Preparedness

The sine qua non for a disaster is that no one is worrying about the disaster. Earthquakes are less damaging in Tokyo than the same earthquake would be in New York, because in Tokyo buildings are designed to be earthquake-resistant. This is also true in markets; if investors are guarded about purchasing equities because of all the bad things that can happen, then prices of equities will be very low and it will be difficult to effect a true crash in such a circumstance.

The opposite doesn’t necessarily follow in the physical world (if you don’t prepare for an earthquake, it doesn’t increase…so far as we know…the probability of it happening), but it occasionally does in the financial world. I pointed out in January the work by Arnott and Wu which indicates that a company which enjoys “top dog status” in terms of having the greatest market capitalization in its sector tends to underperform the average company in the market by 5% per year for a decade. This is largely because investors in such companies are not prepared for adverse surprises, so that any such surprises tend to be taken poorly. Similarly, problems in Cyprus had an outsized effect on markets because (remarkably) no one was prepared for there to be problems in Cyprus that the rest of the Eurozone wouldn’t simply write a check to cover.

By this standard, inflation is growing more dangerous by the day, as more and more investors and pundits start talking – incredibly – about deflation. St. Louis Federal Reserve President Bullard today told an audience at the Hyman Minsky Conference in New York that it is “too early” to worry about deflation. That statement must hit most readers of this column as hysterically funny, given how many readers typically complain that the CPI is far lower than their personal experience of inflation. Bullard also noted that he favors an increase in the pace of QE if inflation falls further. Since core inflation is currently at 1.9%, Bullard is essentially putting a floor on inflation near where we once thought the ceiling was.

I read somewhere today that the recent declines in copper and gold are “signs of deflation.” I disagree. At best, they are signs of fears of deflation, right? But even that, I don’t buy. While breakevens in the TIPS market have declined recently, they are still not particularly low by any historical standard (see chart of 10y BEI, source Bloomberg). Moreover, a not-insignificant part of that decline represents a direct response to energy’s retracement and isn’t a reaction to a softer opinion about core inflation.

In fact, the core inflation implied by the 1-year inflation swap, once energy is extracted, is above the current level of core inflation and near the highs that have been seen since early 2011 (see chart, source Enduring Investments).

So I suspect, rather, that the causality runs the other way: the decline in copper and gold has caused an increase in chatter and vocal concern about deflation. But the people who are investing directly on whether deflation will happen aren’t seeing it. This is somewhat comforting, as it’s the people with actual money (rather than pundits and economists) who determine whether their institutions are ready.

Now, to the extent that the increased chatter actually leads to renewed relaxation in inflation expectations (ex-energy), it sets the stage for worse damage when it inevitably happens. Inflation, like earthquakes, is more injurious when societal institutions have not prepared for it. Median inflation in the U.S. over the last decade is about 2.5%. But in South Africa, it is 5.7%. In the U.S., a 5.7% inflation rate would cause major havoc, but South Africans would be amused at that since they deal every day with that pace of price change (as did Americans, in the 1980s). In Turkey, median inflation has been about 9.5%, but there again the society has adapted to it. To the extent that there is any fear in the U.S. about inflation rising to 5% or to 10%, institutions will prepare for it, and they will eventually learn to deal with it. It’s the shift to that new reality that can be especially painful.

The rest of the week has only minor economic data releases, with the Philly Fed report on Thursday (Consensus: 3.0 vs 2.0 last) the most important of them. A few Fed speakers will be on the tape. But the real market concern is concern in the market: the VIX has risen to 16.5 after having receded slightly on Tuesday; the dollar today retraced all of Tuesday’s decline and then some. Gold and commodities have not fallen further after the washout on Monday, but neither have they rejected the lower levels and rallied back. The S&P has support at 1540 or so but below that level there could be a substantial further fall. All of these markets have potential for important moves, and in the meantime there is the potential for renewed headlines out of Cyprus where there is consternation over the new demands from the EU. The trader in me would guess (stress: guess) at further weakness in equities, an attempt made by energy markets to hold near these levels, a halting rally into resting sell orders in precious metals markets, steady nominal bond markets but with some rebound higher in long breakevens. But here are the problems: (1) these are all connected – so I could easily miss on every one of these guesses; (2) any big move will affect sentiment on the others, so that there are copious feedback loops; (3) much of what happens will depend on the next quantum of news to hit the screens, and (4) Wall Street is less and less in a position to take risk and maintain orderly markets, as it has in the past. We might even simply tread water into the weekend and take our volatility on Monday. But I’m fairly convinced that more volatility is coming before markets calm down again.

But that’s not a problem, if you’re prepared for it!

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Whose Move Is It?

Markets have been surprisingly quiet over the last few days. Some of that, no doubt, is due to the NCAA basketball tournament, to the Good Friday/Easter Monday holiday in the U.S. and in Europe, and to baseball’s Opening Day.

We also had Japanese year-end and the end of Q1 in the U.S., and to the extent that the last week has brought any market moves of interest at least a portion of that can be put on the account of the calendar. On Thursday, the S&P set a record month-end close, although a higher intraday print was established in October of 2007. But while news accounts attributed the almost-record to an “easing of Cyprus fears,” it is much more likely that it was due to the normal (and well-known) quarter-end “mark ‘em up” machinations of less-scrupulous fund managers in illiquid market conditions.

In a similar vein, the quirk of having the quarter end on a Thursday three days before the calendar turns helped exaggerate a massive move in grains, especially corn, on a mildly bearish crop report. Those who are invested in commodities for tactical reasons are being flushed because they’re tired of waiting, as an article in today’s Wall Street Journal made clear. The investors who are leaving do not have comfort in the asset class because they don’t understand the drivers of the asset class; the result is that they become performance chasers. So, when crop reports suggest that the real price of corn should fall a little bit, investors slash nominal prices 10% in ‘get me out’ orders.

But as I said, these investors don’t understand the fundamental drivers of the asset class. The article cited above regarded the breakdown of the correlation between commodity indices and equity indices as something sinister, saying that the correlation is at its lowest level since 2008 and suggesting that this means that one of the two markets is wrong. As it turns out, though, the correlation of stocks and commodities is a relatively new phenomenon. Over the last 5 years, the correlation of monthly changes in the DJ-UBS index and the S&P is 0.61. However, for the 17 years prior to that, the correlation was 0.04 (see chart, source Bloomberg).

For the GSCI commodity index, the last-5-years correlation is 0.65, but for the 38 years prior to that (the GSCI has a longer history) the correlation was -0.02. In short, there is no reason to read a whole lot into the recent decoupling of stocks and commodities, except that it may suggest the hot money is finally leaving commodities. The correlation breakdown is also a good thing for anyone who believes – as I do – that stocks are overvalued. And, since a good portion of commodities’ long-run return comes from a rebalancing effect that is larger when the inter-commodity correlations are lower, this is more good news.

The choppy melt-up in stocks on Thursday was partially reversed by the new-quarter blues today, but all of this is mere detail. Over the last week, while authorities in Europe have encouraged investors to put the Cyprus issue to bed additional details have emerged that deserve mentioning. For example, it turns out that the larger depositors (over €100,000) investors in one of the Cypriot banks will not get a 10% haircut, or a 20% haircut, but something close to a 100% haircut – 37.5% of the deposit balance in excess of 100k will be converted to equity in the bankrupt bank. There are some reports that certain deposits belonging to “EU funds” will be exempt from the haircut. There are of course the stories that capital controls implemented in Cyprus were ignored in non-Cyprus branches of Cypriot banks, and one Cypriot newspaper is claiming that relatives of the president withdrew substantial funds from Laiki bank just before the bank was shut down.

While the worst of the immediate crisis has surely passed, it seems madness to me to pretend that it never happened or that it will have no knock-on effects. For that matter, it seems madness to conclude that since the knock-on effects were not immediate, that no such effects exist. On the other hand, when events are no longer going bang-bang-bang in rapid succession, it is reasonable to ask “whose move is it?” Will bank deposits begin to flee from periphery countries, or wait to see what assurances European officials give? Are central bankers already injecting liquidity into shaky banks, or are they waiting for the invitation from the banks in-country? Are investors reducing risk and diversifying away from European assets, or are they waiting to see if other investors do so first? All of these actions entail costs, and so there is a natural desire of every party to delay action…but to not delay action so long as to cause those costs to rise substantially.

As a trader, my inclination is to hit a bid and get out, and not worry about the bid/offer spread or those other costs. But I am not dealing with billions of Euros when I do that. Still, the insight is that when bad things might happen, the here-and-now transactions costs are usually a poor reason not to seek protection. This is why T-Bills over the last couple of years have occasionally had negative nominal yields (see the chart of 3-month T-bill yields below, source Bloomberg). Yes, it’s clearly dumb to pay $1.01 now to receive $1 in the future. But is it dumber than the alternatives?

Bailing In

Cyprus, for now, has seen disaster averted. In a flurry of weekend maneuvers, Cypriot and troika officials decided on a plan to merge the top two banks, fully protecting the insured depositors while socking the uninsured depositors of those two banks and the non-government financial stakeholders. In short: depositors at the largest bank will lose ~40% of their deposits above the guaranteed threshold, depositors at the second-largest bank will lose ~100% of their deposits above the threshold, bondholders (both senior and subordinated) at the second-largest bank will be wiped out and bondholders (including senior bondholders) at the largest bank will be wiped out. Equity holders in both banks will be fully wiped out.

That’s not completely accurate, because there are various classes of government (Cyprus) and supranational stakeholders (e.g. the ECB) who it appears will be spared, but the rest will be fully “bailed in.”

Yes, let’s take a minute to examine this addition to the lexicon. “Bailed in” is the opposite of “bailed out.” We already had a term for that; we used to say that these people were “wiped out.” But now, the idiocracy has decided that “bailed in” is a kinder and gentler way of saying that you’ve lost everything, but thanks for your contribution to the bailout.” It’s based on the law of conservation of bailing, I think, which states that for every bailout there is an equal and opposite bail-in.

Personally, I don’t think it’s a word and Microsoft Word doesn’t think so either.

However, we should get used to the word because the head of the Eurogroup of Eurozone finance ministers said that the Cyprus solution is the “new template” for resolving future Eurozone banking problems. I would hope that somewhere here it would occur to these people that the “template” they arrived at after almost losing Cyprus was something like what a financial-sector analyst (say, three years out of school) would have come up with as the “first-pass after thinking about the problem for five minutes” solution. Unfortunately, the “after thinking about it for five more minutes” solution recognizes that this solution pushes assets into the too-big-to-fail banks, since no person (or corporation) in his right mind will hold more than the deposit insurance maximum at any given bank (even if that person believes that the idiocracy learned a lesson and won’t grab insured deposits in the future), unless it’s very unlikely that the bank would ever be allowed to fail in the first place.

To be sure, the Powers That Be are aware that this solution isn’t perfect, since banks in Cyprus are to remain closed “until further notice.” This is because the obvious side-effect to the implemented Plan B is that every uninsured deposit will flee the country’s third, fourth, fifth, and sixth-largest banks the moment the wires open. This is the classic problem with bank runs. If you ring-fence a group of banks, the weakest bank outside of that circle immediately becomes the weakest overall bank and the run commences there. Thus, unless you protect all of the banks, the run will continue until there are no more uninsured but vulnerable deposits.

Now, if the original Plan A hadn’t called for the “bailing in” of depositors even at more-stable banks, then the bank run may not have happened since “vulnerable” then would be taken to mean “deposits at a weak institution.” But now, depositors in Cyprus are on notice that “vulnerable” means “deposits in a country that has weak banks, whether or not that includes this one.” Indeed, I would expect many “insured” deposits to leave the banking system for mattresses and other alternative savings vehicles, now that we know that an “insured” deposit in Cyprus is just exactly as secure as the politicians’ spines allow it to be. This time, the spines held (and three cheers for the Cypriot legislature who declared they’d secede before allowing their insured citizens to be mugged), but what about next time? In their place, I’d be taking out enough to live on for a few months, at least.

Incredibly, despite the fact that the stock market got exactly what it wanted, market gains evaporated within minutes of the opening bell as smart money sold to the folks who did what CNBC told them to do (it’s okay…it’s just that they’re trying to bail you in. You want to help the institutions, right?). Commodities and bonds were flat, but there’s always tomorrow. Ironically, today’s weak market performance came on the heels of a couple of strong regional Fed reports from Dallas and Chicago, and ahead of what is likely to be decent Durable Goods (Consensus: +3.9%, +0.6% ex-transportation), New Home Sales (Consensus: 420k from 437k, but that would still be the 2nd highest non-tax-break number since 2008), and Consumer Confidence (Consensus: 67.5 from 69.6, but still closer to the highs than the lows of the last few years) data. Also out is the S&P Case Shiller index for January, which is expected to have risen 7.85% from year-ago levels.

All of which, and much more, is already in the price. Stocks only look good if your alternative is a bank account in Cyprus.

They Really Do Care

It really is a marvel of a market these days. It doesn’t strike me as completely odd that stocks have recovered almost all of the losses they experienced on the first Cyprus news, but what is amazing to me is that the VIX index has retraced about half of its jump and that “fear index” sits just about a point and a half above six-year lows.

Yes, Cyprus is a small country, which is a point that seems endlessly repeated as a sort of incantation, a warding against bad stuff happening. As my friend Andy F pointed out, subprime-mortgage-backed paper was also pretty small (roughly 1.3T in size compared with a worldwide bond market around 80T), and somehow still managed to leave a mark. Cyprus is very small, relative to the Eurozone. But if it was as small in significance as it is in relative GDP, do you think the EU finance ministers would be wasting this much time on them? It’s a bit like saying “I don’t care about my grade in Calculus,” and then staying up all night studying. There’s a clue that perhaps someone cares more than they’re letting on.

If Cyprus was insignificant, as opposed to small, then the other Eurozone countries would simply pony up the dough, or wave goodbye and let Cyprus exit the Eurozone.

But they can’t just pony up the dough, as that would continue a bad precedent.

And they can’t just wave goodbye. Why? Because Cyprus’s significance far outweighs its size. If Greece had left the Euro, there would be no precedent value to Cyprus’s doing so and this crisis would have been but a blip. But it doesn’t matter how big the first domino here is: the EU has sworn that the Euro is inviolate, that it’s impossible to undo, that there’s no provision from anyone leaving the union, etc. If any country leaves the Euro, the statement of absolutes is exposed to be false. And worse, from the standpoint of the elites…what if a country leaves the Euro and survives?

So, while everyone tries to persuade investors (and they’re largely succeeding, it seems) not to be concerned about Cyprus because it’s so small, the country declared that its banks will remain closed through next Tuesday. Russians are lecturing Europeans on how the seizure of private property reminds them of Soviets.  And, after declaring that the Cypriot government had to enforce the levy or lose the bailout funds – and then watching the legislature vote 36-0 to reject the levy – European officials are trying to find some way to look like they are sticking to their principles while compromising them. The ECB has delayed a decision on whether to keep supporting Cypriot banks as the discussions between Cyprus and Eurozone finance ministers continue. Looks like someone really does want to pass that unimportant Calculus exam! Perhaps we should not take the protestations of insignificance at face value.

All of which is to say that within a week or two, unless the Eurozone capitulates, Cyprus is still going to go through bank failures and sovereign default and possibly exit or be ejected from the Eurozone. The market is pricing a near-100% chance that these finance ministers capitulate, scuttling their own political futures for the sake of the Euro and returning the Euro crisis to a slow simmer from a rolling boil – not solving anything, but delaying the inevitable. So far, this has been a good bet. But 100-1 odds are probably worth taking, especially when it involves a politician sacrificing his/her future for an idea.

The FOMC also met today, and as expected the pedal remains pressed to the metal. If there had been any question about that one week ago (and I don’t think there really was), the Cypriot events eliminated any chance that the FOMC would even hint at an eventual walking-back of liquidity. It’s not going to happen any time soon.

On Thursday, we’ll get a look at Existing Home Sales for February. While most focus will be applied to the headline number, which is expected to touch 5.0mm sales for the first time (absent government programs) since 2007, I am much more attentive to the year-on-year rise in the median home sales price. That figure was last at an astounding 12.61%, and surely can’t go much higher than that?

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.

Willie Suttonomics

I am sure that the Eurozone finance ministers have never heard of Willie Sutton. But they are engaging now in Willie Suttonomics.

Willie Sutton was the bank robber from the early part of the 20^th century who, when asked why he robbed banks, reputedly answered “because that’s where the money is!” This weekend, the Troika agreed to extend a critical loan to Cyprus in order to stave off a default for the small Eurozone nation. The €10bln loan was extended on condition that bank depositors be levied 6.75% or 9.9% of their deposits (the lesser amount if under €100,000) as part of the solution, and the new president of Cyprus said he accepted because he was given no choice.

I fail to see how this differs from what Willie Sutton did, except that Sutton at least went to prison – multiple times – for the crime. You went into the bank on Thursday and your deposits read €20,000 as you were saving for a new car, or a house, or college; on Monday, you have €18,650. It is being called, disingenuously, a “tax,” but considering that no Cypriot body approved the “tax” it is hard to see how that appellation fits. The money vanished from the vault with no warning. That seems more like a bank robber’s job…except that ordinarily, when a bank is robbed the depositors are protected. The depositors would have been better off if the money had been stolen by Willie Sutton!

My son, who is 9 years old, saw it the same way when I explained the basic facts of what happened to the depositors. He said “that sounds like something Lex Luthor would do.” From the mouths of children…and I don’t judge him wrong on this.

On Monday, I imagine that markets will try and behave as if this “puts the crisis behind us” again. But also on Monday, I imagine that every corporate Treasurer who has money in a bank in Europe will be trying to diversify those deposits to other jurisdictions. Perhaps, if I am such a treasurer, I will pull money from Italy to put into Germany or perhaps I will put it into UK or US banks. But one thing I certainly will not do is leave all of it in a bank in Italy, or Portugal, or Hungary, or Spain.

It is possible that nothing will happen, or at least not right away as stunned European depositors wait to find out if it’s really true, and some dwell in denial. But it’s also possible that we could see the mother of all bank runs, because it’s no longer necessary for depositors to stand in long lines to withdraw their cash, as happened in every major banking crisis that happened before deposit insurance. This is exactly the opposite of deposit insurance – instead of the government protecting depositors, the government is opening the vault for the robbers.

Now, it’s not completely approved as of this writing. According to Reuters, the Cypriot parliament will vote on Sunday whether to mug depositors for the levy. But, since the alternative is that Cyprus will have to default on Tuesday, the odds are good that either they’ll approve the levy (which banks have already sequestered, without any law to tell them to do so), or there will be some 11^th hour brinkmanship with the Troika and Cyprus on Monday. But by Tuesday, you will either have the disorderly default of a Eurozone member, or confiscation of deposits held in banks of a Eurozone country. Now that’s a Hobson’s choice if ever there was one.

Here are some stories elsewhere about the crazy Troika scheme: here, here, and here. And I rarely cite Zerohedge but here is a good summary of some quotes from well-placed individuals in Europe. Comfortingly, the response so far has been shock and anger. Most observers are, rightly, dismissing the soothing statements that this action is an “exception.” Yes, it is – a confiscatory exception, and one that was completely random and unforeseeable by the depositors. Does it make one feel better that the crazy man on the street just set his neighbor’s car on fire, if he says “but it’s just his car – no one else’s.” No, because you know he’s a crazy man, and now you know there is nothing he won’t do. Random injustice is worse than systematic injustice.

Hold on to your assets, folks – I have no idea what happens on Monday but I have a feeling it will require more liquidity. But then, doesn’t everything these days?

Global Gridlock

It’s hard for me to truly grasp the reality of a world in which the downgrade of the British Empire’s credit (late on Friday) was the third most-important story, but so it is.

The UK was dropped from AAA to AA1 (one notch, but an important one) by Moody’s on Friday, and sterling dropped to the worst level against the dollar since 2010. In the grand scheme of things the drop to $1.51 was not critical, and the cable is still almost in the range it has held for the last few years, but some technicians are sure to see the breakdown as an ugly technical development (see chart, source Bloomberg).

But, fortunately for Britain, the Italians were drawing global attention to themselves and the Euro. As ballots were counted in the election to establish the balance of power in that nation, global markets careened up and down depending on the latest tallies. Ultimately, it appeared that a split government was in the offing, with a general repudiation of the politicians which have been party to austerity measures. The party of Berlusconi, who ran opposing the austerity measures, combined with the “Five Star Movement” party of Grillo, who advocates suspending interest payments on Italian debt and holding a referendum on Italian membership in the Euro, would represent an outright majority in the Senate although the lower house ends up in the hands of Bersani because of a “bonus premium” that guarantees the winning coalition will have a majority.

In the end, the reason the Italian election matters more than the downgrade of the UK isn’t because the election raises questions about whether Italy is committed to austerity; it’s that the election raises questions about whether Italy is committed to the Euro. This isn’t Greece. With a $2 trillion economy, Italy is the third largest member of the Eurozone, behind Germany ($3.4T) and France ($2.6T). It is the size of the other four PIIGS combined. And they’ve also issued a lot of inflation-linked bonds, by the way, so look carefully if you own an inflation-linked bond fund that invests in non-US bonds, just so you know.

Now, Italy isn’t going to default any time soon. They’re going to have another election, and in the lead-up to that one there will be more concern and angst. But then the leaders will use that as a bargaining chip, etc. etc.. We’re a long way from a default or exit of Italy from the Euro. But we’re probably not as far from fear of default or exit.

Still, the immediate uncertainty is past. The markets will calm back down reasonably quickly (which doesn’t mean they’ll rally, being overpriced to begin with). Each successive fire drill will cause a shorter and less-intense period of instability in Europe, until eventually the crisis completely passes, or one episode turns out to be qualitatively different and the whole thing breaks down.

And speaking of episodic crises brings us to fiscal cliff redux. The U.S. will hit the sequester barrier in a few days, with almost no chance that it will be averted. The Republicans seem comfortable that this isn’t such a big deal, and that if it turns out they are right then the scare tactic they feel is being used against them will be defanged. The Democrats seem to believe (and intent on making sure everyone else believes) that any cut in expenditures is tantamount to the End of Days. I don’t think the market ought to react very seriously to it, because we’re only talking 0.25% of GDP, but that all depends on how much hyperventilating we get from the media.

Still, it’s an interesting story because if it turns out that the budget can be cut by 2% (albeit 2% from baseline, which is still an increase over last year) without the economy going into the loo, then we’ve moved the goalposts for future negotiations. And if both sides can understand that, then cutting spending (even real spending!) by 2% per year will slowly get the budget back on a course that, while not sustainable, at least doesn’t lead to immediate immolation.

I am not sure how stocks will react to all of this (have I mentioned they seem expensive?), but I know that all three stories should be bond-bullish. The 10-year yield made it all the way back to 1.87% today after peeking over 2% several times the last few weeks. I think there is further upside to bonds for now, and that may mean that breakevens can also retreat some from near all-time highs. If I am right, then selling 10yr notes if they approach 1.65% or buying 10-year BEI near 2.40% represent better placement for the long term trades, which I expect to be higher in yield and in breakevens over 2013.

The Currency War Is Not New: It’s Merely Escalating

A quick summary of where we are in the “global currency war:”

For several years now, global central banks have been engaging quietly in this war. Each central bank has been implicitly playing “beggar-thy-neighbor” by making its currency relatively plentiful, and therefore relatively cheaper, than its neighbors. In one case, that of Switzerland, the currency issue became explicit rather than implicit, though not to weaken its currency but rather to stop it from strengthening without bound (see Chart, source Bloomberg). It is instructive that, in order to accomplish this end, the SNB had to pledge to print unlimited quantities of Swiss Francs to sell – essentially saying that if it can’t beat ‘em, it would have to join ‘em.

Now, in January some well-known asset managers muttered the ‘currency war’ phrase, and Japan’s Economic Minister Akira Amari suggested that the Yen could fall 10% (and Japanese officials have implied that they are looking for such a move to help end deflation). Since then, both the G20 and the G7 have discussed whether countries ought to be engaging in currency adjustment as a means of confronting macroeconomic challenges. Searches for the term “currency war” on Google (see chart, source Google) have risen appreciably. But again, this isn’t really new; what’s new is that people are actually talking about it.

Earlier this month Adair Turner, chairman of the Financial Services Authority talked about “permanent monetary easing” and said that central bankers “may need to be a little bit more relaxed about the creation” of money. By permanent, he means that the central bank would print money with the express intention that the printing would never be reversed. Ignoring history, Lord Turner said “the potential benefits of paper money creation [to stimulate the economy] should not be ignored.” Today, the Bank of England released its quarterly forecasts, showing policymaker expectations that inflation will stay higher than the Bank’s target for longer than expected, and growth will be weaker than expected. Even less surprising, given talk about “permanent” easing, is that 10-year UK inflation swaps are now back above 3.40% (see chart, source Bloomberg). The first 30bps of this jump was due to the decision by the ONS to maintain the current definition of RPI for existing contracts (I mentioned this here), but some amount of it is probably due to the currency wars talk.

It bears noting too that the 10-year US inflation swap is within a handful of basis points of its post-Lehman highs.

The UK inflation market has been around longer than other inflation markets. Index-linked Gilts date back to the early 1980s. So I wonder whether we shouldn’t be a bit more curious about how much of the rise in UK inflation expectations actually reflect a rise in global inflation expectations due to the currency wars that are (and have been) underway.

Because to some extent, the question of “who will win” the currency war is difficult to discern, and to some extent the question is moot. Like in the movie “WarGames,” the only thing that has been certain since the currency war started a couple of years ago is that there will be a lot of scorched earth. The only real “winners” are debtors, relative to lenders.

Who will win? To change the analogy: if you’re in a bay surrounded by people in boats who are pumping water in so that they can see who can sink his boat the fastest, the winner is the one who is wearing a life vest. All the others are just some varying grade of loser. Don’t be the last one to grab a life vest.

Increasingly Wary

Monday’s decline in global equities wasn’t exactly a wrenching selloff, except for one thing: it seemed to be completely unexpected. While the S&P only fell 1.2% – reversing almost every penny of that decline today – European equities was where the pain really was. The Eurostoxx 50, representing a pan-European collection of big firms such as Siemens, Volkswagen, Nokia, etc (about 25% Financials, 18% Consumer Goods, and other sectors weighted 10% or less), fell 3.1% on Monday and rebounded only 1% on Tuesday.

Don’t go to sleep, Americans! We have not necessarily heard the last of the crisis in Europe!

In the U.S., stocks remain up 6% since December 31, but on Monday’s close the Eurostoxx was actually down for the year. And don’t blame it all on Spain’s Prime Minister Rajoy and the scandals currently swirling about him; Italian 10-year bond yields are also up 30bps in the last week and a half. It isn’t entirely clear where the sudden case of the jitters is coming from, but it certainly doesn’t help the global economic recovery that Brent Crude is nearing $120/bbl again, up nearly 30% from the June lows realized in the teeth of the crisis.

(Incidentally, Carlo Rosa at the New York Fed just published an interesting paper that argues “monetary policy news has economically important and highly significant effects on the level and volatility of energy futures prices and trading volumes.” He finds that the Fed’s LSAP1 and LSAP2 programs “have a cumulative financial market impact on crude oil equivalent to an unanticipated cut in the federal funds rate of 155 basis points.” I have no confirmation of the rumor that Mr. Rosa has been disinvited from the Fed’s President’s Day bash this year.)

Now, economic data has been weaker in January than in December, at least in the U.S., but so far at least not by as much as I thought. Still, stock markets are priced for something more than “not as bad as I thought,” and having February gasoline prices at record highs (see chart, source Bloomberg) for this time of year – albeit not by much above last year’s record, yet – is a buzzkill for anyone hoping for a 2013 blastoff.

It also is a buzzkill for Federal Reserve members, I am sure. While the Fed concentrates on core inflation, since it is less volatile (and better-related to 2-year forward inflation than headline inflation), consumers notice and set their expectations based on the whole consumption basket. The best possible outcome for the Fed would be that both core and headline inflation decline, while they work to juice the system. The second-best possible outcome is that core rises, but headline stays low as lower fuel prices help both growth and inflation perceptions. The absolutely worst outcome is that core rises because Fed easing is pushing asset prices (for example, in homes) higher while headline prices scream past even faster because of higher energy prices…and those higher energy prices also serve to retard growth.

One-year headline inflation swaps are currently priced at 2.03%. While core inflation is currently at 1.9%, for reasons I’ve cited here before that is very unlikely to persist for any length of time, and if energy prices sustain any kind of rise at all, a 2.03% headline inflation over the next year seems optimistic to me. To be fair, I should note that the gasoline futures curve is reasonably backwardated, so an easier way to make the same trade is probably to buy March 2014 gasoline futures at $2.69 compared to $3.04 for prompt March.

Although it seems all is well in the U.S. stock market, investors should be increasingly wary. I wrote last week that there are signs some markets are catching the scent of inflation; while growth in the U.S. looks okay and our stock market is riding high, let this note be a warning that other markets are catching the scent of something still stinking in Europe. Implied volatilities are still low, and this may be a good time to buy protection.

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.