Comparisons

With little economic data on the calendar, and the Fed speakers back-loaded at the Chicago Fed conference later in the week, there is time to reflect on other questions (unless, of course, the Israel/Syria back-and-forth turns into something more than the last couple of jabs have produced).

It is interesting to me that analysts and journalists truly enjoy finding comparisons between present situations and actors, except when the comparisons suggest unpleasant conclusions. This is at a time when there are really no comparable periods in history to compare to, at least with respect to major global policy initiatives!

I read comparisons between Shinzo Abe’s pressure on the Bank of Japan and Fed Chairman Bernanke’s campaign to resurrect the American economy with ever-greater monetary policy shocks. Somewhere, I saw an analyst ask “isn’t Abe taking note of the failure of U.S. monetary policy to goose the economy?” But the comparison is not apt because the two men, and the two economies, face very different challenges. Abe doesn’t need to increase consumer spending and reinvigorate the economy with monetary policy. While that might be nice, the main goal of Japanese monetary policy now is to raise the price level and the rate of inflation. They are using exactly the right tool to do so: lots of monetary easing. On the other hand, Bernanke is trying to kick-start the real economy with a monetary tool, while at least in principle avoiding an inflationary outcome. That’s like trying to hammer a nail with a fish. It might work, but it’s the wrong tool for the job. So the comparison doesn’t work: one man knows how to use his tools, the other does not.

Here is another useless comparison: “Bond Buyers See No 1994 as Bernanke Clarity Tops Greenspan.” The myth that transparency really helps markets in the long run is sort of silly: is there any sign that the crises caused by monetary policy have become less frequent since the Greenspan glasnost than they were before? I know that’s the belief, because the Fed has told us that’s the way it is. But my scorecard tells a sorry tale of bubbles and crashes since the early 1990s. It isn’t a lack of transparency that causes routs. It’s leverage, and negative gamma. Mortgage hedgers are more active now than they were in 1994, and they have larger books. Hedge funds are orders of magnitude larger. And Wall Street is smaller, and is able to provide less liquidity – partly because they are more levered (which they think is okay because of “Fed transparency”), and partly because the government doesn’t want them to take bets with the leverage they have (which, since they’re paying for failures under the current system, isn’t wholly absurd).

So will the next bond selloff not be as bad as in 1994, because the Fed will give more warning? Remember that no matter how transparent the Fed is, there is still a transition point. Somehow, the market goes from a state of thinking there will be no tightening of policy, to a state of thinking that there will be a tightening of policy. That requires a re-pricing, whether it occurs because the Fed signaled it in a speech or a statement, or because they signaled it by doing Matched Sales for the SOMA account with Fed funds already trading above target (as was the old way of telling us something had changed). There is no way to go from “not knowing” to “knowing” without a moment of realization. And when that phase change ultimately occurs, the greater leverage inherent in the market and the diminished role of market makers will cause the selloff (in my view) to very likely be more dramatic than in 1994.

One place where we cannot prevent comparisons – nor should we want to – is in the asset markets. Stocks are doing well, despite absurd valuations, because most other markets are either more-absurdly valued (e.g., Treasury bonds) or have horrible momentum that means they’re not popular right now (e.g., commodities). I have no doubt that equity performance over the next 10 years will be very uninspiring, because equity markets that start from this level of valuation never produce inspiring returns. But when people ask me what the trigger will be for a selloff, I have to shrug. There have been plenty of “reasons” for that to happen. But I think the ultimate reason is probably this: equities are perceived as the “only game in town.” I have read several articles recently that echo this one: “Bond Fund Managers are Loading Up on Stocks.” When there is some other asset class, or some other world market, that starts doing appreciably better, perhaps investors will decide to allocate away. Unfortunately, the candidates for that market are pretty few, given the general level of valuations. Could it be commodities, which is one of the few genuinely cheap markets? Or perhaps real estate, which is still only fair value but has some pretty striking momentum? I don’t know – but I am also not sitting around waiting for a “trigger event.” There may well be a selloff without such a trigger.

Stealing Really Is That Bad

Cyprus banks are closed until Thursday. At this point, the Cypriot legislature has not voted on any particular scheme of theft, although some Eurozone officials seem to think that it would be okay to only rape the people who have deposits bigger than €100,000, just as long as it’s a really brutal rape to make up for letting the smaller depositors off. (This only sounds like it makes sense if you use their words, but not if you use their meaning.)

It is incredible but the Eurozone elite really don’t seem to understand why the Cyprus plan is so bad. They really are natural Socialists! As Merkel and her party became the primary defenders of the decision to seize Cypriot depository assets today, there was a very good article in Businessweek that contained several jaw-dropping quotes.

“I have to go to my constituency and explain to my people in my constituency why we are willing to lend more than 3 billion euros ($3.9 billion) to Cyprus,” Michael Fuchs, deputy parliamentary leader of Merkel’s Christian Democratic Union party, said in an interview with BBC Radio 4 today. “Why should Germans bail out these people and they are not willing to accept at least a minor bailing out by themselves?”

Well, Mr. Fuchs, here is the problem: you didn’t ask them if they would “accept” at least a “minor” bailing out. You ordered people who didn’t need a bailout – savers with earned balances in the banks – to pay for the bailout. I daresay that it doesn’t seem “minor” to those who had their money stolen to save someone else.

Yes, I understand the parallel, that you feel the alternative was to have your taxpayers foot the bill, and they don’t need a bailout either so why should they pay for it? As Merkel said: “the responsible people are partly included and not only the taxpayers in other countries.” But here’s the thing – at least you have the authority to order that the taxes your citizens paid be used for things they didn’t want, but you did. You have no authority, and indeed no one had the authority, to order the seizure of private assets for something you wanted. (Cyprus, and Cypriot banks, had the ability to seize the assets, but that’s not the same as the legally-sourced authority to do so.)

Moreover, you had another alternative, and that’s to recognize that the elite who want the Union to survive in its current form can’t afford to foot the costs for it to do so – and to let Cyprus go. Yep, I understand that to you that would have been tantamount to Armageddon. But the more you destroy the foundations of capitalism and the free market in favor of naked Socialism, the more appealing Armageddon looks by comparison…

And here’s another quote, by the budget spokesman of Merkel’s main opposition party: “The profiteers of the Cypriot business model must pay the bill – not the European taxpayers.” I heartily agree, but the “profiteers” aren’t the depositors! If that appellation is attached to anyone, it would be to the bank equity holders, and perhaps the bondholders. Arguably, it may apply to the citizens of Cyprus, but almost equally to the people of the Eurozone who benefited when Cyprus lived and consumed beyond her means. But the depositors were not ‘profiteering’ by putting deposits in the bank. They were saving.

So it’s the Russian and the Greek depositors that you really wanted to target? Then why not target anyone who is Russian or Greek? I would go further and say that it isn’t the Russians’ fault that Cypriot banks were willing to take their money, and not the Greeks’ fault that European oversight of Eurozone banks was so fractured that Cypriot banks sought out these deposits as they grew and became unsustainable, ungainly creations. Being a Greek or a Russian with money isn’t a crime – unless you’re a Socialist. And if you’re a Socialist, then it isn’t the Greek or Russian part…it’s the “having money” part.

But they don’t seem to see why people are concerned.

Now, in the micro picture none of those reflections are very market-oriented, but in the macro picture they certainly are. We all have to deal on a day-to-day basis with the reality that markets are nakedly manipulated by central banks these days (with fancy names like “portfolio balance channel,” for example). I was speaking today to an investor about a particular type of arbitrage in my sphere of expertise. As we were brainstorming what could go wrong with the trade, the biggest possibility was “what if one central bank decides to stop manipulating markets and another central bank continues, but they’re the wrong ones? Or what if they start manipulating markets in a different way?” We didn’t directly consider the question of “what if they just seize the profits?” but investors actually now need to consider that in the calculus of risk and return.

But that part isn’t new, as some readers of my articles have pointed out. Government witch-hunts have long been carried out in search of the miscreants who “caused” market mayhem. After the 1929 crash, the Senate held hearings and even went after stock exchange members who’d actually held long positions during the crash. What is new is the targeting of people who have saved simply because it would be more convenient for the government to have their money.

They came for the hedge funds, and I didn’t speak out because I wasn’t a hedge fund. They came for the banks, and I didn’t speak out because I wasn’t a bank. They came for the savers…and there was no one left to speak for me. Right?

Equities took the news with surprising aplomb. Yes, stocks fell 0.55% after being down somewhat more than that, but that reverses only two average days during this most recent run. Commodities, which should be a direct beneficiary of global monkey-business associated with fiat money deposits, sold off hard with the notable (and reasonable) exception of gold. That is borderline insane, but consistent with the insanity of the last couple of months. These days I wake up every morning half expecting to see commodities prices offered at zero. Interestingly, inflation traders seemed to grasp the point, as 10-year inflation swaps and breakevens were stable even though rates generally declined. But commodities is Q1’s red-headed stepchild (and I say that as a red-headed stepchild).

It sounds crazy to say, but Europe losing its collective mind on this topic is bad for equities only if the bank run spreads to other countries in Europe, or if Cyprus decides to leave the Euro and to flee into the tender mercies of Russia’s embrace. Those aren’t certainties by any stretch of the imagination. Consequently, anything that looks vaguely like calm will likely be rewarded by a melt-up in stocks, probably to new highs. The outcomes are distinctly binary at the moment, which isn’t risk I personally care to take since equities are aggressively valued even if these risks were not present.

One Less Good Reason to Be Bearish On Inflation

If you’re bearish on U.S. inflation, I think your view boils down to one of the following arguments:

1. I think growth will remain soft, or we might even slip into another (global?) recession. You can’t have inflation without too-rapid growth, so inflation isn’t going to happen.
2. I think inflation expectations are well-anchored, and actual inflation only happens if people start expecting inflation and so adjust their demands for wages and/or prices.
3. I perceive that wage growth is weak, and so there is no ‘cost-push’ inflation.
4. Although money supply has been growing at a 7-10% pace for the last couple of years, money velocity has been declining. It is likely to continue to decline while banks and sovereigns are under structural pressure to de-leverage.
5. I trust the Fed to tighten in time. I’m not sure what ‘in time’ means, but I figure they know what they’re doing.
6. I think the whole darn thing is going to collapse.

You are entitled to hold any of those views, of course.

If #5 represents your view, I can’t help you. If #6 is your view, then there’s not much that can be done anyway. If #1 is your view, I won’t bore you with a recitation of the arguments I’ve presented before that suggest growth and inflation are correlated only spuriously and that the proposition that growth is the dominant consideration when forecasting inflation can be considered refuted (for example here, here, and here). #3 is more defensible, in my mind, since the evidence on leads/lags of wages versus prices is not conclusive although it seems to me that wages tend to follow prices, rather than lead them (there are some clear examples of wages following prices, and there are some times that they appear to move simultaneously, but I am not aware of any clear examples of prices following wages). #2 is not disprovable, since we don’t have a way to measure inflation expectations directly that is very useful (see here for a thorough discussion, and here for a shorter discussion). Therefore, while it may turn out to be true, I think this boils down to a question of faith, like #5.

So, to my mind, the most plausible argument that inflation is not going to be a concern – despite the fact that monetary policy stimulus is being applied around the globe to an unprecedented degree – is the supposition that money velocity is going to continue to slide for structural reasons for a long time. While U.S. banks have been growing commercial bank credit again at pre-crisis rates for the last year or so (see Chart below, source Fed Board of Governors), this may partially reflect a gain in lending market share versus European banks because the latter have been under severe pressure for the last year.

Global inflation ought to depend on global velocity as much as global money supply, which led me to write back in August that

If you want to make a case for slowing U.S. inflation, I do not believe you can look to the U.S., but rather must look to Europe. If domestic lending (and hence velocity) is rising partly because European lending (and velocity) is contracting, then some of the inflation potential is being sucked out, at least temporarily, by financial and credit strains in Europe.

In my view, the only plausible way we get appreciably lower inflation is if central banks abruptly stop quantitative easing (I don’t think there’s any measurable chance that they tighten) and the velocity of money in Europe (and Japan) drops faster than the velocity of money in the U.S. rises.

The reason I bring this up now is that one of the ‘negative tail’ outcomes became significantly less plausible yesterday after the Basel liquidity rules were delayed (for four years) and softened (by changing the definition of what assets are ‘liquid’).

Regardless of whether or not that increases the vulnerability of the banking system to another credit crisis (it surely does), it lowers the banks’ cost of funding a loan and thus, all else being equal (which it surely is not), should lead to a greater loan volume at any interest rate. In my view, this significantly reduces the likelihood that money velocity in Europe will collapse further (at least for a while) as banks hoard capital, and thus removes as I said one of the ‘negative tail’ outcomes from the list of active concerns.

Breakevens responded positively to this news, as did the equities of European bank stocks, especially ones such as Natixis and Commerzbank which have been under pressure for a long time. Commodities also rose, for a change: this year, commodities have had an awful start to the year despite the roaring of equities out of the gate. The chart below (source: Bloomberg) shows that the ratio of the S&P to the DJ-UBS index has now exceeded the highest relative valuation of the last year, and indeed the highest relative valuation of the last ten years.

By now, my suggestion should not be surprising – commodity indices are the place to position for a bad inflation event. A continuation of low and stable inflation in conjunction with a generous financing environment (if, for example, core inflation retreats gently to 1.75% or so even though central bankers continue to ease) will push this relationship further in the direction it has recently headed. The market is pricing in just such an outcome. An adverse outcome will likely cause a reversal of this relationship, implying a great outperformance of commodities relative to equities over the ensuing several years.

It’s anybody’s guess when and if that will happen, but as noted above I think one argument for the long-stocks/short-commodities trade has just receded.

Mounting Pressure

The most striking facet of today’s trading was that the stock market actually reacted to the Fed’s announcement, which was precisely as universally expected: no change in anything but the technical language about where the economy currently stands. It wasn’t a huge reaction, but the fact that the S&P actually dropped 5 points on the news is mind-boggling to me because it implies that some people were expecting big things out of the Fed today.

To be sure, the arrow of action on the Fed is clear and pointed to ever-increasing amounts of liquidity, but this wasn’t ever on the docket for today. However several Street economists have predicted, plausibly I think, that when Operation Twist expires in December (partly because the SOMA will run out of short-dated Treasuries to sell) the Fed might keep going with the buying leg of the Twist – effectively increasing the monthly outright purchases of paper to $85bln (including Treasuries) from $40bln (all mortgage paper) currently.

Operation Twist has been a useless operation from the standpoint of monetary policy – it has neither added nor subtracted liquidity from the system. It may have had some value from the standpoint of asset-market-maintenance policy, by removing duration from the market and forcing investors to accept more risk for the same amount of reward. So it may be the case that Twist had some effect, but mostly a bad effect since it certainly doesn’t seem from market pricing that investors have been timid about taking risk. And I suppose it ought also be observed that “asset-market-maintenance” isn’t part of the legislative mandate of the Federal Reserve. However, legislators can be generous when markets are being pumped up – it’s when the air goes out that they’re unhappy.

Weirdly, though, I would prefer Operation Twist, which has little impact, to what is likely to replace it (additional QE).

Policymakers globally are growing increasingly bold about quantitative easing. In Europe today, ECB President Draghi told German legislators that outright bond purchases by the ECB “will not lead to inflation. In our assessment, the greater risk to price stability is currently falling prices in some euro-area countries. In this sense, OMTs are not in contradiction to our mandate: in fact, they are essential for ensuring we can continue to achieve it.” (See also this story.)

Central bankers are getting bold, but I’m not sure I understand why. They clearly see the connection between QE and inflation – fending off deflation was the purpose of QE2 and Draghi is clearly indicating the same even though core inflation in the Eurozone has risen from 0.8% in 2010 to 1.5% now (see chart below, source Bloomberg). That’s not exactly flashing red signals on inflation, but it is utterly fantastic to suggest that it indicates deflation is a greater risk.

In the U.S., QE3 and the likely acceleration of QE3 later this year is happening in the context of year-on-year rises in median new home sales prices (released today) and existing home sales prices (released last week) of over 11%, as the chart below (Source: Bloomberg) shows. Note that the existing home sales data is much more dependable on a month-to-month basis, because the number of existing homes and existing home sales swamps the number of new homes sold, but both show the same, clear trend. Home prices are now rising nearly as fast, nationwide, as they did in the bubble years.

For the record, the all-time record one-year price rise in existing home sales was 17.4% in May, 1979. Of course, in May 1979 core inflation was rising at 9.4%. In fact, with the exception of the last phases of the bubble of the early ‘Aughts, existing home sales prices are rising at the fastest margin above core inflation ever, as the chart below shows (Source: Bloomberg; Enduring Investments calculations)

Policymakers, and investors, seem to be numb to the threat of additional QE for one of two reasons. Either it is because of the belief that prior QE did not cause inflation (incorrect, as illustrated above and by the statements of intentionality of the policymakers themselves) or because they’re buying the line that QE is only adding to “sterile” excess reserves.

I think that this is dangerously sanguine. In fact, although it is true that QE initially results in greater excess reserves only, and these have only slowly trickled into transactional money, I think there’s reason to believe that adding more QE may increase that pace of transmission. Picture a large cylindrical vat, open on top with a small valve at the bottom. The water in the vat represents excess reserves, and the water trickling out through the valve is transactional money.

Many things can affect the pace at which the vat water flows through the valve – lending opportunities tied to credit demand and credit quality, disincentives to lend such as Interest on Excess Reserves (IOER), and moral suasion in both directions. Crank IOER to 25%, and all of the water poured into the vat remain as sterile excess reserves and QE is just reliquifying the banking system. Put IOER at a 10% penalty rate, and all of the water going in the top will flow out of the bottom very quickly – and all of the other water that’s already in the vat, too.

But even if you don’t adjust the valve at all, the greater weight of water in the cylinder, as you keep adding more water, will increase the flow out of the valve. Adding more QE is akin, economically, to increasing the weight of water in the cylinder.

The parallel economic concept is that a greater of excess reserves increases the opportunity cost of reserves. The average return on assets for a bank gradually declines as more of these assets become excess reserves rather than required reserves against lent funds. Leverage also declines, with the result (as I have pointed out before) that return on equity suffers. The chart below (Source: Bloomberg) shows the return on equity for large banks (those with more than $10bln in assets). You can see that while bank earnings have recovered significantly from the nadir of the crisis, they also appear to have leveled off at around 8% compared to the 15% that was the consistent standard prior to 2007.

The lending officers in these banks, although they’re being told to increase the quality of their loans, are being told more and more to also increase the quantity of their loans. They cannot do both, but as the pressure of too many reserves on the balance sheet builds, the pressure to make more marginal loans increases as well. This is the part of the valve that the Fed cannot control, and where danger lies going forward. The multiplier may well respond, eventually, to the weight of the reserves themselves.

There May Have Been Life Here Once

There’s just nothing like August in the financial markets, unless it is the barren landscape that is Mars. “I think there may have been life here, once!” one muses with wonder, scanning the bleak horizon for some sign of motion.

Well, nothing today. Maybe we’ll find something tomorrow.

Markets were nearly unchanged across the board from stocks (+0.2% S&P), bonds (-0.5bps in the 10y), and commodities (+0.1% DJUBS), and on low volume.

Gone, but not forgotten, was the robust equity rally from Friday. Regardless of what you may have heard, the rally in equities that day was not due to the Employment data, which was weak.

While Payrolls surprised on the upside, that was mainly due to rotten forecasting – one auto maker didn’t lay off workers during the seasonal re-tooling period, leaving the BLS seasonal factors to “replace” workers that hadn’t been laid off as they usually are. (By the way, this means that the seasonal factors will expect those workers to be added back next month – but since they weren’t ever laid off, the seasonal factors will bias the number lower next month). We knew this effect was there – that’s why the Initial Claims number plunged 25k in early July, only to bounce 36k and then plunge 31k again. Economists just forgot to add it.

There was nothing game-changing, in short, in the Employment report. A better-than-expected Payrolls increase was not particularly exciting once revisions to prior months and the re-tooling effect are accounted for, and the Unemployment Rate ticked up very slightly (8.254% rounded higher, but was very close to unchanged).

What had pushed the market higher was a surge of optimism about the EFSF again, because some members of Frau Merkel’s party – although pointedly not Merkel and not the Bundesbank either – expressed a vague acceptance of the ECB buying periphery bonds. But how strong is that acceptance? One speaker said German lawmakers would have ‘veto rights’ over bond purchases by the EFSF and ESM. How would that work, exactly? It sounds to me as if someone was promised something that cannot actually be delivered. Obviously not everyone can have veto rights over the bond purchases, or else they won’t make any bond purchases!

Some observers were surprised that the Knight Capital imbroglio did not meaningfully impact market direction, but market professionals generally knew better. Knight Capital’s problem was nothing like the problems experienced by Long Term Capital or a primary dealer like MF Global. All three of those entities put capital at risk on a regular basis, but here’s the fundamental difference: no one needs to have confidence in Knight to deal with them, since you don’t face their credit. You have probably faced Knight numerous times in the market but never knew it, as they are exchange market-makers. Consequently, they don’t have lots of interconnections to other firms that need to be collateralized and can be called. In this respect, the damage done by a Knight insolvency, if it had happened, would have been much more like the collapse of Amaranth, which was a hedge fund that largely dealt in futures markets. No one faced Amaranth (at least, in futures). And similarly, few institutions had exposures to Knight. So if you owned Knight shares, you were hurt badly; but the market continued to function. And over the weekend, Knight got more capital (since their fundamental business model isn’t really in question), and is back to business as usual, for the most part.

Consider this Exhibit 2,375 in favor of pushing as many instruments as possible onto exchanges.

So we move onward, but we’re left with one overarching truth: it’s August. That doesn’t mean that the markets won’t move – in fact, illiquid market conditions often produce ample moves (as Friday illustrated). It does mean that the news cycle, which in the last couple of years has been primarily Europe-driven, will probably slow to a relative crawl.

The Importance of Being Clueless

We wrote off last week’s dull equity trading to the fact that the U.S. had a holiday in the middle of the trading week. Despite some interesting data, including weak Employment news on Friday that moves us closer to another Fed action (as I wrote on Friday), trading was lethargic. I’ve been chronicling the decline in equity volumes for a while now. It has become unusual to break 900mm shares unless there is an options or futures expiration, or a month-end. Cumulative year-to-date volumes are only 81% of last year’s volumes, and only 58% of the last 5 years’ volumes (see Chart, source Bloomberg).

Sure, some of this is due to the moving of share volumes off of traditional exchanges, but that doesn’t explain that much of the trend – if you measure other volumes, instead of NYSE volumes, you get a similar story. I hold that a lot of this is due to the crusade against high-frequency trading (some of which is actually market-making), some of it is due to new SEC and CFTC rules concerning reporting, and a significant part is due to Volcker Rule restrictions. Hopefully, some of it is also due to public disenchantment with the stock market as a path to easy wealth – that would be a healthy development.

But we’re not exactly going through a boring time in the markets. Just a couple of weeks ago we had a really exciting European summit, and on virtually every day since we have unwound the significance of what happened then. Today, ECB head Mario Draghi said that the ESM (which is supposed to recapitalize Spanish banks) will not be functional until 2013. Oh, and Italy and Germany still need to give their final approvals.

Spanish yields in the meantime continue to slip higher, with the 10y Spanish yield back above 7% today. U.S. bonds weren’t asleep: the 10y Treasury rallied 4bps to 1.51% (10y TIPS rallied to -0.60%). But stocks snoozed, even when President Obama announced his intention to seek an extension of the Bush tax cuts for all taxpayers earning less than $250,000 per year. That ought to have launched stocks higher, and in years past certainly would have. It’s a bad sign for the President when the market takes his big announcement as being nothing more than a cynical political ploy. Hey, even if it is a cynical political ploy, it ought to be supportive of equity values since it removes one reason to sell stocks this year to take gains under a lower tax regime!

Commodities certainly weren’t asleep: the DJ-UBS added another 2% today, with across-the-board strength in Crude (+1.8%) and Gasoline (+1.6%), Grains (+3.6%, now up 25% over the last month), Softs (+2.0%, up 12.6% over the last month), Precious Metals (+0.9%), and Industrial Metals (+1.0%). Where did that come from?

I admit to bias here. Readers know that for a long time I have been pounding the drum for commodities as the cheapest conventional asset class (and which provides inflation protection besides). Partly, this rally – for the DJ-UBS, it’s 7% over the last 7 trading days – is due to the asset class being semi-loathed and certainly under-owned. Yes, grains are shooting higher because of Midwestern drought, but what about Nymex Crude? Sugar? Coffee?

I think there may also be an inkling from the so-called ‘smart-money’ along the lines of what I wrote Friday. The weak data recently increases the odds of QE3, at least in the form of an elimination of interest paid on excess reserves. Europe has already taken that step, with some immediate effects:

1. JP Morgan, Blackrock, and Goldman closed their European money market funds to new money after the ECB lowered the floor rate. This was the Fed’s stated fear, that ultra-low rates could cause the money market industry to close down. Then who would buy the Treasury’s TBills?!
2. The first French T-Bill auction after the ECB rate cut resulted in negative yields (for the first time), joining Germany and the Netherlands in doing so. It turns out that all we will do by letting the money funds go out of business is to save a layer of fees! By the way, I still think that if money funds just reorganize into a form where there is no forced $1 share price, then problem solved. Maybe that takes legislation, but it certainly insurmountable.
3. Commodities launched higher. While the launch occurred prior to the actual rate cut, it wasn’t like the cut was a complete shock.

The real question, as central banks eliminate these floors, is what happens next. What should happen if the Fed stopped paying interest on excess reserves, or made it a penalty rate?

The Federal Reserve has made much ado about how their large-scale asset purchases (LSAP) have “acted like” a further easing of interest rates. But I am not so sure of that. The money went into vaults, and short term interest rates didn’t decline. The effect on longer-term interest rates is unclear – while it’s plausible to think a ‘portfolio balance channel’ drove long-term rates lower, it’s hard to read the magnitude of such an effect with the huge amount of noise from changing issuance patterns, various flight-to-quality events, and so on. If the Fed wants to see how much LSAP affected short-term interest rates, then let the market find the clearing price! If the Fed declared that there would now be a -2% penalty rate to keep money at the Fed, I have no doubt that the clearing rate for overnight rates in the U.S. would be clearly negative. And there’s nothing at all wrong with that, philosophically. Repo rates already trade negative from time to time, as do T-Bills. The market can cope. Really.

But if the Fed did that – said “take your money back,” essentially – where would it go? It would definitely in that case push the short end of the yield curve even lower, perhaps even out to 2-years, and by extension the entire curve would be affected since longer-term rates are after all just impounded expectations of short rates.[1] More importantly, some banks would choose to make more loans rather than endure negative carry on reserves. With commercial bank credit now growing at a post-2008 high rate of 6.0% over the last year, this seems less important, but if the Fed believes they can do something about growth, this is the thing they can do and I think a prime candidate for what they will do. Some of this cash also will flow into assets that historically earn zero real returns: commodities, for example.

Now, in Europe it is harder to figure out what will happen. If banks can give money back to the ECB rather than experiencing increasing negative carry, they may. I don’t remember if the LTRO allows that. European banks seem to be increasingly stuffed to the gills with sovereign paper, and are probably less able than U.S. banks to extend loans given the sorry state of their balance sheets. Gold at least stores well, but there’s a lot of volatility there, and it means dollar exposure as well.

I don’t know the answer, but the freeing of short rates to go negative is potentially a game-changer. I think it’s far more important than more asset purchases, especially because investors are likely to be somewhat clueless about how important it is and what it should do to the inflation outlook. That cluelessness is important, because the last thing in the world that central bankers want to do is “unanchor” inflation expectations. (Personally, I don’t think inflation expectations matter, but the important thing is that the central bankers think so).

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[1] Well, okay, they’re not “just” impounded expectations of short rates, but in many ways they behave like that, so if we allow negative short rates then we impound lower expectations in longer nominal rates and they should decline.

The Not-Laid Plans Of Mice And Men

The nice aspect about Europe being the only thing that matters these days is that I don’t have to wait until the end of the U.S. trading day to begin writing an article. All of the damage is done early in the day, and then we watch the markets trade more or less sideways or sometimes even correct a bit once the sun sets on the Continent.

Wednesday was no different. Earlier in the week, there had been some optimism that Greek voters on June 16^th might vote into power a bailout (and austerity)-friendly coalition. With weeks to go before the election, this seems a thin reed on which to base a strong rally, especially since the polls in question are both highly variable and highly suspect, given the perceived extreme importance of the election. Personally, I don’t see the election being extremely important – mathematics trumps politics, so no matter who wins the election the outcome won’t change. Greece will almost certainly leave the Eurozone, and the only questions are how soon it will happen, and how prepared Euro institutions will be. The answer to that latter question is somewhat frightening, since the headlines last week focused on how this country or that agency or that supranational organization was “discussing contingency plans” in case Greece exits the Euro. It is incredible to me that such a contingency hasn’t already been discussed in each of these institutions sometime over the last year, even if a Greek exit was seen as very unlikely. It’s prudent to plan! (Then again, I spent hours last night getting home because New Jersey Transit had no plan in place describing what to do if a tree fell on the tracks).

The optimism early in the week faded quickly and markets were more or less in rout mode today. Spanish 10-year yields rose to 6.65% (see Chart, source Bloomberg), near a new crisis high, so we are only days or at most weeks away from that situation coming to a head.

In Spain, the bailout of Bankia has taken on a drama all of its own. The original estimate of the size of bailout required was, of course, too low. Spain cleverly proposed to inject €19bn of its own government bonds to Bankia, that is would then use as collateral to borrow actual money from the ECB. Spain would count this as an investment, rather than as a debt, so that it would improve the country’s balance sheet rather than worsening it. The ECB thought this too clever by half, and by the way far too transparent a violation of the ECB’s stricture against “monetary financing of governments,” and rejected the plan out of hand.

But that’s okay, because this morning some EC functionaries passed around the notion that they were “open” to using the ESM to lend directly to banks. Markets rallied euphorically but briefly on this news, but the rally quickly failed on some little details…such as the fact that the ESM isn’t set up yet. Actually, the best discussion of the merits and demerits of this idea was Peter Tchir’s article “National Acronym Day in Europe. Don’t Underestimate the ECB.”  Pete explains why there’s some desire to use the ESM rather than the EFSF:

“If ESM can be launched, and it can get a banking license, then the EU has a powerful tool.  The ESM is allowed to do all the things the EFSF can do – participate in new issues and the secondary market and lend to countries for them to support their banks.  Without a banking license its firepower is limited.  With a banking license it can leverage itself to a very high degree and can tap all the cheap funding already in place and whatever new programs the ECB decides to launch.”

As Pete and others noted, the fact that the ESM isn’t set up yet is an important qualification of this idea. The other qualification is the fact that Germany and Finland, whose backing is absolutely required if the ESM is to have any value at all, flatly rejected the idea.

Markets erased all of Tuesday’s gains and then some, with the S&P dropping 1.4% on the day. Commodities, which increasingly seem to be suffering from divestment flows (and possibly momentum players on the downside), fell also with the DJ-UBS down 1.3%. That index is -8.4% on the month, even worse than the -6.1% of the S&P. NYMEX Crude was -3.7%, Gasoline -2.2%. In fact the commodities for the most part were down in direct proportion to their liquidity, with the main exceptions being gold and silver. Yes, the dollar is strong versus the Euro, but it is weak versus the yen! The buck is nearly 6% weaker versus the Yen since its highs in March, and 7% stronger against the Euro. Fortunately for commodities bears, Asians don’t use commodities…right?

Confounding expectations, including mine (although thank heavens I covered that short-bond trade), nominal and real rates continue to decline. The 10y Treasury yield hit 1.62%, 13bps lower on the day, while the 10y TIPS rate fell to -0.48%. The 30-year real rate is now only 0.55%. While real rates and nominal rates continue to hit record lows, inflation expectations do not. 10-year inflation swaps ended the day around 2.41%, well below the 2.75% of March but still well above the 2.20% of last autumn, the 2% of autumn 2010, and the 1.25% of late 2008 (see Chart, source Bloomberg).

As silly as it was for the EC to propose using an ESM that isn’t even set up yet, I actually think that the idea is targeting the right response in a way. The best (remaining) solution, in my view, involves kicking out the weaker members of the Euro and then bailing out the banking system with the huge amounts of money that will be required. Yes, it will have to be printed because there’s just not enough real capital available. But the Euro is untenable in its form, at least now. And any disaster that supposedly follows the exit of one or more members will primarily stem from the carnage it would inflict on a financial system that is loaded to the gills with sovereign debt.[1] Bailing out the financial system – not indiscriminately, mind you, but favoring the stronger albeit not necessarily the larger institutions – won’t be popular but is not entirely unfair in this case since the banking problem in Europe was partly caused by dumb regulatory risk weightings that encouraged banks to hold more sovereign debt, partly by ill-considered moral suasion used to persuade banks to hold more sovereign debt, and only partly by poor risk management.

That solution will never happen, because it would require a whole lot of legislatures to authorize some extreme solutions, and such an approach is not politically palatable. What is more likely to happen, because it is constituted of bite-sized political pieces, is closer to the worst case: don’t kick out the weaker Euro members, so that the imbalances remain, and bail out banks in serial fashion rather than all at once.

Not that there weren’t better solutions, mind you, in the past – but the time for them is gone. We’re down to just hard solutions. In this case, the cheapest fix remaining will be liberally applied: cheap money. Yes, I know that the Fed is insisting (as Fisher did today) that more stimulus isn’t needed. And they’re right, because stimulus doesn’t work. But it’s still perceived as a cheap lunch, and as the situation in Europe worsens and the bank runs accelerate, central bankers will fire up the technology that fired up Bernanke’s imagination back in 2002: the printing press.

Back on the boring side of the Atlantic, tomorrow ADP (Consensus: 150k) and Initial Claims (Consensus: 370k) will be released. There is reason to be wary of these numbers. Last month ADP came in at 119k, which was well less than expectations. History shows that with ADP economists tend to miss in the same direction at least a few times in a row, so another soft print is likely. It’s unlikely to show the economy is collapsing, but it will reinforce the sense that the U.S. economy is slowing, and unlikely to be robust enough to pull Europe (and perhaps China) out of the tailspin. This will not hurt the bond market, but if the data is weak…yet not dramatically weak…then equities may get a bounce from the idea that QE3 just got closer.

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[1] Of course many other businesses will suffer losses on cross-border contracts that were poorly constructed, not providing a fallback currency arrangement to the Euro. This violates the girlfriend rule of thumb: Don’t make plans that are further in the future than you have been together so far. Greece joined in 2001, so if you wrote a contract in 2007 that went further out than 2013 without a fallback mechanism, shame on you!

A Time To Refrain From Embracing

Today’s bit of wisdom comes either from Ecclesiastes, or from The Birds (depending on your religious background): to everything there is a season, whether for casting away stones or for gathering them together, whether for embracing or for refraining from embrace.

This too is good market wisdom – and in the current circumstance, it appears it is a time to refrain from embracing. Two sovereign wealth funds have apparently stopped buying European sovereign debt, according to stories out today. One is China’s CIC (which is interesting: I suppose they figure that their pledge to the IMF is more than sufficient exposure to the region! If that is the case, then surely this falls in the category of an unintended consequence!). The other is Norway’s $610bln oil fund, which will actually divest holdings of Eurozone sovereigns. It had held 50% of its total bond holdings in Eurozone sovereigns and has cut (or maybe will cut – the story is unclear) its exposure to under 39%, according to this story on Reuters.

Frankly, if I was another sovereign wealth fund, I would read these stories and wonder whether it is time for me to cut my exposure as well, since I surely don’t want to be the last one out. As I said, perhaps this is a time to refrain from embracing.

That being said, as I wrote on Tuesday “I think it’s likely that European prices will rise at least as fast as US prices” and opined that “I think Europe is going to be catching up to the U.S. in the monetary-profligacy race.” I wrote that, and today a story appeared in Der Spiegel: “Breaking a German Taboo, Bundesbank Prepared to Accept Higher Inflation.” The ECB is already losing its “Bundesbank DNA” since being taken over by Mario Draghi. Now it looks like the Bundesbank itself is losing its singlemindedness when it comes to inflation.

This is a game-changer, obviously, when it comes to inflation in Europe (German inflation carries about a 25% weight in the calculation of Euro inflation) but also when it comes to inflation globally. I noted yesterday that Euro M2 accelerated to a 3.1% pace in the year ended March, and that that was the highest pace since September of 2009. I can’t imagine these two things – an acceptance by Germany of potentially higher inflation, and faster Euro-area money supply growth – are unrelated.

This may or may not be an error. If Germany is acceding to higher inflation because she believes that faster inflation will be a result of faster Euro-area growth, it’s an error since inflation derives from money growth, not real growth. But if Germany is allowing inflation to rise in Germany relative to the rest of the Eurozone, as a way to ‘rebalance’ her economy relative to the Eurozone, then it’s not a bad idea; the only problem is that since Germany doesn’t have a lever to pull on monetary policy that’s separate from the ECB’s lever, I don’t see how they can raise Germany’s inflation rate relative to the other nations. Between countries with flexible currencies, this adjustment happens through the money supply and currency. How do you effect such a ‘rebalancing’ in this case? I don’t know.

Speaking of errors, JP Morgan announced a whopper today after the close. About a month ago, a story circulated about a trader at JP Morgan who had amassed positions in corporate credit-related derivatives that were so large they were affecting the indices of credit risk. Today, JP Morgan revealed that the unit where the trader works (the chief investment office, which is meant to hedge firm-wide risks rather than to take positions) had lost $2bln on synthetic credit instruments. JP Morgan CEO Jamie Dimon said on a call today that the losses could ‘easily get worse,’ implying that the positions remain open for now.

There will be many questions about how the bank amassed a $2bln loss in the short time that has passed since quarter-end, especially given relatively sedate trading in the credit markets. There are both positive and negative fact sets that could apply. On the positive side, we could posit a smart risk-management officer that read those earlier stories and investigated whether the book was being marked at levels that were being affected by the trading of those instruments by the book, or whether they were fairly considering the likely loss in the event of liquidation. Discovering that they were not being marked conservatively, Risk Management and the CEO decided to disclose the loss as soon as they knew it should be. If that is what happened, it would be hard to fault the bank’s disclosure even if you could fault some of their controls. But Dimon is also a pretty crafty fellow, and I can certainly imagine a circumstance where the bank figured “if we announce the loss on the credit hedge now, then when the gain on the other side shows up in the regular earnings we might be able to persuade analysts to treat this as an ‘item.’”

So what I’d want to know if I was a regulator, or a reporter, or an investor, is whether the error here was that the chief investment office departed from its hedging function and made some bad prop trades. If the answer is yes, then I want to know how that happened in large size without senior approval. If the answer is no, then the next question is whether this loss was offset by a gain somewhere in the bank, since it must be a hedge. If the answer to that question is no, then we simply have some stupid hedging. If the answer to that last question is yes, then I want to know why an announcement was made at all because the hedge worked! Sometimes hedges lose money, after all…when the thing being hedged shows a gain.

On Friday, Dallas Fed President Fisher is speaking on the topic of “Too-Big-To-Fail.” How timely.

Also due out on Friday are Michigan Confidence (Consensus: 76.0 from 76.4) and PPI (Consensus: 0.0%/+0.2% ex-food-and-energy), neither of which is an important release. Have a nice weekend.

The Downside Of Healthy Banks

For the third day in a row, equity volume was passable, near 800mm shares. That’s the best 3-day performance, volume-wise, since early February. What does it mean, on a day that stocks rallied another 0.6%? Bulls will say that it is supportive, showing that the rally is gaining adherents and some of the sidelined cash is returning to the market. Bears will say that it looks like retail is finally chasing the market higher.

I don’t know which (if either) of these is true, but either way the market has the support right now of solid, if unspectacular, economic fundamentals. Empire Manufacturing came in at 20.21, Initial Claims fell to 351k, and Philly Fed printed 12.5: all three releases were as good or better than expectations.

Bonds had sold off in the overnight session before rallying back and managing to fall only a smidge, with yields +1bp on the day.

Commodities were generally strong, but the energy sector fell with gasoline off -1.8%. Energy traders were a bit rattled by a Reuters story that the UK and the US had agreed to coordinate releases from strategic stockpiles. Spot Crude dropped $2 instantly. In a way, it is an odd reaction because there are only two reasons to announce a release of reserves now. The first possibility is that it is a political gambit by the Obama Administration to take away a talking point from the Republicans, pushing gasoline prices (ironically, only a week or so after the President said that a plan to lower gasoline prices to $2.50 – proposed by candidate Gingrich – was a ‘phony, election year promise.’) But if the main point was political, then why involve the UK when any important domestic effect would be driven by a release of US stockpiles?

Possibility two is that a behind-the-scenes discussion on releasing stockpiles in the event of hostilities in the Middle East was taking place. This isn’t as much of a stretch to consider as you might think; the current naval deployment map shows that in addition to two aircraft carriers already present in the Gulf region, the U.S. has newly moved a big-deck amphibious warfare ship into the region; also, two other carriers recently put to sea, with one halfway to the Mediterranean already. The Administration’s denial of the Reuters story, which caused prices to rebound warily, was also phrased curiously, with White House press secretary Carney saying that “It is inaccurate…that any kind of agreement was reached.” “Inaccurate” seems a bit wishy-washy if what he meant was that there were no discussions being had, or that the report was outright false.

If there is any chance of hostilities near-term, of course, it would be stupid to release reserves before shots were fired, because then prices would still spike on news of combat. Any agreement would presumably concern a co-ordinated stockpile release to be announced after fighting commenced. This is not a prediction of war – I am even less qualified to comment on that than on many other things people bash me about. I am simply saying that I am raising my antennae as a result of this curious combination of events.

Any prospective rise in oil prices, as well as the lagged effect of energy price increases which have already happened, is additive to whatever numbers are reported tomorrow in the BLS’s CPI report. The consensus estimate is for a rise in headline inflation of 0.4% and 0.2% on core inflation, keeping the year-on-year measure of headline at 2.9% but allowing the year-on-year core reading to slip to 2.2% from 2.3%.

I don’t think we will actually get a downtick in core inflation. If core is only 0.17% month/month, then it will be sufficient to sustain the 2.3% year/year print (which was really 2.27%), so to get a downtick to 2.2% you either need 0.15% or 0.16%, or month/month needs to surprise by coming in at only 0.1%. In fact, last February core CPI rose 0.20%, so in order to get an uptick only a +0.27% monthly print is necessary.

It has been 15 consecutive months that we have watched year-on-year core inflation rise, the longest such streak since the mid-1970s. If we get a clean, unrounded 0.2% rise in Core CPI, it should be enough to set a record by edging year-on-year core inflation higher for a sixteenth consecutive month. A downtick is possible tomorrow, but I believe we will set a record.

Record or not, the underlying reasons for being concerned about inflation are just not going away. The latest data on Commercial Bank Credit show that the “wall of money” that was safely in sterile reserves a few months ago continues to leak out. The year-on-year rise in commercial bank credit has finally surpassed 5%, the first time it has returned to the “normal” 5-10% range since the crisis began (See Chart below, source St. Louis Fed).

So if 9%-10% M2 growth, where year-on-year growth in that metric has been for the last 32 weeks, doesn’t bother you because of the decline in M2 velocity, the acceleration in commercial credit growth should cause at least a mild discomfort. Yes, banks are healing – and while that is mostly good news, the flip side of healthy banks is recovering money velocity.

My Two Cents On Nonsense

I had not planned to write tonight, but there was too much that happened today, and too much that is likely to be misunderstood and misinterpreted. Not, necessarily, that what follows will help that situation, but I felt a need to add my two cents (which, don’t forget, is two cents more than you paid for it, so you’re two cents ahead no matter what).

Let us start with the good news, however. Retail Sales exceeded expectations, with +0.9% ex-autos and even +0.6% ex-autos and gasoline (yes, higher gasoline prices show up as higher retail sales), with upward revisions to both series last month. Clearly, retail sales are doing better than expected and are a bright spot; as I’ve said for a while, the trick here isn’t figuring out that the economy is improving, but figuring out whether that improvement will be consistent and can be built on. The jury is out on that one, and I will say that I am not exceedingly optimistic. But that is not today’s trade!

The Fed met today, and the market actually took a statement that was nearly empty of significance and wrung drama out of it. Stocks leapt, because while the Federal Reserve acknowledged that the economy was improving there was no sign of any wavering in the resolve to provide easy money for the next couple of years. They were correct to do so (based on that interpretation), although the curious thing was that commodities rose only sluggishly, and precious metals actually dropped 1% or so. That’s confusing because easy money for a couple of years ought to have the most direct effect on the prices of commodities. The dollar strengthened, though, partly because of the strong economic data, and this blunted some of the natural upward pressure in this circumstance.

Bonds sold off, also correctly, on the lack of any sign from the Fed that QE3 is being considered in any form. The question is, when the Fed is done with Operation Twist II, who will be buying the 10y note at 2%? China recently announced a large trade deficit on the basis of declining exports; this is probably a one-off but it raises the question of whose surplus will be dedicated to buying Treasuries (obviously, there is a net surplus somewhere; every country can’t run a deficit! We just don’t know whether the other surplus countries will prefer to buy Treasuries). Accordingly, the 10y note yield rose to 2.125%, up 9bps to the highest yield since the false breakout in late October last year (see Chart). While it is probably early to say that this will lead to a big rise in rates, every trader knows the old saw that the market will find the greatest pain, and right now there is a holder of trillions of dollars of long Treasury securities who has no way to sell them and is growing tired of supporting the market at these yields.

The rise in yields was predominantly due to a rise in inflation expectations; indeed, over the last week 10-year yields have risen 18bps; 16 of them have come from an increase in 10-year inflation expectations and only 2 of them from a rise in 10-year real yields. See the chart below of 10-year inflation breakevens, which are back at the highest levels since August.

This is significant, especially as it extends, because the Fed continues to profess that one reason they are not concerned about the rise in core inflation is because “inflation expectations are contained” and this is less and less true, whether you’re looking at market indications or listening to retail customers (whose perceptions of inflation turn out to be driven quite significantly by fluctuations in gasoline prices). Today retail gasoline prices reached $3.80 nationally, and given the usual lags in wholesale-to-retail transmission, it appears that record prices above $4/gallon are likely in the next month or so. Whatever the implication for economic growth (negative, but probably not as bad as the first time we saw those prices) and core inflation (no real effect), the effect on inflation expectations will be large and not helpful for either the Fed or a Treasury which still has a few trillions in securities to unload this year.

And this takes us to the final, and most interesting, event of the day. It began when JP Morgan trumpeted a nickel increase in its dividend and a $15bln stock buyback. My first reaction was that this is not a phenomenon you tend to see in bear markets or early in bull markets, but rather in mature bull markets. Firms have a marked tendency to buy stock back when it’s expensive, not when it’s cheap, and an even more marked tendency to announce a buyback when they want a stock price supported. An announcement of a buyback program is not a promise to buy, and often no stock is actually bought. It is only an announcement of an intention to buy, which the firm need not honor. And this is a bank. Anyone with even a passing knowledge of Basel III knows that banks are going to be raising Tier 1 capital – especially in Europe, but in the U.S. as well – for a while. There is no way that banks, whether or not they feel overcapitalized by 2000s standards or not, are actually going to be buying back large chunks of stock. So my second thought was “wow, are they actually going to scare up the stock so that they can sell more? That can’t be legal.”

Moments later, we found out what the real point was. It seems the Fed had completed the stress tests and informed all of the banks a couple of days ago (it’s unclear when), and were going to make a public announcement on Thursday.

Sidebar: This is why people think that Wall Street is run by a bunch of crooks. The moment that banks had this information, they were in possession of material nonpublic information that should have been immediately released if the banks were going to prepare any offering in their own securities. Whether the Fed says they can or can’t, the information must be released. And here is one positive checkmark for JPM: they announced that the Fed had approved their buyback and dividend plans in the context of passing the stress test. But thanks a lot, Fed, for putting banks in the awkward position of having to choose between ticking off the Fed, or ticking off the SEC. And great job, bank managements, for mostly choosing to keep a secret that makes you look like a member of an elite club/secret cabal, rather than choosing to release the information. Good job, JPM. (But I’m not done with you yet).

So, the Fed decided that they needed to immediately release the stress tests results, early. Well, not immediately; they decided to wait until 4:30ET, after the markets closed to retail investors, because golly it would be too much to ask to let people get the information when the markets were open. Sidebar: this is why people think the Fed is run by a bunch of crooks who are in bed with the Wall Street crooks. Who is running the PR at the Fed?

Bank of America bravely followed JP Morgan through the breach to announce that they, too, had passed the stress tests. US Bank announced a share buyback, dividend hike, and a passing stress test grade. (Quick quiz, with the answer to be given later: are the banks announcing share buybacks likely to be the strong banks or the weak banks with respect to the stress test? Write down your answer and we’ll come back to it.) Volume on the exchange spiked, with better than 50% of the day’s volume coming in the last hour of trading, and almost 30% in the last 7 minutes before the bell.

The stress test results were released, and four financials failed: Ally Financial, SunTrust, MetLife, and Citigroup. Well, good luck raising capital now, Citi. (Important Disclosure: I am expressing no opinion on any of these individual equities or any of the other securities of these companies. I neither own, nor intend to buy, nor sell, any of their securities in the near future. My negative opinion on banks generally is well-known, but I do not have any position, positive or negative, on the banking sector, nor do I plan to make such a sector bet in the near future).

Now, initially the press coverage listed three of the four firms that failed, but not MetLife, so I was forced to go skimming through the “CCAR” report to find the fourth one. If I hadn’t done that, I almost certainly would not have noticed Figure 7, which is reproduced below for your easy reference.

You can see the four banks which failed are the shortest bars on this chart, so you can easily pick out Ally, Sun Trust, Citi, and with a straightedge you can conclude that MetLife is the fourth. But then it’s a really close race for fifth-worst with KeyCorp, US Bank, Morgan Stanley, and… JP Morgan. It must be great to be JP Morgan. When you wonder why they drew the line where they did, you might imagine the counterfactual situation where JP Morgan came out on the other side of the line. JP Morgan, which was the Fed before there was a Fed, and will probably be the Fed after the Fed is gone. JP Morgan, which the Fed called on multiple times during the crisis to save the world (for example, by serving as a lending conduit to entities which the Fed could not directly lend to). I wonder what the odds are that JP Morgan would be allowed to fail? I’m going to speculate: zero. And that’s why the line is where it is.

Now, it is interesting to see which banks scored very highly. They’re banks that don’t have exposure to as many of the blow-up areas that were tested by the Fed (which is not to say they aren’t exposed to blow-ups: just that they’re not the ones that the Fed tested).

By the way, don’t let anyone tell you “well, this was a really severe test, and so these banks are actually in really good shape.” Yes, this test is much more stringent than the cotton-candy version the European regulators put their banks through last year, but it only measures expected reactions to broad macroeconomic events, and not the interaction of the entire system under such a stressful scenario. That reaction is non-linear, and it is very difficult to model. Moreover, we can’t model the unknown: a rogue trader, a $65billion Ponzi scheme, a tsunami and nuclear meltdown in Japan, a terrorist attack in New York. As Roseanne Roseannadanna used to say, “It’s always something.”

When all is said and done, are we better off that the Fed did these stress tests? I suppose the answer is yes, if only because it means the regulators actually took some interest in looking at these businesses and their risks. But if it creates a false sense of comfort, or reverses the trend towards greater capital cushions, then probably not. Time will tell.

I am about ranted out for today, and there are no important economic releases tomorrow. It will be interesting to see how the spin machines work on Citigroup and JP Morgan, which are after all separated by only a thin line on Figure 7, but by a huge gulf in reputation.