Diary of a Financier

When the Guards Join the Inmates Running the Asylum

In Capital Markets on Fri 2 Dec 2011 at 01:25

My last four StockTwits give a good appraisal of my mindset:

20111202-080801.jpg

Those notes are all important.

The US Dollar secular bull is definitely on hold.

The Eurocrisis has definitely been deferred for the short term, which means risk will rally, particularly with monetization lifting the tide of equity/hard asset values. This was the worst case scenario I feared:

…America can (and likely will) remedy her misfortune with carefully combine monetary & fiscal intervention on the other side of Europe’s reckoning. Therefore, a prolonged process in Europe would be the worst outcome for all parties.

I mean, I pounded the table about the warning signs being flashed by Eurodollar futures, and global central banks decided to swoop in and address it. That’s a good thing, no doubt, but it doesn’t fix anything. The former plummet in Eurodollar futures and the ongoing spike in interbank (LIBOR) markets are both symptoms, not the virus itself.

In addressing a complaint about short sellers, Hugh Hendry once bemoaned the artifices erected to promote markets, exclaiming, ‘artificial policies create artificial markets that ultimately collapse; we saw that at work in the America’s short selling ban on financials, and we’ll see it again in Europe’s.’ I’ve cited the same notion in regards to currency pegs a la the Asian crisis, China’s Yuan, and the ERM:

Trading, trends, psychology and reflexivity can push a security up or down, but long-term, fundamentals are an undeniable attractor to which true value is chained.

To put that in empirical terms, look at the European Exchange Rate Mechanism (ERM)… [which] artificially manipulated FX rates for too prolonged a period. You can’t fight nature for the long-term and expect to win. Hence, the Black Wednesday crash in 1992 manifest the gravitational force constantly drawing the Pound Sterling (GBP) and Italian Lira (ITL) down toward their fundamental equilibria. The force intensified the longer ERM exerted FX dislocations per its “bandwidth pledge.”

The coordinated move by global central banks to lower the cost of USD swaps can join that group of artificially manipulated rates. Yes, it promotes liquidity. It’s also QE end-around that averts Congress and an unsuspecting populace. It doesn’t amend the outrageous Debt/GDP of Eurozone banks & memberstates. The debt is still massive; the GDP still paltry. In fact, the “solutions” of Eurobonds/bailouts and austerity only amplify that ratio. What will fiscal unity accomplish but an arduous interim that ends in collapse? Ms. Merkel wants “stricter penalties enforced upon members who violate the bloc’s standards of debt & deficit.” Yea, she’s really suggesting the EU-17 tax the bums for being poor. That won’t help.

As bad as it would be for the ECB to monetize the debt, it’s worse to lure more capital to the table–more hands, deeper in the cookie jar–when the outcome is eventually default and when the difficult solution of monetary union dissolution resolves this with a much smaller backdraft. Since the USD is the globe’s reserve currency, I can accept these swap line infusions. I’m still a pissed-off US taxpayer, and I won’t let my government fund a walking-dead bailout of Europe–whether explicit or via our 17% share of IMF contributions (which includes those of Eurozone members, who won’t be bailing out themselves).

That’s why I look at this market and say it’s on borrowed time (literally). The technicals comfort me with conviction in the short-term bull drift higher. As my StockTwits communicate, I want to wait and see if this weekend brings any tumultuous news from Europe, because policy makers rarely identify a crisis in enough time to preempt it with intervention. The rate reduction for USD swaps goes into effect on Monday (December 5), and this whole charade would make sense in retrospect if someone like Greece were to secede from the currency bloc in favor of its own drachma. I’m waiting for the passage of this weekend to assure me of the contrary, then I’ll add some long equity exposure in enough size to keep me nimble.

Yes, it seems as if I’ll chase a non-sensical risk rally. I will. The calendar of European macro events soon runs dry, with a few summits for Eurocrats to talk a lot (and say nothing) until December 19 kicksoff a doozy:

19-31 December: Greek redemptions. E8.1bn of Greek government debts are due with E5.2bn consisting of a 3-year, zero-coupon special bond issued by the Hellenic Republic to support the liquidity of Greek banks (Law 3723/2008) in Dec 2008 (lending facility to draw liquidity from the ECB). These securities are not payable by the Greek state hence not include in public debt (or PSI v1). Therefore the true financing need from bond redemptions is E2.8bn (E8.1bn less E5.2bn).

This all feels imprudent, doesn’t it? That’s just what happens when the guards join the inmates who run the asylum.

–Romeo

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  1. The recent coordinated action from major Central Banks finally pushed Euribor futures upward.
    I’ve been discussing this price action with some friends as I too pay a lot of attention to what is happening to the short-end of both EURIBOR and EURODOLLAR curves and also the underlying trend in actual BBA / EBF submitted fixings (BBG> LEND BBAL0 ) and what such price action / trends imply in terms of banking stress.

    Before the coordinated move I thought, in my head, that markets WERE pricing in rate cuts by the ECB, but at the same time they were doing such rate-pricing because markets believed the funding situation was so severe that lending required a premium, therefore Euribor implied rates simply weren’t going down.

    After coordinated action the Euribor markets seems to have discounted this liquidity squeeze a bit.

    BUT… I don’t think it will hold as economic activity has just started to decelerate and darker days lie ahead and fears could be spreading faster than many think.

    Cheers.

    • That’s interesting. “fears could be spreading faster than many think”… your take from the ground-level? The real question is: how fickle will markets be if Europe offers short-term lipstick for these PIIGS?

      As I said above, I worry about this weekend. Some more signs troubling me:

      1. US Markets pulled back from overnight highs in futures (ES +~1.4%) to close the trading day flat.

      2. CME Hikes FX Margins: AUD, CAD, JPY, RMB Impacted.
      http://www.zerohedge.com/news/cme-hikes-fx-margins-aud-cad-jpy-rmb-impacted

      3. ICAP Tests Systems’ Ability to Handle Drachma Transactions.
      http://www.zerohedge.com/news/here-comes-drachma-icap-preparing-return-currency

      These CME margin hikes, in particular, concern me. CME is either really prescient, or they’ve got a “Bat phone” from policymakers, which I had mentioned back in May: https://thebuttonwoodtree.wordpress.com/2011/05/16/engineered-markets/

      • 1) The rally was very strong since the bottom and I think markets will exaggerate to both directions. Right now some stronger economic data came out from the US (ISM, ADP?), but today the unemployment data was kinda soft… avg hourly wages, participation rate, U6, average duration of unemployment… so overshooting to the upside + some so-so data this Friday made for a flat-day IMHO.

        2) Well, wouldn’t you do that if you were a public company having to look after your shareholders? I would. And I would have done that earlier. I’d be scared.

        3) Well, really have no opinion on this one.

        I just think that economic fundamentals are currently deteriorating and I am not saying they’re coming down quickly. But what are the bullets in the chamber now? Can Europe pull fiscal stimulus? Can a 1% cut make a huge difference (ECB-case)? US/Japan/Canada have no interest rates to cut.

        Liquidity swaps to solve lack of aggregate demand?
        Liquidity lines won’t make a sane bank lend to another and bad economic outlook won’t make banks lend to businesses.

        But to defend that I am structurally VERY fundamentally bear, but am not heavily short the markets in general I think a lot of the bad news is already priced in I am actually hoping there IS a rally so better asymmetry comes back to short the market again.

        I have been away from the markets lately (as I mentioned here: http://thetailchaser.blogspot.com/2011/11/any-job-opportunities-out-there.html ) so I can’t tell you for sure if there are lots of opportunities laying around, but… it is getting more interesting
        every day.

        Great learning…

  2. […] against the Euro. In fact, the SNB announced an explicit floor to EURCHF at 1.20. I’ve always asserted that market manipulations like currency pegs can only be maintained in the short-term, because […]

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