Trading Weeks

High Yield Plummets and VIX Flares Most In Almost 3 Months

2012-02-11T10:06:00.001+01:00

Credit (and vol) continue to lead the way as smart deriskers as ES (the e-mini S&P 500 futures contract) ends down only 0.5% - which sadly is the biggest drop since 12/28. The late day surge in ES, which was not supported by IG or HY credit (and very clearly not HYG - the HY bond ETF - which closed at its lows and saw its biggest single-day loss since Thanksgiving), saw heavier volumes and large average trade size which suggest professionals willing to cover longs or add shorts above in order to get filled. Materials stocks underperformed but the major financials had a tough day as their CDS deteriorated to one-week wides. VIX (and its many derivative ETFs) had a very bumpy ride today. VXX(the vol ETF) rose over 14% (most in 3 months) at one point before it pulled back (coming back to settle perfectly at its VWAP so not too worrisome). After the European close, FX markets largely went sideways with the USD inching higher (EUR weaker) as JPY strength reflected on FX carry pair weakness and held stocks down. Treasuries extended their gains from yesterday's peak of the week yields as 7s to 30s rallied around 6bps leaving the 30Y best performer on the week at around unchanged. Commodities generally tracked lower on USD strength with Oil the exception as WTI pushed back up to $99 into the close (ending the week +1.1% and Copper -1.1%). Gold and Silver ended the week down almost in line with USD's gains at around 0.25-0.5%. Broadly speaking risk has been off since around the European close yesterday and ES andCONTEXT have reconverged on a medium-term basis this afternoon (to around NFP-spike levels) as traders await the potential for event risk emerging from Europe.

As we warned yesterday, the significance of the divergence with credit in Europe and US was becoming palpable and the Storm that we noted was coming has begun we suspect. Stocks managed to cling to the cliff-edge that is the post NFP spike levels while credit has fallen significantly below pre-NFP levels. No follow through at all in credit on that late day surge in stocks and HYG seeing its single worst day since just before Thanksgiving (chart below).

Let's see how many investors who reached for yield stick with them when they realize that a third to a half of their annual yield just got taken away in 2 days - as we've said before, there is a reason they have a high yield.

VXX (the Vol ETF) was very volatile today as VIX (above) saw its largest jump in three months - as many know this is very typical VIX behavior, slow leak down and abrupt flare-up. We suspect the implied skewness and kurtosis discussions we had earlier in the week are being laid again after normalizing.

Treasuries roared back to life late yesterday and through today as supply ebbed and risk appetites dropped. 10Y seems the most volatile - perhaps on its mortgage hedging exposure - but 30Y outperformed on the week - ending just a little higher in yield.

The USD pulled back towards unchanged today after reaching its lows for the week just around the European close yesterday. Day after day we have seen the most volatility during the European day session with reversals into and around the closes and opens. After hours today EUR is pushing modestly higher on news that the Greek cabinet has approved loan plan but it is staying under 1.32 for now. JPY was the biggest loser on the week though stable as the USD strengthened against the other majors - this carry-pair impact dragged broad risk assets lower - though chatter is that a rotation to the EUR as a funding currency is occurring though we suspect the binary nature of the currency makes it a little too noisy for the risk-sensitive players.

To get a sense of how broad risk assets have been behaving this week we use a medium-term (as opposed to the short-term model that is used for trading and arb) CONTEXT - which as you can see is well synced with last week's pre- and post-NFP behavior. The whole week has seen a very narrow range for US equities that again and again has seen CONTEXT (broad risk asset proxy) and stocks converge around that post NFP spike level (green oval). Monday saw a broader derisking among risk assets but US equities maintained into Tuesday where Oil and Treasuries led risk-on and the faded to convergence. The sell-off and curve steepening in Treasuries along with Oil strength and FX carry all helped to push CONTEXT aggressively higher but the divergence lower in the latter part of the week reflects back to credit's underperformance dragging on stocks. Today saw Treasuries rally, curves flatten, and carry lose ground as non-equity risk assets fell back to earth and reconverged with stocks for pretty much the entire day session today in the US.

On the late-day news from Greece, Treasuries are modestly higher in yield, EUR (and carry) is modestly higher and CONTEXT is leading for now (as ES is closed) suggesting a 3-5pt bounce only. It will be along weekend.

See the original article >>

Ten Minutes With Italy's Mario Monti

2012-02-11T09:53:00.002+01:00

by CrownThomas

Submitted by CrownThomas on 02/10/2012 22:43 -0500

Italy's Prime Minister (and self appointed economy minister) shot over to CNBC after his meeting with President Obama this afternoon to discuss how well everything looks for Italy since he was elected took over.

Notable Comments:

Italian banks are "vulnerable" but have recapitalized themselves (rather, the ECB has given them money )
He had a good meeting with Obama, and Obama is supportive (he's careful to mention not financially supportive - perhaps forgetting how much theFederal Reserve bails out Euro banks )
A plan has been in place since January 1st to balance the budget by 2013 (Obama apparently didn't pay attention to this little tidbit )
Political cost is not a relevant matter... for the unelected government - the people will be happy to know it doesn't matter one bit what they want, the former Goldman Advisor knows what's best for them
He plans to transfer tax burdens to indvidual property owners and not burden corporations (should help the middle class)
S&P decision to downgrade Italian banks was due to previous leadership's decisions (he learned a little from President Obama)

FTW: "If somebody considers investing in Italy now, thy should not be too worried about what comes next"

A few visuals on why nobody should worry:

Implications of a Positively Correlated SPX and VIX

2012-02-10T13:03:00.002+01:00

by Bill Luby

For those who missed today’s market action and just looked at the post-mortem reports, today probably looked like just another in a series of uneventful days. For those who were paying attention to the likes of the VIX futures and ETPs based on VIX futures such as TVIX (+10.7%) and VXX (+5.2%), however, the tension in the air was obvious.

But the SPX, DJIA and NASDAQ composite indices were all up today, so what’s the big deal? It turns out that investors are easily spooked if the VIX (+2.6%) and the SPX (+0.1%) both move in the same direction. As the graphic below shows, the VIX and the SPX move in the same direction about 22% of all trading days. I think the real issue behind the concern about the direction of the VIX and the SPX is related to a hypothesis I laid out yesterday in What the VIX Kitchen Sink Chart Says :

“…the general consensus seems to be that stocks just do not deserve their current lofty valuation. In this type of environment, many investors become particularly susceptible to confirmation bias and scramble to find one or more indicators which will tell them what they have already begun to believe: that a major correction is likely just around the corner.”

The last time I crunched the numbers for VIX and SPX daily correlations , was in May 2007 and in looking at data from 1990, I concluded that a High Positive Correlation Between VIX and SPX Often Signals Market Weakness . Interestingly, when I ran the numbers today, the data from the last five years had completely reversed the conclusions. Thanks to some particularly strong results from 2009 and 2010, the full data set (1990-2012) now shows that when both the VIX and SPX are up on the same day, the mean returns for the next 1-100 trading days far exceed the typical returns for the full data set.

In terms of key takeaways, it now appears that stocks perform best following days when the SPX is up and the VIX is down (the ROI +1 column refers to the performance of the SPX one day hence) and worst on days when the SPX is down and the VIX is up. Interestingly, if one combines the up/down and down/up days, as I have done in the “split up/down” row, the aggregate data set of the SPX and VIX going in different directions looks almost exactly the same as the full data set in terms of future performance.

Getting back to the up/up phenomenon of today and yesterday, this bodes quite well for stocks going forward, based on historical data. By the same token, down/down days correspond to future performance that is, on average, well below the full data set.

Of course another key takeaway is that no matter what the data says today – for this study or any study – future events may overwhelm the current historical data and invalidate the generally accepted conclusions, even with a large sample size.

Now I will be the first to admit that stocks are overdue for a pullback, but just because the VIX and SPX both advanced on two consecutive days does not necessarily mean the planets are aligning for an Aquarian selloff. If investors are looking for that market reversal silver bullet, the SPX-VIX correlation data are not going to make them happy.

[For the record, the data in the table below includes Fridays and Mondays, so it is possible that calendar reversion may have had an impact on the results.]

Below is a larger than usual set of links for those who may be interested in digging into the history of some of the SPX-VIX correlation themes in this space.

See the original article >>

What the VIX Kitchen Sink Chart Says

2012-02-10T13:00:00.000+01:00

by Bill Luby

One of the more interesting developments of 2012 has been to watch the diminution of the strident bearish narrative that has been focused largely on the collision course between a preponderance of debt and low or negative growth. The bullish beginning to 2012, however, has not prompted many in the way of converts to the bullish camp. Instead, there have been whispers of “…overbought…” that have turned into a soft murmur and are now verging on becoming a loud chorus. Suddenly the general consensus seems to be that stocks just do not deserve their current lofty valuation.

In this type of environment, many investors become particularly susceptible toconfirmation bias and scramble to find one or more indicators which will tell them what they have already begun to believe: that a major correction is likely just around the corner.

For better or for worse, a look at the VIX is often one of the first stops for those who are looking for evidence of a market reversal.

In the chart below, I have updated and extended a chart from three years ago that I call my “VIX kitchen sink chart” – as it pokes and prods the VIX in a number of different ways. Standard VIX analysis attempts to determine whether the VIX has strayed too far from historical norms, whether this be in the form of moving averages, Bollinger bands or other mechanisms. I have even included a separate rate of change study (with its own Bollinger bands) and a Bollinger band width study below the main chart in order to provide a couple of additional analytical twists.

The bottom line, however, is this: if stocks are overbought and a correction is indeed just around the corner, the VIX does not appear to be aware of any such inevitability. Instead, it looks a lot more like business as usual in the land of the CBOE Volatility Index.

See the original article >>

The Fed’s Inflation Target; QE3, QE4, QE5, etc. are in the Queue

2012-02-01T18:17:00.000+01:00

By David Knox Barker

The U.S. Federal Reserve policy announcement on Tuesday, January 25, 2012 marks an important moment in monetary history. The forecast by a majority of the members of the FOMC for interest rates to hug zero until late 2014 was of interest and points to the FOMC conviction extended global economic stagnation at best, reflecting the long wave forces at work in the global economy. However, more importantly, it was the first time that the U.S. Federal Reserve has clarified its interpretation of its mandate for price stability, i.e. the target for inflation.

This announcement is preparing global markets for the primetime monetary super bowl of inflation vs. deflation, aka U.S. Federal Reserve quantitative easing (QE) driven inflation efforts vs. a Kondratieff long wave debt deflation depression. Since bad debt is the problem in a long wave debt deflation, the Fed plans to buy all the bad debt required to hit their inflation target and put it in on their balance sheet until it matures and repaid or is written off. The Fed only has two mandates; maximum employment and stable prices. These objectives are a bit sketchy and have not been specific targets historically, so an actual inflation target sends a clear message.

The Fed officially informed market participants that its target for inflation is two percent. The Fed is signaling to global markets the message that below this level of inflation, they are within their mandate to keep the monetary spigots open by buying any debt, and therefore we can anticipate additional rounds of QE released from the queue on a regular basis over the next few years if inflation falls below this target.

The CPI, like interest rates, is following its natural long wave trend. It is on schedule to reverse higher in a new long wave spring in 2013 and beyond. Unfortunately and ironically, the Fed’s attempt to produce inflation could prolong the deflation by socializing bad debts and weighing down the U.S. and global economy. The CPI annual rate of change below demonstrates the long wave forces at work.

The natural global long wave disinflation and deflation is in the process of clearing non-viable bad ideas out of the global economy with what Schumpeter called creative destruction. QE wants to keep those bad ideas in business, taking profit and reward away from the more prudent and better ideas in the market. The problem is that central banks are pouring trillions of additional debt into the economy when a long wave spring is right around the corner. This creates a real risk of hyperinflation once the long wave winter season is over and a new long wave spring gets underway, a real life bonfire of the vanities.

This is an election year. The Federal Reserves likes to be removed from the economic equation in election years. Unfortunately, in light of a long wave winter season of debt deflation and overproduction in an anti-business political environment, they represent a very large piece of the U.S. and therefore global economic equation. The inflation target announcement is an attempt to put their cards on the table early in an election year cycle, an election year that promises to be driven largely by global economic, financial and monetary policy news.

The more the U.S. Federal Reserve attempts to stop deflation with quantitative easing, the more other central banks around the world are buying gold. Gold is becoming the natural alternative world reserve currency with every new round of QE released from the queue. The chart below demonstrates a Fibonacci projection grid that reflects the desire of central banks and others to boost their gold reserves. Gold is trading like a currency, because it is one. Gold was snapped up as it corrected down to the golden ratio in the projection grid in late December. There is something extra compelling about the forces generated by a golden ratio on a gold chart. The price action of gold is directly related to actual and anticipated QE programs.

The Fed has basically announced that below that two percent inflation number, their balance sheet will keep on growing with new QE programs, including reinvesting the earnings of their growing portfolio and QE3, QE4, QE5, etc. The further inflation drops below two percent, the larger the new QE interventions and debt purchases are likely to be. Markets and investors now have an important piece of the Fed’s game plan.

The two percent inflation number represents the level of inflation below which the Federal Reserve will feel additional debt purchases are within its mandate. There is nothing to stop them from going beyond government bonds and mortgages. The Fed has the authority to buy Zimbabwean sewer bonds if necessary. The Fed has enjoyed this power since the Monetary Act of 1980. Let us hope that sort of QE is not deemed necessary as the debt disaster continues to engulf the global economy. The $7 trillion plus, depending on who’s numbers you use, that the Fed loaned out in recent years reflects just how far they are willing to go to stop the long wave debt deflation.

The call for another trillion dollars in QE in the mortgage market has already begun. However, there are tens of trillions in debt in the system, much of it potentially bad debt. This debt is in various stages of a great long wave winter season deleveraging. It is presumptuous to think that only a trillion more or so in QE can stop the potential deflation and get inflation back up to two percent.

Unfortunately, as the global debt crisis accelerates, it may take far more than a few trillion in QE to stop the deflation. Will it work? No one knows for sure. It may take $10 trillion or more. Even then, the debt levels are so high that global debt deflation could still get the upper hand, and accelerated deleveraging could and likely will trigger deflation and not inflation. Is there the political will in the U.S. to stomach $10 trillion in QE if that is what it takes to get to the magic two percent inflation rate.

The cumulative effects of the QE in the system has produced a late sugar high in U.S. economic activity that will wear off shortly. When it does, the business cycle is going to turn down hard. Taxpayers know they must be taxed to pay for the debts created by QE purchases of government bonds. This puts a damper on economic activity in the form of a QE hangover, and no one knows where the level of QE triggers systemic shock.

The amount of QE required to stop the deflation will paralyze those that know they will be the ones required to repay the debts produced by QE bond buying. Economic activity will slow, triggering more debt defaults, and more deflation. A vicious cycle and not a virtuous circle will produce only more ineffective debt and more deflation, just like in Japan for the past 20 years.

To track the impact of past and future QE keep an eye on commodities. Commodity prices are a good reflection of how the battle is going between the Fed’s QE driven mandate targeted inflation and the forces of Kondratieff long wave deflation that threaten to pull the CPI under two percent and then negative.

Take a look at the chart below of the CRB commodity index. In spite of the trillions in intervention and QE in recent years, the CRB appears to be signaling that deflation and not inflation has the upper hand. Keep an eye on the Fibonacci drill-down grid in the CRB. The Level 1 support at the 38.2% target of 293.42 appears to be critical. If that support goes, debt deflation is laughing in the face of trillions in QE, when tens of trillions in debt is rolling over. Presently the CRB is knocking on the door of the Level 2 38.2% target of 319.76, so QE inflation has the wheel at least for the moment.

In the end, using QE to manipulate inflation rates toward the announced two percent target will not work. The only way to counter the forces of debt deflation will be aggressive pro-growth policies and spending cuts, which will restore confidence to business and investors and get the real global economy moving. Fortunately, the global economy is on the cusp of a new long wave spring season in 2013 and beyond. Aggressive and pro-growth economic policies can mute the natural forces of debt deflation at work in the long wave cycle. Unfortunately, slow growth tax and economic policies are in place now that will slow the coming spring season.

QE programs are a government-sanctioned and central bank administered process of shifting financial risks and losses from the parties that created the risks and losses onto innocent parties, the taxpaying public. Essentially, profits are being privatized and losses are being socialized on a massive scale. By shifting bad debt from private hands onto taxpayers and extending the maturities on the debt, the central banks are essentially shifting the financial risks onto the unsuspecting public in a future cycle. QE lengthens the cycles, but it does not stop them. The long wave, business cycle and trading cycles are simply expanding.

The expectation had been for political constraints to keep unlimited QE in check in the United States and globally. Clearly, the politicians are giving central bankers a green light and free reign to continue the QE and shift the risks onto the public. Based on statements, it would appear that no limit on QE is on the table. Essentially, trillions more in QE is not out of the question.

Political forces could still emerge to constrain the central bankers, but this is growing less likely. If political forces do not emerge to put a limit on the QE, although deflation remains the most likely outcome, the risks of a deep debt deflation V shaped crisis is declining. It is clear that the central banks are willing to use QE on an unlimited basis. Trillions in bad debt will be transferred onto the public in the final phase of this long wave winter season. The coming long wave spring will be a shadow of its true potential for global growth due to the maturity on the debts being extended and shifted into the next long wave cycle.

If the central banks show restraint, it is possible that pro-growth policies, combined with a global long wave spring season, the economy will start to turn the corner by mid-2013. However, without fiscal constrain and responsibility, and if excessive QE is on the balance sheets of central banks, it will turn into an inflationary force that will do great damage.

By mid-2013, after multiple additional QE programs in pursuit of the two percent inflation target, the amount of QE in the system may be so high that it threatens the foundations of the global economy. The Fed and ECB will both likely engage in QE in pursuit of the illusive two percent inflation target. The QE attempts to stop global debt deflation will likely turn into hyperinflation.

If PQ Wall’s interpretation of Oswald Spengler’s cycles in The Decline of the West were correct, this is the ninth and final Kondratieff long wave in the fall season of western civilization. He believed that the winter of western civilization lies directly ahead. Like the White Witch in the Chronicles of Narnia who cast a spell and created an unending winter in the land beyond the wardrobe, the central bankers are in danger of creating a perpetual long wave winter season. Unfortunately, instead of a new long wave spring, with too much QE, a perpetual winter and a new dark age is possible

See the original article >>

New Stock Markert Cycle is Bearish for the Year-End

2011-12-02T21:17:00.001+01:00

By: Anthony_Cherniawski

The up sloping Head and Shoulders pattern had successfully decline to its target of 1160.00. Normally head and shoulders neckline's are not recrossed once they are violated. However, up sloping Broadening Wedge formations have a 7% probability of an incursion back into the formation. This is one of those rare incursions.

The only model suggests that the final wave five of c may go as high as 1288.67. Elliott Wave relationships suggest a top at 1279.00. What we now have is a smallish wave (i) and an oversized wave (ii).

The next opportunity for cycle turn is Monday morning. The low on November 25 is 1 1/2 daily pi cycles early, which is outside the normal range for a trading cycle low. For example, the October 4 low came one half pi cycle early.

However, the cycles were calling for a Master Cycle low between November 20 and November 29. It appears that the Master Cycle was on time. This Master Cycle is not the dominant cycle, but will have to keep an eye on it as we go and 2012.

In the meantime, I am still expecting a new low by December 8. That new low should take up the new head and shoulders neckline at 1158.67 and with it the October 4 low at 1074.77. Under the new cycle regime, it appears that we may get a bounce into options expiration week, ending December 16. However, that bounce may fail and produce a very nasty year end for equities.

See the original article >>

CDS Implied Probability of Default – Be Careful

2011-09-25T21:14:00.002+02:00

by Peter Tchir

Unless something changes in the next 24 hours, I expect we will hear more and more talk about default, not only of Greece but of other countries and of banks. Just in case that happens, here is some information that may help you make good decisions. There will be lots of chatter about the “likelihood of default” the CDS market is implying, but although it can be a useful statistic, it can also be very misleading. Before jumping into trades based on erroneous assumptions, it is worth spending a few minutes reading this. If all it does is confuse you, maybe that is a good thing in itself, because you won’t take a headline about default probability as fact.

Recovery is Key and is often assumed away making default probability calculations less useful

Let’s start with a simple example. You have bonds of 2 different companies, each maturing in the near term, both trading at 70. What is the probability of default of each of these companies? You don’t know because that isn’t enough information. You know the bonds are trading at 70, and without a default they would pay par, providing a 30 point return. What you need to know to figure out the probability of default, is what the recovery value will be. Let’s assume that the recovery value for one company is going to be 60 and for the other will be 10. Then in the first case, the default probability is 75%. There is a 75% chance an investor would lose 10 points, and a 25% chance that they would lose 30 points, giving an “expected” value of 0 (today’s risk free rate). In the second case the default probability is only 33% (66% chance of 30 point gain plus a 33% chance of a 60 point loss).

So recovery is a key element of determining what default probability the market is pricing in. Yet, although it is key, it is often assumed to be 40% or some other number based on historical averages. That is a reason to be very concerned when you see a default probability mentioned. It is useless without looking at the recovery value, and recovery value isn’t easy to figure out. Recovery value is figuring out the enterprise value of a company after it has defaulted. It is not any easier than figuring out enterprise value of a company that is not in default, so treat estimated recovery values with the respect they deserve.

In the CDS pricing model, there are 3 key variables: the spread, the recovery value, and the up-front premium. If you know any 2 of those 3, then you can solve for the other. The market trades with the assumption of 40% recovery. That let’s traders quote a spread, and then the up-front premium is just a calculation. This is done more out of convenience than anything else. Agreeing to a recovery rate on each trade would be time consuming, and 40% seems reasonable enough for the purposes of calculating the up-front.

For high quality (tight spread names) the up-front premium is not very sensitive to recovery.

For names that trade at 400 over (BAC for example), the probability to default over 5 years is 21% with a 10% recovery, and 51% with a 70% recovery. So you need to take any probability of default derived from CDS prices with a grain of salt. Without a rational assumption for recovery, the probability of default is somewhat meaningless. Since changing recovery would change the “up front” premium, you could try and argue that the recovery must be valid. I would argue that the smartest credit investors figure out what premium they need to earn to take the risk, based on their assumptions, and then figure out what spread in a 40% recovery model world gives that up-front premium.

At the other extreme, names will eventually trade in “points”. With a 40% recovery in the model, there is no spread that can give an up-front premium of more than 60. If a dealer was willing to buy protection and pay 55 points up front, or sell that protection at 57 points up front, most investors wouldn’t complain about the liquidity. It would be as good as in the bond market. On the other hand, if the same dealer quoted that market as 3470/4430 some client might argue that 1000 bps seems egregious. Also, if a company has a bond trading at 35, dealers will not want to floor recovery at 40 since a bond trading at 35 shouldn’t exist if recovery is 40. So as default becomes more likely, the model becomes less useful.

The Curve is also important

For simplicity and market convention, the 5 year cumulative default probability is based on a flat curve. As a situation deteriorates it becomes more important to look at each point on the curve. Two names trading at 1000 in 5 year CDS would have the same implied probability of default from the standard model. But if one is trading “inverted” at the short end, and the other is steep, then at the very least the timing of default that is being priced is very different. An inverted curve means the risk of default in the near term is much higher. If you, as an investor are going to make decisions based on default probability headlines, you need to look at the curve. The 5 year default probability is a nice headline, but the devil is in the details.

Sovereigns are even more problematic when divining default probabilities

Sovereign CDS for Eurozone countries trades in USD. CDS on US government debt trades in Euros. This helps explain why CDS trades so wide for many sovereign names. If you bought €10 million of a European sovereign at par, and it defaulted, recovering 40%, you would have lost €6 million. If you had bought CDS in Euro that trade would basically offset it. If you bought protection in $’s and the exchange rate was unchanged, you would break even on the trade. But many investors believe that a default of a European sovereign would cause the Euro to get a lot weaker. So let’s say at the time of the trade the FX rate was 1.40. You would need to purchase $14 million of CDS to cover the €10 million bond position. If the default occurs and the FX rate went to 1.20, then you would have made $8.4 million on the CDS trade, which when converted back to Euros at 1.2 is now €7 million.

If investors believe an FX move is highly correlated with default, they will pay more for CDS. They make more on their negative view than they would if the FX trade wasn’t embedded. Similarly they lose less if the market rebounds. Their position in the bonds will go up, while their losing position in CDS gets converted back into more expensive Euros, thus mitigating their losses.

So on sovereign CDS, particularly at times of stress where the market clearly believes that a default is bad for the currency, the CDS spread is not just pricing in default, it is pricing in default with a currency move, making implied default probability less useful.

On top of that, recovery for sovereigns is purely guesswork. Creditors have NO rights. There is nothing they can do to try and collect on their bad debts. It is purely a negotiation. That is why the distressed investors don’t do much in sovereigns, because they are used to playing by rules, and in a sovereign default there are no rules. In some sovereign defaults, shorter dated bonds have received better treatment than longer dated bonds. That is uncommon in corporate defaults, but not uncommon in sovereign defaults, making picking a recovery value even more difficult.

Cheapest to Deliver Bonds

For banks, financials, and sovereigns the cheapest to deliver option embedded in CDS has less impact on daily CDS prices because they are such frequent issuers. For companies with fewer bonds, the cheapest to deliver option can impact CDS prices, without really impacting probability of default in the real world. If two very similar companies existed, but one had only issued bonds at times of high coupons, and the other had issued when rates were very low, the CDS on the low coupon bond company should trade a bit wider. Investors who like the “basis package” where they buy bonds and buy CDS generally prefer to buy lower priced bonds because they can benefit from a “jump to default” and lock in their basis trade profits sooner than later.

See the original article >>

SPY Trends and Influencers 9/24/2011

2011-09-25T16:27:00.004+02:00

by Greg Harmon

Last week’s review of the macro market indicators looked to bring more consolidation for Gold ($GLD) in a broad range, but with the bias to the down side if forced to pick a break direction. Crude Oil ($USO), the US Dollar Index ($UUP) and US Treasuries ($TLT) all also look to be headed lower in the short run. The Shanghai Composite ($SSEC) looks to continue lower while Emerging Markets ($EEM) consolidate further. Volatility ($VIX) looks to remain elevated with any break bias to the downside as Equity Index ETF’s $SPY, $IWM and $QQQ are set up to extend their gains. The QQQ is by far the strongest of these index ETF’s and should be watched for broad direction. The correlations to watch for driving the Equity markets this week are the inverse relationship to the US Dollar and US Treasuries. Should these areas reverse and move strongly higher Equities will likely fall. Gold should play less of a role as it is moving in a broad range.

The week began with Gold moving sideways before a massive collapse and Crude Oil falling lower. The US Dollar Index and US Treasuries also drifted before launching higher and as warned knocking the Equity Indexes lower. The Shanghai Composite continued to consolidate while Emerging Markets were sucked into the downdraft again. What does this mean for the coming week? Lets look at some charts.

As always you can see details of individual charts and more on my StockTwits feed and on chartly.)

SPY Daily, $SPY

SPY Weekly, $SPY

The SPY gapped lower out of its bear flag Thursday and then held that range Friday, at the closing low support since early August. The RSI is pointing lower and the MACD crossed negative on the daily time frame. All of the SMA’s are sloping lower on both time frames except for the 100 week SMA. The weekly chart also shows a bearish RSI but the MACD is diverging, starting to improve. It is not as certain of the flag break on the weekly chart. The bias is to the downside for next week with support below 112 at 110.26 and then 108 and 104. Any bounce above the gap level of 114 should see resistance within the bear flag and first near 116.

Rolling into the last week of the third Quarter, Gold and Oil are ready for more downside. The US Dollar Index and US Treasuries look to continue higher. The Shanghai Composite and Emerging Markets also look to continue their down moves. Volatility looks to remain elevated and possibly break higher. The equity Index ETF’s, SPY, IWM, and QQQ are all looking better to the downside. The QQQ again may be the key to holding the market together. If it loses support of the flag, the SPY and IWM could take the whole market lower. A spike in Volatility and continued moves higher in Treasuries and the Dollar Index should ensure it. Use this information as you prepare for the coming week and trade’m well.

See the original article >>

The 3 Most Vulnerable Sectors

2011-09-25T16:17:00.003+02:00

by Tom Aspray

These major market sectors are still looking very vulnerable and are likely to continue to underperform the S&P in the months ahead. Use careful risk controls to avoid big losing positions.

The late-in-session drop in the stock market after the Fed announcement was consistent with the deterioration in the technical outlook discussed yesterday. The McClellan Oscillator has broken below support, which makes a further drop very likely.

Three of the major sectors look most vulnerable to further selling and they are likely to underperform the S&P 500. Even though technology was also lower, it continues to show better relative performance, or RS analysis, which suggests the tech sector will hold above the August lows.

For the Select Sector SPDR – Energy (XLE), it is important to keep an eye on crude oil prices. As I have frequently pointed out, crude oil often leads the stock market on both the up and down side. November crude oil was down over $2 yesterday, and a break of key support would be a negative for the energy sector and stocks in general.

Click to Enlarge

Chart Analysis: November crude oil completed its flag formation, lines a and b, on Monday, but so far, the short-term lows in the $84.65-$84.90 area are holding. The key chart support is now at $83.47.

There is further support at $79.76 and then at $76.61. The 127.2% Fibonacci retracement target is at $72.53
The on-balance volume (OBV) broke its uptrend, line c, on September 9 before rebounding sharply
Volume has been heavy over the past three days and the OBV now shows a pattern of lower highs and lower lows
Crude oil has resistance at $88 with stronger resistance in the $89-$90.63 area

The weekly chart of the Select Sector SPDR – Energy (XLE) shows that it is not far above the weekly uptrend (line d) and the 50% retracement support in the $59-$59.40 area. XLE completed a daily head-and-shoulders top formation in May.

The major 61.8% Fibonacci support stands at $54.50
The relative performance, or RS analysis, turned positive in October 2010, signaling that XLE was going to be stronger than the S&P 500. The RS analysis topped in May and is negative, as it is still below its declining weighted moving average (WMA)
The weekly OBV formed a negative divergence, line f, at the late-April highs. The OBV needs to break this downtrend to turn positive. The OBV is below its weighted moving average
There is initial resistance for XLE at $67.76-$69.90

Click to Enlarge

The Select Sector SPDR – Industrial (XLI) has been one of the weakest sector ETFs, down 24.6% from the April high at $38.98. The daily chart shows a completed head-and-shoulders top formation, as the neckline (line a) was broken in July.

The daily chart shows next support at the uptrend (line b) in the $29.50 area
Major 50% retracement support stands at $27.40 with the downside target from the daily chart formation at $26.40
The daily uptrend in the RS (line c) was broken in May and still looks negative
Daily OBV confirmed the completion of the top formation when it dropped through long-term support at line d
Weekly OBV formed a negative divergence at the May highs and is still negative
There is initial resistance for XLE at $32.20 and then at $32.89

The Select Sector SPDR – Materials (XLB) closed below short-term support, line g, on Wednesday. This suggests it will continue to lead the market lower. The daily chart shows a completed top formation, lines e and f.

Major 50% retracement support is at $29.70
The daily chart formation has downside targets in the $28.50 area
The daily uptrend in the RS, line h, that goes back to the 2010 lows, was broken in early May. The RS is now dropping very sharply and XLB is acting weaker than the S&P 500
The OBV is in a solid downtrend, line i, though we may have seen a selling climax in early August

What It Means: These three key sectors have been the weakest over the past four months. The weakness in crude oil suggests it is ready for one more decline, but the longer-term technical analysis for crude oil suggests that this could complete a bottom formation. Therefore, the energy sector may bottom out first.

The industrials and materials sectors gave weekly sell signals in May (see “2 Key Sectors Top Out”). Both now look ready to lead the markets lower, and a resurgence of growth in the emerging markets is likely necessary before these sectors turn around.

How to Profit: I see no real profit opportunities at this time, but those holding stocks in these sectors should be sure to use stops on all positions to limit the risk. It is tough to come back from a 30%-40% hit in one position.

See the original article >>

Dollar breakout ...

2011-09-25T16:13:00.002+02:00

by Kimble Charting Solutions

See the original article >>

Dow Reaches Lower Channel Line

2011-09-25T16:11:00.000+02:00

by Trader Craig's

The Dow has reached the lower parallel channel for the entire rally from the March 2009 low. The channel lines were created using the Andrew's "pitchfork" method with the November 2008 low as the origin and the January 2009 high and March 2009 low for the base. It is easy to see how well the Dow has followed the channel lines over the last two and half years. There is every reason to believe that some sort of intermediate term low is imminent near term based on this chart. A rally to the median line somewhere around 12,000 by late this year or early next year is the most likely next move.

I expect that after that rally the currently developing low will be retested by mid 2012. If that test is successful, another leg up in the stock market should follow. At the risk of sounding repetitious this process will last several more months. Be prepared for difficult choppy conditions and use more conservative trading targets.

See the original article >>

Choppy Stock Market May Bottom Soon

2011-09-25T16:07:00.001+02:00

By: Tony_Caldaro

After some big gains last week and a SPX 1216 close, the market gave it all back this week with a SPX 1136 close. Economic reports were light, but still mostly to the downside. On the positive were building permits, existing home sales, the monetary base and a downtick in weekly jobless claims. On the negative were declining housing starts, FHFA/NAHB housing prices, leading indicators, excess reserves and the WLEI. The big news for the week was the ‘sterilized’ Operation Twist. A $400 bln program to purchase long term debt with short term debt. The market apparently wanted more liquidity in the form of outright purchases. For the week the SPX/DOW were -6.45%, and the NDX/NAZ were -4.85%. Asian markets lost 5.0%, Europeans markets lost 5.2%, the Commodity equity group lost 10.3%, and the DJ World index dropped 7.7%. Next week will be highlighted by Q2 GDP, the Chicago PMI and Case-Shiller.

LONG TERM: bear market highly probable

When the markets start displaying a bunch of mixed signals it is best to step back and look at the overall picture. Between March 2009 and May 2011 the stock market doubled in a five wave advance, (SPX 667-1371). After the peak the stock market experienced a modest decline to SPX 1258 and then a fairly good rally to SPX 1356. While this was unfolding many foreign markets were starting to break down. After a review of the long term technical indicators we concluded these two waves represented the beginning of a new bear market. After posting these findings the US stock market started breaking down. The decline was quite swift, and within a month the SPX dropped from 1356 to 1102, or 18.7%.

The weekly chart signalled there was potential trouble ahead when the first decline, SPX 1371-1258, was quite oversold, (RSI red arrow). This typically does not occur during bull markets, as you can observe on the chart. When the market started breaking down the MACD turned negative. This also does not occur during bull markets. While OEW quantitative analysis has yet to confirm a bear market it certainly looks like we are in one. This is the reason we have been posting, since early August; “bear market highly probable”.

All bear markets unfold in three significant waves, ABC, not five. They are corrections to previous bull markets of a greater wave degree. The declining A and C waves may take the form of a five wave structure, as demonstrated by the 2007-2009 bear market. Or, more typically, a three wave decline, as demonstrated by the 2000-2002 bear market. Until the first signficant wave completes, wave A, either combination is possible. To cover these two possibilities we have been tracking an ABC decline on the SPX charts, and a 1-2-3 decline on the DOW charts.

Also of note on the weekly chart is the two green, wave structure, support lines. The first is at SPX 1011, the Primary wave II low. This level also represents a Fibonacci 50% retracement of the entire bull market. The 38.2% retracement level was hit exactly at the August low of SPX 1102. The second green line is posted at SPX 869, Major wave 2 of Primary I. This would be the logical wave structure support, should the first one fail. It represents a 70.7% retracement of the bull market. For the record there is one intervening level of support, the Fibonacci 61.8% retracement: SPX 936.

The overall picture suggests we are in a bear market with the first level of support at SPX 1011, the next level at SPX 936, and the likely maximum level at SPX 869. The market closed at SPX 1136 on friday.

MEDIUM TERM: July downtrend likely still underway

From the SPX 1356 uptrend July high this market declined in three waves: SPX 1296, 1347 and then 1102 on August 9th. After that the market went into a trading range between SPX 1121 and 1231 for five weeks. This week it took out the 1121 low on thursday when it hit 1114. Our first thought was the low of the range, SPX 1121 on August 22nd, ended the downtrend with a failed fith wave, (higher than the third). We then tracked the market as if it were a counter-rally uptrend. This approach worked quite well for the past four weeks, until the market started breaking down after the FOMC meeting.

Our counter-rally uptrend scenario suggested the market would hit the OEW 1240 pivot, and higher, from the September 12th SPX 1136 low. On tuesday, however, the market made a double top at SPX 1220 and started to decline. When it dropped through the OEW 1187 pivot, the previous short term support, on wednesday afternoon we knew something was amiss. Anticipate, monitor, and adjust. On thursday the SPX found short term support at 1114 and then rallied, from extremely oversold levels, to 1142 on friday. On thursday, however, the DOW made a new print low for the July downtrend suggesting it had resumed after several weeks of sideways activity. We then posted a special thursday night update: http://caldaro.wordpress.com/2011/09/22/thursday-night-update/.

When we take into account these recent events. The new print lows in the DOW, TRAN, and NYSE. The fact that OEW has yet to confirm an uptrend. And, the somewhat sloppy wave counts on the SPX charts. We have shifted the short term count posted on the DOW charts to the SPX charts. This is now the preferred short term count. The alternate count is now posted on the DOW charts. We should know for certain, in a week or so, which of these two counts is the market’s count.

The updated SPX chart is as follows. From the July SPX 1356 high the market has declined in four waves: Int. i SPX 1296, Int. ii SPX 1347, Int. iii SPX 1102 and Int. iv SPX 1231/1220. Int. i and iii were five wave declines, Int. ii was a zimple zigzag, and Int. iv was a complex inverted failed flat ending at 1220. We had observed these inverted failed flats during the previous bear market.

SHORT TERM

Support for the SPX is at 1136 and then 1107, with resistance at 1146 and then 1168. Short term momentum ended the week around neutral. Anticipate, monitor and adjust. When we take into account the preferred short term count the anticipated medium to long term wave structure changes just a bit. The long term supports, noted in the long term section, remain the same. The wave structure for this bear market, however, can now be either a 5-3-5 ABC, or an abA-B-abC ABC. Both options are again possible.

We did a Fibonacci analysis on the relationships between the Intermediate waves and arrived with the following numbers: @ SPX 1093 Int. waves iii thru v = 2.618 Int. i, @ SPX 1080 Int. v = 0.618 Int. iii, @ SPX 1074 Int. v = 2.618 Int. i, and finally @ SPX 1060 this third wave (trend) down = 2.618 the first wave (trend) down. Since we have OEW pivots at 1090 and then 1058, we’re probably looking at either the SPX 1093 relationship, or the 1060 relationship, for the end of this Int. wave v and downtrend. Best to your trading!

FOREIGN MARKETS

The Asian markets were all lower on the week for a net loss of 5.0%. China and Hong Kong made new downtrend lows.

The European markets were also all lower on the week losing 5.2%. The Stox made a new downtrend low.

The Commodity equity group all dropped substantially for a net loss of 10.3%. Canada and Russia made new downtrend lows.

The DJ World index made a new downtrend low as well and lost 7.7%.

COMMODITIES

Bonds continued their extended uptrend gaining 1.2% on the week. The 10YR dropped to 1.70% before ending the week at 1.81%. The 30YR hit 2.75%.

Crude tumbled 9.0% as its choppy attempt at an uptrend ended with a continuation of the ongoing downtrend.

Gold also tumbled, losing 8.4%. We had expected both Gold and Silver to be in downtrends and this week’s action confirmed it. In fact, Gold has already come down to our anticipated support zone $1650-$1700, and even dipped below it on friday. As soon as this downtrend ends the bull market will resume.

The USD continued to uptrend, especially against the Euro, and gained 2.5% on the week. The EURUSD lost 2.2%, and the JPYUSD gained 0.1%.

NEXT WEEK

New home sales kick off the economic week on monday at 10:00. On tuesday we have the Case-Shiller index and Consumer confidence. On wednesday Durable goods orders, and then on thursday Q2 GDP, the weekly Jobless claims and Pending home sales. Friday closes out the week with Personal income/spending, PCE prices, the Chicago PMI, and Consumer sentiment. The FED has two speeches scheduled. FED governor Raskin on monday before the open at 9:15 AM. Then FED chairman Bernanke on wednesday after the close at 5:00 PM. With this week representing the end of the month, and the quarter, it should be quite interesting. Remember we’re probably in a bear market, so tread lightly.

See the original article >>

Bull Bear Market Phases, Dow Theory Update

2011-09-25T15:55:00.002+02:00

By: Tim_Wood

According to Dow theory, both bull and bear markets have three phases. Between each of these phases there are important counter-trend moves. Our Dow theory founding fathers explained that these counter-trend moves are misleading and tend to be taken as a continuation of the previous long-term secular trend. Based on the longer-term phasing and value aspects of Dow theory, the evidence continues to suggest that the last great bull market began at the December 1974 low and peaked in October 2007. This data also continues to suggest that the decline into the March 2009 low was merely the Phase I decline and that the rally out of the March 2009 low serves to separate Phase I from Phase II of a much longer-term secular bear market.

That's right, the rally out of the March 2009 low was not a new bull market or a continuation of the previous long-term secular bull market. Rather, it is part of a correction within a much longer-term secular bear market that began at the 2007 top. In fact, based on my longer-term bull and bear market relationship studies and other historical characteristics, the evidence suggests that once the rally out of the 2009 low has run its course, the Phase II decline should prove to be far more devastating than the Phase I decline. Therefore, from a longer-term perspective I remain very bearish.

More recently, on August 4th both the Industrials and the Transports closed below their March 2011 secondary low points. As a result, a Dow theory trend change occurred and since this is the first such trend change since the rally out of the March 2009 low began, we cannot take this development lightly. However, history shows that not all Dow theory trend changes are ominous and based on other technical data, there is a very good chance that the rally out of the March 2009 low has not yet run its course. If not, the rally separating Phase I from Phase II is not yet over. The details of these other technical studies are covered in the monthly research letters. Point being, the market is currently doing a bit of a technical high wire act in that while we do have a Dow theory trend change in place, on the other hand there is also other data that is actually still rather bullish and that suggests a higher level low is being made. This may or may not change and as a technician the key is to monitor the ongoing structural and statistical developments.

Based on the prevailing consensus, the current pessimism actually makes perfect sense. As a rule, the market does what it has to in order to confuse the most people. Ever since the decline into August began, it seems that the consensus has turned rather bearish. In fact, I personally know of no one that genuinely believes a move back above the May 2011 high is possible and maybe it isn't. But, I do find it very interesting that such bearishness is being seen in conjunction with such inconclusive technical data. As a result, it seems that the most confusing thing the market could do is to continue to rally.

I have again included the chart of the 1966 to 1974 bear market period below for comparison. The decline into the 1966 low marked the Phase I decline of the 1966 to 1974 secular bear market. This decline appears to be synonymous with the decline into the 2009 low. The rally separating Phase I from Phase II of the 1966 to 1974 bear market carried price up some 26 months into the 1968 top. I continue to believe that the rally out of the March 2009 low is synonymous with the rally into the 1968 top. Once all of the technical factors are in place I look for the fallout to be much the same as was seen following the 1968 top. I realize that the same old message and comparison is not exciting or sexy. But, the message of the market it is what it is as the bear continues to confuse the masses. Once the technical DNA Markers are all in place, the Phase II decline should get very very nasty. In the meantime, it currently appears that a much larger trap is likely being set.

See the original article >>

When Stocks Yielding More Than Treasuries

2011-09-25T15:47:00.000+02:00

By Charles Rotblut

On Wed. Sept. 21, the divided Federal Reserve voted to revive a half-century-old procedure to push down long-term interest rates and make it cheaper for businesses, municipalities and consumers to borrow funds. The Fed announced it would direct $400 billion from the sale of short-term Treasuries to investment in those with maturities of six to 30 years.

The decision came at a time when the yield for the S&P 500 exceeds that of 10-year Treasury bonds. As of Monday morning, the S&P 500 had an indicated dividend yield of 2.13%; 10-year Treasury bond yields were below 2%. (An indicated yield is the sum of expected dividends for the next 12 months divided by the stock’s current price.)

Sam Stovall of Standard & Poor’s pointed out the occurrence, observing, “On a quarter-end basis, this has happened only 20 times since 1953. The good news is that in the following 12 months, the S&P 500 rose by an average 20%. The bad news is that past performance is no guarantee of future results.”

Prior to 1953, the yield situation was reversed. Stocks had higher yields than long-term Treasuries. The chart below, and the yields behind it, can be found on the Historical Market Data spreadsheet in the AAII.com Download Library. (This is the same spreadsheet I mentioned two weeks ago.)

There are a few ways you can look at this data. The first is that long-term Treasuries are not a great value right now. The second is that it makes sense to diversify your bond holdings. Corporate, municipal and foreign bonds can all help you get higher yields without much additional credit risk if you choose wisely. The third is that on a yield basis, large-cap stocks appear to be cheap.

I should point out a few caveats. First, a stock can stay cheap (or expensive) far longer than anyone expects. Second, if the U.S. economy remains in a slow growth mode for an extended period of time, interest rates could stay low. Third, bonds provide return of capital, something that stocks do not. Fourth, stocks offer more potential price return than bonds, so total return should always be considered when looking at stocks. Finally, stock and bond returns have been historically uncorrelated, meaning that diversification benefits can be realized when the two are held in a portfolio.

Thus, there is rationale for owning stocks and owning bonds, even in the current uncertain environment. If you are concerned about the economy, consider a mixture of fewer economically sensitive stocks (consumer staples, utilities, health care, etc.) and more growth-oriented companies (technology, energy, etc.). The idea is that you will lower your risk, but you still have the opportunity to profit should the economy turn out to perform better than you anticipate. On the bond side, you can offset interest rate risk by buying bonds with different maturities and reinvesting the proceeds as each bond matures—a strategy referred as bond laddering. Alternatively, you can buy a diversified bond fund with an intermediate duration (a measure of interest rate sensitivity), such as five years.

The Week Ahead

Just three S&P 500 member companies are scheduled to report earnings, all on Tuesday. They are Accenture (ACN), Jabil Circuit (JBL) and Walgreen (WAG).

August new home sales data will be published on Monday, starting off the week’s economic calendar. Tuesday will feature the September Conference Board’s consumer confidence survey and the July S&P Case-Shiller home price index. August durable goods orders will be published on Wednesday. Thursday will feature August pending home sales and the final revision to second-quarter GDP. August personal income and spending, the final September University of Michigan consumer sentiment survey and the September Chicago PMI will be published on Friday.

Minneapolis Federal Reserve Bank President Narayana Kocherlakota will speak publicly on Monday. St. Louis Federal Reserve Bank President James Bullard will speak on Monday and Friday. Atlanta Federal Reserve Bank President Dennis Lockhart will speak on Tuesday. Boston Federal Reserve Bank President Eric Rosengren will speak on Wednesday and Thursday. Philadelphia Federal Reserve Bank President Charles Plosser will speak on Thursday.

The Treasury Department will auction $35 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

See the original article >>

Multi-Trillion Euro Bailout Plan Allegedly in the Works; Plan Has Failed Already

2011-09-25T15:38:00.001+02:00

by Mike Shedlock

The rumor mills are flying this Saturday regarding a Multi-trillion plan to save the eurozone.

Telegraph: European officials are working on a grand plan to restore confidence in the single currency area that would involve a massive bank recapitalisation, giving the bail-out fund several trillion euros of firepower, and a possible Greek default.

German and French authorities have begun work on a three-pronged strategy behind the scenes amid escalating fears that the eurozone’s sovereign debt crisis is spiralling out of control.

Their aim is to build a “firebreak” around Greece, Portugal and Ireland to prevent the crisis spreading to Italy and Spain, countries considered “too big to bail”.

Mish: If that's the plan it, it has failed already. The crisis has already spread to Spain and Italy. In fact, one look at European bank stocks says it has spread to France and Germany as well.

Telegraph: Sources said the plan would have to be released as a whole, as the elements would not work in isolation.

Mish: Lovely. In a typical bicycle wheel if one spoke gets broken the wheel still works fine. In the proposed wheel, if a spoke breaks, the bicycle crashes.

Telegraph: First, Europe’s banks would have to be recapitalised with many tens of billions of euros to reassure markets that a Greek or Portuguese default would not precipitate a systemic financial crisis. The recapitalisation plan would go much further than the €2.5bn (£2.2bn) required by regulators following the European bank stress tests in July and crucially would include the under-pressure French lenders.

Mish: Will French leaders and French banks go along? Just last week they were insistent that French banks were well capitalized.

Telegraph: Officials are confident that some banks could raise the funds privately, but if they are unable they would either be recapitalised by the state or by the European Financial Stability Facility (EFSF) – the eurozone’s €440bn bail-out scheme.

Mish: Recapitalized "by the state" means taxpayers. Will Germany, Finland, Austria, and the Netherlands go along?

Telegraph:The second leg of the plan is to bolster the EFSF. Economists have estimated it would need about Eu2 trillion of firepower to meet Italy and Spain’s financing needs in the event that the two countries were shut out of the markets. Officials are working on a way to leverage the EFSF through the European Central Bank to reach the target.

The complex deal would see the EFSF provide a loss-bearing “equity” tranche of any bail-out fund and the ECB the rest in protected “debt”. If the EFSF bore the first 20pc of any loss, the fund’s warchest would effectively be bolstered to Eu 2 trillion. If the EFSF bore the first 40pc of any loss, the fund would be able to deploy Eu1 trillion.

Using leverage in this way would allow governments substantially to increase the resources available to the EFSF without having to go back to national parliaments for approval, which in a number of eurozone countries would prove highly problematic.

Mish: This leveraged proposal with the ECB backing it up has already been rejected by the ECB. Moreover, such a proposal with the ECB taking leveraged risk would be in violation of the Maastricht Treaty.

Telegraph: Gathering turmoil in financial markets has convinced Germany to begin work of some kind of variant of the US plan, despite having initially rejected the notion as unworkable as threatening to compromise ECB independence.

The proposal would be hugely sensitive in Germany as its parliament has yet to ratify the July 21 agreement to allow the EFSF to inject capital into banks and buy the sovereign debt of countries not under a European Union and International Monetary Fund restructuring programme. The vote is due on September 29.

Mish: The current EFSF proposal is sketchy enough already. It will likely pass. However, Merkel may go down in flames because of it. The Guardian notes "Merkel looks sure to win the Sept. 29 vote on the European Financial Stability Facility because opposition parties support the bill, designed to give the EFSF more powers after an agreement by EU leaders in July. However, her job could be on the line if she has to rely on the opposition and fails to persuade rebels from her conservative camp and the Free Democrats (FDP), her junior coalition partners. Opposition parties have said Merkel would be finished politically if that were the case and have threatened to call for fresh elections. If that happened, the ensuing uncertainty would send shockwaves through the euro zone as it tries to tackle its debt crisis."

Bear in mind the above mess pertains to the existing proposal for 440 billion Euros. What would the vote be for a €2.5 billion proposal?

Telegraph: As quid pro quo for an enhanced bail-out, the Germans are understood to be demanding a managed default by Greece but for the country to remain within the eurozone. Under the plan, private sector creditors would bear a loss of as much as 50pc – more than double the 21pc proposal currently on the table. A new bail-out programme would then be devised for Greece.

Mish: Will the ECB, IMF, and France go along with that? What about the German parliament?

Telegraph: Officials would hope the plan would stem the panic in the markets and stop bond vigilantes targeting Italy and Spain, which European and IMF figures believe should not be in any immediate distress but are in need of longer-term structural reform.

Mish: So here we are, with a half-baked 2+ trillion Euro proposal, highly likely in violation of the Maastricht Treaty, that all 17 nations in the Eurozone would have to approve. Finland, Austria, the Netherlands, and Germany are already balking over various proposals and Finland in particular wants collateral.

This multi-trillion idea is "in hope the plan would stem the panic in the markets and stop bond vigilantes targeting Italy and Spain".

The plan is supposed to pass by November? Really? And the aim is to spend 2 trillion to stop something from happening that has already happened.

See the original article >>

“Why I’m An Austrian In Economics”

2011-09-25T15:34:00.003+02:00

By Thomas Mayer

This article is by Dr. Thomas Mayer, Chief Economist for Deutsche Bank Group and Head of Deutsche Bank Research. Before Dr. Mayer joined Deutsche Bank in 2002, he worked for Goldman Sachs in Frankfurt and London (1991-2002), and for Salomon Brothers in London (1990-91). Before moving to the private sector, he held positions at the International Monetary Fund in Washington D.C. (1983-1990) and at the Kiel Institute for the World Economy (1978-82).

We welcome Dr. Mayer to the Daily Capitalist.

Introduction

The financial crisis has led many people to doubt the merits of free markets and a liberal economic regime. They blame markets for the financial and economic crisis and demand tighter regulation and, in effect, more central planning by governments as a remedy. We shall argue that both the analysis on which this view is based and the policy recommendations are flawed. This crisis has been caused by too much reliance on the effectiveness of economic and financial planning. Failure of the “liquidationists” to overcome the Great Depression of the early 1930s prepared the ground for an era of interventionist economic policies. Modern macroeconomics and finance nourished the belief that we can successfully plan for the future. But the present crisis teaches us that we live in a world of Knightian uncertainty, where the “unknown unknowns” dominate and our plans for the future are regularly thwarted by unforeseen and unforeseeable events. We have suffered from “control illusion.” We need to recognize the limits of planning for the future and the superiority of a market-liberal economic order, where states, firms and individuals can be held liable for the financial decisions they have taken.

The predecessor of today’s crisis

To develop our point we first take a look at the historical predecessor of today’s financial crisis, the depression of the 1930s. During the 1920s easy monetary conditions and an exaggerated appetite for risk, evidenced by extreme leverage in the popular equity trusts, fuelled the build-up of a stock price bubble. When monetary conditions were tightened eventually, the edifice of leverage came down and the stock market crashed in October 1929.

At the time, the authorities took the crash in their stride. Many policy makers felt that the crash and a possible recession afterwards were needed to eliminate the excesses and imbalances that had built up during the roaring twenties. Andrew Mellon, then US Secretary of the Treasury, brought this view to the point when he said:

“…liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.” (Hoover, Herbert (1952). Memoirs. Hollis and Carter. p. 30). Inspired by Mellon’s attitude, those sharing the idea that a recession was a “cleansing event” were later dubbed “liquidationists.”

The “liquidationists” could claim theoretical support for their view from the Austrian school of economics around Joseph Schumpeter and Friedrich von Hayek, which built its view of the business cycle on the work of the Swedish economist Knut Wicksell. Wicksell distinguished between a natural rate of interest, which reflects the return on investment, and a market rate, which reflects the borrowing costs of funds charged by the banks. When the market rate is below the natural rate, companies borrow to invest and the economy expands. In the opposite case, investment is reduced and the economy contracts.

The Austrian school used this idea to develop a theory of the business cycle that puts the credit cycle in the centre (see picture left). Low interest rates stimulate borrowing from the banking system. The expansion of credit induces an expansion of the supply of money through the banking system. This in turn leads to an unsustainable credit-fueled investment boom during which the “artificially stimulated” borrowing seeks out diminishing investment opportunities. The boom results in widespread overinvestment, causing capital resources to be misallocated into areas which would not attract investment if the credit supply remained stable. The expansion turns into bust when credit creation cannot be sustained – perhaps because of an increase in the market rate or a fall in the natural rate – and a “credit crunch” sets in. Money supply suddenly and sharply contracts when markets finally “clear,” causing resources to be reallocated back toward more efficient uses.1

The liquidationist approach to economic policy in the aftermath of the 1929 stock market crash – for which Mellon became the symbol – accepted the downturn in the early 1930s as inevitable. What they missed was that extreme risk aversion can keep the market rate above the natural rate even after ?the rottenness? has been “purged out of the system.” Franklin D. Roosevelt, who beat Hoover in the 1932 presidential elections, seems to have intuitively understood this problem. Perhaps the most important action Roosevelt took shortly after his inauguration in early 1933 was to guarantee bank deposits. As a result, cash that people had hoarded under their mattresses came back to the banks and improved their liquidity situation. When the Roosevelt administration later in the year recapitalized banks, credit extension picked up again and the economy recovered. It is interesting that there was no big fiscal policy stimulus in 1933 – the famous New Deal was felt only later. Hence, contrary to conventional wisdom, the spark that ignited the recovery of 1934 was the turn in the credit cycle (see chart).

The experience of the depression and the Roosevelt recovery induced John Maynard Keynes to launch a heavy attack on the Austrian school. In his General Theory, written in 1935, he made a strong case for government intervention. Fiscal policy should come to the rescue when the public feared deflation and hoarded money. Many students of economics today believe that it was the application of Keynes’ theory that ended the downturn of 1930-33. We do not agree. In our reading of events it was the policy-induced turn of the credit cycle that did the trick. Hence, the recovery of 1934 was more “Austrian” than “Keynesian”. Let us be clear: The liquidationists were wrong to allow the depression to happen as they failed to recognize that fear can beget fear. Roosevelt recognized this when in his inaugural speech he said “the only thing we have to fear is fear itself,” and he was right to intervene and stabilize the banks. But what he did – opening the credit markets – is what follows from an Austrian reading of the business cycle.

The Austrians have warned that a policy-induced extension of the credit cycle before all excesses have been eliminated in the economy will only delay the day of reckoning. But also they would have had to conclude that after the depression of 1930-33 one could hardly still see “excesses” in the economies of the western world. Nevertheless, the economy tanked again in 1937 when the monetary and later fiscal policy support was withdrawn. Most economic historians argue that the period of economic instability in the US only ended towards the end of the 1930s when the country prepared for war. The British historian Niall Ferguson has even argued, that Germany got out of the depression ahead of the US because of its earlier and more aggressive preparations for war. It seems that only in the anticipation of war the “fear of fear itself” ceased to be a de-stabilising factor in economic developments.

The historical review of the Great Depression leaves us with a disturbing conclusion: The Austrian credit cycle theory seems to have a better fit to events than Keynes’ theory of the liquidity trap and power of fiscal policy (see chart). What the Austrians seem to have missed is that an economy paralyzed by extreme risk aversion may need a jolt by confidence-building economic policy measures. But this was not what most economists and policy makers concluded.

Lessons from the Great depression: “Over to governments…”

At the end of WWII a number of western intellectuals and economists flirted with Soviet-style central planning. After all, the Soviet Union had prospered during the 1930s while the capitalist countries had been in crisis. Did this not prove that their economic model was superior?

Having lost the intellectual battle with Keynes and followers in the 1930s, the Austrians made a last stand against central economic planning with Hayek’s powerful book “The Road to Serfdom” published in 1946. They won the war of principles and the western world did not subscribe to Soviet-style central planning, despite the allure this model was exercising on many intellectuals after WWII. Even Keynes sided with the Austrians as far as the high ground was concerned and wrote to Hayek: “In my opinion it is a grand book … Morally and philosophically I find myself in agreement with virtually the whole of it: and not only in agreement with it, but in deeply moved agreement.”

Nevertheless, the Austrians lost the battle over economic policy in the post-WWII western countries. Keynes’ idea of “demand management” through fiscal policy became the mantra there after the war. Somewhat belatedly, in 1971 when he ended the link of the US Dollar to Gold, even Richard Nixon is reported to have said “I’m now a Keynesian in economics.”

From the 1950s to the end of the 1970s western economic policy makers used and abused fiscal policy as an economic management tool. Governments were quite happy to raise borrowing in economic downturns, but generally reluctant to bring it down in upturns. Towards the end of the 1960s, the use and abuse of fiscal policy created strains on government finances that could only be eased by the monetization of government debt. As a consequence, Richard Nixon on August 15, 1971 suspended the link of the USD to gold, and in effect launched the post-WWII system of fiat money.

During the post WWII period of the implicit gold standard under the Bretton-Woods System (where the USD was supposedly as good as gold), there was hardly any room for pro-active monetary policy (which, however, did not prevent the US government to use the money printing press as an auxiliary funding tool). This changed drastically after Nixon’s decision of 1971. The result was a bout of inflation as government debt and deficits were financed in part by the money printing press. As both growth and inflation disappointed, the word ?stagflation? was coined to describe the economic conditions of the 1970s.

… “over to the central banks”

The failure of the young new fiat money regime was that it lacked a monetary anchor. As a result, monetary policy ended up accommodating fiscal policy and wage policy developments. This was eventually recognized by policy makers in the early 1980s. In the seventies, Milton Friedman had proposed limits on the expansion of money supply and laid the ground for the introduction of independent central banks. As Stagflation killed the idea that there was a trade-off between inflation and unemployment, the time of monetarism had arrived. Federal Reserve Chairman Volcker used the monetarist demand to “gain control over the money supply” as a justification to engineer a deep recession that brought inflation down. Hence, the early 1980s were a period of repentance for the sins of Keynesianism committed in the late 1960s and 1970s. With the development of the theory of rational expectations and efficient financial markets, the pendulum seemed to swing back from the constructivism of economic policy before to a more market liberal regime.

But the straitjacket intended by Friedman for monetary policy did not hold long. In the course of the 1980s monetary policy freed itself from the Friedman straitjacket and turned pro-active. The great champion of this approach to monetary policy was Alan Greenspan, who followed Volcker in 1987.

The 1987 stock market crash was the first application of the proactive use of monetary policy. To fend off recession risks, Greenspan cut interest rates. The therapy worked and instead of decelerating the economy accelerated during the late 1980s. The next occasion to apply the Greenspan method came in the wake of the savings-and-loans-crisis at the end of the 1980s, which contributed to the recession of 1990-91. Again, the Greenspan Fed cut interest rates to support the economy and again succeeded in mitigating the downturn. In the following years, the Greenspan method was applied again to fight the Asian emerging market and LTCM crisis of 1998 and again when the dot.com bubble burst in 2000-2002. Until the great financial crisis that began in 2007, it seemed that the Greenspan method, the pro-active use of monetary policy to fine-tune economic developments, had succeeded in abolishing the business cycle as we knew it. Thanks to the art of central bankers, the age of the Great Moderation had arrived.

The great financial crisis that erupted in 2007 uncovered the Great Moderation as a great illusion. Nevertheless, the old reflexes led to the combined deployment of monetary and fiscal policy on a so far unprecedented scale. As the excessive leverage built up in the illusory age of the Great Moderation was unwound, the crisis moved from the US sub-prime mortgage sector to the money markets, the banking sector and more recently to the public sector (see chart). The principle has been to shift the unbearable burden of debt from weaker to stronger shoulders and lower debt service costs through monetary policy induced interest rate cuts. But in this process the previously strong shoulders have also been weakened. Somehow the old tricks seem to have lost their magic, and the crisis triggered by massive de-leveraging appears to be getting out of control.

The theory behind “Greenspanism”

What was the major flaw that led us into this crisis? The belief that even in a world of uncertainty economic and financial outcomes could be planned was in our view a major contributor. The assumptions of rational expectations and efficient financial markets laid the ground for overconfidence in the ability of policy makers, firms and individuals to successfully plan for the future despite the uncertainties surrounding us.

At the macro level, rational expectations and efficient markets theory laid the ground for inflation targeting by major central banks, which replaced the monetary targeting of the early 1980s. The economy was expected to grow in a steady state, if only the central bank ensured stable and low consumer price inflation. The overconfidence in the power of the central bank led Paul Krugman to claim in the late 1990s:

“If you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: It will be what Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.”

When individuals had rational expectations and markets were efficient there was no need to worry about asset markets or regulate financial markets. After all, how could central banks or regulators know more than the market when market prices reflected all available information about the future? Anyone questioning the wisdom of the ruling paradigm was regarded as old-fashioned by the academic cardinals of the Church of Anglo-Saxon economics, which has reigned supreme. In retrospect, it seems a bit odd that academics overlooked financial markets’ obsession with central banks and the cult status they awarded central bankers. How could financial market participants hang on the lips of central bankers, when they so efficiently processed all available information in real time? But economists were too enamored with their theories to dwell much on such oddities.

At the micro level, rational expectations and efficient markets theory laid the ground for many highly leveraged financial products and risk management. Financial market participants saw only “known unknowns” that could be quantified with probability theory. In a world of “known unknowns” they felt that there was little need for contingencies for the truly unforeseen, the “unknown unknowns”.2 Hence, it seemed fully appropriate to raise leverage to the extreme. After all, risk managers could calculate continuously and real time the value that could be lost when the unknown happened. The feeling of being in control – of being able to plan ahead with good, if not perfect, foresight – laid the ground for the extremely high leverage that was built into financial products and the balance sheet of financial firms.

After the burst of “control illusion”

The collapse of these theories enforces the radical reduction of leverage. If we cannot anticipate the range of future outcomes with a relatively high degree of certainty, we need more slack and buffers in the system for unforeseen events, and hence cannot afford high degrees of leverage.

The helplessness of the economic profession in the face of the present crisis manifests itself by the recommendations of prominent economists for ever-stronger incentives for a renewed increase of leverage. They advise that fiscal policy turn expansionary again, central bank policy rates be kept at zero for a long time, and central banks purchase financial assets.

At present the central banks fight the reduction in leverage with the issuance of ever more central bank money. As outside money implodes inside money explodes. For now, the aim to reduce leverage depresses asset prices and leads to a flight into money. But the more the central banks succeed to replace the reduction of outside money through de-leveraging by an expansion of inside money, the more likely becomes the monetization of outstanding debt.

The desperate attempt to avoid an economic crisis caused by the necessary de-leveraging could eventually lead to a crisis of the fiat money system itself. On August 15 this year, the fiat money system celebrated its 40th birthday. Since Nixon cut the dollar’s link to gold on August 15, 1971, the dollar has depreciated by 98% against gold (see chart). Depreciation came in two stages: First during the 1970s, when the excess supply of US Dollars created towards the end of the BW-System and at the beginning of the new fiat-money system boosted consumer price inflation, and secondly after the implosion of the credit-driven ?Great Moderation? as of 2007, when bad assets started to move from private sector via public sector to central bank balance sheets.

When fiat money fails it may well be replaced by money backed by real assets that cannot be augmented with the stroke of the pen of central bankers. How could this happen? One possibility – which at present may sound a bit like science fiction – would be for China and other big EM countries to peg the value of their currencies to a basket of commodities. It would then be up to the industrial countries to try to stabilize their currencies against the Yuan, or accept the inflation that goes along with secular depreciation.

To conclude:

Modern macro- and financial economics are based on the belief that economic agents always hold rational expectations and that markets are always efficient, in other words, that the earth is flat. We now find out that this is not true. There are elements of irrationality and inefficiencies in the behavior of people and markets. Therefore we need to dump the flat-earth theories promising that economic and financial outcomes can be planned with a high degree of certainty and need to look at other theories that accept the limits of our knowledge about the future. A revival of Austrian economics could be a good start for such a research programme.

Unfortunately, however, the battle cry of the public and politicians is for more regulation: regulate banks, regulate markets, regulate financial products! But those who push for blanket regulation suffer from the same control-illusion that got us into this crisis. In our view, instead of more regulation we need more intelligent regulation. At the heart of such regulation must stand the simple recognition that we can at best tentatively plan for the future and must feel our way forward in a process of trial and error.

In a world where we need to reckon with “unknown unknowns” – in a world where Knightian uncertainty reigns – financial firms and investors need larger buffers to cope with the unforeseen, i.e. more equity and less leverage. In a world, where markets are not always liquid but can seize up in a collective fit of panic, financial firms and investors also need a greater reserve of liquidity. Regulation can help to achieve both objectives, but it needs to realize its limits. Regulation will create a false sense of security, unless firms and investors have the incentives to follow sound business practices. The best incentive to do so is to make failure possible. Hence, we need effective resolution regimes for financial firms.

In a world where people have imperfect foresight and do not always behave rationally, and markets are not always efficient, we need to accept that economic policy cannot fine-tune the cycle. All that policy can do is to lean against excessive exuberance and depression during the credit cycle and help avoid the excessive swings of risk appetite that we have seen over the last 10 years. It is unhelpful to pro-actively manipulate the market rate to achieve certain economic growth objectives. Instead we should try to create the conditions for a steady development of credit by allowing the market rate to closely follow the natural rate. When accidents happen, we need to prevent that “fear of fear itself” perpetuates economic crises by ensuring that the banking system is capable to satisfy the demand for credit.

Finally, economists should be more humble. For too long we have tried to be like natural scientists. Like they we like to develop our theories with the method of deduction – start from a few axioms and describe the world in mathematical terms from there. This was a little presumptuous, to say the least. We need to realize that we are to a significant extent a social science. Social scientists, like historians, use the method of induction. They observe, and then develop tentative descriptions of the world from these observations. Because we did not pay enough attention to economic history and relied heavily on formal models of the economy we repeated a number of the mistakes that caused the Great Depression.

See the original article >>

Catastrophic Success

2011-09-25T15:29:00.003+02:00

By John Mauldin

400 Billion Yellow Aspirins
The US Government Is in the “No-Money-Down” Mortgage Business
Crash Alert?
Is Social Security a Ponzi?
Catastrophic Success
Europe, and Breaking the Light-Speed Barrier

Breathes there a man with brain so dead
Who never to himself hath said,
“Social Security looks like a Ponzi Scheme?”
- With apologies to Sir Walter Scott

Today we look at Social Security. In the US, Texas Governor Perry touched the third rail of Social Security and called it a Ponzi scheme, which of course immediately made him the leading candidate in the “shoot the messenger” category. Behind the rhetoric, we look at some actual numbers. No, not the unfunded liabilities, that’s too easy. Let’s look at what a heartless, uncompassionate man President Roosevelt was when he started Social Security (and that’s what many will call me after reading this!). Behind the tongue in cheek, there are some very real issues that do not get addressed when we talk about Social Security, but that need to be part of the discussion. And of course, we must start off with the results of the FOMC meeting, which has me feeling not at all amused. What are they thinking? Apparently, they are seeing the results from another, alternative universe. There is a lot to cover as I head off to London, where I will finish this letter.

But first a very important announcement. I am very excited to be able to introduce my readers to a new mutual fund offered by my friends Altegris Investments. This fund is a blend of five commodity trading advisors or CTAs. Normally, to access a CTA you be to be an accredited investor, with all the net-worth requirements and limited liquidity. But Altegris has figured out how to wrap a mutual fund around CTAs and create a fund of commodity traders with all the usual aspects of a mutual fund (daily pricing, liquidity, etc.).

I have long been involved in the commodity-trading advisor space (some 20 years) and am a proponent of CTAs as a way to diversify portfolio risk. I have written a detailed report on this fascinating sector in relation to the fund, and it is available for free at http://www.altegrismutualfunds.com/landing/mauldinreports1.aspx, along with more information on the fund (including the offering memorandum and important risk disclosures, which are also included at the end of this letter).

The fund has been very well received since its launch and has grown rapidly to over $1 billion. There has been very active interest in the professional community, as advisors and brokers are looking for simple and realistic ways to diversify their clients’ portfolio risk, as well as a way that is truly noncorrelated to typical stock funds and many other asset classes. Whether you are a professional or individual, you really should take the time to research what I think is a very solid fund. My partners at Altegris have decades of experience in the CTA space, with the largest database of CTAs and long-term relationships with many of the managers (I actually started my investment career in the commodity fund space, so have more than a passing knowledge of the arena). Given the potential for volatility in the global markets, I think it makes sense to have some exposure to funds that can go both long and short (depending on their models). I urge you to read my report.

http://www.altegrismutualfunds.com/landing/mauldinreports1.aspx

400 Billion Yellow Aspirins

My mother used to tell me, “John, if you can’t say something nice, then don’t say anything at all.” So let’s see if I can find something to nice to say about the FOMC announcement. How about: “At least they didn’t cause TOO much damage”? As Rich Yamarone tweeted immediately after, they announced they would buy 400 billion white aspirins and sell 400 billion yellow aspirins. This was not something that should have been done, but thankfully they only did some $400 billion and not a few trillion, which could have really screwed (a technical economics term) things up.

With Operation Twist as part of their new mix, they announced they would sell short-dated and buy long-dated treasuries. This sent the ten-year yield down to 1.72% (yields were already dropping), although as I write it is back up to 1.79%, which without the recent action would be the all-time low. The 30-year is below 3%, at 2.85%, which makes those of us who have been predicting such an event for many years finally right. I think I will just savor the moment and not make any more predictions for a week or so. It was a long time coming. It would have gotten there anyway, even without this Fed action. Which makes what they did impotent and pointless. More below.

However, such low rates are not cause for merriment but for thoughtful pause, as low rates might be good for the government and for those looking for mortgages, but they threaten to wreak havoc on pension plans, as the bond portfolios on which they are built are paying less and less, and that means they are becoming more and more underfunded, and stocks are not helping. The problem pension fund trustees have is that lower yields require them to raise their assumption for future liabilities, which must be discounted at a lower rate. Lower bond yields, like falling share prices, increase funding gaps.

While few are mentioning this aspect, Spencer Jakab of the FT sent me this note: “A sensitivity study by Credit Suisse done in mid-August shows how big an impact this can have. The underfunding for S&P 500 members was then an estimated $390bn. A 25 basis point fall in discount rates would have inflated the deficit to $435bn – about the same as 4 percentage points of investment underperformance this year. In August alone the deficit among the broader S&P 1500 widened by some $75bn, Mercer Consulting found. Slumping equities and bond yields brought the deficit from 12 to 31 per cent since April alone.”

Not to mention what low rates do to people who are trying to live off their savings. How can you survive on 1% yields from a small income portfolio? That means you start reaching for yield in places that are not as safe or liquid, which is precisely what we do NOT want our retirees to be doing. Wrong, wrong, wrong. An unintended consequence of this Fed policy is that retirees are being put at serious risk. And it is an important consequence. So many retirement plans were formed ten years ago, assuming they could safely withdraw 5% a year. Now that is difficult, at least if we’re talking “safely.” There is going to be a plethora of schemes to entice retirees with “safe” higher-yielding investment programs. Please, remember that there are no free lunches. If you are getting above-market yields, you are taking above-market risks.

Now, let’s look at what the Fed is actually likely to do. They have indicated their actions will occur over the next nine months. This also means they will sell most of their short-term treasuries and increase their duration, but not necessarily their risk. It is still US government debt. These projections are from Bridgewater.

Treasuries the Fed will likely sell:

	What the Fed Has	Likely Sales
0-1 Years	$138	$138
1-2 Years	$156	$156
2-3 Years	$221	$106
Total	$515	$400

On average, $400bn at 1.5-year maturity
Treasuries the Fed will likely buy:

	Eligible Total	Eligible Outstanding	Eligible New Issue	Likely Purchase
6-7 Years	$353	$179	$174	$140
7-10 Years	$581	$383	$198	$160
10-30 Years	$521	$395	$126	$100
Total	$1,455	$957	$498	$400

Rates have already moved in anticipation, as seen below.

One has to go out beyond 5 years to get more than a 1% yield. Who is buying this stuff? Any pension plan doing so is locking in low returns and underfunding for that period. This is just a disaster in the making in the pension and insurance world. If you couple that with a recession, a Muddle Through Economy, and a secular bear market, it is a prescription for a pension-funding train wreck of epic proportions, which means that the large companies will have to start writing checks, which will be a hit on earnings.

Note: Adding to pension concerns about the stock market, the ECRI weekly leading indicator has been down for six of the last seven week. More evidence that we are in for a real slowdown, if not a recession, sooner rather than later. This just in from the Wall Street Journal:

“Providing fresh evidence of weakening global trade, FedEx Corp. said Thursday it is cutting capacity and trimmed its full-year earnings forecast amid weaker demand, mainly due to slowing sales of consumer electronics made in Asia.

“The news comes as a slide in Asian air cargo traffic that started in July has shown no immediate signs of abating. The slowdown extends to the makers of perishable foods, high-end apparel and automotive and industrial parts that fill the holds of planes flown by FedEx and rivals such as United Parcel Service Inc. and Cathay Pacific Airways Ltd.

“‘The consumer just doesn’t have an appetite’ for spending more, Chief Executive Fred Smith said during a post-earnings conference call. As a result, he added, ‘we don’t anticipate a significant peak [shipping season] this year.’” –Bob Sechler of the WSJ

But that’s just it. What happened with QE2? The money went into commodities and stocks (for which Bernanke again took credit), giving us inflation and a good feeling. But the economy, in terms of jobs, hours worked, incomes, and GDP, went south or sideways. Where was the carry-through? I somehow don’t remember that the stock market was part of the dual mandate, yet Bernanke listed its rise among the results of QE2. My bet is that with QE off the table, that will come to be seen as a temporary rise. A sucker’s rally.

And now that we have used that QE bullet, where are we? The stock market is tanking, as are commodities. Bond yields are making new lows. The dollar is getting stronger. Can someone tell me why we went through this exercise? It seems we are right back where we were, yet with even more uncertainty. And now we start something that my Dad would call a piss-ant (a small, rather noxious and foul variety of Texas ant) program called Operation Twist, which has no real hope of doing anything that will help the dual mandate. It simply creates the illusion the Fed is doing something.

I said at the time of the 2^nd QE that the main problem I had was that we were wasting a bullet that we would (and now do) need when the next liquidity crisis came. And we have now kicked inflation up. As Rob Arnott wrote me in a private message, when you look at the next four months, which will “drop off” the year-over-year rate of inflation, it’s not pretty. Core could easily run up to more than 2.5%. The Fed may have handcuffed itself at the very time we need some liquidity. QE2 was a very bad and ill-conceived move, as is the current one. It is not smart to mess with Mother Market. (Can anyone say Fisher for Fed Chair?)

The US Government Is in the “No-Money-Down” Mortgage Business

The Fed was very clear in its statement that it wants mortgage rates to go down. But anyone with a pulse knows that the problem in the housing market is not that rates are too high. Dropping rates another 25-50 basis points is not going to help all that much if you can’t get the 20% down you need to finance a house, let alone get a nonconforming loan or, God forbid, a jumbo loan. With banks feeding into the market “REO” homes they get from foreclosures, it will be several years until we get close to a bottom in housing. But new homes are being built. So what gives?

This week I went to a fund presentation on new-home construction and sales. I was invited by a very knowledgeable real estate consulting firm (John Burns), and I was interested to know, how do you raise money in this market for new-home “spec” construction? The numbers and the company sales history they presented looked very impressive, but I could not figure out how they were closing the rather significant number of homes per development they did. No one else I knew of was close, from what I have seen (I watch these things). When the person who presented sat down, I looked at the mailer they send out by the millions. They send it to apartment renters. It says, “Why would you rent an apartment when you can buy a new home for $699 a month with NO MONEY DOWN?” And at very low rates, I might add.

These are starter homes, smaller but quite nice. (Note: a lot larger than the houses I grew up in with three siblings!) But they are on the outskirts of town, and that triggered a thought in the back of my head. Joan McCullough had tipped me to this.

“Are you using USDA financing to get the no-money-down?” The short answer was yes, along with FHA (3% down) and VHA. And what, you may be asking, is USDA financing? And how do I get some?

The USDA is the US Department of Agriculture. They currently have $24 billion they can use for government-guaranteed financing of homes (up from $12 billion last year). This is not Fannie or Freddie, this is the good old US D of A. As in farms and stuff (and food stamps and housing and… basically they got all these odd mandates long ago, when congressional agricultural committees wanted to expand their power). From Real Estate Economy Watch:

“Founded in 1949 to spur home sales and development in rural areas, the US Department of Agriculture’s popular direct and guaranteed rural housing loans today are one of the few places in America you can still get a mortgage with no money down at competitive rates.

“Borrowers don’t have to be lower income; in fact they can make slightly more than the median. To qualify for the government guaranteed loans, borrowers can earn up to 115 percent of the median income for the area. Nor do they have to buy in a rural area. They can live relatively close to a major urban area or in a popular resort community, however qualifying areas were recently redrawn to comply with the program’s rural mandate.

“Best of all, no down payment is needed to get financing through approved lenders, which makes the USDA program more attractive to borrowers who qualify than FHA.” (emphasis mine)

And there are actually subsidies available, so that you might not need to make the entire payment. Now, you can’t use this to buy a McMansion. You have to be in a rural area, which has come to be defined as outside the city limits (except in certain areas). There are income limits. The program does attempt to help lower-income families, and I am not trying to be snarky here, but these are government-guaranteed loans (read: taxpayer-guaranteed) at 100%, being handed out in areas where in the city homes are going into foreclosure and need someone to live in them, yet right outside the city you can buy this cute new home. Which is a situation more or less guaranteed to keep home values down in the rural outskirts, yet we want first-time buyers to snap these up!

The intention here is all well and good. And the buyers are seeing it as a way to reduce their monthly payment, and a house is still the American Dream. And, over time, it will be. If they stay in them long enough and don’t need to move, etc. I just think the unintended consequences (there are those words again, as we’re talking about a government project) are likely to be larger than anyone thinks.

I invite you to go to http://www.rurdev.usda.gov/Home.html. Look around. Notice that 4 of the first 5 press releases on the home page have the words job creation in their titles. Plus a lot of other current buzz words, like energy, environment, etc.

This whole side trip got started with our analysis of the Fed and its recent actions. Let’s quickly return, before moving on to Social Security. This week’s action is not useful. It falls under the category of “Let’s do something to show we know there is a problem.” It will provoke suspicion or opposition among those of a conservative monetary bent, probably hurt small and medium-sized banks (as it drives down the yield curve, which bankers depend on to make money), and lower interest rates for savers.

Crash Alert?

This is from my good friend Art Cashin today (he’s head of floor operations of UBS, and you see him all the time up on CNBC). I thought it should go here, after the market action of the last few days. Just as a heads-up.

“The Thursday/Monday Syndrome – We had suggested yesterday that we should probably explore the history of what old fogey traders refer to as the Thursday/Monday syndrome. While it would be pretensions to say that was prophetic, it was, to say the least, serendipitous, for yesterday’s action looked like the perfect first step in a Thursday/Monday setup.

“We had intended to give you a more thorough history of the syndrome with lots of analytical examples starting with the classic one – October 1929. Unfortunately, events are moving too fast this week, so we have neither the time nor space to wax poetic on the topic. So, you will just have to rely on my recollections of 50 years of watching markets and hundreds of nights studying market history.

“The classic Thursday/Monday syndrome starts with the kind of action we saw yesterday. The markets open under pressure and selling accelerates in swelling volume. By early afternoon, there is a virtual stampede of selling. Then, later in the session, stocks stabilize a bit based on some reassurance. On Thursday, October 23, 1929, that reassurance came in the form of Richard Whitney bidding ‘205 for 10,000 steel’ on behalf of the bankers’ rescue pool. (Read a terrific account in the chapter ‘The Crash’ in Fredrick Lewis Allen’s marvelous and essential ‘Only Yesterday’.)

“The action on Friday (and Saturday in the case of 1929) is uneven, often ending choppily steady or somewhat weaker.

“Then on Monday, the trapdoor opens with liquidation and margin calls bringing tsunamis of selling.

“Is that what’s going to happen? Who knows? If it were that easy, kindergarten kids could do this. But chance favors the prepared mind. Old fogeys will guard against undue risk and exposure. Some may even get out a special shopping list. They will set their basket right, put in silly bids and hope some panicky soul throws a bargain in. Recall the story of the floor messenger boy, who, in 1929, according to legend, bought White Sewing Machine with his silly bid of one dollar when all other bids canceled.

“One final note on the syndrome. Not infrequently, the Monday massacre spills over into Tuesday morning – a capitulation bottom in mid-morning resulting in a massive reversal to the upside.”

Is Social Security a Ponzi?

Breathes there a man with brain so dead
Who never to himself hath said,
“Social Security looks like a Ponzi Scheme?”

- With apologies to Sir Walter Scott

Governor Rick Perry has been getting slammed of late for his comment that Social Security is a Ponzi scheme. Note: This is NOT an endorsement of Perry or any other candidate; it is a segue into the more important issue of Social Security.

Perry is not saying anything that has not been said for over 20 years. I seem to remember that back in my younger days (as in the ’80s) I actually published a book on Ponzis. The classic Ponzi is where you get money from one group and then find another group to pay the “returns” to the first, and so on, until you run out of people and the game is up. The difference between a Ponzi and Social Security is that SS is legal and is done in full view of the public with everyone knowing the deal.

As long as each succeeding generation is willing to pay and is large enough, SS can go on. But now we have trillions in unfunded liabilities. All Perry is suggesting is that we admit the problem and fix it. Not exactly radical or suggesting we end Social Security, as Romney and the others claimed.

(Side note. I found that use of the attack mode disgusting and totally devoid of the leadership I want to see on that stage. It was trying to create a “gotcha” moment. Why not turn it into a teaching moment, to say how you would fix Social Security or admit you have no clue as to the true nature of the problem? Afraid to touch the third rail of Social Security? Then get out of the race. You have no ability to lead this country through what will be a crisis presidency if you can’t even admit to some basic, obvious truths. And how will you even get to the real problem, Medicare?)

Most of the “fixes” are some combination of increasing the retirement age, raising the cap on how much is subject to SS taxes, and/or some form of means testing. Social Security can be fixed if the political will is found to do one or all of those. Some comments on those choices:

First, there is some resistance to means testing, as it would be an admission that Social Security is a form of welfare and not a “savings account” that is in some hidden lock box. By now, anyone with a neuron firing knows there is no lock box and the Social Security funds are an entry into a government accounting book that don’t really exist except as an IOU. Politicians of all stripes have used the Social Security money to pay for other government expenses. Those funds were even counted to offset the deficit, although now that Social Security is no longer in a surplus, that has gone away.

Isn’t that what Ponzi did? He took money from one group, telling them they would get it back later, and then spent the money with another group, telling them the same thing.

OK, think using the term Ponzi is harsh? Some Republican theme? Then let’s quote uber-liberal Paul Krugman from 1996:

“Social Security is structured from the point of view of the recipients as if it were an ordinary retirement plan: what you get out depends on what you put in. So it does not look like a redistributionist scheme. In practice it has turned out to be strongly redistributionist, but only because of its Ponzi game aspect, in which each generation takes more out than it put in. Well, the Ponzi game will soon be over, thanks to changing demographics, so that the typical recipient henceforth will get only about as much as he or she put in (and today’s young may well get less than they put in).”

Let me say, I am all for Social Security. While I supplement my mother’s income, her Social Security check is very important to her. Not enough to live on, but every bit helps. (I have friends whose parents’ sole income is Social Security, and I totally get how small it is in today’s world.)

I also have seven kids. Hopefully, most or all of them will not need Social Security when they retire in 40-50 years. But some might. I want it to be there for them if they need it. But if we don’t properly fix it, it won’t be. I want it fixed.

I turn 62 next month. I am eligible for Social Security. I have paid in a lot of money over the last 45 years of working, for the last 20 years at the max level (with some off years here and there). Am I “due” something? Based on the current law, I am. But I must confess that life has been good of late (there have been times when I thought I would need every penny of Social Security!).

I think Social Security should be means tested. We should recognize it for what it is, for what Krugman called it: a redistributionist scheme. And a good and necessary one from the perspective of civilized society. Means testing would go a long ways to “fixing” the problem. But it doesn’t get us there.

We need to raise the retirement age, and by more than a few years. And this is where I get called a heartless (insert expletive)! “How could you want us to work until 70 or even later? How can we do that? Is that fair?”

Let’s use as our model that icon of the left, the King of Compassion, President Franklin Delano Roosevelt (FDR). He created the Social Security Act in 1935. He put the retirement age at 65. From today’s perspective, that seems about right, if not a little early. But what did it look like back then? I refer you to a report from the US Senate in 2006 on life expectancy in the US. Interesting reading, but for our purposes we will scroll down to page 26 and the detailed life-expectancy tables. (http://aging.senate.gov/crs/aging1.pdf)

In 1900, the average life expectancy was 47 years (shockingly, the life expectancy for black males was only 32). By 1930 it was 59, which, if they kept such records then, would have been what they were looking at when the designed Social Security. In 1935 it had risen to 61.

So FDR set the retirement age four years above the average life expectancy. So much for compassion. He (they) assumed you would work into what was for them advanced old age. Today, 62 does not seem all that old (at least from my vantage point!). Look around – there are lots of people in their 60s and 70s with very active lifestyles.

Why is that? Let’s fast-forward. In 2003 life expectancy was up to 77. Today it is 79 and change. Life expectancy has been rising more or less steadily rate at about 1 year for every 4 years of the calendar. So that means that in 40 years life expectancy, if it continues as it has, will be around 90. Under today’s laws one could retire at 62 or 65 or 67 and, if you just lived an average lifespan, get far more in benefits than you paid in. Remember, 90 will just be the average.

So when someone suggests that we move the retirement age to (gasp!) 70 in a few decades, I just smile and think back to what FDR would do. If Social Security had been set up to track life expectancy in 1935, when it was formed, then retirement would be set at 83 or 84 today! Not exactly the golden-years concept, is it?

Catastrophic Success

But then we come to what I call Catastrophic Success. Advances in medicine and biotech in the next 10 and then 20 years are going to radically alter life expectancy. Alzheimer’s disease will be gone. I will tell you about a potential cure for cirrhosis of the liver (and all kinds of cirrhosis) in a future letter. Heart disease? Soon be something that can be dealt with. Diabetes? Will be controlled or gone.

And cancer? There are numerous approaches, but I am following one that will be in human trials next year and that, in numerous mice studies, shows the potential to be a silver bullet for cancer in general, and relatively inexpensive (not a public company).

I could go on and on, but the point is that this Boomer generation is not going to live up to its part of the generational Social Security bargain. We are not going to die on time in anything close to the actuarial certainty the government now assumes (nor do the private pension funds!). Short of a Soylent Green-type debacle, Boomers will not only break the deal, they may destroy it, if we do not tie Social Security to the average lifespan.

Health care will soon be a Catastrophic Success. Wildly successful from the point of view of the individual, but a catastrophe from the point of view of Social Security. And we are debating whether to raise the retirement age from 67 to maybe 70 at some distant time in the future?

We need to be raising the retirement age by one year every four years. That means in 20 years the retirement age needs to be five years higher. I can hear the screams and moans from those 45 and under.

“What a heartless [insert expletive] Mauldin is. How long does he think I should have to work? It is all well and good for him,” etc.

I want the Social Security system to be there for my kids in 40 years. And not dealing with the rapid age increase is one way to make sure it is not. OK, I will offer a way to retire earlier. If you agree to forego any new medical treatments introduced after, say, 2014, then I will say you get to retire at the current SS levels. Like that trade? I didn’t think so.

Think I am being overly optimistic about lifespan? I am not even close. I am having a small private dinner in a few weeks with Mr. Optimistic Future himself, Ray Kurzweil (among other books, he wrote The Singularity Is Near – a very important work on the waves rolling toward us from the future). We will talk of many things, and I hope to get him to contribute to my next book, The Millennium Wave, which is all about how the world will look in 20 years. If we stay on his track, then shortly after that time (by 2032) we will be regenerating the entire human body. Ray (and many others) see a path to humans living to 150 and beyond, in good health, with younger bodies. It doesn’t make you immortal. You can still look the wrong way and step in front of a London bus or climb the wrong mountain and fall off. (Note: Ray does see a path to immortality of a sort, when we can download our minds into machines and then reverse the trip. But that’s a whole different level of discussion and farther down the road.)

I am talking to scientists who are doing the human trials on the first real regeneration of a human organ, the cardiovascular system. How about a 50-year warranty on your new heart and cardio system? Then it’s on to the next organ system. One down, 203 to go. (Start with cardio, as it’s the easiest to deliver the targeted stem cell to.) Sadly, it will be done in Asia and not in the US, so we lose tens of thousands of high-paying jobs and don’t get to train a cadre to physicians on how to do it. Nothing against Asia, but this is US-developed technology … that would take five years to get through the FDA. For the management team of the company doing the work, who really do hate the concept of people dying from old age, that’s too many deaths as a result of waiting. And there is still a long way to go before we get true regeneration. We (as in those of us over 60) won’t have time for 20^th-century regulators to get in the way. The clock is ticking.

(Side note for those of you who don’t want to live a very long time: I am sorry your life is so boring. I see nothing but wonder and new worlds to explore and cultures to find and tens of thousands of books to read. Ask me in a few thousand years how it’s going. I’m in no hurry to knock on the gates of the Other Side. We get there soon enough.)

Social Security as it is set up today is close enough to a Ponzi scheme for government work. That can be changed, but we have to have the will to do so. Let’s hope that not just Perry can decide to lead us there.

Europe and Breaking the Light Speed Barrier

Heads up, you Junior Rocket Man Kids (remember those days?). Physicists are doing amazing things. My son Trey and I got a private tour this summer of CERN, the great physics lab in Geneva. Very cool. But Wall Street is also legendary for the number of physicists it hires to work on high-frequency trading programs. Evidently, they have figured out how to get trades done 190 milliseconds in the future. Is the race on to see who can cross the one-day mark? What is the speed of light when compared to the speed of money?

“Nanex: On September 15, 2011, beginning at 12:48:54.600, there was a time warp in the trading of Yahoo! (YHOO) stock. HFT has reached speeds faster than the speed-of-light, allowing time travel into the future. Up to 190 milliseconds into the future, or 0.19 fantaseconds is the record so far. It all happened in just over one second of trading, the evidence buried under an avalanche of about 19,000 quotes and 3,000 individual trade executions. The facts of the matter are indisputable. Based on official UQDF/UTDF exchange timestamps, there is unmistakable proof that YHOO trades were executed on quotes that didn’t exist until 190 milliseconds later!” (http://www.nanex.net/Research/fantaseconds/fantaseconds.html)

Going forward in time is cool, and the same day I got the above notice I read that the physicists at CERN and in Italy have found subatomic particles that move slightly faster than the speed of light, making it possible to travel back in time (only a few nanoseconds, but it’s a start):

“But now it seems that researchers working in one of the world’s largest physics laboratories, under a mountain in central Italy, have recorded particles travelling at a speed that is supposedly forbidden by Einstein’s theory of special relativity.

“Scientists at the Gran Sasso facility will unveil evidence on Friday that raises the troubling possibility of a way to send information back in time, blurring the line between past and present and wreaking havoc with the fundamental principle of cause and effect.

“Researchers on the Opera (Oscillation Project with Emulsion-tRacking Apparatus) experiment recorded the arrival times of ghostly subatomic particles called neutrinos sent from Cern on a 730km journey through the Earth to the Gran Sasso lab.” (http://www.guardian.co.uk/science/2011/sep/22/faster-than-light-particles-neutrinos?newsfeed=true)

Now, just in case you buy this (and if you did, contact me about a bridge I have), let me attempt to disappoint. First, as my curmudgeon PhD from MIT and VC friend Bart Stuck writes, “I think they both had time-stamp errors.” I can’t vouch for the Swiss and Italians, but I would bet the keys to the kingdom that there is a computer glitch at the NYSE. High-frequency trading (HFT) is distorting the markets. It is enriching a few pockets (and that of the exchange), and I simply do not see how it is in the interest of the public to allow it.

I also know that fighting HFT is spitting into the wind, as faster tech comes along every few months. If you force the HFT funds to put their servers across the street (losing the time advantage of not being co-located with the exchange servers – milliseconds count!), it will only be a few years until technology has given the edge back to them. In ten years, when artificial intelligence and connection speeds are far more advanced, how will human traders compete? Hire yet another AI to fight back? Wire yourself into the system (already being done, by the way, in rudimentary ways)?

The only way to effectively end HFT is for the exchanges to stop giving incentives for such trading. I can see the profits for the traders and the exchanges. I just don’t see the benefit to the rest of us. The SEC should step in and settle some hash over missed time stamps. If a small broker-dealer has a wrong time stamp, they are all over us, and you can bet there are fines. Something is wrong here. If one trade can go “back to the future” then how many more? Really? A one-off or a symptom? And to finish this on a light note, here’s a cartoon from my favorite cartoonist, Gary Larson.

It is getting close to time to hit the send button. It has been good to be home for almost seven weeks and let my body recharge, and spend more time with my kids and grandkids. Life is not easy for all of them at times. Poor Lively (perfect angel that she is) was getting a “spanking” as I left for the airport. I can’t imagine her doing anything naughty, but her mother (Tiffani) thought otherwise. Two of the adult kids needed some help. It is never the same two at the same time. And on and on.

This trip should be fun. I love London. And I’ll be in Malta with my European partner, Niels Jensen of Absolute Return Partners. I will be hosting CNBC Squawk Box on Wednesday in London. Then it’s on to Dublin and lots of meetings, as I try to get a handle on the crisis there (my first trip to Ireland). And a little time driving through the Irish countryside, on our way to Galway. Then to Geneva to be with friends and clients for two days as I turn 62. First, dinner with the always fascinating Lord Alex Bridport (the only lord I know, so I love applying that title) and then a birthday dinner hosted by Herwig van Hove of Notz Stucki. And then it’s back home to Texas.

In four weeks I head to Cape Town, South Africa, where I will speak at the Momentum Wealth Investment Summit, and then, back in Texas, I’ll speak November 6 for a charity fund-raising event sponsored by Hedge Funds Care, a wonderful group that raises money for children’s causes. You can learn more by going to http://www.hedgefundscare.org/event.asp?eventID=74. I hope to see you there!

Have a great week and enjoy the weather if you can. The forecast for Europe is beautiful.

Your wondering if he’ll find his Irish ancestors analyst,

John Mauldin

See the original article >>

CREDIT UPDATE – THE EMERGING MARKET CONTAGION

2011-09-25T15:19:00.002+02:00

By Martin

“If you don’t have a functioning financial system the world economy won’t be revived. All the major economies have their responsibility to assist at a pace which is required to clean up the balance sheet of the banking system and to ensure that credit flows are resumed.” - Manmohan Singh

Contagion we have in Emerging markets:

Source CMA:

The trend in Ukraine:

No more Viagra ((Pfizer (PFE) long-term rating cut to A+ from AA- by Fitch; Outlook Stable) for China, as one stimulus after another is getting pulled out – this time around, it is not like Haier Electronic Group as we discussed previously with subsidies for home appliances. Instead, loan approvals are getting withdrawn:

China’s Squeeze on Property Market Nearing ‘Tipping Point’ – Bloomberg – 23rd of September:

“The squeeze on China’s property market may be reaching a “tipping point” that drives growth lower just when exports are under threat from a global slowdown and investor confidence is plunging, said Zhang Zhiwei, Hong Kong-based chief China economist at Nomura Holdings Inc.

Land transactions in 133 cities tracked by Soufun Holdings Ltd., the country’s biggest real-estate website, fell 14 percent by area in August from a month earlier. Prices of new homes declined in 16 of 70 cities last month compared with July, according to government data.”

Pop goes the real estate bubble in China, from the same article:

“Property construction is a mainstay of investment that last year drove more than a half of economic growth while land sales contributed 40 percent of revenues earned by local authorities that have amassed 10.7 trillion yuan ($1.67 trillion) of debt.

A funding squeeze on developers risks a “domino effect” as companies needing cash cut prices, forcing others to follow, Credit Suisse Group AG said yesterday.

“We’re reaching a tipping point where land sales are dropping much faster than before, developers are losing more access to bank financing, and housing prices are showing weakness,” Nomura’s Zhang said in an interview in Beijing yesterday.”

And Bloomberg to add:

“The price of land in Beijing slumped 76 percent in August from a month earlier, while in Guangzhou it plummeted 53 percent, according to Soufun. Land auction failures surged 242 percent in the first seven months of this year because of government curbs on the property market, the Beijing Times reported Aug. 3.”

A Chinese Subprime crisis in the making?

“Some developers have turned to trust firms for financing, usually in the form of loans that are repackaged into investment products and sold to retail investors. The debt is typically funded by banks or investors themselves, according to Samsung Securities Asia Ltd.”

Worst Asia Currency Drop Since ’97 Spoils Debt – Source Bloomberg:

So, no safe haven anymore even in Asia as its redemption/liquidation time for some global macro players.

Source Bloomberg – Kyoungwha Kim and Jiyeun Lee – 23rd of September:

“The Bloomberg-JPMorgan Asian Dollar Index slumped 4.3 percent this month, heading for its biggest loss since December, 1997, led by a 9.6 percent decline in South Korea’s won. Korea Exchange Inc. prices show the yield on 10-year government debt soared 27 basis points, or 0.27 percentage point, to 3.82 percent, from an all-time low on Sept. 14. The yield on similar Indonesian debt jumped 68 basis points this month to 7.47 percent, after touching a record low on Sept. 9.”

And EM for Global Macro players is a crowded trade according to Bank of America Merrill Lynch research, hence the liquidation we started to see and mentioned in the post “Markets update – Credit – Anterograde and Retrograde amnesia“:

Emerging Markets, which until recently had been preserved from the onslaught, have been affected as well by the revised growth picture published by the IMF, cutting its forecast to 4% from 4.3% in June 2011 – Source Bank of America Merrill Lynch Research:

So Australia and Australian banks please beware:

And given commodities based countries are in the frontline in relation to a Chinese slowdown, it is of no surprise that commodities based currencies are taking a beating in the process:

AUD/USD, 2008 until the 22nd of September picture – Bloomberg:

Canadian dollar is exposed as well:

And my good credit friend to comment:

“The equity market finally realized what the credit market was” flashing” for a while… and reacted accordingly. But the race to catch back with the credit market has still a long way to go…and the path may not be a straight line. Bottom line, equities will go lower as the new “norm” of slow economy worldwide will be accepted…

Which means lower prices for commodities (goodbye Canadian dollar and Australian dollar carry trade), higher US dollar (a higher US dollar and slower growth will be the poison pill for the international US corporations)…”

No more safe havens, even in Switzerland, as the country now flirts with deflation, Japanese style:

Source Bloomberg.

Like Japan, Switzerland is suffering from currency appreciation, tipping it towards deflation in the process, with 30 year Swiss Government bonds yielding less than Japanese 30 year bonds, with a yield at around 1.30%. The Swiss National Bank is warning that its Consumer Prices may decline 0.3% in 2012.

As a follow-up on our last post where we discussed the sell-off in Emerging Markets currencies, we now have 4 countries trying to prop up their currencies, namely, Russia, India, Argentina, and now Brazil. According to Bloomberg in relation to Brazil:

“The central bank sold 55,075 currency swap contracts in auctions, which was equivalent to selling dollars in the futures market. The last time policy makers entered the derivatives market to weaken the dollar was in June 26, 2009, according to the central bank. Yesterday’s measure marked a reversal of a 28-month-old strategy of buying dollars to weaken the currency.”

Brazil Sovereign CDS climbed 23 bps on the 22nd of September to 219 bps according to CMA. No, inflation is not the immediate threat, deflation is. US treasuries returned so far 1.7% in September, 8.9% gain year to date. And my good credit friend added on this:

” ‘No more risk free assets’ may result in a big re-pricing of all asset classes.

When there is too much debt in a system and when everybody is reluctant to erase the debt, the only solution is to deflate the value of the debt and the capital in order to bring them in line with the value of the assets or collateral… The trend will be “to deflate”, because we are in “deflation” … even if nobody wants to hear it.”

Ratio MSCI EMERGING MARKETS/ MSCI WORLD:

See the original article >>

Loud Rumors of Greek Default

2011-09-25T15:14:00.003+02:00

by the trader

As Europe is enjoying Saturday evening we are getting multiple loud rumors of Greece defaulting. A default is necessary, the only question is how much bankers are willing to loose/sacrifice. Below some early Saturday rumors. The night is loooong.

From Telegraph; German and French authorities have begun work on a three-pronged strategy behind the scenes amid escalating fears that the eurozone’s sovereign debt crisis is spiralling out of control.

Their aim is to build a “firebreak” around Greece, Portugal and Ireland to prevent the crisis spreading to Italy and Spain, countries considered “too big to bail”.

Greece needs a decade to regain competitiveness by Reuters.

Greek Default Gets Louder by Ekathimerini.

…and here is BBC’c quick guide to the different scenarios.

See the original article >>

Germany Demands "Managed" Greek Default And 50% Bond Haircuts In Exchange For Expanding EFSF, Peripheral "Firewall"

2011-09-25T15:05:00.001+02:00

by Tyler Durden

Back on July 21, the same day as the Greek bailout redux hit the tape, we speculated that the biggest weakness in the Second Greek Bailout is that the EFSF would have to be expanded to well over the current E440 billion (which even at its current size has not been fully ratified in Europe, and based on recent events may not be implemented until 2012 thanks to Slovenia and Finland), or about E1.5 trillion (and possibly as much as E3.5 trillion). The reason this is a "problem" is that it would have to come exclusively at the expense of Germany which would have to pledge anywhere between 50% and 133% of its GDP (as France would have long since been downgraded and hence unable to participate in the EFSF at a AAA rating). We also assumed that the debt rollover with a 21% haircut would not be an issue as it should have been a formality: on this we were fatally wrong - the debt rollover plan has imploded and means that the entire Greek bailout has collapsed as some had expected. And now that it is clear that contagion is threatening to sweep through the core, it is back to Germany to prevent the gangrene, no longer contagion, from advancing beyond the PIIGS. However, in order to prevent a full out revolution, Germany's economic elite has said it would agree to an EFSF expansion and hence installation of European firewall, but at a price: a "controlled" default by Greece and 50% haircuts for private bondholders (as German banks have long since offloaded their Greek bonds).

This means that "Lehman" is indeed here: just like back in 2008 Paulson et al thought they could contain the adverse effects of a Lehman bankruptcy, while the financial system ground to a halt 4 days later when money market funds broke the buck, so now Greece is somehow expected to remain in the eurozone even as it files bankruptcy. How or why they think the market will buy any of this is beyond stupefying, but we are sure all those armies of lawyers who never have a practical sense of what actually ends up happening in the real world, and who are poring over tomes of EU and EUR charter to see if they can file Greece without expelling it from the Eurozone, certainly has something to do with it.

So as part of this new strategy, here are the three key components of the plan to "firewall" contagion, via the Telegraph.

Sources said the plan would have to be released as a whole, as the elements would not work in isolation.

First, Europe’s banks would have to be recapitalised with many tens of billions of euros to reassure markets that a Greek or Portuguese default would not precipitate a systemic financial crisis. The recapitalisation plan would go much further than the €2.5bn (£2.2bn) required by regulators following the European bank stress tests in July and crucially would include the under-pressure French lenders.

Officials are confident that some banks could raise the funds privately, but if they are unable they would either be recapitalised by the state or by the European Financial Stability Facility (EFSF) – the eurozone’s €440bn bail-out scheme.

The second leg of the plan is to bolster the EFSF. Economists have estimated it would need about Eu2 trillion of firepower to meet Italy and Spain’s financing needs in the event that the two countries were shut out of the markets. Officials are working on a way to leverage the EFSF through the European Central Bank to reach the target.

The complex deal would see the EFSF provide a loss-bearing “equity” tranche of any bail-out fund and the ECB the rest in protected “debt”. If the EFSF bore the first 20pc of any loss, the fund’s warchest would effectively be bolstered to Eu2 trillion. If the EFSF bore the first 40pc of any loss, the fund would be able to deploy Eu1 trillion.

Using leverage in this way would allow governments substantially to increase the resources available to the EFSF without having to go back to national parliaments for approval, which in a number of eurozone countries would prove highly problematic.

The arrangement is similar to the proposal made by US Treasury Secretary Tim Geithner to the eurozone at the September 16 EcoFin meeting in Poland. Gathering turmoil in financial markets has convinced Germany to begin work of some kind of variant of the US plan, despite having initially rejected the notion as unworkable as threatening to compromise ECB independence.

In other words, Germany will be humiliated to appear weak after conceding to Geithner's proposals even after everyone in Europe already took turns at mocking the tax cheat. Which is why Germany has decided in turn to humiliate Greece, and in the process initiate a chain of events that will bring the end of the Eurozone, albeit, mercifully, much faster.

The proposal would be hugely sensitive in Germany as its parliament has yet to ratify the July 21 agreement to allow the EFSF to inject capital into banks and buy the sovereign debt of countries not under a European Union and International Monetary Fund restructuring programme. The vote is due on September 29.

As quid pro quo for an enhanced bail-out, the Germans are understood to be demanding a managed default by Greece but for the country to remain within the eurozone. Under the plan, private sector creditors would bear a loss of as much as 50pc – more than double the 21pc proposal currently on the table. A new bail-out programme would then be devised for Greece.

And with incompetent hubris bringing us here, we are happy to see said hubris is still front and center. Because if Europe really thinks there is such a thing, quadrillion sin USD FX swap lines notwithstanding, as a "managed" bankruptcy, then it fully deserves to ride into the sunset, battling the windmills of evil shorters and vile bloggers, on the much suffering back of Don Quixote's Rossinante.

See the original article >>

There Will Never Be A “Good” Time For Greece To Default

2011-09-25T14:58:00.001+02:00

By Peter Tchir

I have been a proponent that Greece should default sooner rather than later for a long time. At first most people argued that Greece would never have to default. Now many people argue that Greece should default, but now isn’t a good time. The argument goes that Europe needs time to prepare for the default or the risk of contagion is too high.

My view is that Europe needs to let Greece default. Europe needs to abandon the existing perimeter and fall back to a more defensible position. Europe doesn’t need to collapse, but it does need to retreat to a core, stronger position, where it can dig in its heels and defend itself. Battles are not lost because every soldier is killed, battles are lost when morale gets so low that the soldiers give up and flee for their lives. Wars are won when isolated, broken units, are captured or killed. I think Europe has to take the pain now, or risk further pain.

My argument against “waiting for a better time” is that it may never come. Europe has squandered the last year. Europe was in much better shape to deal with a Greek default last year than they are now. Contagion was a concern back then in regards to Ireland and Portugal, now it is a reality. Only the darkest of the doom and gloom crowd believed that contagion could really spread to Spain and Italy, yet now that risk is palpable. Banks were more worried about fighting Dodd-Frank, and raising dividends, and creating almost record bonus pools, not trying to convince employees that the firm’s are solvent.

Contagion in many ways has already hit. The EU stocks are down over 20% in the past 12 months in most cases. Germany has performed better than the rest, but that is a very large drop and the market in Europe as a whole are in a Bear Market. The U.K. with its proximity to Europe, and Japan with the earthquake are also lower, but the U.S. stock market has remained relatively unscathed (despite what you might be reading this weekend about how our sell-off is overdone). China and Brazil are experiencing some troubles in their own stock markets. In spite of the hype of the BRIC’s coming to the rescue, they may be too busy taking care of themselves. It is worth noting that the EUR/USD exchange rate was 1.36 on September 30th last year, and is 1.35 now, so it is not all about exchange rates.

The credit story is more bleak and stark. Credit has clearly picked the safe havens, the next Greece, and those in between. Italy and Spain are now trading almost where Portugal was a year ago. How much easier would it have been for Italy to withstand a Greek default when it’s 5 year bonds were trading at Bunds + 134 instead of Bunds + 407. CDS has blown out across the board, including the allegedly cash rich China, but there is a “basis” swap element as the CDS trades in a currency different than what the country uses (ie, all Eurozone CDS trades in dollars).

It is hard to look at the data and note with that the bold steps of letting Greece default, had been taken last year when countries were in better shape. It is also clear, that the contagion has occurred without a default. Portugal has clearly moved to the plagued group and Italy and Spain are trying to fight it off.

Last September, the Eurozone and the U.S. had just posted 2nd quarter GDP growth of about 0.9%. This year, both the Eurozone and U.S. only had 0.2% growth in the 2nd quarter. At the risk of being ridiculed by proper economists, you cannot guarantee that GDP growth will be even worse or in contraction if we wait any longer for Greece to default.

It also worth pointing out that at the time, the ECB was only an amateur at overpaying for bonds. It has since purchased even more bonds well above the current market price. All that purchasing power would be nice to have now, but it has been spent. They can always spend more, but the ECB would be much stronger if it wasn’t sitting on such a big inventory of losing positions, that clearly did little to stem the crisis.

What about the banks? Don’t we need to wait so the banks can be stronger?

It doesn’t take a rocket scientist to see that the banks squandered a year to improve their capital base. BAC wasn’t selling cheap options to Warren Buffett when their stock was at 13. The SocGen CEO wasn’t on TV trying to convince investors that they had no funding or capital problems when his stock was at 42. The banks are even worse off than most of the countries, but why should anyone assume that waiting will make it easier for them to digest a Greek default.

To me, it seems that a lot has already been priced in and that the contagion is occurring whether we want it to or not, so we may as well let Greece default now and figure out how much has already been priced in and how to really stop the contagion from spreading to Italy and Spain and to banks that deserve to be saved. Let’s just admit it is gangrene and that it has already spread farther than is safe, but it is still better to cut off an arm to save the body. If we keep waiting it may not be possible to save the patient. The patient is getting weaker by the day, and being blind to that is just as big and just as dangerous as letting Greece default now.

See the original article >>

Record Correlations + Record Low Mutual Fund Cash + Soaring Dispersion = Recipe For Redemption Driven Disaster

2011-09-25T14:50:00.002+02:00

by Tyler Durden

The topic of surging market return correlation (and the death of alpha on broader terms) is nothing new to long-term Zero Hedge readers: every time the market appears poised to crash, stock and sector correlations reach new highs while return dispersion drops as fundamentals and technical are broadly ignored, and only the roar of the thundering herd matters. And while whether a spike in volatility is a precondition to correlation jumps, or simply a coincident factor, is unknown, in recent weeks an equity correlation of 1.000 has been matched by a jump in volatility not seen since the days of September 2008. What this has done is to make return dispersion for the hedge fund community higher than historical associated with comparable episodes of palpable market fear, exposing a broad rift between the outperformers (very few, mostly macro hedge funds) and underperformers (many, long-biased primarily). Curiously in the (massively levered) mutual fund community everyone is broadly underperforming with roughly the same intensity. Which means that while in the past one’s returns could suck, at least so would everyone else’s, the past month has accentuated the ability of funds to generate alpha (and even beta) lead to broad reallocation of capital by fund LPs. The will force the en masse selling of winners to satisfy margin calls, exacerbated by record low mutual fund cash "dry powder" positions, and sets the groundwork for even more volatility as all traditional hedging strategies fail. So what is an investor to do in such a confusing environment? Pray... is the short answer. As for the longer one, there is not much that can be done according to Goldman, which in its latest weekly chartology has little if any words of encouragement for both clients and market speculators alike.

From Goldman’s David Kostin, who first describes the latest record surge in correlations:

Correlation of market, sector, and intra-sector returns has soared to record levels as macro themes continue to drive equity market performance. Investors believe a high correlation environment is associated with low return dispersion. However, stock volatility has been elevated and a high volatility regime typically corresponds with high return dispersion. A high correlation and high volatility situation suggests mixed dispersion of returns. Indeed, dispersion of equity returns at the market and sector level has been slightly above average compared with the past decade.

The 3-month trailing daily return correlation among the ten major sectors hit 0.94 last week, the highest in more than 20 years, more than two standard deviations above the ten-year average and a level approached only once before, during the aftermath of the financial crisis in February 2009 (0.91). The sector correlation averaged 0.67 during the past decade and 0.58 over last 20 years (see Exhibit 1).

Correlation of returns across all 500 constituents in the S&P 500 index stands at a record 0.75, 3.1 standard deviations above the ten-year average. Intra-sector correlation of stock returns within each sector equals 0.78, a new high, and 2.8 standard deviations above the ten-year average of 0.49.

As for what hedge funds can do in this kind of market, the answer sadly is, not much

Three strategies exist for investors to combat a high correlation market: (1) Nimbly trade the macro news, although this approach involves high risk given the volatile global political and economic environment; (2) identify thematic characteristics that will drive relative performance, although sharp reversals have meant few strategies have delivered consistent returns; and (3) use a long investment horizon to capture perceived mispricing, although this approach requires a patient capital source to allow time for the disparity to close.

Translation: nothing in the hedge fund arsenal works in the current investing/speculative environment, where redemption requests in many cases soar after just a month (if not week) of underperformance.

What’s worse is that anyone expecting a moderation in correlation will be disappointed based on a realistic appraisal of what is coming:

The news flow for the balance of 2011 will continue to be dominated by geopolitical uncertainty on three continents led by the European sovereign debt crisis, ongoing budget negotiations in Washington, DC, risk of US recession, and slowing pace of economic activity in China. The trading backdrop certainly appears conducive for global macro funds to outperform given the key market drivers are primarily macroeconomic related.

Making matters even worse is that in addition to already much discussed margin calls sapping investor cash, mutual funds are levered to record levels as we noted first months ago:

And as the redemption requests start piling in, the slow money will be forced to proceed with a rapid liquidation of winning holdings (as gold experienced last week, assuming of course that the CME margin hike had not been leaked).

But are mutual funds really going to see a spike in redemptions? You betcha:

Global macro hedge funds have posted strong returns in 3Q and YTD. These funds have nimbly traded the treacherous environment with the typical macro fund returning 4% in 3Q with 2/3 of macro funds returning between - 1% and 9%. Macro funds have returned an average of 8% YTD through September 16th. These returns are impressive considering the huge price swings in equities, commodities, interest rates, and currencies in 2011.

S&P 500 index has outperformed both long/short equity hedge funds and large-cap core mutual funds YTD as of September 16 (-2%, -4% and -4%, respectively). Relative returns of long/short hedge funds was slightly better in 3Q (-4%) versus -8% for S&P 500 and -9% for mutual funds.

The painful 7% plunge in the S&P 500 this week has pushed the 3Q and YTD returns for the S&P 500 to -14% and -9%, respectively, as of September 22nd. Mutual funds have lagged the market, falling 15% in 3Q and 11% YTD. Just 30% of large cap core mutual funds has outperformed the S&P 500 YTD. We estimate long/short hedge funds have returned -12% in 3Q and YTD.

For style advocates, just 34% of large cap growth mutual funds and 46% of large cap value funds have beat the Russell 1000 Growth and Russell 1000 Value benchmarks, respectively, YTD in 2011 as of September 22nd.

The paucity of outperforming mutual funds and long/short hedge funds is surprising given dispersion of stock returns at the overall market and within sector level has actually been above the ten-year averages (see Exhibit 4).

As noted previously, correlation of returns is extremely high but the dispersion or range of stock returns is large in absolute terms. For example, during the past 30 days, while the S&P 500 returned 1%, the best performing stock in the S&P 500 (GR) surged 47% while the worst performing stock (NFLX) fell 37%. The range of returns represents the potential alpha generating opportunities that existed for both long-only mutual fund and equity long/short hedge fund managers.

We fully expect that the investing community will proceed to sell all of the best performing stocks imminently as this last bastion of cooperative game theory falls apart.

Yet in all this gloom there is some bad news: job prospects for FX traders and analysts have never been better, as macro has emerged as the only strategy (modestly outperforming the market if still negative) that matters.

Looking ahead, a normal return dispersion climate should mean security selection matters. But it is hard for a portfolio manager to focus on the nuances of stock selection when the prospects of a US recession keep rising and the outlook for the European financial system seems more precarious, not less, on a daily basis. Simply put, the macro is overwhelming the micro.

The biggest loser? Last year’s biggest winners – quant, HFT and algo traders (who are now much deservedly demonized on every down day and broadly ignored when the market trades higher), and their CEOs who suddenly find themselves without a compass or GPS in the most treacherous market seen in years if not decades, and with BODs intent of finding scapegoats. For the prime examples of this look no further than Goldman’s now former Global Alpha and ever more correlation (Insert Greek Letter Insert Number) prop desks blow ups (the irony of course being that if UBS had followed the stipulations of the Volcker rule, its CEO would still be in his chair). These are just the beginning, as the true severity of record correlation and investing leverage are gradually disclosed.

See the original article >>

In Italy we had "dwarfs" and "dancers" to the government ... now we have also "donkeys" ......

2011-09-24T17:44:00.001+02:00

Roma, 24 set. - "Non ce ne eravamo accorti, ma il Ministero dell'Istruzione dell'universita' e della ricerca italiano ne e' sicuro. Esiste un tunnel di 732 Km tra il Cern di Ginevra e il Gran Sasso e non lo sapevamo. Di piu': 'Alla costruzione del tunnel tra il Cern ed i laboratori del Gran Sasso, attraverso il quale si e' svolto l'esperimento, l'Italia ha contribuito con uno stanziamento oggi stimabile intorno ai 45 milioni di euro'. Gelmini dixit".

E' l'attacco della Rete 29 Aprile ("Ricercatori per una universita' pubblica, libera e aperta") al ministro dell'Istruzione Mariastella Gelmini, che nel commentare l'esperimento con cui si e' scoperto che i neutrini possono superare la velocita' della luce, aveva parlato ieri per l'appunto di un tunnel tra la Svizzera e l'Abruzzo attraverso cui erano stati fatti correre i neutrini.

"Nessun tunnel - replicano i ricercatori - ma un fascio di neutrini che e' stato 'sparato' dal Cern di Ginevra per un viaggio sotterraneo che dura 2,4 millisecondi, raggiunge la profondita' massima di tre chilometri per effetto della curvatura terrestre e termina al Gran Sasso, dove il fascio e' 'fotografato' da un rilevatore e ne viene misurata la velocita'. Quindi tranquilli, soprattutto i cittadini di Firenze che si trovano sulla traiettoria: il viaggio delle particelle, perfettamente rettilineo, non impegna nessuna struttura costruita dall'uomo; e nessuno potra' usare tale esperimento per giustificare una nuova TAV sotto il Trasimeno.

Purtroppo pero' per noi, il ministro pensa che i soldi che l'Italia da' per la partecipazione al Cern siano finiti nella costruzione di qualcosa che con la fisica delle particelle ci sta come i cavoli a merenda: un bel tunnel che farebbe impazzire dagli incubi qualsiasi progettista: ben 732 chilometri, opera inconcepibile e impossibile (quello piu' lungo costruito dall'uomo e' a tutt'oggi il nuovo San Gottardo, solo 57 chilometri, roba da ragazzi). Il ridicolo toglie il fiato" .

See the original article >>

Roubini and Soros Say The U.S. Already in Double Dip Recession and Warn of Uprising

2011-09-24T15:15:00.001+02:00

By EconMatters

Dr. Doom Roubini has grown even more pessimistic since he put a 60% probability of a U.S. double dip in 2012 just about three weeks ago. Business Day reported that speaking at a press conference in Johannesburg on Sep. 20, Roubini now says, "The US is already in a recession although it will not admit it." and that the rest of the world would not be insulated from the effects of another global meltdown. (Clip Below)

Regarding Greece and Euro Zone, Roubini thinks Greece would do best to default on its debt and leave the euro zone, and that Europe needs to step up austerity measures: .

Eerily, George Soros also said almost exactly the same in a CNBC interview. Soros believes the U.S. is already in a double dip recession, and that "a number of smaller euro zone nations could default and leave the single currency area." Soros also sees Europe could be "more dangerous" to the global financial system than the Lehman Brothers in 2008, due to "Euro zone policymakers repeatedly following the wrong policy shifts."

But there's a reason Boubini earned his "Dr. Doom" reputation as he made an even more ominous prediction that there would be protests as well in the world’s largest economy.

"There is growing inequality all over the world. We have already seen middle-class unrest in Israel. Germans have smashed fat cats' cars.....As we go into another recession, there will be unrest in the US."

Interestingly, Business Day quoted Roubini that he was not averse to state involvement in the economy and held up Singapore — which had state ownership of firms and joint regulation and free markets — as an economy that might be shielded from global shocks.

EconMatters Commentary

While we are a bit surprised that Roubini seems to have lost total faith in capitalism by embracing a somewhat socialistic structure of the Singapore Model, we have to admit, on first blush, we (along with the markets) are sufficiently freaked out by both Roubini and Soros asserting the double dip status of the United States.

However, that feeling quickly dissipated as we think about the definition of recession - two down quarters of GDP, or when National Bureau of Economic Research (NBER) declares one, and realized the U.S. so far has not met these conditions yet.

We do believe Europe now holds the key as there's a distinct risk that the U.S. could be pushed over the recession edge by the Euro Zone debt crisis due to the interlinkage of the global financial system.

On the other hand, the current euro zone debt crisis is quite similar to the debt ceiling fiasco in the U.S. a while back. The bloc has an inherent structural weakness - central currency without a central political governing body. But eventually there will be resolution, be there a Greek default and leaving the currency union, or a super-roid-charged bailout package as the stakes are too high for a Euro collapse.

Meanwhile, the U.S. economy could be facing a tough patch in the next two years or so, but the odds are still in favor that backed by its tremendous natural and human resources, the country could pull through and resume growth.

Roubini has been consistent with his double dip recession gloom and doom for the past three years; however, Soros track record suggests that his recession talk could be nothing more than a reflection of his current trading position, knowing his influence over the market, rather than an objective economic assessment.

See the original article >>

Greece needs decade to get competitive: German finance minister

2011-09-24T15:13:00.000+02:00

by Reuters

German Finance Minister Wolfgang Schaeuble said in a magazine interview published on Saturday that Greece would not be able to return to capital markets next year and would need a decade to make its economy competitive.

Schaeuble told business weekly WirtschaftsWoche that it was "clear that Greece will not be able to return to capital markets in 2012, as we thought in 2010."

"Greece will need a decade rather than a year to get fully competitive," added the minister from Chancellor Angela Merkel's center-right government.

With anxiety about a possible Greek sovereign debt default rising in Europe, the chief economist of German insurer Allianz (ALVG.DE) said a major haircut for Greek government bondholders would only increase the risk of contagion in the euro zone.

"I don't believe the time is right for a debt haircut like this," Michael Heise told German radio, in response to Greek media reports -- denied by Athens on Friday -- that one option was an orderly default with a 50 percent haircut for creditors.

The economist said such a default scenario would create more problems and increase the risk of contagion to other euro zone countries, which would create "a very, very serious situation."

Athens denied reports in two Greek newspapers that Finance Minister Evangelos Venizelos had outlined various options to lawmakers, including a bailout by Europe and the International Monetary Fund, a haircut and a disorderly default.

Merkel said on Friday that a Greek default was "not an option for me" as the damage was "impossible to predict."

With heavily-indebted Italy also giving increasing cause for concern, her finance minister Schaeuble said in the interview Italy was "a strong country with good economic data."

"Italy's debts are manageable and could be brought back into the guidelines relatively quickly," he said, adding that the downgrading by rating agency Standard & Poor's could prove beneficial by encouraging Italy "to implement the already decided measures more quickly and urgently."

But Italian Economy Minister Giulio Tremonti suggested on Friday that the ball was in Germany's court and the European economic powerhouse had to overcome its own "uncertainties" about whether to save the currency union.

"Now everything depends on Europe, and Europe depends on Germany, and that depends on the capacity Germany must have to overcome its uncertainties and understand that Europe is in everyone's interests, including theirs," he told Italian TV.

He appeared to be referring to a threatened revolt among some members of parliament in Merkel's coalition on a crucial vote on the European Financial Stability Facility -- the euro zone's current bailout mechanism -- in Berlin on September 29.

See the original article >>

THE BIGGEST BUBBLE OF ALL-TIME

2011-09-24T15:10:00.002+02:00

By Randall Wray

Sorry, this is a day late (but hopefully not a dollar short).

Back in fall of 2008 I wrote a piece examining what was then the biggest bubble in human history: http://www.levyinstitute.org/pubs/ppb_96.pdf.

Say what? You thought that was tulip bulb mania? Or, maybe the NASDAQ hi-tech hysteria?

No, folks, those were child’s play. From 2004 to 2008 we experienced the biggest commodities bubble the world had ever seen. If you looked to the top 25 traded commodities, you found prices had doubled over the period. For the top 8, the price inflation was much more spectacular. As I wrote:

“According to an analysis by market strategist Frank Veneroso, over the course of the 20th century, there were only 13 instances in which the price of a single commodity rose by 500 percent or more. For example, the price of sugar rose 641 percent in 1920, and in the same year, the price of cotton rose 538 percent. In 1947, there was a commodities boom across three commodities: pork bellies (1,053 percent), soybean oil (797 percent), and soybeans (558 percent). During theHunt brothers episode, in 1980, silver prices were driven up by 3,813 percent. Now, if we look at the current commodities boom, there are already eight commodities whose price rise had reached 500 percent or more by the end of June: heating oil (1,313 percent), nickel (1,273 percent), crude oil (1,205 percent), lead (870 percent), copper (606 percent), zinc (616 percent), tin (510 percent), and wheat (500 percent). Many other agricultural, energy, and metals commodities have also had large price hikes, albeit below that threshold (for the 25 commodities typically included in the indexes, the average price rise since 2003 has been 203 percent). There is no evidence of any other commodities price boom to match the current one in terms of scope.”

Now here’s the amazing thing about that bubble. The staff of Senator Joe Lieberman and Representative Bart Stupak wanted to know whether the bubble was just due to “supply and demand”. Relying on the expertise of Frank Veneroso and Mike Masters (two experts on the commodities market), I was able to conclude beyond any doubt that it was a speculative bubble driven by a “buy and hold” strategy adopted by managers of pension funds. Hearings were held in Congress, with guys like Mike Masters testifying as well as representatives from the airlines and other industries.

The pension funds panicked, realizing that their members would hold them responsible for exploding prices of gasoline at the pump. Pension funds withdrew one-third of their funds and oil prices fell from about $150 per barrel to $50. If you want to read the detailed analysis, go to my paper cited above—it has to do with commodities indexes, strategies pushed by your favorite blood sucking vampire squid (Goldman Sachs), and futures contracts. It gets wonky. To make a long story short, the bubble ended in fall of 2008.

But then the crisis wiped out real estate markets and the economy. Managed money needed another bubble. They whipped up irrational fears of hyperinflation that supposedly would be caused by Helicopter Ben’s QE1, QE2, and the newly announced QE3. Better run to good “inflation hedges” like gold and other commodities. That did the trick. The commodities speculative bubble resumed.

And boy, oh boy, what a boom. An April report by expert Jeremy Grantham looks at the last decade’s bubble in commodities; Frank Veneroso expands upon that in a more recent report. Here’s the elevator speech summary. Take the top 33 commodities that are globally traded—everything from gold and oil to to rubber, flaxseed, jute, plywood, and something called diammonium phosphate. Over the past 110 years, an index price of these 33 commodities has declined at an annual rate of 1.2% per year. (Sure there are variations across the commodities—this is the average. And so much for inflation hedges. Commodities prices fell—they did not keep up with inflation. If you liked negative returns, commodities were a good bet.) Although demand for these 33 commodities has increased a lot over the century, new production techniques plus successful exploration has resulted in a declining price trend.

Further—and this is a bit surprising—deviations from the trend follow a normal distribution (you learned about this in high school; it is a bell curve with nice properties; chief among these is the finding that about 68% of outcomes fall within one standard deviation; about 95% fall within two standard deviations (once a generation); and you’ve got just about a snowball’s chance in hell of finding outcomes that are three or four standard deviations from the mean).

But what is more surprising is that over the past decade, the price rises you find for these 33 commodities are just about beyond the realm of possibility—2, 3, and 4 standard deviations away from trend. It is a boom without any precedent. Quite simply, nothing even close has ever happened before, in any market, including hi tech bubbles and real estate bubbles.

By now you’ve all read about black swans with fat tails—a reference to supposedly “unexpected” and highly improbable default rates on subprime mortgages and other toxic waste assets. (Way out the normal distribution’s “tail”.) As an insider quipped, you had once in 100,000 year events happening every day. But that is misleading. These were junk assets that from the get-go had nearly 100% probabilities of default—NINJA loans and so on. The models were flawed, indeed, fraudulent. That was all a scam. Those weren’t black swans with fat tails—they were Hindenburg blimps filled with explosive hydrogen just waiting for someone to light a cigarette.

By contrast, in the case of commodities, this is real stuff (not IOUs of deadbeats with no prospects). Barrels of oil that someone really wants. Corn to turn into pig and steer fat, or fuel for Midwest automobiles. Or gold to be hoarded by the University of Texas. There really is a demand for it; and someone produces it.

Yes, commodity bubbles happen, but eventually reality sets in and brings the price back down to reality. You don’t get 3, 4, and 5 standard deviation events. A four standard deviation price rise falls outside 99.994% of all outcomes—one in 100,000 years; a five standard deviation price rise is about one in 2 million years. That pretty much covers the time since our ancestors beat things with big sticks.

But wait a minute. The standard deviation of price rises for iron (5), coal, copper, corn and silver (4), sorghum, palladium, and rubber (3.5), flaxseed, palm oil, soybeans, coconut oil, and nickel (3), and so on down through jute, cotton, uranium, tin, zinc, potosh and wool (2) are so unlikely that they quite simply could not have happened. Individually. Together, the likelihood that we’ve got an unlikely boom in almost all of the 33 commodities? All at the same time? Impossible. Cannot happen. Not in the lifetime of our sun, let alone our planet.

But it did.

Why? China. Peak oil. Supply disruptions. Some markets cornered by speculators. Market manipulation by oligopolistic suppliers.

Yes, OK, those have played some small role. But remember, we are in the worst global slowdown since the 1930s. I will not go through all the data, but demand for most commodities is actually slumping. For many there is substantial excess supply. And China wants to slow. China is still largely a socialist society. China basically does what it wants to do. China will slow.

And yet the prices rise far beyond anything that has ever happened before. Beyond anything that can happen.

Why? Financialization. Just as homes became financialized (in many ways, including serving as the collateral for “ATM” cash-out home equity loans), commodities became thoroughly financialized. (So did healthcare and death, with peasant insurance and death settlements—topics for another day.)

Here’s the reason. Believe it or not, commodities markets are tiny; except for soy, oil, and corn they are smaller than tiny. Managed money is huge—tens of trillions of dollars floating around the world looking for high returns. US pension funds alone are three-fourths of US GDP–$10 trillion give or take. If you put even a fraction of managed money into commodities index funds, you blow up the prices.

The weapon of choice is the futures contracts—essentially you buy commodities for future delivery (a couple of months from now). When they mature, you do not take delivery but instead sell the contract to someone who actually wants the commodity, and roll into another futures contract. This is what pension funds, and so on, have been doing. If prices rise, you always win on the roll (sell for more than you paid).

The typical argument is that this cannot affect prices since for every buyer (long position in the contract) there must be a seller (short position). The balance between these two keeps prices in line with “fundamentals”.

In normal times, yes, more or less. But here’s the deal. What if I supply diammonium phosphate (whatever the heck that is) and you are speculating that the price will rise. You and every other pension fund and client of Goldman Sachs. I want to lock in the expected price rise, so I am a happy seller of future commodities. If prices go down, I do not get hurt—I locked in the price rise and have the right to sell the commodity at the higher price. And so even as prices leave all fundamentals, the producers continue to sell futures contracts to lock in higher prices.

I win, you win, we all win with price appreciation.

Now, to be sure, the whole thing is going to blow up, in what Frank Veneroso calls a commodities nuclear winter. As prices rise, consumption of the commodities falls (as we are already observing) both through substitution and through conservation. At the same time, additional supplies come on line. Real world suppliers feel the imperative to slash prices to have some actual real world sales. They cannot forever live in never-never land with rising prices and collapsing sales.

There are many shoes that will drop, bringing back the Global Financial Crisis with a vengeance. Commodities crash, default by a Euro periphery nation, failure of a Euro bank, or the closure of Bank of America or Citi. All of these are likely events, less than one standard deviation from the mean; probably all of them will happen within the next year.

No matter what the triggering event is, that commodities nuclear winter will happen.

Soon.

Sooner than later.

See the original article >>

Five Banks Account For 96% Of The $250 Trillion In Outstanding US Derivative Exposure; Is Morgan Stanley Sitting On An FX Derivative Time Bomb?

2011-09-24T15:06:00.002+02:00

by Tyler Durden

The latest quarterly report from the Office Of the Currency Comptroller is out and as usual it presents in a crisp, clear and very much glaring format the fact that the top 4 banks in the US now account for a massively disproportionate amount of the derivative risk in the financial system. Specifically, of the $250 trillion in gross notional amount of derivative contracts outstanding (consisting of Interest Rate, FX, Equity Contracts, Commodity and CDS) among the Top 25 commercial banks (a number that swells to $333 trillion when looking at the Top 25 Bank Holding Companies), a mere 5 banks (and really 4) account for 95.9% of all derivative exposure (HSBC replaced Wells as the Top 5th bank, which at $3.9 trillion in derivative exposure is a distant place from #4 Goldman with $47.7 trillion). The top 4 banks: JPM with $78.1 trillion in exposure, Citi with $56 trillion, Bank of America with $53 trillion and Goldman with $48 trillion, account for 94.4% of total exposure. As historically has been the case, the bulk of consolidated exposure is in Interest Rate swaps ($204.6 trillion), followed by FX ($26.5TR), CDS ($15.2 trillion), and Equity and Commodity with $1.6 and $1.4 trillion, respectively. And that's your definition of Too Big To Fail right there: the biggest banks are not only getting bigger, but their risk exposure is now at a new all time high and up $5.3 trillion from Q1 as they have to risk ever more in the derivatives market to generate that incremental penny of return.

At this point the economist PhD readers will scream: "this is total BS - after all you have bilateral netting which eliminates net bank exposure almost entirely." True: that is precisely what the OCC will say too. As the chart below shows, according to the chief regulator of the derivative space in Q2 netting benefits amounted to an almost record 90.8% of gross exposure, so while seemingly massive, those XXX trillion numbers are really quite, quite small... Right?

...Wrong. The problem with bilateral netting is that it is based on one massively flawed assumption, namely that in an orderly collapse all derivative contracts will be honored by the issuing bank (in this case the company that has sold the protection, and which the buyer of protection hopes will offset the protection it in turn has sold). The best example of how the flaw behind bilateral netting almost destroyed the system is AIG: the insurance company was hours away from making trillions of derivative contracts worthless if it were to implode, leaving all those who had bought protection from the firm worthless, a contingency only Goldman hedged by buying protection on AIG. And while the argument can further be extended that in bankruptcy a perfectly netted bankrupt entity would make someone else who on claims they have written, this is not true, as the bankrupt estate will pursue 100 cent recovery on its claims even under Chapter 11, while claims the estate had written end up as General Unsecured Claims which as Lehman has demonstrated will collect 20 cents on the dollar if they are lucky.

The point of this detour being that if any of these four banks fails, the repercussions would be disastrous. And no, Frank Dodd's bank "resolution" provision would do absolutely nothing to prevent an epic systemic collapse.

...

Lastly, and tangentially on a topic that recently has gotten much prominent attention in the media, we present the exposure by product for the biggest commercial banks. Of particular note is that while virtually every single bank has a preponderance of its derivative exposure in the form of plain vanilla IR swaps (on average accounting for more than 80% of total), Morgan Stanley, and specifically its Utah-based commercial bank Morgan Stanley Bank NA, has almost exclusively all of its exposure tied in with the far riskier FX contracts, or 98.3% of the total $1.793 trillion. For a bank with no deposit buffer, and which has massive exposure to European banks regardless of how hard management and various other banks scramble to defend Morgan Stanley, the fact that it has such an abnormal amount of exposure (but, but, it is "bilaterally netted" we can just hear Dick Bove screaming on Monday) to the ridiculously volatile FX space should perhaps raise some further eyebrows...

See the original article >>

The Perfect Storm in a Kondratieff Long Wave Winter

2011-09-24T14:59:00.008+02:00

By David Knox Barker

Crashing global stock markets, debt defaults, overproduction, falling prices, tumbling interest rates, global debt deleveraging, and the clear necessity for austerity, they are all classic long wave forces now in full tilt, producing the perfect storm in a Kondratieff long wave winter. Only long wave theory explains the economic and financial events now unfolding daily in the global economy and financial markets.

You still have time to prepare for the final crisis phase and debt collapse, but don’t delay. The global economy is now unequivocally in the final years of the long wave winter debt purge and what will be a sharp decline in corporate efficiency. Once this storm passes the global long wave economic reset button will be tripped, and the new global long wave spring season will begin.

The Russian economist Nikolai Kondratieff was the first to observe and document the remarkable recurring long wave patterns in the global boom and bust cycle, driven by global debt and overproduction. He published his findings in the 1920s. His work anticipated the next downturn that unfolded as the Great Depression. Politicians appear to be incapable of seeing beyond a single election cycle. Politicians have ignored the evidence for the long wave once again. Most economists have as well, although a few are starting to pay more attention as the long wave facts are now difficult to ignore.

Some of Kondratieff’s original charts indicate just how far ahead of his contemporaries Kondratieff was in understanding the dynamic ebb and flow of international free market capitalism. There are those that claim he only discovered an agricultural commodity cycle. The charts below and his own words suggest he discovered a long wave dynamic cycle that permeates the entire economy and all of society. He wrote, “The long waves, if existent at all, are a very important and essential factor in economic development, a factor the effects of which can be found in all the principal fields of social and economic life.”

Political and monetary policies have exacerbated and magnified the natural long wave forces at work in the global economy and financial markets. The global economy now finds itself in a blinding blizzard in the Kondratieff long wave winter season. Many are unprepared and under the delusion that government intervention can and will save the day. Government meddling only makes matters worse. Investors or businesses that count on government policies to save them will be sorely disappointed. The long wave winter season will run its course and the current perfect storm will shatter the illusions of government as savior of international free market capitalism. Keynesianism will die a merciless death in this long wave winter storm.

Federal Reserve Chairman Bernanke has admitted that he does not understand why the economy has not responded to the aggressive monetary stimulus of lower interest rates and quantitative easing, so now he tries the twist. Bernanke should read Kondratieff and the findings at the System Dynamics program at MIT, which has validated long wave theory. The long wave is the natural cycle of creative destruction in a free market economy; ignore it at your peril.

The long wave turn from winter to spring is just as natural as winter invariably giving way to spring in the natural seasons of the year. Only long wave theory explains the combination of the current economic and financial market conditions, where excessive debt levels and overproduction are now chipping away at corporate efficiency, forcing investor around the world to discount the present value they are willing to pay for future cash flows. Future corporate margins and therefore cash flows are rapidly becoming uncertain as prices received plunge from overproduction funded with too much debt. In short, global financial markets are getting an old fashion haircut, maybe even a buzz cut.

The fact that free market capitalism goes through a long wave rough patch is a natural law of sorts in free market capitalism. Don’t mess with mother nature. The Obama Administration has been shocked to discover that fiscal stimulus has failed to generate the expected jobs. The president should expand his reading list. He is now in line to lose his job along with millions of others around the world. In addition to Kondratieff, the president should put Ludwig von Mises’ Human Action, Adam Smith’s Wealth of Nations, and Bastiat’s The Law, on his reading list. Government should not try to do what only a free market, free trade and individuals in pursuit of purpose are capable of doing. Human liberty and freedom, unhampered by government intervention can achieve great things. It is the only solution to the global problems produced by a long wave winter.

Entrepreneurs, new businesses and innovation in existing businesses are the only viable engines of growth and job creation. Substantially lowering corporate taxes for small business and closing tax loopholes will cause the economy to boom and create jobs. Enterprises funded by government in exchange for their political contributions are destined for failure. The politicians involved in any such bribery and conspiracy with taxpayer funds should be sent to jail. Without free market forces and individual responsibility, and swift and harsh punishment for failure, capitalism will not function correctly. Seed stolen from farmers and planted in winter is doomed to failure. It only harms the real farmers and reduces future crops in their natural season.

On the bright side, corporate profits have held up remarkably well in light of the long wave winter forces in play, a testimony to management and the resilience of free market capitalism in crisis. Profits have been driven by emerging market demand, increases in efficiency, lower interest rates, payroll reductions through layoffs and low wage growth. Business has cut to the bone to deliver profits, and there is nothing left to cut. Unfortunately, the global economy is now in a long wave winter storm. Businesses are facing a global collapse in demand, in addition to political interference and stifling regulation. These forces are idling production and putting extreme downward pressure on prices. The CRB is plunging as overproduction swamps global markets with an excess supply of products and services. The long wave forces in play are now beginning to erode corporate profits.

Global leaders are in shock at the specter of a sovereign debt default that is shaking the global financial system to its core. The hopes pinned on emerging markets are fading fast, as even the economies in China, Brazil, Russia and India cool as anticipated during the long wave winter. The perfect storm is gaining strength. Emerging markets are stumbling; corporate profits will now take a hit when the global economy can least afford it.

The global economy is now in the final crisis years of the long wave winter season that will be cruel to corporate profits. The long wave is essentially at its heart a boom and bust cycle of corporate efficiency produced by human action. The winter season is driven by overproduction, this exists in goods and services, which puts downward pressure on prices received. Prices paid are also falling, but in a long wave winter storm prices received will fall much faster. This occurs when excessive debt and the inevitable debt deleveraging by consumers, businesses and governments is creating a severe decline in demand. The overproduction feeds additional price declines and additional contracting corporate margins.

The long wave boom and bust cycle of corporate efficiency is eventually recognized by global investors searching for a piece of corporate profits to buy in the form of publicly traded stocks. This is occurring now. Every long wave contains two bull markets and two bear markets. The spring and fall seasons of the long wave of rising corporate efficiency and expanding margins are bull markets, the summer and winter seasons of declining corporate efficiency and declining margins produce bear markets.

It takes a while for investors to catch on. The bear market of the global long wave winter began in the late 1990s in most developed markets. It is now in its final years of rapidly deteriorating corporate efficiency and investors around the world are recognizing the squeeze facing corporate profits. There are other long wave forces at work, but the ebb and flow of corporate efficiency and profits is critical to bull and bear markets. Profits are the mother’s milk of stocks, and the milk production will plunge as this long wave winter storm plays out.

The current bear market will run its course along with deteriorating corporate efficiency. The demand destruction of global debt deleveraging will drive corporate margins and profits lower into the expected long wave bottom of 2012-13. A severe global bear market will take stock markets much lower as corporate efficiency and profits are squeezed into the long wave winter bottom.

If you have never seen a long wave in real data, you have never seen a long-term graph of the U.S. 30-Year long bond. Interest rates are the price of money. During a long wave advance, the demand for money is growing and its price is rising, during a long wave decline, the demand for legitimate uses for money is shrinking and its price is falling. The U.S. long bond is a great proxy for the price of money. The demand for borrowing money and its price is falling.

The demand to borrow money by legitimate borrowers that understand what it takes to earn a dollar, i.e., those that have a chance of paying it back, is declining. They do not want to borrow money at this time. For years, my call for a U.S. 2% 30-Year bond and a 1% 10-Year bond at the bottom of this long wave winter has been in place. I see no reason to change that call now. The low in the price of money will coincide with a low for stock prices from late-2012 to mid-2013. The perfect storm of this long wave winter season is driving the price of money lower. Since Chairman Bernanke has called for low rates into mid-2013, maybe someone showed him this chart. Kondratieff would no doubt have loved this chart, which confirms his theory concerning the dynamic ebb and flow of international free market capitalism is not subject to the vagaries of misguided Keynesian manipulation.

The current business cycle is the final business cycle of the long wave cycle. What few investors and traders are aware of is a method of technical analysis that suggests that a Kondratieff long wave divided by 144 produces a miniature long wave cycle, a Wall cycle. There are nine Wall cycles in every business cycle. By tracking these Wall cycles both investors and traders can discover more optimal times to buy and sell to reduce risks and maximize returns. This applies whether they buy stocks for the discounted present value of future cash flows, growth, or just to trade the cycles. Unfortunately, global markets are in Wall cycle number six of the current business cycle. This is a third last and weakest cycle, so prepare for outsized volatility and price declines into the bottom of this cycle.

Investors are panicking, even though global markets are experiencing something as natural as a winter blizzard in January. Before it is over, this global bear market will present investors with the greatest discounted buying opportunities for future cash flows since the early 1930s. Keep much of your power dry; 8-16% dividend yields on great global franchise companies are coming to a stock market near you before the perfect long wave winter storm gives way to a global long wave spring in 2013. Those great buys and dividend yields will be compounded many times over during the coming long wave spring season.

See the original article >>