-state the reason why the unorthodox view of this cross rate, where the yen is being used as the base currency as opposed to the more conventional quotation with the Aussie as the base currency, can provide a useful perspective on the risk appetite orientation.

The simple idea is that moving up the vertical axis (i.e. increasing strength of the yen) equates to diminished appetite for risk and moving down the axis suggests a growing appetite for risk assets - especially emerging markets and commodities.

The key ratios on the chart show that the Aussie dollar has reached a fairly key level following the earlier 2010 strength and that in reaching back towards the 50% retracement level on the chart but managing to stay below that level the prevailing market tone remains somewhat neutral with respect to the risk on/risk off dichotomy. A more supportive environment for risk assets would be assisted by a drop below the pink cloud formation on the right hand side of the chart and using the more conventional AUD/JPY quotation method this is in the vicinity of 81.

TRADE OPPORTUNITIES/SETUPS FOR FRIDAY SEPTEMBER 3, 2010

The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions.
None of these setups should be seen as specifically opportune for the current trading session.
For a more comprehensive listing of price formations detected by our pattern recognition algorithms please visit TradeWithForm

EURGBP

I am planning to look for pullbacks to increase long exposure on EUR/GBP with an initial target of .8380.

ACWI iShares MSCI ACWI Index

ACWI, the MSCI World Index, appears to be setting up for another attempt to test the bounce level following the May 6th plunge which is indicated by the arrow on the chart

Japan's conundrum - a strong yen and a weak Nikkei

2010-08-31T04:10:00.000-07:00

There are few trends in the capital markets which are more easily discernible at present than those relating to two key asset classes relating to Japan - the exchange rate of the yen against the dollar, usually quoted as USD/JPY and the Japanese benchmark equity index, the Nikkei 225.

The first chart below shows a weekly view of the Nikkei 225 captured after trading on Tuesday, August 31st when the index suffered a 3.5% decline to take it back to its lowest level since March 2009.

The weekly perspective from the last three years or so reveals several technical weaknesses which are worth noting:

The index failed to overcome resistance at the 38% retracement level from the twin highs on the chart around 18,300 seen in H1, 2007 and the twin lows just above the 7000 level seen at the end of 2008 and in Q1, 2009. The 11,400 level is now a key upside threshold for this index as it represents the failure at this key retracement level as well as the 200 week exponential moving average.
However from the overall configuration of the chart it would seem that the upper threshold is not on the agenda but rather the lower levels which may need re-testing in view of the clear break of uptrend lines which have been inserted with dashed lines
Also pertinent is the drop below the weekly cloud formation with no obvious cloud levels to provide possible support raising the possibility that the 7000 level is now exposed as a potential target area for testing.

To a large extent the fate of the Nikkei is interwoven with the outlook for the yen. The inverse relationship between yen strength and Nikkei weakness is one of the most widely acknowledged examples of strong correlation, albeit an instance of negative correlation. The weekly chart below for USD/JPY, which shows the relationship of the dollar to the yen and thus weakness on the chart (i.e. lower rates) corresponds to yen strength, is yet another example of a market which is decidedly uniform in direction with an unrelenting trend downwards for the dollar against the yen.

What is striking about the chart for USD/JPY, and this underlines the value of using an Ichimoku framework for analysis, is the failure of the dollar to break above the extended cloud formation which occupies most of the right hand side of the chart. At several points, indicated by the arrows, the attempts by the US currency to break out of the persistent downtrend against the yen have failed to penetrate the cloud from below.

In summary I would suggest that since the outlook for the Nikkei 225 is so closely related to the direction of the yen, unless (and until) the USD/JPY chart can show a convincing and decisive break above the cloud patterns, and the yen can begin to retreat, the prospects for further weakness of the Nikkei, perhaps back to the 7000 level, has to be taken seriously.

Daily Form August 25, 2010

2010-08-25T04:08:00.001-07:00

Inter-market Technical Analysis using algorithmic pattern detection

WEDNESDAY AUGUST 25, 2010 11:00:00 GMT

It seems that almost every commentary and item of financial analysis that I came across at present is talking about metrics of historic proportions. To cite just a few examples

Yields on 10 year UK gilts and 10 year bunds are at their lowest ever.
Yields on 2 year US Treasury notes are at their lowest ever
The yen is registering highs against the US dollar not seen for at least 15 years and the highest level in 9 years against the euro
Debt to GDP ratios in many major economies including Japan, the US and UK are at their highest peacetime levels
Existing home sales, as reported yesterday in the US, are at their weakest level since 1995

And I could go on.

Perhaps the best (and most ominous) chart I can show today is the 20 year perspective on the Nikkei 225 as seen below. The index fell by another 1.7% in Asian trading but that is small change when considered to the almost 80% drop that this index has seen since the last trading day of 1989. When commentators talk about the possibility of a Japanese style deflation experience for some of the "old economies" it is worth keeping this chart in the mind’s eye.

The S&P 500 futures are currently trading in Europe within the confines of yesterday’s fairly extensive range. We should find out possibly today whether the "blip" below the 1040 level needs to be tested before any kind of relief rally can be mounted or whether the bears really are in the driving seat and ready to move into high gear.

The Russell 2000 came within 3 points of validating the comment made here this week that 585 was a near term target. The doji like candlestick is intriguing, but could well be indicating hesitation about how well lower levels have been robustly tested rather than a conviction that a rebound is now the path of resistance.

The call made here on Monday regarding AUD/CHF was timely and the suggestion is that even lower levels seem likely in the medium term. I have used the arrow to point to exactly the critical weakness point in the technical picture which was the failure to make it up into the overhead cloud formation following the break below the trend-line. Foreign exchange markets are relatively easier to discern with these kinds of patterns than the more algorithmically driven equity markets.

I just want to make reference to the trade setup which I discussed in yesterday’s column regarding CHF/JPY and how qualifications should always be made in regard to specific levels targeted. At the time of writing the pair seemed as though a move up to 81.40 would precede the move down that was anticipated. Soon after the newsletter was published the pair actually went down almost exactly to the 80.40 level without any rally up towards my proposed entry level of 81.40. In such circumstances the setup should be disregarded and not enacted after the initial target has been achieved.

Daily Form August 24, 2010

2010-08-24T04:05:00.001-07:00

Inter-market Technical Analysis using algorithmic pattern detection

TUESDAY AUGUST 24, 2010 10:56:00 GMT

The big event in European trading this Tuesday morning (so far) occurred just after 0700 GMT when USD/JPY dropped almost 100 pips and bounced just before hitting the 84 level. This puts the yen at a multi-year high against the dollar - a fact that reflects the unease which is also keeping the yields on several key government bond benchmarks, including the 10 year bund, at or near historically low levels.

In overnight trading the Nikkei dropped and then closed below the 9000 level and this gives rise to a real possibility that there will be concerted action from the BOJ and other central bankers to try to "manage" the situation as things could get rather ugly from here on.

S&P 500 futures are trading at present down below their close yesterday at 1056.

With one week remaining in August and US equities also sliding downwards the chart for the Nasdaq 100 looks in some ways the most vulnerable and a drop to 1750 could be a realistic target if not before Labor Day then soon afterwards.

The technical pattern on the 60 minute chart for USD/JPY is a classic break from a downward wedge pattern and since we are now in uncharted territory on this key exchange rate it would take a braver man than me to guesstimate where we go next. Clearly the BOJ will be watching developments closely and trading this pair at present is high risk in my opinion.

GBP/JPY looks set to revisit the 128 level which was seen in May in the aftermath of the wonderfully prescient "flash crash" event.

When considering two safe haven currencies, the yen and the Swiss franc, the chart below for the cross rate highlights the extraordinary strength that the yen has at present. The 240 minute chart below especially illustrates the recent topping pattern of the Swiss currency and its inability to break above 83.
Similar concerns about central bank intervention would apply to trading this currency pair right now, but it would be tempting to make a short term trade of selling CHF/JPY at the 81.40 level with a stop at 81.90 and a longer term target at 80.40 (with scaling out of the position as an appropriate tactic).

TRADE OPPORTUNITIES/SETUPS FOR TUESDAY AUGUST 24, 2010

The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions.
None of these setups should be seen as specifically opportune for the current trading session.
For a more comprehensive listing of price formations detected by our pattern recognition algorithms please visit TradeWithForm

AAPL Apple Computer Inc.

Several individual stocks caught my attention from the TWF daily scanning routines and are worthy of consideration with the qualification which should always be made, that these are not specific recommendations for today's session but rather indicative of broad patterns which may bear fruit in coming sessions.

AAPL triggered an Ichimoku signal yesterday, which can be an early indicator of impending weakness, based upon the Tenkan Sen line crossing the Kijun Sen line from above. More details about this pattern are available to premium subscribers along with other useful clues provided by technical pattern analysis.

ALTR Altera Corp.

Altera has a clearly visible bear flag pattern which could be on the point of breaking down and the close dropped below the cloud formation.

AMCC Applied Micro Circuits Corporation

AMCC also has a well defined bear flag pattern.

RS Reliance Steel and Aluminum

One of the patterns which I scan for pays attention to those stocks which have volume which is greater than 1.2 times the 15 day moving average of volume but less than 1.5 times the average volume. These stocks could be at an inflection point and getting ready to make a decisive directional move.

Reliance Steel (RS) fits the above description and also dropped below the cloud and looks ready to revisit the recent low.

TK Teekay Shipping Corp.

Teekay Shipping (TK) also fits the volume characteristics described in reference to RS and also dropped out of a cloud formation.

In this case with the 200 day EMA lying less than a dollar below yesterday's close I would be inclined to wait for a rebound before looking on the intraday patterns for a suitable entry on the short side. If such an entry doesn't present itself then be prepared to move on and look at other opportunities.

Daily Form August 23, 2010

2010-08-23T08:09:00.000-07:00

Inter-market Technical Analysis using algorithmic pattern detection

MONDAY AUGUST 23, 2010 10:08:00 GMT

Equity markets appear to be hanging on by their finger tips to fairly critical levels. No where is this more true than in Japan where the Nikkei came within 90 points of the key 9000 level in Monday’s trading.
The index closed at its lowest level since last November and I will repeat my comment from Friday’s newsletter that a clear break below 9000 could be a watershed event for global risk appetites

I am still of the view, despite the intriguing hammer formation on the chart from Friday’s session, that the Russell 2000 looks vulnerable to a test of the 585 level.

EUR/USD is trading below $1.27 in European trading and on the daily chart has now entered the cloud formation. The annotated break of a key trend-line suggests an eventual testing of the base of the cloud formation which suggests we could see $1.2450 in coming sessions.

I shall be looking for suitable entry levels on the short side of AUD/CHF in today’s trading. The region around .9350 would seem to offer firm resistance.

The chart suggests that there is a relatively attractive longer term position play by selling the Aussie dollar against the Swiss franc on any significant rallies of AUD.

TRADE OPPORTUNITIES/SETUPS FOR MONDAY AUGUST 23, 2010

The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions.
None of these setups should be seen as specifically opportune for the current trading session.
For a more comprehensive listing of price formations detected by our pattern recognition algorithms please visit TradeWithForm

XOP SPDR Oil and Gas Exploration

Here again is my comment on XOP from Friday's commentary

XOP, the exchange traded fund for the oil and gas exploration sector, has dropped below the cloud formation and other technical weakness suggests lower prices ahead.

For premium subscribers there is a daily listing of key ETF's and equities which have made significant moves in relation to many key technical indicators, including those which have dropped out of Ichimoku cloud formations or emerged from such clouds in an upward direction. Notably at the moment there are very few instruments which are emerging upwards from such clouds apart from inverse ETF's.

IDX Market Vectors Indonesia ETF

IDX should be monitored for evidence of a third lower high.

IXN iShares S and P Global Technology

IXN, a sector fund which tracks global technology stocks may struggle to regain a footing within the cloud formation and will be on my watch list for this week for a possible drop down back to the early July level indicated on the chart.

Daily Form July 28, 2010

2010-07-28T04:10:00.001-07:00

Inter-market Technical Analysis using algorithmic pattern detection

WEDNESDAY JULY 28, 2010 06:46 ET

The volumeless rally in equities continues and for the S&P 500, despite some whipsaw behavior in yesterday’s session, the expectation is that the 1130 target could now be seen in the next few sessions, possibly even today.

Plenty of cheerful commentators are to be found, and the Eurozone woes, which were hanging over the market just a few weeks ago, seem to have been relegated to the bottom of the pile of things to worry about, along with evidence of anemic growth in the "mature" economies, weak consumer sentiment and evidence that local and governments throughout the US are facing major budgetary crunches.

Just for perspective it is worth recognizing that current world GDP is about $60 trillion and about half of that total is accounted for by the US and EU states. The often cited powerhouse economies such as India and China together make up less than 10% of the total, although their rates of growth are far in excess of anything seen in western Europe and North America. Weighed against the bullish case for the BRIC economies, much of the rest of the world continues to de-leverage and as the consumers of last resort in the US, UK and other states which previously never saw a new product which they didn’t immediately want to own, have either exhausted all of their available collateral for credit or are too cautious to carry on with their previous profligacy.

Anyway back to the charts and purely from a technical perspective one would expect there to be strong resistance at the 1130 zone, although a nice false break above it could lure some cash off the sidelines.

Should we see a decisive break through the obvious flat cloud top (which serves to underline the strength of the resistance) on the chart, then the absence of any further cloud above suggests that the bulls could really run with the ball during August. However, as mentioned here last week, one should remember that the month of the year when many investors are more concerned about reaching for the suntan lotion than monitoring their portfolios, has had a track record of creating nasty surprises.

The Japanese yen could fall to the 112 level in this inverted chart of the more customary dollar/yen pairing before the uptrend would have been technically violated.

That would equate to 89.20 on the usual quotation method and I would suspect that level to be tested in coming sessions.

As part of my recent work for a book that I am writing and for workshops which I shall be presenting on inter-market analysis such as the following in London in September I am becoming more focused on the theme of forex basis rotation in which certain key currencies such as the yen, euro, dollar and Swiss franc seem to maneuver themselves in relation to other movements in the capital markets. One of the keys to trading FX, which continues to present the most interesting challenges, is to align one’s position in other asset classes in accordance with which currency base is in the ascendancy at the time.

As conjectured the recent era of the Japanese yen prevailing, with the euro as a basis trailing, is now in transition, but my suspicion is that a US dollar centric perspective lies on the not too distant horizon.

One of the most predictable inter-market relationships is between the yen’s performance and the Nikkei 225. As the yen retreats so the Nikkei rallies in almost 100% correlation. Trading in Tokyo on Wednesday fitted the bill exactly with a 2.7% rise.

The rally may find some resistance at the base of the pink cloud, but, if as I suspect the yen has further to retreat, we could see 10,000 on the Nikkei as we enter August.

One of the challenges in committing one’s thoughts about the markets to a daily chronicle is that it is easy for someone to point back to previous errors of judgment, and there are certainly enough to be found. But there have been some good calls as outlined below.

The last time I discussed the FTSE 100 was on July 13th and the reference can be found here .

I suggested then that the index would make it to the 5366 level which is exactly where it closed yesterday with a tail above the cloud.

TRADE OPPORTUNITIES/SETUPS FOR WEDNESDAY JULY 28, 2010

The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions.
None of these setups should be seen as specifically opportune for the current trading session.
For a more comprehensive listing of price formations detected by our pattern recognition algorithms please visit TradeWithForm

DGL PowerShares DB Gold Double Long

Also discussed in this column on July 6th, for which the reference can be found here, was a prognosis that gold and the miners seemed vulnerable to a setback
The action in DGL is following a downward staircase pattern, but if you are short I would be exiting close to current levels as the 200 day EMA lies just below the steep drop yesterday. For the time being, apart from retiring short positions I would stand aside.

EEM iShares MSCI Emerging Markets Index

Although in the longer term my allocation preferences for equities are very definitely in favor of the emerging markets rather than US and European sectors, the lack of volume in the EEM sector fund suggests that there is not a lot of passion for these new economies at present. India and Brazil are showing signs of overheating with interest rate hikes now on the front burner, and I intend to remain flat for the BRIC sector for the time being.

JPY/GBP

In yesterday's session, which I actually found to be more interesting than a simple review of the closing prices on many charts would suggest, I was in and out of the GBP/JPY cross rate.

Essentially I misjudged the fact that sterling would be quite so aggressively bid up against not only the yen but also the euro as the data from the UK continues to be surprisingly good. Overall I ended up the session giving back all of the gains I made earlier in the session from shorting the pair.

As can be seen on the chart below - which again is an inverted view of the more customary presentation - the drop below the cloud and the 200 day EMA is significant. For now I would rather see further confirmation that this was more than a lot of Canary Wharf shenanigans before positioning myself on the long side of this pair as the euro based currencies (and I include sterling in that category) continue to rise against the yen.

EDV Vanguard Extended Dur Trs Idx ETF

The exchange traded fund EDV, which represents a play on long term Treasury prices, could have delivered a good profit on the short side as suggested here in early July.

DBC PowerShares DB Commodity Idx Trking Fund

DBC, a sector fund tracking overall commodity prices, has failed again to take on the $22.80 level

Financial lessons to learn from the World Cup

2010-07-04T03:11:00.000-07:00

Watching Germany play Argentina in the World cup yesterday, they were so efficient and disciplined, it is not hard to see why they are so exasperated at being the Eurozone's lender of last resort.

Priming the pumping

2010-07-04T03:10:00.000-07:00

If Joe Sixpack could borrow at the Fed's discount "window" (nice metaphor) then we'd all be be back in business

Daily Form June 11, 2010

2010-06-11T03:12:00.001-07:00

Inter-market Technical Analysis using algorithmic pattern detection

FRIDAY JUNE 11, 2010 06:02 ET

There has been a notable change across the asset class spectrum in the last 72 hours indicating that risk appetite is increasing.
The S&P 500 rallied strongly off the open yesterday as expected, then entered a complex consolidation phase which lasted most of the middle part of the session, and then closed with a late rally.
From my Twitter account yesterday I suggested that there were twin targets which I now believe are in play for today’s session

1. The S&P 500 cash index will need to break above 1094 - which I suspect it can do - but will then find stiffer resistance at 110, which, as the chart below illustrates, is also the level for the 200 day EMA
2. I believe that the euro will attempt a challenge at the $1.22 level in today’s session.

Since there is some inter-connection between the two events and since I expect that EUR/USD will encounter stiff resistance starting from $1.2185 up to $1.22, it would not be surprising to see both stall at the levels suggested in the near term.

EUR/GBP has been very volatile but is still showing a tendency to want to go higher and if the cross rate can decisively break above .8280 - the level indicated on the 30 minute chart below - then further progress back towards 0.8380 should be expected in the coming sessions.

GBP/USD has risen steeply over the last two days and I would suggest that it has now put in an intermediate term top, which would be confirmed once the dotted trend-line is convincingly broken.
I would suggest that the first area of support will be the top of the cloud formation around 1.4640 and then further support at $1.4580.

As the appetite for risk assets grows again (for how long is debatable) then the US 10 year note yield should move back towards 3.5%.

TRADE OPPORTUNITIES/SETUPS FOR FRIDAY JUNE 11, 2010

The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions.
None of these setups should be seen as specifically opportune for the current trading session.
For a more comprehensive listing of price formations detected by our pattern recognition algorithms please visit TradeWithForm

XME SPDR Metals and Mining ETF

A short term scalp with XME discussed here yesterday moved up to the $50 level as expected. From here upwards the risk/reward ratio increases but if risk appetites are back in favor we could potentially see a move up to the cloud formation.

TBT Ultra Short Lehman 20 Plus ProShares

The chart for TBT, which moves in tandem with increased yields on long term US Treasuries, suggests that a feasible target in coming sessions would be the 50 day EMA (the red line) which is in the vicinity of $42.50.

WSM Williams-Sonoma Inc

The chart for Williams Sonoma (WSM), which I drew attention to last Friday as a candidate for the short side, proves, yet again, how useful the cloud formations are in setting entry/exit targets.
Notice how Tuesday's candlestick peeked below the cloud but came to a close just above the cloud.
A profitable trade would have resulted from an entry at last Friday's open, subsequent to entry within the cloud and with an exit on Tuesday's close after peeking below the cloud.

EWA iShares MSCI Australia Index

EWA recommended here yesterday gapped up on the open but managed a five percent plus move and may still have further to go towards the arrow indicated on the chart.

Australian equities ready to bounce?

2010-06-10T04:53:00.000-07:00

Perhaps the best tactical opportunity for those looking to scalp a bounce on an ETF which has suffered recently and is about to confirm the "death crossover" is EWA - which provides exposure to Australian equities. The renewed enthusiasm regarding China's growth has a direct impact on Australian equities - and the Aussie dollar - and at present there seems to be a bit of a bandwagon developing for the notion that China will lead the world away from the real risk of a double dip.

This bandwagon may not last long but it could lead to some upward price pressure on a variety of risk assets, including industrial metals, (consider XME for a quick bounce as well), and could be seen as lending some more credibility to the potential emergence of a right shoulder for the S&P 500.

Looking at sudden weaknesses in EUR/GBP as buying opportunities

2010-06-10T04:50:00.000-07:00

EUR/USD is finding some traction in trading in Europe with a rally back to 1.2085 at the time of writing. As suggested here last week I would expect this rally to eventually test 1.22 but I would expect substantial renewed selling pressure to emerge at this level.

My preferred play at present would be to buy EUR/GBP on any abrupt weaknesses and expect a rally towards the level indicated on the chart below. Sterling is now facing more pressure - at least in the near term - until the details of the UK budget are announced and until Fitch, and the other credit rating agencies, have weighed in with further concerns about the troubled state of the UK public finances.

The link between deep sea drilling and dodgy derivatives

2010-06-10T04:43:00.000-07:00

The news regarding BP goes from bad to worse and there would seem to be a case for suspending the dividend - not because the company cannot afford it but out of political expediency.

The dreadful ecological devastation resulting from the spill, in my opinion, only serves to highlight the fragility of complex business processes and the underestimation of the risks involved. If that sounds familiar that was how it was intended. While there may be little obvious comparison between deep sea drilling and the inventions of financial technocrats - when things go wrong the consequences are far worst than the worse case scenarios predicted by the "experts".

The weekly chart for the Amex Oil Index reflects this new heightened awareness of risk, as a clear buy channel, which was in effect during 2009 and until recently, has been convincingly violated as revealed on the chart below.

Valuing BP and more pain for buy and hold investors

2010-06-01T05:08:00.000-07:00

BP's market capitalization has dropped by almost one third in the last few weeks. Clearly some major institutions have been selling and probably a lot more are on the verge of doing so. Many of those selling are institutional investors such as pension funds which are run by managers who claim to be proficient in properly "valuing" businesses, and indeed are paid well for that proficiency.

While other companies have suffered large drops in a similar length time frame the situation with BP is rather different. This is not a sexy, flavor of the month company that has suddenly passed its sell by date but a rather boring oil company (until recently).

What is one of the more disturbing aspects of BP's plight, dwarfed, of course, by the ecological disaster, is that the collapse in the company's share price calls into question the entire methodology of corporate valuation and the critical role that risk assessment plays in that process.

The BP calamity can also act as an antidote for typical investor who has had BP in his/her portfolio for several years as a blue chip that need not be scrutinized frequently. The prospect of a Chapter 11 filing for the company, if the worst estimates of the costs and damages to the company turn out to be true, would be yet another example of wealth evaporation inflicting serious pain on those subscribing to a passive buy and hold investing philosophy.

Global financial system is sick and needs an extended period of convalescence

2010-06-01T04:15:00.000-07:00

My two cents worth on a lot of the macro calls being made by cheerleaders that the economic fundamentals are improving and that a major rally lies ahead is that they fail to distinguish adequately between the financial economy and the real economy (i.e. the trade in goods and services (not financial)).

The global financial system is sick and needs an extended period of convalescence or it will suffer from a major cardiac arrest. The plight of central banks is that they are running out of options to provide the right kind of intensive care and meanwhile the hapless private sector bankers are still running the asylum.
Strange isn’t it?

Trichet asked about Anglo Saxon plot against the euro

2010-05-31T06:07:00.000-07:00

The following quotes come from an interview with Jean Claude Trichet, President of the ECB on May 31st 2010.

Perhaps the most significant comment comes in the context of the conduct of the financial services industry with this very outspoken view:

I am deeply concerned by this gulf between the values of our democracies and those of the financial world, reflected particularly in the abnormal behaviours observed so often in recent years. This problem is faced by all of our democratic societies, and certainly on both sides of the Atlantic. The values of the financial world must change. In the prevailing ethos, they will no longer be tolerated as they are.

Not surprisingly Monsieur Trichet would not be baited into a discussion about a Plan B should Greece "fail".

If, for some reason, Greece does not honour its commitments, might there be a need for a “plan B”?

That is not part of our working assumption. Greece must and will honour its commitments. The European Commission, together with the ECB on the one hand and the IMF on the other, is following developments in the recovery programme very closely.

And finally, just to set the context for this rather remarkable question, the interview took place between M. Trichet and three French journalists

Sometimes, one imagines a sort of Anglo-Saxon plot against the euro. What do you think of this?

No, one should be wary of any conspiracy theories. I simply believe that some international investors struggle to understand Europe and its decision-making mechanisms. They have difficulty in gauging the historical size of the European construction and in anticipating the capacity of Europeans to take decisions that are just as important as those taken a few days ago.

It takes a far more febrile imagination to conjure up the notion of an Anglo-Saxon plot to attack the euro than it does to imagine that the structural weaknesses of a currency union without a political union, could ultimately see the EMU falling apart.

The Flash Crash and the European referendum wheeze

2010-05-30T03:35:00.000-07:00

The large intraday "crash" from May 6th no longer looks like an aberration but, strangely suggests a forward looking market that uncannily may have been discounting the possibility that the second most traded global currency could be coming apart at the seams. If it does, and in some ways this would be the preferred solution for not only the Club Med countries but also for Germany, it will once again highlight the folly of our belief in the robustness of the creations of financial technocrats. A monetary union without a fiscal union lacks credibility and it may, in years to come, be seen as remarkable that, with only a 10 year track record, so many placed so much faith in the Eurozone arrangements.

On the other hand, when I remove my Armageddon hat, which has a nasty tendency to appear on occasion (somewhat like Doctor Strangelove’s salute), there is always the possibility that a new fudge will buy more time for the political elite of Europe to spin some new schemes for European unification. If, as in the past, European voters give the wrong answers when asked in a referendum about further integration, they simply hold additional referendums until they get the right answer.

But maybe next time it will be different.

1040 is the key level to watch on the S&P 500

2010-05-30T01:56:00.000-07:00

There has been a lot of commentary in the last few days about the alleged appearance of a developing Head and Shoulders pattern on the S&P 500 Index, for example this piece which can be found at the Seeking Alpha site.

Here's another perspective on key levels on the S&P 500 cash index and, to declare my interest up front, I take a rather agnostic position with respect to H&S patterns. Even though the pattern template seems to be less easily discernible than is often suggested in TA text books, there does seem a good case for using the notion that the size of a correction will often equal the distance from a multi-period top to a key support line (could be called a neckline).

The critical support level from Feb 5, 2010 on the S&P 500 was actually 1044.5 - the intraday low.

Since then we have always managed to close above this level, even during this recent correction.

So we have about 175 points head room up to the April top and if we subtract 175 from 1045 it puts us at 870 which is probably the most important level for the whole period from the March 2009 low onwards and the level which was keenly tested in early July 2009.

It would seem to me that whether or not a right shoulder forms (which could take us back to 1130/50 or thereabouts) or, whether another sovereign debt/FX crisis takes us below 1040 on a closing basis, in a shorter time frame and more abrupt fashion, there is a growing probability that we will need to re-visit the 870 level again in the next 12 months.

Also 875 is the 62% retracement of the swing low of 666 and the high of 1220.

The fundamental story behind such a technically driven move (should it occur) would most likely coincide with a lot of talk about a global double dip and the mistakes being made by too many policy makers of bringing in fiscal austerity packages too soon.

Saving the most ominous technical signal to last, on May 25th (i.e. last Tuesday) the intraday low breached the Feb 5 low mentioned above and actually reached down to 1040 (the lowest level since November 2009).

In a pre HFT market environment, it strikes me that this breach could well act as a more immediate anxiety point that would need to be looked at again before the bulls would have confidence to mount a sustained attempt at taking us back in to the 1130-1150 zone.

But HFT algorithms seem to be less anxiety prone than us humans---when things get really scary they just shut down. And that is the new dynamic which produced the flash crash of May 6th and which makes a lot of traditional TA less useful than in the past.

Inter-market analysis using cues from FX, especially the larger scale patterns in the action in the yen, euro and the Australian dollar are, in my work, becoming far better clues as to the direction of US equities than ever before.

Ten reasons for current market turmoil

2010-05-21T04:05:00.000-07:00

The recent near panic conditions across all asset classes showed no signs of abating yesterday with evidence of acceleration.
Even though my area is technical analysis, and I have a certain skepticism for much of the "reasoning" that is put forward to explain what is currently troubling markets, there are certain things that seem obvious to me. Here are my ten observations on the current turmoil facing markets

1. The Eurozone architectural framework is deeply flawed and to suppose that a monetary union can survive without proper fiscal and political integration was something the architects were clearly wrong about
2. The current austerity measures being insisted upon, primarily by Germany - which is required to pay the most in the EZ bailout - will only act to reinforce deflationary tendencies in the global economy
3. Markets are often irrational. How else can one explain the extraordinary love affair that many asset managers have had for the Australian dollar, currencies from emerging markets and EM funds in general.
4. A massive FX carry trade unwind is taking place that has very little do with "market fundamentals". It has more to do with quant funds that have been synthesizing investable funds to play with in the algorithmically based equity markets
5. Politicians should never say that they are going to take on markets - don’t bite the hand that feeds you.
6. Uncertainty surrounding financial regulation is keeping financials under pressure
7. France and Germany are not seeing eye to eye over the future direction of the EU and both countries are doing their best to protect the balance sheets of their own private sector banks which have huge exposure to debt from southern Europe
8. Inter-market correlations/alignments are far more significant as causes behind the mayhem than one month’s job claims number - although yesterday’s US numbers do suggest that the notion that the global economy is on the verge of "growing" itself out of the sovereign debt crisis is highly suspect
9. Valuation of assets based on fundamentals, P/E multiples etc. goes completely out of the window when investors behave viscerally which is why TA is so useful
10. Central banks can only prop up a flawed currency, i.e. the euro, for so long before markets lose total confidence in its integrity. The capacity for damage to global financial confidence from a disintegration of the EMU and the euro, is enormous and still has not been factored into current asset prices.

The S&P 500 faces a key test at 1050 and a close below that level would suggest that a large scale correction is under way with targets eventually down to 870 needing to be tested. Interestingly the 1030 area is an area indicated on the weekly Ichimoku chart as perhaps more fundamental technical support.

The clue to near term direction for US equities is more so than at most times to be found in the FX markets and in particular the direction of the euro and the yen.

Greece has violated the "no-Ponzi" condition

2010-05-09T08:41:00.000-07:00

I found this extraordinary citation from John Hussman's newsletter in this article at Seeking Alpha and will simply repeat it without comment:

"The basic problem is that Greece has insufficient economic growth, enormous deficits (nearly 14% of GDP), a heavy existing debt burden as a proportion of GDP (over 120%), accruing at high interest rates (about 8%), payable in a currency that it is unable to devalue. This creates a violation of what economists call the "transversality" or "no-Ponzi" condition. In order to credibly pay debt off, the debt has to have a well-defined present value (technically, the present value of the future debt should vanish if you look far enough into the future).

"Without the transversality condition, the price of a security can be anything investors like. However arbitrary that price is, investors may be able to keep the asset on an upward path for some period of time, but the price will gradually bear less and less relation to the actual cash flows that will be delivered. At some point, the only reason to hold the asset will be the expectation of selling it to somebody else, even though it won't be delivering enough payments to justify the price.

"Unless Greece implements enormous fiscal austerity, its debt will grow faster than the rate that investors use to discount it back to present value. Moreover, to bail out Greece for anything more than a short period of time, the rules of the game would have to be changed to allow for much larger budget deficits than those originally agreed upon in the Maastricht Treaty."

Getting it right rather than ready by a Sunday evening

2010-05-09T06:38:00.000-07:00

This weekend there are apparently frantic talks taking place in Brussels to come up with some new EZ stability framework. Meanwhile in London the messy result from the election is causing great urgency to discussions between two parties trying to hash out a pact to cooperate

There is a new meme, which highlights the impotence of politicians, which is that in regard to any major issue where they fear,(even mistakenly), that markets may fall precipitously that they've got to "solve" the problem and get out a press statement "before the markets open Monday".

Markets can plunge for all kinds of reasons -as was seen last Thursday, where still no satisfactory explanation has been provided, and sometimes the best policy is to tell the markets (whatever that means) that we're still working on the solution.

Surely it would be better to get it right rather than ready by Sunday evening.

Machines, market liquidity and casinos

2010-05-09T05:57:00.000-07:00

There is an interesting piece from Mark Cuban about the illusion of liquidity in today's markets provided by HFT algorithms and how easily - to pursue the metaphor - that liquidity can evaporate so abruptly as it did in US trading on May 6th. The S&P 500 futures dropped like a stone losing more than 100 points at one point, and the DJIA managed a 1000 point plunge - all in the space of a few minutes. Hardly the kind of behavior which is designed to engender confidence in the investment community.

Here are some brief thoughts on the matter which I posted in conjunction with the piece:

Ironically, in my estimation, one of the reasons why regulators have indulged HFT shenanigans is that they believed that they would bring greater liquidity into the markets - which saw an astonishing lack of liquidity in October/November 2008.

As last Thursday showed machines don't panic - they leave that to us humans - but they just decide not to run their algorithms when certain parameters/thresholds are crossed. That may be an entirely logical response (the thresholds, of course, would have ultimately been set by the algorithm's programmers), but, paradoxically, markets require fractiousness and emotions to function, and it was only when the machines were turned off and bottom fishing humans got involved that the free-fall ended.

Longer term systemic liquidity requires confidence that the playing field can produce winners and losers and that skill will be rewarded. If traders/investors sense that markets are not only casinos, but ones where an Ocean's 13 type software crash can wipe out everyone, they will not want to play in them.