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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.

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