The Liquidity Trade

I realise the above chart is a bit chaotic, so let me just explain what line is what and what is going on.

Orange - ADXY (Asian FX Index vs USD)
Dark Blue - SPX
Yellow - GOLD
Light Blue - EUR
Green - 3m EURUSD Xccy Basis Spread
Purple - 10yr US Real Rates

3m EURUSD Xccy Basis is the additional premium vs pure interest rates (which are essentially zero in both US & EU) that market participants have to pay in order to borrow USD through the FX Forward market. Importantly, it is a means of keeping track of the attractiveness and participation in the FX Carry Trade (because it provides a measure of the OTC market, which straight IMM positioning data do not).

It is well known that the Fed have been pushing the "rates on hold forever" story over tte past six months, and accordingly, US 10yr Real Rates collapsed to as low as 1% a week ago. There has been much speculation about the USD carry trade (i.e. - borrowing in USD to buy anything with any sort of yield) as rates have fallen and the Dollar has been under pressure.

The above chart illustrates this - the EURUSD Xccy Basis Spread and US Real Rate are measures related to both the financing of the carry trade, and also of the attractiveness of owning it. Interestly, over the past week or so, these measures have begun to turnaround somewhat (Green Line & Purple line). Coming after yesterday's surprise ECB announcement with respect to the LTRO, it appears that the liquidity cycle may well have peaked.

This does not necessarily mean that growth-related assets look vulnerable (after all, much of this move comes on the back of stronger US data), but it does signal that the cross-asset correlation that we have seen this year may be about to break down. Specifically, if the moves in the Basis & Real Rates continue, the USD could rally very strongly.

Given that a year-end sell-off in the USD has been a clearly-highlighted seasonal trade, the risk is that the market finds itself in some pain.

Black Swan?

The past couple of days remind a lot of when those Bear Stearns Credit funds went under: massive panic about something in an esoteric corner of the market that was viewed as being a non-issue appearing on the front page of the FT & WSJ, followed by dip-buying off the lows as participants attempt to shrug off the news.

I'm sure you'll remember that Suprime was considered to be "contained" (I think that was the choice phrase) and would not be a broader issue for markets. Indeed, $250bn of securities were clearly not enough to land the financial system with $3trn of losses. But what did happen was that market participants were forced to do their homework and did not like what they saw. The point being that there were wider issues that were brought to view and the events in themselves led to large strains across various segments of the financial system.

The reason I bring up this similarity is that an excellent article (from the good people at Nomura) I read today hit the nail on the head: this is a BLACK SWAN. It points out that the issue here is willingness to pay, not ability to pay. And that, I think, is the heart of the matter. The UAE clearly has ample amounts of money. The last time a sovereign defaulted from being unwilling to pay was Equador a couple of years ago (recall Chavez's socialist revolutions across South America) [and of course Russia in 1998]. But Equador is an irrelavent country on the periphery and that was at a time when the banking system was not in a bad state.

Dubai is different because the West is exposed to it in not insignificant size. Sure, the size in itself is not an issue (just as $250bn of subprime securities were not an issue in themselves for the banks), but I would draw attenion to the willingness to pay issue. Sovereign defaults usually occur when either a country has an inability to pay, or the market believes them to have an inability to pay - there is a classic-style run on the capital account and a crisis ensues. In recent years there have been very few countries that fell into this bracket (the Baltics, Iceland) as most EM countries have built up very large FX reserves in recent years (in addition, the presence of China has ensured that commodity prices - EM countries' main exports - have remained high, thus reducing the risk of a balance of payments crisis). So EM countries have the ability to pay, but do they all have the willingness to pay?

What I am trying to say is that is this event going to force market participants to re-examine EM risk premia? I don't think that it is a scenario that can be ruled out.

Clumsy Thoughts on the Front-end

The front-end today has a feeling of capitulation/"get me in!", with the 2yr yield down to a low of 0.67% (!), the lowest since the Dec08/Jan09 deflationary panic and the 14-day RSI at its lowest since the bottom in yields on 16th Dec (the day after the FOMC). With GC trading 15bps the yield pickup of ~2bps/month from here just can't compensate for the potential risk that growth either rebounds strongly or inflationary worries come to the fore (TIPs 5Y5Y still near the top of their range).

To do a very rough back-of-the envelope approximation, term-risk premia from the back-end Eurodollars looks to be about 15bp/year, meaning that over historical carry, there is a mere additional 0.9bps per month pickup over the next two years. Regardless of your view of the Fed being on hold indefinitely, there is very little juice left in this trade.

To look at it another way, Mar11 FOMC OIS is trading at 1.159%, or 82bps of tightening (subtracting risk premia and Effective funds) . A "normal" tightening cycle would involve ~250bps over a 1 year period (ie 25bps at every FOMC meeting), so that would imply around a 1 in 3 chance that the Fed has begun its hiking cycle by Mar11, but the timing of this and also its magnitude are uncertain. If rates are to be "normalised", for example, that might require a series of 50bp clips, given that we are starting from a much lower level. For example, 350bps in 1yr would be 50bps/meeting, and indicate just a 23% probability that a rate hike cycle had begun by Mar11. Conversely, the fact that we are recovering from a financial crisis might mean a much slower normalisation.

Perhaps a "better" way to think about this is to consider the probability of a hiking cycle beginning in any one single month (I assume that 50bps would be the first move, but it could easily be 75bps). In the 15month period to March 2011 there are about 10 FOMC meetings, so this translates to 8bp per meeting. Or in any single month there is about a 16% chance that the Fed begin a rate hike cycle. That is slightly lower than the approximation that assumed 50bps/month, but in the same ball-park, so we can assume the two approaches are roughly consistent with each other.

But what is clear from both approaches is that the market is attaching an extremely high probability to the idea that rates will be on hold well-into 2011.

The Yen, Flow of Funds and the Stock of JGBs

I've been meaning to put this piece together for a while, but couldn't face ploughing through the Flow of Funds data on the BoJ's website - a traumatising exercise indeed. There has been a lot of noise recently about Japan's Government Debt soaring above 200% of GDP and John Paulson & David Einhorn have been telling anyone that listens that interest rates in Japan are going to rise dramatically, spuring a default and possible currency crisis. They tell a good story that is certainly not outside the realms of possibility and they are both extremely smart individuals, but I think they have got this wrong. As a warning, this is a bit wonkish...

There are several arguments for a sustained sell-off in JGBs. First, the DPJ have announced that they will be ramping up fiscal stimulus (as part of their rebalancing strategy) which will result in a signficant jump in issuance, sending the fiscal deficit to nearly 11% of GDP and the stock of government debt to well over 200% of GDP. Second, the collapse in USDJPY over the past couple of years has led many to argue that the Yen is overvalued - PPP measures support such a conclusion, but as will be detailed below, the reality is more subtle. Third, the tepid rebound in Japanese Industrial Production in the face of dramatic rebounds in, for example, Korea has led many to argue for competitive devaluation. Fourth, net portfolio flows in recent months suggest that foreigners are abandoning Japanese assets, while Japanese continue to accumulate foreign assets (see below chart). And Fifth, that the combination of these factors will mean that financing the deficit will require much higher fiscal premia and the possibility of a fiscal crisis is thus very high.

But these arguments make several assumptions about the structure of Japanese capital markets and neglect to consider the fact that Japan runs a large (although, admittedly smaller than it was a couple of years ago) Current Account surplus. First, the issue of Yen valuation: indeed PPP measures suggest an overvalued currency, however, long-run REER measures (see below JPMorgan's Broad REER Index) suggest that the level of the Yen is about right - the real issue was the severe undervaluation of the Yen in the period 2005-8. An optical focus on the USDJPY rate rather than broader measures is probably responsible for this conclusion.

For many years, Japan has recycled its Current Account surplus by purchasing foreign assets - especially USTs. As can be seen from the below chart from the US Treasury's TIC data (brown line is Total Foreign Holdings of USTs, white line is Japanese holdings), this has accelerated over the past couple of years, presumably as a result of rising risk aversion and a desire to "average in" as the USD fell. But the fact that these purchases have continued at about the same rate as during the periods of extreme risk aversion despite the fact that risky asset markets have recovered much of their lost ground suggests something else is going on.

Usually, these foreign purchases have been left unhedged on an FX basis as the cost of the hedge has historically been quite high (selling USDJPY and funding it day to day or via an FX Forward resulted in paying significant negative carry). But this is no longer the case: since central banks globally have slashed rates, there has been a convergence of short-term interest rates. Specifically, it has never been this cheap to fund a short-USDJPY position: the Tom/Next Yen FX Swap is essentially zero. So I believe that Japanese financial institutions have been playing a carry trade whereby they have bought long-dated USTs and hedged the FX risk by selling USDJPY and are funding it short-term. And it is for this reason that those that have been (fashionably) short the Yen have been repeatedly frustrated this year. Such weakening is unlikely until either (i) long-term UST yields converge sufficiently with JGB yields, (ii) the Fed hikes rates sufficiently to make funding short-USDJPY positions more expensive, (iii) portfolio flows move sufficiently negative as to offset the recycling of the Current Account, or (iv) Japan ceases to run a Current Account surplus. It is clear that there is a long way to go before the former conditions are met, and given foreigners own such a small amount of Japanese financial assets (a mere 6.8% of JGBs are foreign-owned, in stark contrast to 35% of Gilts and 50.3% of USTs!) it is unlikely that the third condition will be met. The final condition is perhaps the only one that seems reasonable - however, if the broad rally in risky assets continues, even in the face of central bank intervention, major competitor currencies (such as the KRW) should appreciate and reduce the pressure on the trade balance.

Regarding the issue of whether increased issuance of JGBs can be financed without recourse to higher interest rates or a slide in the currency, the key issue here is FLOW OF FUNDS not STOCK OF JGBs. And it is here that I think Paulson & Einhorn's arguments fall down because they are talking about the stock of JGBs, which as a proportion of GDP is certainly approaching dizzying levels that have in some cases historically been associated with default, but in others (notably during wars) have not. Those who have read their financial history will note that there have been very few instances of sovereign debt crises where the country in question ran a Current Account surplus. In fact, off the cuff, I can't think of any. There is a reason for this: a Current Account surplus represents an excess of savings, and in Japan's case, the Government's borrowing is more-than offset by domestic savings. The point being that government liabilities can be funded entirely domestically and the currency is only at risk if the domestic population suddenly decide that their currency is worthless. There are plenty of instances of this occuring historically, but they have always been accompanied by hyperinflation, whereas deflation is entrenched in Japan.

_

One of the key arguments that the bears put forward is centred around the idea that the Household's savings rate has declined dramatically as Japan's demographic problems materialise, and thus there will be no household financial surplus to fund the very large 11% government deficit. That household saving will not be able to fund the deficit is certainly true to an extent, however, given the damage done to household balance sheets over the past couple of years, it would be reasonable to expect some increase in saving to repair this damage. But much more importantly, their argument neglects to consider the financial surplus of private sector corporates. Specifically, corporates have been squeezed from all sides: the Yen has rallied sharply against major competitors, the global recession has suppressed external demand and the DPJ's fiscal stimulus has been aimed squarely at consumers, rather than at them (past stimuli have usually been comprised of corporate tax cuts and infrastructure/pork barrel policies). Faced with such headwinds, corporates have no choice but to build their savings - in response to the transition of the Japanese banking crisis into its acute stage in 1997/1998, corporates rapidly ramped their precautionary savings and slashed CapEx (see below chart of Financial Surplus/Deficits from the Flow of Funds data - the BoJ altered the construction of this data in 1999 so the crossover levels may not be perfect, but will not detract from the overall argument). Indeed, given the large amount of spare capacity both domestically and also globally, it is unlikely that corporates will be looking to invest in the near-term. Thus, corporates holdings of JGBs are likely to rise both directly and indirectly (via their bank deposits being recycled into JGBs by the banking system). There is a slightly more subtle corrollary from this effect. An increase in corporate savings is equivalent to a fall in demand for loans from financial institutions. As a result, bank loan-to-deposit ratios will fall further - they are already below 80% in aggregate - and as has historically been the case, financial institutions will increase their share of the stock of JGBs.

To conclude, those who expect the Japanese Government Debt to GDP ratio to result in an imminent crisis are confuing Stock and Flow of Funds. It is undoubtably true that the ratio is approaching unsustainable levels, but it is not clear whether a catalyst will present itself to force the issue. The simple existance of Japan's Current Account surplus and structure of its capital markets (where 93.2% of the stock of JGBs are held domestically, and only 5.2% of these directly by households) make it extremely unlikely that a sovereign debt crisis can occur [UPDATE: As reader GE succinctly points out, Japan will never default on its own people]. Additionally, the low cost of funding external carry trades in, for example, USDJPY means that there is additional support for the the Yen in the form of FX hedging, preventing the exchange rate from acting as a lever to force the issue. Finally, note that this FX hedging by Japanese financial institutions also allows the BoJ to increase its purchases of JGBs without risking weakening the currency (as has been the case with the US and UK versions of Quantitative Easing). To summarise, those attempting to short JGBs and the Yen on the expectation of a sovereign debt and currency crisis are likely to lose money like those before them did on numerous occasions in the 1990s.

June 2007 Redux

I have been hearing a lot of things recently that remind me of June 2007. Bearish sentiment is perhaps not what the AAII Bull/Bear survey indicates (not too surprising given is a better gauge of retail positioning given the focus on newsletters).

Specifically, over the past few days:

"The Fed is long stocks, why fight them?"
"There is liquidity everywhere"
"Liquidity will search for yield"
"Bad data is good because it means rates are lower for longer"
"There is a structural bid from Real Money"
"There is huge amounts of cash on the sidelines"
"Eastern Europe can still rally if there is a sell-off in risk" (yes someone even tried to
convince me of this!)
"Risk has to rally at least into Q1"
"Rates on hold mean you need to move out of cash into risky assets"
"There's nothing to stop SPX hitting 1200 by year-end"
"Equity markets will climb a 'Wall of Worry'"

Compare with some examples from June 2007:

"The Fed has got your back"
"There is liquidity everywhere"
"There is a thirst for yield"
"There is a structural bid from Structured Credit"
"Bad data is good because it means that the Fed will cut rates"
"Carry & EM won't be affected by a US slowdown, they can continue to rally"
"EM can decouple from the US"
"Subprime is 'contained' "
"Equity markets will climb a 'Wall of Worry' towards 1600"

Breakevens to the Fed: "Your move"

Today is perhaps the most interesting day in Rates markets I can remember since the Fed first formally announced that it would begin Quantitative Monetary Easing in March. It is interesting because 5y5y TIPS Breakeven Inflation looks about to close at a new high around 2.9%. This is important because it is outside the accepted range considered to be "well-anchored" and would be the first time that they have closed outside of this range.

We have been here before on several occasions over the past couple of years. The market has often interpreted the Fed (and policymakers in general - excluding the ECB) as always "going for growth. Many will recall the rants of Jim Rogers et al crying that the Fed was printing money and trashing the Dollar and that Gold was the only sane investment for those wanting to preserve their purchasing power. The recent break of Gold above 1100, cheered on by several notable hedge fund managers, and supported by several Emerging Market central banks, is adding to this perception. Will the Fed tolerate this given the criteria laid down during last week's FOMC meeting.

There are a few examples that I want to discuss, along with the Fed's responses to these moves. Firstly, in mid-January 2008, as equity markets were melting down as rogue trader Jerome Kerviel's portfolio was liquidated, TIPS breakevens widened significantly in response to the Fed's intrameeting cut of 75bps - an unprecedented move up to that point. The curve very quickly moved to price in a high probability of a 100bp cut at the end of January. However, the Fed - perhaps in response to this widening, as well as moves in the USD and Gold - disappointed markets. Breakevens duly tightened again back into the range.

Secondly, as Bear Stearns was undergoing its final liquidity squeeze in mid-March 2008, breakevens again widened to an intraday high of 2.94% on 14th March as the market began to price in the possibility of a 125bp rate cut from the Fed. With a rescue orchestrated for BSC, the FOMC once again disappointed, and breakevens returned to their range.

The next example comes in the week following the G7 meeting of late-April 2008 in which currency market volatility was discussed, but the statement did contain anything more than a vague promise to cooperate on exchange rates and the usual boilerplate around FX volatility. The FX market viewed this as a "carry on as before" message and duly took the USD to new lows. During this period, TIPS once again widened above 2.8% intraday. Shortly after, Fed rhetoric on inflation was stepped up and the front-ends of curves collapsed as rate cuts were priced out (cumulating in Trichet's summer "present"), TIPS returned to their range.

The final example is 15th September 2008, the date that Lehman Brothers filed for Chapter 11. Many financial market participants initially viewed the event as an extreme Dollar-negative (myself included) as a classic EM-style run on the capital account - by virtue of refusing to fund the banking system - would require a full fiscal bailout of the financial system and associated debt monetisation. 5y5y TIPS breakevens traded to an intraday high of 2.935% that day before collapsing in October & November under the weight of dealer deleveraging and a view that a deflationary outcome was inevitable. But an event that far fewer remember is that at the FOMC meeting that week, despite the curve pricing in rate cuts in response to the Lehman failure and other associated fall-out, that the Fed kept rates unchanged.

It is clearly evident from their prior behaviour that the Fed is uncomfortable with inflation expectations straying too far from their implicit target. It appears to me that a chain of events has been set in place whereby the Fed (and policymakers generally) have told financial markets that they will not be enacting exit strategies for a significant period of time. The size of the output gap is cited as the reason that inflation will stay low - and is one with which many participants (including myself) agree with. But something is wrong. If this is the commonly held view, then why are breakevens soaring to new highs that indicate that the market expects higher inflation? A dangerous game is being played whereby the market is calling the Fed's bluff - will the Fed step up to the table? The market knows that the Fed knows that it cannot afford even to let expectations stray a little - because as soon as they stray a little and nothing is done, they will stray a little more, and so on. Central banks have cashed in a lot of the capital they have built as inflation-fighters over the past 30yrs, and it is remarkable that it has taken until now for it to be seriously tested.

The liquidity-driven rally in everything that is not the USD has been given an implicit "OK" by policymakers. Will they be "OK" with the side-effects?

My sense is that we are on a collision course with a policy response.

Unemployment Jumps and Recessions

Today's payroll numbers were slightly worse than expected, but not terribly so. However, the unemployment rate jumped by 0.4% to 10.2%, a move that is worrying in several respects. Firstly, from a Consumer Sentiment standpoint, it is not encouraging - especially given the high correlation between sentiment and consumption (given that Consumer Credit has been shrinking for a while now, it is not obvious where the financing for consumption growth will come from). Secondly, the Stress Tests specified a peak unemployment rate of 10.3% in the "more adverse" scenario. Given the acceleration in the unemployment rate, it is clear that the trends in employment are not favourable, and a further deterioration seems likely. This could very well bring concerns about the writedowns back to the fore.

But most importantly, there are merely two examples since the official data series was first constructed in 1948 in which unemployment jumped 0.4% month-on-month and was not in recession: 1986 and and 1995. Both of these were mid-cycle slowdowns in the midst of high, above-trend periods of growth. This clearly cannot be argued to be the case now.

In fact, in the observation period, the US was in recession 5.5% of the time and experienced periods in which the unemployment rate increased 0.4% and the economy was in recession 4.6% of the time, implying that the empirical probability that the US is currently in recession is ~82%. Clearly the consensus view that the recession was exited in June 2009 is either wrong, or we are currently entering the much talked about "double dip".

Oil, CPI, Inflation Expectations and the FOMC

The FOMC statement was largely taken as "dovish", with rallies in EM, SPX, TIPS breakevens and a re-steepening of the curve. But a closer look at the statement, as pointed out by the FT's Krishna Guha (http://blogs.ft.com/money-supply/2009/11/04/final-reflections-on-the-fed-statement/), suggests that the market may have misinterpreted the statement. Guha points out that the committee, whilst retaining the key language on rates being kept low for an "exceptional" period of time (generally assumed to be six months), they attached conditionality and outlined the criteria that would push them to hike in the next six months.

Specifically:
- low rates of resource utilisation (i.e. - the unemployment rate).
- subdued inflation trends.
- stable inflation expectations.

Now, while the unemployment rate is unlikely to come down anytime soon, the latter two conditions are not as certain to remain unbreached. Firstly, the liquidity-driven rally across risky assets this year - along with the infatuation many have with Chinese commodity demand - have resulted in commodity prices retracing a large amount of their 08H2 sell-off. In particular, the Oil price is one of the main drivers of headline CPI, and the base effects are about to become extremely large. For example, if the Oil price stays at its current level of $80 into year-end, its year-on-year increase will be just under 150%. The (albeight naïve) chart below highlights the coming surge in headline CPI towards a 3%-handle by January, and beyond if Oil continues to march on (which is not inconceivable if the naked liquidity trade continues).
While core inflation has been trending lower (in response to the size of the output gap), and the market knows that it this that is more important, the weight of positioning in the "lower for longer" trade may be unable to withstand such an acceleration in the headline number. Indeed, most will remember the ECB's reaction function to the march of Oil into July 2008 and the associated collateral damage across asset classes: it is clear that the potential for a "rush to the door" is there.

Secondly, the Oil price has affected inflation expectations before, and it will affect them again. The below chart of the University of Michigan's 5y Inflation Expectations survey, and shows that last year these rose above their historic 2.75%-3% range. There has been much research that concludes that surveys of inflation expectations are highly correlated with coincident inflation numbers, and it would be unwise to expect no effect upon these gauges as the headline begins to accelerate.
The Fed also pay significant attention to market-based inflation measures, such as TIPS. As the deflation scare took hold in 08Q4, TIPS break-even inflation rates collapsed, but have since recovered much of their ground. The outright TIPS are not as useful for determining expected inflation due to issues of liquidity, financing and inflation risk premia, but the forward-starting TIPS do not suffer from all of these problems (though, they are still not perfect). The below chart shows that 5y5y forward breakeven inflation has returned to the top of the range generally considered to be "anchored" - of 2.25%-2.75%. Indeed, breakevens widened another 6bps in the aftermath of the FOMC statement.
Finally, the USD has been in a downtrend and is approaching the levels at which last year caused concern for policymakers - indeed, Gold has surpassed its prior peak, and a break of 1100 would likely lead to further USD selling more broadly. The key issue for policymakers is the extent to which this sell-off begins to affect inflation expectations via the feedback loops into Commodities and back again - much as was the case in the first half of 2008. Yesterday's reaction across asset classes (as discussed above) was particularly telling in this respect, and the risk is - that with the conditions for a policy move having been set - that the USD sell-off vs other currencies and Commodities accelerates and forces the Fed's hand, just as in the second quarter of 2008. In such a scenario, the risk-reward must be to hold shorts at the front-end of the curve around six months out. As ever, the Fed's reaction function will be to first downplay an acceleration in inflation, but such moves usually result in yet more USD selling which exacerbates the problem. Perhaps short the Dollar and short Equities is an effective way to play what will be an eventual self-defeating acceleration of the liquidity play.

Regulation

This post is a bit off-base from what I normally write about.

There is a regulatory battle currently going on in Washington pitting the (largely Wall Street-friendly) Treasury against the (largely FDIC-friendly) Democrats, led by the enigmatic Barney Frank. Much has been discussed elsewhere about the pros and cons of reviving the Depression-era Glass-Steagal Act, so I won't go into too much detail there. However, I will put forward a simple counter-argument to claims by those (such as Gordon Brown) that reviving the Act won't help, because Northern Rock was a retail bank and Lehman Brothers was an investment bank, yet they both failed. This argument neglects to consider the impact of the ability to use balance sheet: commercial banks could offer their balance sheets in securitisation and debt/equity issues, whereas investment banks could not. So investment banks were forced to move into ever-risky ventures, while in moving into the securities & derivatives business, commercial banks were putting their own balance sheet at significant risk. Furthermore, the march of financial innovation encouraged their retail arms to lend to more risky entities and the ability to sell these as ABS allowed them to feel much more comfortable with high LTVs and borrow more on the wholesale markets. It is blatantly obvious to anyone with a brain that abolishing Glass-Steagal digitally increased the aggregate risk the financial system was able to take, as well as increasing its interconnectedness.

But that is not the only problem. The increasing march into exotic derivatives as well as the exponential growth of dealer inventories of derivatives overtook the expenditure on internal infrastructure. As an example, several booking, settlement and payment systems for derivatives at some institutions are nearly 20yrs old! These creaking systems have been gradually updated by "bolt-ons" and "sticky-tape" solutions but they could not keep up with the ever-increasing back-log of trades. I would expect that the problem is even worse in the very large banks that have endured years of mergers. It does not help that morale in back-offices is usually very low. IT and infrastructure spending increases to modernise this archaic structure needs to be significantly increased.

Furthermore, there is no real industry standard for valuing even the most vanilla of OTC derivatives - an issue that becomes exceptionally complex when taking into account counterparty risk and Mark-to-Market collateralisation. Listing vanilla derivatives on exchanges removes this complexity, increases price transparancy as well as significantly reducing interconnectedness in financial markets. I have witnessed several attempts by the exchanges to introduce contracts that very closely replicate such OTC instruments, but the banks have repeatedly stonewalled. If we are attempting to change the regulatory structure in order to reduce systemic risk, there is simple no excuse for not doing this.

Exotic derivatives, and more custom derivatives, are of course a different story. However, moves such as JPMorgan's release of its CDS model into the public domain should help to gradually establish some valuation standard. Regulators should aim to insist full collateralisation of mid-point valuations of the two counterparties, and for uncollateralised transactions insist that capital charges are adequate. I note that many banks have now set up Credit Valuation Adjustment (CVA) desks - these attempt to try to hedge firm-wide credit risk on uncollateralised MTMs in the interdealer derivative market. Some banks have also introduced P&L accrual rules on longer-dated trades. These are steps in the right direction.

The Frank proposal (which is heavily influenced by the FDIC) is to set up a systemic institution resolution fund, and Geithner's argument that having it there will merely increase moral hazard does not really stand up. The Frank proposal aims to discourage firms from being Too Big To Fail - surely this is a good thing? There are plenty of examples of the "financial supermarket" model failing: American Express, Travellers, Citi, RBS etc. As Mervyn King once said (and I am far from his biggest fan), "Too big to fail is too big to exist". It really is that simple.

The leverage issue is far more complex. There are far too many examples in history of financial systems becoming over-leveraged and becoming the epicentre of financial crises - if you haven't already read it, Kindleberger's "Manias, Panics & Crashes" will supply those examples. The key issue is that individual banks exhibit no control over systemwide credit creation - they only care about maximising their own profits, so it natural that they will lend as much as they can in order to make more money. In absense of competitors, their lending decisions will be "prudent", but the introduction of competition encourages lending to riskier ventures. There is nothing wrong with that per se, but notice that the overall amount of credit creation is larger in this case. There is plenty of evidence that government allocation of resources is suboptimal, however, government control of aggregate credit creation could be one sensible means of preventing overleveraging and asset bubbles. In such a scheme, the Fed could target credit growth in aggregate use Window Guidance to divide this up between banks, who would then use their individual expertise to decide which entities to lend to. This leaves lending decisions to the free market and macroeconomic policy in the hands of the (supposedly) independent central bank. Of course, the dividing up of growth targets is an issue here as banks are incentivised to go for market share, which is the main problem with the strategy. An alternative suggestion has been for counter-cyclical capital requirements and leverage ratios which is similar to the above in that it tries to indirectly control credit creation by by "leaning against the wind". This, too, is a no-brainer.

Changing topic slightly, it is striking how much legislation has been proposed globally over the past few weeks on the regulation/bonus/banker-bashing front. I can't help but think that recent stories of bankers calling up estate agents and scooping houses up, and a seeming determination to pay bonuses "come what may" in the face of such outrage has brought this on. Governments in their bailouts were generally hands-off in the face of popular demands for bonus curbs, relying on merely capping bank Boards' pay. But the "business as usual" attitude of the past few months has embarrassed politicians into action, and for that, we all will suffer. It never ceases to amaze me why bank employees were not issued large amounts of equity capital in place of cash bonuses, aimed at replacing depleted capital, allowing cleansing of balance sheets and ultimately a break of ties with their State owners. In such a situation, pre-provision earnings would result in these bank share prices flying, reaping rewards for all stakeholders: employees, management and taxpayers. Sigh. I digress...

The Belgian windfall tax on bailed-out bank profits was swiftly adopted by the French - a country with a significant market share of global banking - and now there is no longer a worry that "he who regulates first loses market share". The latest incarnation of bailouts of RBS and Lloyds appear purely designed to kill their investment banking arms. Whether or not they find loopholes allowing them to pay bonuses, these are likely to find their way into the press and create political firestorms. Such institutions will not be able to fight for talent and they will go back to being "boring utility banks" following the 3-4-3 model. This seems to be "de facto" Glass-Steagal. Coming on the back of the break-up of ING, it is clear that there is now no real obstacle to breaking up large institutions in the US either. The Frank legislation comes on top of these.

Regulators are getting serious.

Positive Feedback Loops and the Pound

It's been a long time since I've written anything about the Pound, but with the seemingly universal bearishness on it - and the UK as a whole - I thought it was about time to have a more detailed look at it. I'm sure many remember the dark depths of January 2009 when RBS & Co. were trading (10p!) as if they were about to be nationalised and commentators were decreeing that RBS was "too big to bail out", that without finance the UK was doomed and that it would have to go to the IMF.

That was before it became apparent that the fall in the exchange rate (which has been very large, historically speaking) had had a significant effect upon economic activity (recall that the UK was the first country to see a rebound in the data at the beginning of the year). But the persistent dovishness of the Bank of England (led by the exceptionally incompetent Mervyn King) has taken the shine off things and sentiment has once again shifted to the view that the UK is "finished" and that the Pound will become the new funding currency for the Carry Trade as the Bank of England wants to talk it down. Aside from the fact that the BoE's behaviour is dangerous (it was the BoE selling GBP on the sly in the mid-70s that led to a buyers' strike in the Gilt market), it is inconsistent with its mandate as an inflation-targetting central bank. Specifically, if the strength of the PMI data (which I will discuss below) is confirmed, with inflation remaining stubborn, the BoE will be hiking very quickly.

It is well-known that, thus far, strength in the survey data - such as PMIs - has not been replicated in the hard data (such as IP & GDP). But this is not unusual: there are usually lags of several months as survey optimism based upon orders transmits into actual production. The below chart clearly shows that in both the UK & Eurozone this lag has been 4-7months, and the exceptional strength of the UK Services PMI is remarkable - it is the highest of the developed markets, and sits a full 5pts higher than that of the Eurozone, the next-strongest. It is also well-known in economics circles that the constructioin of the UK official data series is extremely poor - unfortunately, years of low pay at the ONS has resulted in Retail Sales statistics that only cover 20% of consumption (no, I'm not joking!) and GDP statistics that are unrecognisable from the PMI survey until final revisions a long time after. The BoE shares this view, having done much research on the retail sales numbers (that have been inconsistent with their own surveys) and have published research suggesting that the PMIs are a reliable forecast of post-revision GDP. In summary, the PMI data is likely to be correct, not the official data. The BoE are behaving as if they do not believe their own research, but I think this has more to do with their inflation mandate of keeping expectations close to their 2% target.

Next, as with the US, the UK's fiscal position is looking very precarious. But that is nothing new - in fact it has improved significantly as asset prices have rebounded, reducing the probability that the Asset Protection Scheme (APS) will be tapped by any of the participating banks. Moreover, the recovery in financial markets has been accompanied by a V-shaped recovery in banker-pay, and thus, tax revenues. Nevertheless, the deficit is still a significant obstacle to sustained growth, and a fiscal consolidation is now assured, regardless of which government wins the next election. But that does not mean that the UK is heading for a "depression" as Danny Blanchflower publicly declared - in Q4 1976 (shortly after the UK was bailed out by the IMF and forced into a deep fiscal contraction), GDP grew at an annualised rate of 8.4%. The exchange rate matters, as does the question-mark over sustainability being removed - evidence gathered around the time suggested that many consumers had built held back on purchases as a result of the public worry about the deficit. With this resolved, pent-up demand kick-started the recovery. Speaking of consumer demand, anyone walking down Oxford Street will note the following: "never underestimate the stupidity of the UK consumer".

A closer look at sentiment indicates that the market is not just bearish, but positioned as such as well. Indeed, IMM speculative positioning shows a 2.7 standard deviation position relative to neutral - and the LARGEST net short in history. The valuation is not helpful for the bears either - GBP sits undervalued by 13% with respect to the EUR and 17% to the USD.

But what I really wanted to talk about is something that people appear to have completely forgotton about the UK, that was one of the reasons why thing kept getting worse as markets fell. That is, of course, the composition of the national balance sheet. The UK is unusual in that it's Net Foreign Asset (NFA) position can be basically described as "long global equities vs short domestic debt" - i.e. it's assets are "risky" and generally denominated in foreign currency, and its liabilities are bond-like and generally denominated in local currency. This composition acted as a feedback loop that made bank balance sheets even weaker as asset prices fell. But now that they are rising, it is having the opposite effect. In fact, the below chart (which has a simple model of the UK's NFA) suggests that with the currency at current levels, a further 10% outperformance of equities with respect to bonds would result in the UK becoming a NET CREDITOR. This is an extremely significant result - recall that the change in NFA equals the Current Account. In such a scenario, it is rather hard to justify being short the Pound.

Is the Sun finally rising?

The country of Japan has (in economic terms) been a write-off for a very long time. But a few things have happened over the past couple of years that are indicating that the Land of the Rising Sun may well be entering a new dawn. Before getting over-excited, it's worth noting what a very wise friend (who has had the unfortunate luck of being in the business of Japanese long/short equity) once told me - "Remember: the Japanese always disappoint". He is, of course, right: there have been false recoveries in 1992, 1995, 1999, and finally in 2005, all of which either petered out or were crushed by serious policy-mistakes.

There is no doubt that Japan has just experienced a very deep recession, but it was a very different recession to that experienced in the West - namely, it was export-led, and businesses were very quick to slash Industrial Production to levels not seen since the early-1980s. Since the dark depths of Q4/Q1, there has been something of a rebound, but it is highly unlikely that consumer demand from the US and other Anglo-Saxon economies will be anything like it has been over the past 25 years (I will cover this in detail in an upcoming post). And for all the noise about China, I find it hard to believe that the Chinese will import significant amounts of consumer goods from Japan in the medium-term - it is very much following a policy of "in-sourcing" - specifically, sending people abroad to acquire the expertise to produce high technology goods and then making its own cheaper versions. So China's rebalancing is good for China, but not really for anybody else (again, I'll do some work on this for a later post). So if Japan is to keep nominal GDP from falling, it is going to have to find an alternative to export-led growth.

The good news is that I think that Japanese policymakers "get it". Or at least some of them do to certain extents. The first example of this is that despite a relatively large (40%)and rapid (18months) appreciation of the Real Trade-Weighted Yen, the MoF/BoJ did not intervene in the the FX market. Since then, it has rebounded about 12%. Certainly, there were noises made when the moves in the JPY became disorderly, but I am reliably informed that the BoJ do not view the Yen as being overvalued, despite the many Investment Bank research departments that do. To see this, take a look at the below chart, showing the Yen as being at about the same levels it was in 2005 (or when USDJPY was hovering around 110). As can be seen from the chart, the real issue was the serious undervaluation of the Yen between 2003 and 2007.

Secondly, the Japanese have enacted an exceptionally large amount (nearly 100trn Yen) of fiscal stimulus over the past year in stark contrast to the half-hearted attempts of the 1990s. They are serious about trying to stimulate domestic demand. And this time, it looks as though the Japanese Consumer (who has been AWOL since 1990) actually wants to spend: opinion polls are predicting a landslide victory for the Democractic Party of Japan (DPJ) who basically have a single-policy platform to stimulate domestic demand.

Specifically, the DPJ have announced (i) that they do not object to a strong JPY, and have floated the idea of the US issuing JPY-denominated USTs, (ii) that they want banks to lend more both to businesses and to households, and (iii) that they wish to move away from the traditional strategy that has been followed by Japanese policymakers of exiting recession via an export-led recovery in favour of supporting consumption.

The first of these tenets has been discussed above, but it is also worth noting the advantages of a strong Yen. Firstly, it encourages Japanese to repatriate their overseas financial assets (although this seems counter-intuitive, there have been significant investment losses that will be cut, and with Japanese baby-boomers retiring, money needs to come back home to fund retirement). Secondly, it increases the purchasing power of the domestic consumer - it is often said that the Japanese regard foreign goods as inferior, but that misses the point: many of the constituent ingredients of Japanese goods come from abroad, and in fact, many of them are produced abroad, just having a SONY label put on them before they are sold. Thirdly, it forces the rebalancing of the economy as Japanese exports become less-competitive on global markets.

On the subject of bank lending, although the Japanese statistics have been revamped a few times over the past 20 years, it's possible to see from the below charts that credit outstanding (after shrinking post-1997, when the banking crisis became acute) began to grow again in 2005. Despite dipping down over the past year, it is still in a broad uptrend. As Richard Koo has pointed out, when the NPLs in the banking system had been cleaned up as part of the 2003 Koizumi reforms, both loan demand and supply returned and Japan was able to grow. This is important, because the banking crisis in the West has put Japanese banks in a competitive position, as they have both (relatively) clean balance sheets and political backing to expand. These is clearly a significant positive for domestically-orientated corporations looking to expand investment and also to consumers.

But what of domestic consumption? It has clearly been the case that consumption has collapsed in Japan on the back of the recession, but the effects of the fiscal stimulus already enacted, and the DPJ's pledge to enact another stimulus aimed at increasing spending should help. Indeed, it has also been floated a few times that a one-off generational tax-break might be enacted, allowing the asset-rich over-50s to pass a portion of those assets to their children. This is important, because many in their 20s & 30s have no recollection of the late-80s asset bubble that has so clearly affected consumer psyche and encouraged domestic saving. There is a corollary here related to the ability of banks to extend credit to households - with some form of financial assets behind them, these uncorrupted consumers will be less likely to be scared by borrowing and spending.

There is another, slightly unrelated, reason why I am getting enthusiastic about Japan. As a colleague's teenage daughter recently pointed out to him - Japan has all of a sudden become "cool", while America has become decidedly "uncool". As an example, how many people have noticed the relatively recent appearance on the High Street of affordable Sushi restaurants such as Yo Sushi, Itsu etc. and Japanese fashion brands such as Muji? It is also striking to see the closure of many branches of American-branded shops such as Starbucks, GAP and Borders. There are likely to be spill-over effects over the next few years as Westerners come to view Japan as a more regular tourist destination.

So how can we capitalise on this? There is the obvious Long Yen trade, but that is likely to be noisy and the levels are perhaps not as great as they have been. But what is interesting to note, is the extent to which the (exporter-dominated) Nikkei has outperformed the (domestic company-dominated) Topix - a striking 10% since March, and the ratio of the two is now at its highest since 2000. To a certain extent this is a result of the momentum-based nature of the risky asset rally since March, but given the strong history of mean reversion in Japanese equities and what appears like a real desire by the Japanese to change their ways, looking for Topix outperformance seems like a great way to play this rebalancing.

Then again... the Japanese always disappoint...

Trust me, I don't Prefer you

Investors in Trust Preferred securities have had almost a rough a time as those that owned the Common Equity. As evidenced by the Citigroup conversion a few weeks ago, securities that looked like debt to the uninitiated have turned out to be equity-like. If you thought that was bad, spare a thought for the poor investors that bought Bradford & Bingley or Northern Rock subordinated debt who recently were defaulted on by the British Government.

Of course, at the back of their minds, the guys that bought sub-debt always *knew* that if they were being honest with themselves that they were taking equity-like risk. But when those banks were nationalised they thought they had a "get out of jail free" card.

But apparently not.

Fitch yesterday downgraded the subordinated debt of several UK and European banks, and the European Commission has already told Anglo Irish to defer payments on hybrid notes. The idea that subordinated debt & other low-placed elements of the capital structure will take losses has long been my opinion. As losses come through the system, the cack-handed way in which governments enacted their bail-out programs (especially the Americans) means that there is very little chance of them getting more money once the existing funds are drained, so creditors *will* take a hit.


The UK is way ahead of the pack on this one - guarantee the Senior Debt (which ensures that you can fund your Current Account deficit), but rightly hit those who took risk in trying to Arb you (as discussed above, those who bought sub-debt either knew the risks, or *should* have known the risks).


Obviously, the Trust Pfd conversion in Citi represented a large dilution - if a similar thing is going to happen in Europe, then there could be a rush for the door. Something of a shot across the bows (much like the rumours of a rights issue from Lloyds the other week).


But someone must be paying attention for ING's Preferreds to fall 26% yesterday...

TLGP and tail-risk in the financial system

On October 31st 2009 one of the most important parts of the crisis measures - the TLGP (Temporary Liquidity Guarantee Program) - expires unless the FDIC chooses to extend it. In the autumn, the failure of Lehman Brothers and Washington Mutual resulted in a wholesale run on the banking system that threatened Mellon-esque liquidation. This program allowed the financial system to once again fund itself, with the backing of the government.

Since April, the amount of debt outstanding in the program has not really increased much, and since the (Un)stress(ful) Test results, very few institutions have issued debt with a guarantee as risk appetite and very large retail flows into bond funds have hoovered up debt across the financial and non-financial universe. Not only that, but political considerations around the fall-out from TARP and a V-shaped recovery in Banker-pay have strongly discouraged banks from accessing such programs (as well as extricating themselves from the TARP). Further, the FDIC (under the incompetent Sheila Bair: http://brontecapital.blogspot.com/2008/11/why-sheila-bair-must-resign.html) appears to be losing the battle for regulatory power - as evidenced by Geithner's use of several expletives in a recent meeting discussing financial sector reform. In a nutshell, it appears highly unlikely that the program will be extended beyond October.

This is interesting, because the presence of this program removed the roll-over risk for the financing of bank balance sheets. If one has the view that this summer's risk rally has mainly been on the back of strong liquidity and easing financial conditions (as well as the turn in the industrial cycle), then the removal of the TLGP opens up an interesting possibility - tail risk in the financial sector is back. If (or when) the risk rally falters, presumably as a result of the inevitable realisation that a production-driven rebound is unsustainable without a recovery in consumption (which, as yesterday's retail sales data showed is not on the cards), then this risk grows significantly. The large overhang of Commercial Real Estate on commercial bank balance sheets threatens the return of roll-over risks and associated solvency fears.

So why am I writing about this?

What is really interesting is the extent to which Libor-OIS spreads have collapsed to about their average level of the last 20yrs (~25bps - see below chart). There is a consensus in the money market that these spreads will be permanently wider than they have been over the last 10yrs, but the exact level, nobody is sure of. For the record, I'd argue that the range should be 15-25bps, but closer to the top-end of that range. The thing is, the Fed's QE (and other liquidity operations) have dramatically increased the amount of cash in the banking system, so these spreads are being held artificially low at the moment due to the excess liquidity (recall, there are several components that make up the spread - two of which are liquidity conditions and credit risk premia).

We know that the Fed is very reluctant to increase QE further, and appears to be preparing the market for no extension in the amount of purchases in October, although some have suggested that they might pool the MBS & UST purchases instead. Either way, base money is unlikely to be increased significantly in the near term unless there is another financial or deflationary shock. Thus, the downward pressure on cash rates due to liquidity in the system is likely to be muted.

To conclude, with the TLGP gone, tail-risk in the financial sector is back, and should the risk rally falter, it is likely that with the absence of this backstop that bank-related credit spreads should widen. The December 2009 forward-starting Libor-OIS spread is currently 29bps, with about 4bps of that pertaining to the year-turn effect, and represents a very high risk-reward to play this theme.

Some charts to ponder

Presented without further comment.

Implied Oil Demand:

Coal waiting to be loaded offshore at Newcastle, Australia:
LA Port Inbound Containers:

Shanghai Container Throughput:

Taiwan Exports vs expectations:

Baltic Dry Index (down another 4.6% today to 2772):

Emerging Market ETF:
Shanghai Composite:

USDKRW:

USDMXN:

USDZAR:

...and finally... RBS:

Is the Bank of England leaving the building?

*BEAN: BOE WILL WITHDRAW STIMULUS IF CPI OUTLOOK OVERSHOOTS 2%

*BEAN: BOE WOULD LIKELY SELL ASSETS ONLY AFTER RATE RISE

*BEAN: BOE LIKELY TO RAISE RATE FIRST AS PART OF EXIT STRATEGY

With the inflation report out in a few weeks (12th August) it seems a bit odd to give such a specific criterium for the exit (which he explicitly says will be in the form of rate hikes). In their May inflation report, the central tendency for CPI was about 1.5%, and while this is quite a way from 2%, it's not hard to see this being revised significantly higher after the developments of the past few months. Commodity prices have risen significantly (Oil & Copper both +25% since the May report was prepared), the housing market & financial markets have stabilised (though these may turn out to be transitory developments), and the MPC have been repeatedly confronted by upside surprises to CPI. All of the above point to this risk.

It's not the first time that policymakers have opined on their exit strategies, but this is interesting in that it contains specific criteria for their enaction, and is in stark contrast to that of the Fed (whose argument centres around the (very large) output gap). The MPC have a history of their actions being guided by their inflation forecast, which being model driven is obviously far from perfect. Do I think they should raise rates? Definitely not - we are in a Balance Sheet Recession. But that is not the point. Do I think they will raise rates if their (imperfect) model suggests above-target inflation? Absolutely. And I think ignoring this subtle change in their communication strategy is dangerous, and if the inflation report does in fact show this, then Short Sterling will crater.

Positioning in short-end carry trades has once again built up to be quite significant, and while leveraged positions are generally not as big in the bond market as before the 1994 Bond Market Massacre, it is still easy to imagine a scenario where the Reds & Greens sell-off 100-200bps. In conclusion, I think you can sell Short Sterling both outright and against Euribor (a lower risk version of the trade that doesn't pay away as much carry, and Short Sterling will underperform in a sell-off).

Treasure the Treasury Bond

There has obviously been quite a lot of chat about whether there is a bond bubble, but much of this has focused on the supply side of the equation. Evidently, with trillion-dollar deficits in the US and the increasing fiscal costs of bank bail-outs in many Western countries, many are wary of the ability of governments to issue debt to fund these rescues, as witnessed with the dramatic widening in EMU bond spreads and sovereign CDS. But what about the demand side? Firstly, various implementations of the Taylor rule argue for a Fed Funds rate that is significantly negative. With the output gap being so wide there is a clear case that bonds are undervalued, and although extrapolating historical relationships is always risky, bond yields have traditionally not bottomed until the output gap has peaked, and the Fed has not begun tightening monetary policy until the Unemployment rate has peaked (there is certainly a political aspect to this). In such an environment, bonds are likely to be supported.

Secondly, in both the Great Depression and in Japan's Great Recession, the explosion of government deficits did not result in higher bond yields. And, of course, the question is "Why not?". For this, I highly recommend reading "The Holy Grail of Macroeconomics: Japan's Great Recession" (http://astore.amazon.co.uk/breakingviews-21/detail/0470823879) by Nomura's Richard Koo who is arguably the expert on all things to do with Balance Sheet recessions, and Japan's in particular. The basic crux of his argument is that when faced with weak or decimated balance sheets, the private sector ceases to maximise profit, and instead concentrates on paying down debt and repairing its balance sheet. Under such a scenario, private demand for credit collapses and, as a result, domestic credit contracts regardless of the monetary policy that the central bank follows (it does not matter what the cost of funds is if no-one wants to borrow them).

Textbook economics suggests that increases in the monetary base lead to increases in M2 and then to increases in domestic credit via the money multiplier. In the below chart of Japan's experiences, in the late 1980s these three measures grew in tandem until mid-1991 (white vertical line) when policy became too tight and monetary base shrunk and faced with the rising cost of borrowing in the bond market, corporates ramped up their borrowing from banks. When the BoJ finally began to ease, it was too late, and in late 1992 (red vertical line) corporate behaviour changed, and firms began to pay down debt as they realised that their balance sheets had been decimated, leading to a contraction of domestic credit (green line) which continued to shrink until 2005 despite the significant growth in the money supply under QE. Clearly, firms were not interested in borrowing, and thus the very large fiscal stimulae the government enacted throughout the stagnation did not result in inflationary pressure because there was no crowding out of the private sector. This also explains to some extent why QE was not particularly successful in stimulating investment. The corollary to this is that the private sector posted a financial surplus as debt was paid down, resulting in a net inflow of cash into the banking system. In the absense of demand for loans, the banks faced no alternative but to park the money in JGBs - the government was the only entity willing to borrow to invest, and thus was effectively funded by depositors.

And this is what I think is key for the US, UK etc. Rather than being primarily a corporate issue as in Japan (ok, households were also severely affected, but the main problem was corporates), the Western crisis is primarily a household balance sheet issue (in the aftermath of the DotCom bust, firms repaired their balance sheets and generally entered this downturn with reasonable interest coverage from earnings). Faced with negative equity (or the potential to be in negative equity) consumer credit has begun to fall, and with it, consumption has collapsed. The below chart shows the US equivalent of the above Japan chart. As is well-known, the Federal Reserve has ballooned its balance sheet (as illustrated by the jump in the monetary base - red line) and as a result, M2 has begun to accelerate too, but consumer credit (yellow line) has begun to fall as demand for credit from households is falling:The Fed's Senior Loan Officer survey is also showing evidence of this, and the recent credit crunch appears to have been masking this effect:

The credit boom induced commercial banks to reduce their share of holdings of US Treasuries to a record low, but as in past recessions, this fraction tends to increase naturally. However, with households on course to dramatically increase their savings rate and pay down debt, this financial surplus is ever more likely to end up parked in Treasuries. As the below chart suggests, there is no reason why Commercial bank holdings cannot increase to around 20% of outstanding public debt (c.f. China holds ~12%), which provides additional demand of over $1trn.
In conclusion, while there are likely to be occasions when the market gets excited about a turn-up in the data (and eventual recovery), until the output gap peaks, bonds are a buy on dips. The fiscal stimulus is likely to provide such a dip as Q2 GDP is likely to print ~2.5%, and lead the market to price in a false V-shaped recovery, similarly to last spring. Crucially, the above argument does *not* rely on Fed purchases of USTs to create incremental demand (as the market seems to have got itself into a tizz about) - the demand will come from commercial banks themselves.

EMU Bail-out?

Recent comments by German Finance Minister Steinbrueck (http://www.bloomberg.com/apps/news?pid=20601110&sid=ax0ZrocriLAI) have garnered some attention as yet another European-about-turn, suggesting that Germany and France may have to come to the assistance of EU nations in trouble. In recent weeks, EMU CDS and Bond spreads have blown out significantly, to the point that Ireland 5yr CDS (at 400bps) now prices a Cumulative Default Rate of around 20%. Ireland's poor domestic fundamentals are well-known.

I have heard many anecdotes that trading in Western Sovereign CDS has exploded over the past few weeks as Macro hedge funds have jumped onto these trades, which are effectively like a synthetic run on a currency (if these countries had their own currency, that is). It reminds me a lot of the moves in Bank/Broker CDS in March 2008 as hedge funds forced a run on Bear Stearns, and immediately after began to target other banks (e.g Lehman, Merrill etc) after the bondholders were protected but equity holders were effectively wiped out. Government actions effectively provided hedge funds with a precedent, so they jumped onto the next victims.

I bring this up, because I think it is increasingly likely that Ireland will be bailed out, one way or another, in the very near future (possibly as early as this weekend) - even though the Sovereign CDS market is extremely illiquid and probably not a "real" gauge of the market's view of peripheral countries' strength, it is creating such a perception - amplified by media reporting - and has also translated into wider government bond spreads in the cash market. Such actions can demonstrably change the behaviour of both individuals and the market as a whole, forcing the issue and demanding a policy response. I believe that we have reached such a point that action needs to be taken, and Steinbreuck's comments suggest that EU policymakers agree.

Such action is likely to be merely symbolic, at least initially, perhaps involving the Bundesbank being directed to purchase a token amount of Irish Government Bonds in the open market. The problem with this - as seen with the Fed's purchases of MBS - is that to be credible, "significant" amounts of bonds needs to be purchased. However, with the Germans implicitly backing Irish sovereign debt, it is likely that there will be a rush for the door in the CDS market (similar to that in the aftermath of the sale of Bear Stearns). But with a precedent set that Germany will bail-out peripheral EMU nations, the market will begin to gun for other countries, likely targeting Spain, Austria, Italy et al. The obvious question is "where does it end?". There are German elections this year, and given the hardened public opposition to even domestic bail-outs or fiscal stimulus, it seems extremely unlikely that such a move (or succession, thereof) would be tolerated, and inevitable that this becomes a serious political issue.

Secondly, how should we trade such an announcement? The market is well aware of the above (and this is, in part, one of the reasons why the Euro has been under pressure of late), and will likely question the sustainability of such a bail-out policy, and consequently, the existance of the single unit itself. So sell the Euro on the announcement. But what about the adjustments required to regain competitiveness? The below chart shows a few REERs of EMU countries (based upon labour costs) relative to the Eurozone as a whole vs the levels at which they entered the Euro. I couldn't be bothered to do seasonal adjustments, but you can still see the broad trends: the ESP is about 35% overvalued relative to the DEM, the IEP is about 40% overvalued relative to the DEM and interestingly (and contrary to common wisdom), the ITL is about fairly valued with respect to the DEM.

There are some significant misalignments that clearly have to be rectified one way or another to reduce the magnitude of the area's current account deficits (Spain's is as large as 10% of GDP!). Specifically, the likelyhood of leaving the Euro is extremely low - even if the FX market begins to price in this probability - so this adjustment cannot be gained externally via default & depreciation. In which case, the domestic economies must undergo deflation in a similar manner to Latvia (which appears so far to be maintaining its peg to the Euro relatively credibly), which means that growth is going to crushed, making such trades as long DAX vs short IBEX potential winners (the spike in the chart below was the VW/Porsche hedge fund squeeze). Of course, policies designed to ensure fiscal restraint and crush domestic consumption are likely to result in significant social unrest (as we have already seen in Greece), and is likely to add to market fears.

Is the Pound Sound?

I've been meaning to write this for a while now and have finally gotten around to it...

It's very easy to make a case to be short the Pound. The UK runs a Current Account deficit that has been primarily financed by European and Asian purchases of MBS which facilitated the housing boom. Now, however, the housing market is imploding, with many commentators forecasting a 35% peak-to-trough drop. The banking system is on its knees, with net bank lending contracting and mortgage approvals having fallen to historic lows. Moreover, Finance contributes a massive amount to GDP. Goverment capital injections and loan guarantees have failed to restart these markets as the banks concentrate on repairing their balance sheets, and worse still, the market fears that some (e.g. RBS) are "too big to be bailed out". Total external debt sits at multiples of GDP, making the country look like Iceland. Meanwhile, UK policymakers have panicked, with the Bank of England abandoning its moral hazard stance and dramatically slashing rates on its way to Quantitative Easing, while the Labour Government, acting on Gordon Brown's desperation to "win the election no matter what the cost", has unveiled ridiculous measures such as the 2.5% VAT cut. Such a borrow and spend mentality will saddle an entire generation with debt, and worse still, the international debt markets may decide to stop buying UK Gilts. Such an outcome would undoubtably result in another visit to the IMF, accompanied by a sharp devaluation, fiscal austerity and a dramtic fall in the standard of living (check out the 1976 application and behind-the-scenes events here (http://www.bankofengland.co.uk/publications/foi/disc060519.htm), recently released under the 30yr rule). Clearly the "correct" value for the Pound must be $1.00 and EUR 1.00?

Certainly, with such seemingly incompetent policymakers (though perhaps not as incompetent as those about to leave the US Treasury), the budget deficit set to balloon, and the banking system's external liabilities (relative to the size of the economy) being worse than any country save for Switzerland, the outlook for both the UK and its currency does not seem particularly promising. But it's not actually that difficult to make a case for buying the Pound. Actually, many of the above claims are, in fact, incorrect. A common occurance in financial markets is that a claim is made without recourse to the data and is mentioned so often that it becomes an accepted fact, shaping the outlook for prices and behaviour (George Soros's Reflexivity). For example, it is often asserted that the Financial sector contributes to about 25% to GDP and as a result, the UK is especially vulnerable to the ongoing crisis, but according the ONS National Accounts: Blue Book (http://www.statistics.gov.uk/downloads/theme_economy/BB08.pdf) the Gross Value Added by Financial Intermediation is in fact just SEVEN PERCENT, making it less important than Manufacturing (14%). Secondly, whilst UK banks' FX liabilities are extremely large, such statistics must be taken with a pinch of salt given the The City's role as one of the top international financial centres, which often serves to distort the data and provide inaccurate picture of the actual position (e.g. the 2005 reclassification of UK holdings of USTs to those held by foreign central banks and Middle Eastern investors).

Next, it's not actually obvious that UK Government debt is spiralling out of control, but the media (who love a good scare-mongering story) have repeatedly reported that it is. Much of this is an accounting question: how should the ONS account for the very large amount of contingent liabilities that the Treasury has taken on board as a result of the nationalisation of Northern Rock, the interbank loan guarantees and its explicit support for systemically important banks. Firstly, Northern Rock is also an asset that sits on the government's balance sheet to offset the liability that the ONS included in the official debt statistics (along with borrowing related to the Bank of England's Special Liquidity Scheme [SLS]), helping to send the level of public debt to 42.6% of GDP from 36% before the financial crisis hit (the most recent number, which includes other borrowing announced since the crisis started - e.g. for the fiscal stimulus and for the purchases of bank preferred equity - is 44.2%). But on the asset side of Northern Rock's balance sheet sit a great many mortgage loans, many of which will go bad. However, the vast majority will not. But if, for the sake of argument, we assume a blanket 35% loss on these assets (using the 35% peak-to-trough house price fall as a proxy), then the £55bn entry in the public sector debt accounts that covers this really is only a liability of about £19bn, lowering the effective public debt number from 44.2% to 41.7% of GDP.

Secondly, the borrowing embarked upon to fund the SLS is also not really a significant liability for the taxpayer because these Gilts are used as substitute for the Repo market for MBS (the BoE lends Gilts to the banks, taking MBS as collateral). Given that losses on this collateral will be taken by the banks (rather than the BoE) over time, and that systemically important banks are not being allowed to fail, it is not possible for a bank failure to trap these Gilts in the same manner as occured when Lehman Brothers International Europe entered Administration and leave the BoE with a capital loss on that collateral. Thus, subtracting this entry from the accounts, public sector debt falls to just 37.8% of GDP. As a comparison, when the UK was forced to seek an IMF bail-out in 1976, this measure stood at 54%. This also compares favourably with other countries: Germany (65.1%), France (66.1%), Italy (106%), Japan (195%) and the US (43%) - [note that the oft-cited public sector pension deficit issue is a global phenonemon, so the net effect of this issue, as far as currencies are concerned, can be discounted]. Admittedly, tax receipts will continue to fall as the recession deepens, weakening the fiscal balance, but this will also occur globally. Thus, the UK's fiscal situation, when compared with both previous debt problems in the 1970s and the rest of the world, is clearly not a catastrophe and there is significant room to borrow to provide much-need fiscal stimulae.

Thirdly, the UK Current Account has narrowed significantly, from a peak of over 4% to 2.1% of GDP. As the below chart illustrates, the UK C/A deficit is a symptom of the fact that the housing boom was primarily financed by European & Asian purchases of UK RMBS - the yellow line is the ratio of UK Halifax House Price Index to Average Earnings to give a measure of house price affordability. The white line is the yellow line scaled by EUR/GBP to give a measure of external house price affordability (i.e. how cheap is it for foreigners to buy UK housing assets), and the red line is the Current Account deficit as a %age of GDP. Much of this adjustment has been borne by an increase in domestic savings (net Mortgage Equity withdrawl has been negative for the past two quarters now) and a rapid and large fall in the exchange rate. Clearly this chart shows that UK housing affordability has now undergone a significant adjustment domestically (but has a way to go), however, *externally* it has fallen to the cheapest levels since the mid-1990s. Anyone who has been shopping on Oxford Street can testify that there are lots and lots of Europeans in most of the shops (especially the high-end stores) and crucially, they all seem to have shopping bags. The media reports of long queues on the motorway from Dublin to Belfast as Irish shoppers picked up bargins across the border are also well-known. A friend recently visiting a French supermarket remarked that even Champagne is now cheaper in UK supermarkets (where it is subject to heavy taxation) than in (untaxed) France. These factors have been affecting the UK Retail Sales data, which has consistently beaten analyst expectations as Europeans have taken advantage of how easy it is to travel here (thanks to Easyjet et al. and the Channel Tunnel) and arbitrage the 24% PPP-deviation.

Fourthly, according to the Bank of England, the UK's REER has fallen 30% since the crisis began in August 2007 - that is roughly the same adjustment bourne in 1931 when the Gold Standard was abandoned. The gain in competitiveness is very significant for the UK's eventual recovery - the external accounts are heading for balance and there has been little protestation from our trading partners. But the reaility is that the current level of the exchange rate is unsustainable for many European companies - I have heard of several medium-sized companies that are in such dire straits that they are being forced to pass on price rises of 6-9% purely to their UK customers as well as anecdotes of medium & high-end computing equipment prices jumping by similar amounts. I have also heard chatter that German & Japanese auto companies are seriously considering moving plant production to the UK.

Finally, the Bank of England prepared a report "UK export performance by industry" in its 2006Q3 Quarterly Bulletin (http://www.bankofengland.co.uk/publications/quarterlybulletin/qb060303.pdf} which attempts to quantify the response of exports to changes in relative export prices by export sector. Particularly interesting is that the sectors in which the UK can be described as "World Class" (i.e. those sectors in which it possesses a high share of world exports) appear to be those that respond extremely positively to an increase in price competitiveness. Specifically, Medical & Pharmaceuticals (15.3% export share, main competitors: US (16.1%), Switzerland (15.2%) and the Eurozone (33.4%)), Office Machinery & Computing equipment (11.8%, vs US (27%), Eurozone (18.5%), and Japan (22.8%)) and Communications (9.1%, vs US (17.6%), Eurozone (14.2%), and Japan (23.1%)). This study found that a 1% change in relative export prices raises exports by 2.2%, 0.5% and 1.9% respectively for these sectors. The first of these, is a non-discretionary sector and therefore is less vulnerable to the global slowdown, while the latter two are sectors that will play a part in the recovery as business fixed investment which (stagnated in the post-DotCom bubble world) is likely to an area invested in both by governments in fiscal spending and by corporates upgrading obselete equipment as the recovery gets underway.

The above all imply that the UK is in a much better position than the consensus currently believes, and crucially, it has a source of future potential demand (via increases in the market share of industries that are either recession-proof or important to the eventual recovery). The fiscal position does not preclude the government from easing policy and the importance of financial intermediation and liabilities of the banking system are exaggerated. At such unprecedented levels of under-valuation, clearly changing fundamentals (as Europe faces its own recession) and a much stronger techincal picture (the MACD is signaling a "Sell" signal for EUR/GBP and it has broken down through the 23.6% Fibonacci retracement of the move up from October to December) maybe it's time to buy some Sterling?

P.S. - Happy New Year!