Wednesday, August 31, 2011

Bernanke's silence provokes market thunder, Lagardes thunder provokes market silence.

My mother used to tell me that if you can't say anything nice then don't say anything at all. I wonder if that aphorism might not have been going through the mind of Ben Bernanke as he wrote the speech which he delivered in Jackson Hole on Friday. In his much anticipated speech Bernanke did not announce any new policy measures. Indeed, he was at pains to point out the limits of monetary policy. In his public statement Bernanke is always extremely cautious about getting involved in policy debates, particularly policy debates which are the responsibility of the US Congress. In his most recent testimony, which happened to be during the recent bitter budget debate, each side tried to corner him into supporting their position and he simply refused to take a side. His actual words were: “I'm not going to tell you what to do, that's your job to decide. That's why you get paid the big bucks.” I love this guy. So for a man so careful not to get into the business of Congress the closest he can get to taking a shot at them is to simply describe the limits of his own power which was the main point of his speech.

He did point out that the recovery was very weak and that there are serious problems in the real economy that need to be addressed with long term policy. Precisely the kind of policy which Congress seems totally incapable of producing. When the markets read this part of the speech, they dove. But then, interestingly for a speech which was primarily about how little the Fed can do, Bernanke also mentioned that the next Fed meeting would last an extra day. Wait a minute? An extra day? Why whatever for, you've just got done telling us that there is little the Fed can do to address the long term structural problems facing the economy. Hmmm.... Perhaps that means you're going to be thinking extra hard about what policy options you have RIGHT NOW while we wait for Congress to sort itself out. Then the conventional wisdom became that the Fed would take some kind of action and the markets have been screaming higher ever since.

The market rocketship got even more fuel when the minutes of the Fed meeting were released on Tuesday. If you recall at the last Fed meeting the policy announcement was that the Fed would keep interest rates at the current low levels until mid 2013, that is they put a date to their “extended period” language. When the Fed releases its decision it also discloses how many of them agreed with the policy and how many dissented. It does not, however, say WHY they dissented until the minutes are released. At the time, I thought the dissenters were more Hawkish about inflation and therefore thought that the easing was unnecessary. I could not have been more wrong. One of the dissenters did not like the nature of the signaling. He felt that the The other dissenters dissented not because they thought monetary stimulus was unnecessary but that the structural factors in the economy were so severe that it might not even do any good and but would contribute to inflation. It was pretty grim.

Strangely this has put the markets in an unusual position. Since mid-summer the markets have come off quite a lot. The decline has been driven by concerns about Europe, the budget debate, the and the downgrade. It has also been driven by negative economic data. The markets are now at a level where the news has a sort of goldilocks aspect to it. If the data shows the economy is strengthening then the markets will think earnings will be better and the stocks should be higher. If the data is bad then the Fed will be painted into a corner by the time of its two day meeting in September and will likely easy monetary policy further in some creative way. Thus the markets have the same response to good news and bad: they go up. So, Bernanke did not say too much but the markets have heard plenty.

At the same time they seem to be ignoring something else, in particular a quite shocking speech given by Christine Lagarde the new head of the IMF. The speech was especially shocking to be because of an argument I got into a few years ago at a University of Chicago alumni event. The event was a talk by a noted Chicago alum about the financial crisis and the role of the state in it. It was an enlightening talk and the Q&A session led to a lively debate. The debate turned to the subject of what the government could have done to forestall the crisis. A man in the front of the room who was extremely critical of the government generally and the Fed in particular said that obviously the thing to have done was to have the Fed order the banks to raise capital in the summer of 2008. The problem by then was clearly one of solvency, not liquidity, that is to say the the problem was not a short term cash crunch but that the banks did not have enough capital to absorb the losses they would take when the sub-prime writedowns had to be taken.

I could see why the man felt this was a good idea but I thought it was totally impractical. I stood up and argued that if the Federal Government announced to the world that the US banking system was in such deep trouble, and indeed it was not possible at the time to know precisely how deep, that it needed a massive infusion of capital that the capital would not be forthcoming. I felt this way because I remember working in the middle east at the time and watching as a parade of US banks sought out capital infusions from wealthy Arabs and sovereign wealth funds. By the summer of 2008, investor appetite for additional bank capital infusions had waned substantially. My argument was that while it would have been desirable for the banks to recapitalize, no one in their right mind would have put their money into a bank if the banks own regulators were so concerned about its solvency that it was being forced to raise capital.

The man at the front of the room turned around and gave me a look of death, he was obviously not someone used to being argued with, and said “Well, they did all raise capital eventually didn't they.” Smug smile. To which I replied: “Yes, from the taxpayers! And the taxpayers only contributed to it because you go to jail if you don't pay your taxes!”

Well this story has two surprise endings. First the man at the front of the room was Cliff Assness the billionaire founder of hedge fund AQR. For the record, I am not a billionaire. The second is that this past weekend, Christine Lagarde, the head of the IMF called for the European banks to be forced to raise capital. In my opinion this is by far the most important thing to come out of the Jackson Hole conference. Far more important than the non-comments by Bernanke. I would even go so far as to say, that, if the speculative attack on the Eurozone is renewed and is successful, people will be talking about this speech for years to come and Christine Lagarde will become a very important historical figure for being ahead of the curve. The response of the ECB and the EU was to deny that this was necessary and the markets have been listening far more to what Bernanke has not said than to what Lagarde did say.

They should listen more closely. More than anything else what has driven the markets lower this summer is the fear that a major fiscal problem is brewing. The US downgrade is part of this but while this is embarrassing for the US it is potentially fatal for Europe. What the markets are afraid of is that the once the ECB is done with its bond purchases, the speculative attack will resume and it will ultimately succeed in bringing down a European sovereign. If this happens there is going to be an ABSOLUTELY MASSIVE banking crisis in Europe. This is because the Eurozone has created a continental market for banks but, because the ECB is has no taxing power, any attempt at a TARP like bank rescue would have to be funded by individual countries. The problem here is that because they operate across the entire Eurozone the banks are MUCH MUCH larger than the countries which would have to rescue them.

In the US the balance sheets of the top 3 banks are about 60% of US GDP. In France, the balance sheets of the top three banks are 600% of GDP. That's right, the top three banks have assets outstanding equal to six times the size of the French GDP. Remember the TARP? That was 5% of US GDP. It was a big number but the US could borrow it. Now imagine a world in which Spain has gone bankrupt and the French banking system is on the verge of collapse so France decides to implement its own TARP, it would have to be 50% of GDP, or put another way, France would have to instantly borrow as much money as it has in the past fifteen years combined. Do you think there is any chance that this would actually happen? No there is not. What would happen is that those banks would fail and would therefore wipe out the savings of their depositors as well as damage any banks to which they owed money. Keep in mind this is not just France, this is the case in every country. So if there is a major sovereign default the European banking system cannot be saved.

Christine Lagarde's idea is to get in front of this and force the European banks to raise more capital from private sources before the storm breaks so that they have a better chance of weathering it. I take my hat off to her for raising it. That said, as was the case with Cliff Asness, I don't think it can be done though for different reasons. The reason that in 2008 the banks could not be recapitalized in practice was that though there was enough money to do it, no one knew what precisely the scale of the problem was. In this case, we do know what the scale of the problem is but not only is there not enough money in practice to do it, there's not enough money even in theory.

Thursday, August 25, 2011

Do you think Ron Paul, Michelle Bachmann, and Rick Perry are idiots? Would you like to bet on it? Tomorrow is your lucky day.

Since my last post there has been quite a bit of excitement in the markets. The S&P 500 has had about a 10% range and has been moving at least a percent a day, often much more. Given these massive moves its hard to ascribe a lot of meaning to the market action on any given day. That said I think fundamentally three things are at work. One, is that the markets are still getting used to the idea that there is no risk free rate. This is a complicated fact for the markets to absorb given how much portfolio theory and how many pricing models rely on this assumption. That said, its a very subtle impact and the markets seem to have adjusted by fleeing relatively risky assets and piling into relatively less risky ones.

The second story is the Eurozone crisis. Though the ECB has, for the time being, successfully pushed back a speculative attack on Italy and the attack on France in light of the US downgrade has also receded most investors are aware that there remain very deep and vexing problems in the Eurozone. Though many of the consequences of a sovereign default of a major country are unknown they would almost certainly lead to a major banking crisis which would be nearly impossible to contain. Though the markets don't know what the probability of this is they know the consequences are very very bad and this fact is weighing heavily on the markets. More on this in subsequent posts.

What optimism there is stems from two things. One is the hope that though the economy is slowing down the market reaction has been overdone and that the economy and with it the markets will pick up, of on their own in the second half. The other reason, and according to some pundits, by far the stronger, is the idea that the Federal Reserve is going to ride to the rescue. This is because Ben Bernanke is set to give a speech in Jackson Hole at the Kansas City Fed conference of Central Bankers on Friday. It was at this conference a year ago that Ben Bernanke announced that he was embarking on a second round of quantitative easing, or as it has been affectionately called: QE2.

Now the Quantitative Easing policy has been controversial to say the least. Where you stand on this controversy will say a lot about whether you think Bernanke will announce further easing on Friday. Virtually all of the Republican Presidential candidates have come out against Quantitative Easing. Just last week Rick Perry called the policy “treasonous.” Ron Paul, who has made himself heard on this subject repeatedly not only opposes Quantitative Easing but the entire Federal Reserve System and, for good measure, the whole concept of fiat money. Naturally someone who believes that we should return to the gold standard is not going to be a fan of creating reserves in the banking system and using them to purchase Treasury bonds with them. Michelle Bachman has also come out against Quantitative Easing though, if you ask me, not with a particularly coherent objection. It may be silly to call a monetary policy tool “treasonous” but at least you know where the guy stands even if his reasoning can best be called “obscure.”

It is worth taking a look at the arguments that these men and other opponents of QE make because, whether you agree with them generally or not, there are indeed good arguments to be made against it. Opponents of QE have two main objections. The first is that QE is an enabler of government profligacy. That is to say that the fact that the Federal Reserve is creating reserves (printing money) in the banking system and using those reserves to purchase US government securities is creating artificial demand for those securities and as a result is lowering the cost of borrowing for the government. This of course just encourages the government to borrow more than it would otherwise. While it is true that QE does marginally lower the rates at which the government borrows it is not clear to me that it follows that this creates more borrowing. The level of government borrowing is a function of the budget process which is well in the hands of congress and I don't think that the level of interest rates has been of much concern to Congress with regard to those decisions for at least a decade. In any case, even without QE interest rates are at a level which would be unlikely to deter borrowing anyway so I think this is a weak argument.

A more compelling argument is that money creation is well known to be inflationary. Historically countries which have found themselves creating money in order to finance public spending often fall into an inflationary spiral which often has devastating consequences for the country. This is because the artificial creation of money in the hands of the state tends to devalue all the real goods and services in the economy in terms of that currency. That the more money there is the lower its value in terms of actual goods and services and therefore the price of everything goes up. This erodes the savings of the thrifty and devalues the debts of the levered. It also causes massive dislocations in the economy generally. Latin America is littered with examples of this and the recent example of Zimbabwe going over the hyperinflation cliff has once again served as a warning to the world. Of course the most politically momentous monetization of government obligations occurred in Germany in 1922. The subsequent hyperinflation obliterated and then radicalized the German middle class and laid the groundwork for the capture of the state by the Nazi party. So to say the least, the historical record for debt monetization (printing money to finance government spending) is not great.

So the Tea Party guys are not crazy to raise objections to quantitative easing. Given that they think the primary motivation behind it is to facilitate additional government stimulus when the economy slows down it is not hard to imagine why they might think that a fresh wave of it is on the way. GDP growth has been much slower than planned, consumer sentiment is weakening and many economic indicators have come in much weaker than expected or hoped. A few weeks back the Fed revealed that its outlook for the economy has darkened significantly and announced that it would maintain its extremely low interest rate policy through 2013. Given this, it is easy to see why many people expect some kind of announcement of further policy action by the Fed come this Friday and since they hate the idea they are up in arms. On the other hand, stocks are priced in dollars and so, in the event that the Fed announces QE3, their prices are likely to rise which is why many think we have come off the bottom despite continuously grim economic data.

Personally I have a different view of this. While I am not a fan of printing money generally and I am very aware of the historical record I think that, at least in the hands of Ben Bernanke, Quantitative Easing is not to be feared. The reason is that Bernanke had a very specific reason for engaging in QE last year that had nothing to do with a desire to fund the US Treasury more cheaply. The thing to remember is that just as money can be created it can also be destroyed and what Bernanke was doing was making up for monetary destruction.

As mentioned the Federal Reserve Bank creates money through quantitative easing but because the US banking system is a “fractional reserve” banking system the commercial banks are able to create money as well in the course of taking in deposits and making loans. This is because they are only required to hold some of their deposits in reserve (ergo “fractional reserve.”) This is why banks are able to operate with such extraordinary leverage. Banks are also required to have an adequate equity capital cushion in the event of losses so that the equity holders take the losses before the depositors do.

The trouble is when banks take a large losses over a short span of time as they did during 2008 they erode that equity cushion and this means. Since the equity cushion has to be repaired before banks can engage in new money creation large losses shrink the money supply. This is why the Fed embarked on QE1. So the collapse in housing prices has forced the banks to take recognize huge losses on their balance sheets but, as large as those losses are, the markets believe (and are probably right) that there are still far more losses yet to be taken. A year ago this fear and the weakening of the US economy led people to believe that there would be so much monetary destruction that there in the future not only would we not have inflation, we would have its opposite, deflation. Now, as bad as Ron Paul and Rick Perry think inflation is, the thing that scares the hell out of Ben Bernanke is deflation.

This is a little counterintuitive. It's easy to see why inflation is bad, if you want to buy something and the prices are always going up and going up fast its easy to see how this harms you. On the surface it seems that a world in which the prices of everything were always going down would be good, everything is always cheaper so one can buy more of it with the same funds, everybody wins no? No. The thing about deflation is that it doesn't so much function as a permanent sale but as a permanent deterrent to every buying anything. Imagine if everything in the world was always getting cheaper, then you would only buy the things you absolutely needed right now and you would defer all other purchases. Deflation is a HUGE buzz-kill for economic activity. Not to mention that it has the effect of obliterating the solvency of large debtors and the US government is the largest debtor on Earth.

So, seeing deflation on the way last year Ben Bernanke warmed up the printing presses and launched QE2. This sent the stock market higher and whipped cured the deflation problem well and proper. So here we are in the future and not only is there no expectation of deflation, people are concerned about inflation. If the Fed were to engage in Quantitative Easing right now the fears of Ron Paul and Rick Perry and the hopes of the stock market would be fulfilled. This is what gives you an opportunity to bet against Ron Paul and Rick Perry. If you think Ben Bernanke is just part of a nefarious plot to load up the country with debt then you'll probably think he'll embark on QE3 tomorrow and if you do think that you should buy the markets with both hands. If you think that Paul and Perry are all wet and there's no way that Bernanke will do any such thing then you might want to be short going into Bernanke's speech tomorrow. Well, Bernanke speaks at 10AM New York time tomorrow so you'll have 30 minutes to place your bets.

Wednesday, August 10, 2011

What do Rowan Atkinson's MacLaren F1 and Bernanke's Equity Rally have in common? I'll give you one guess.

Whoa, I guess I was more right than I thought with my article about how yesterdays rally might be short lived. This was on account of a renewed speculative attack in the Eurozone this time focused on France. I hope to publish on this sometime before midnight tonight. Sorry for the brevity, this is an interim post.

Forthcoming Post: The Return of the Bond Vigilantes

Thank you friend reader for your unseen but ever-felt presence.


Before I talk about yesterday's action I want to tell you a story.

Back in September of 2007 I was the Global Head of Business Development for what I will call “a large foreign bank.” It sounds impressive but in essence I was “Mr. Fixit” for the guy who ran equities. The thing that needed fixing most at the time was the DIFX, a stock exchange in Dubai owned by one of the largest shareholders in the firm I worked for. MENA was covered by the Emerging Markets group and so whenever I was in London or New York I hung out with the EM guys. We were in the middle of what we knew was likely to be the best bonus year in the history of Wall Street. 2006 had been outstanding and 2007 was blowing it away. Given the events of 2008, it's easy to think of the summer of 2007 as a kind of idyllic past, like June of 1914 or August 1939 and in truth, it was. Of course it didn't seem that way at the time. The trouble in the real estate markets had already begun. Though people were still thinking of how to spend their bonuses, I was contemplating a certain watch at the time, people were getting the sense that the gig was up.

I like to think that the financial crisis officially began on my birthday. On June 7th, 2007 Bear Stearns halted redemption from its High-Grade Structured Credit Strategies Enhanced Leverage Fund. That fund would be wiped out entirely in less than six weeks and in the first week of July S&P put 600 subprime ABS on negative watch. Then in August American Home went bust, and in September the Bank of England halted a run on Northern Rock, the first bank run in England in over a century. People were starting to freak out and the markets started to sell off. The S&P 500 fell from about about 1550 to an intraday low of 1370 in a week and a half, which given recent events, may not seem like much, but considering that it took the market the whole of 2006 to go up 140 points it felt like a big scary move at the time. People were scared, a friend of mine in New York called me at 3AM Dubai time and told me about a meeting he had with our firms asset backed credit traders about the default cascade that could be initiated by the seizing up of the credit markets that caused me to ring up my parents and suggest they move their retirement savings to cash. It was that kind of scary.

Then as now, all eyes were on the government especially after the Northern Rock fiasco in the UK. The Fed had come out and said it would ensure the liquidity of the banking system (back then it still seemed like a liquidity issue rather than a solvency issue) but took no action. Then on September 18th, the Federal Reserve cut the Fed Funds rate from 5.25% to 4.75%. Whoa! 50 basis points in a day? Hallelujha! Daddy Bernanke is home he's gonna make it all right. The markets positively screamed. The S&P jumped 50 points in a single day, think about it, six months of price action in 2006 in a day! Woo Hoo! Happy days are here again, we're all going to get paid after all. Pop the champagne!

I remember September 18th 2007 very clearly. At the time I was commuting between London, New York and Dubai and I had been spending the past week and a half in London putting things together for an IPO we were doing in Dubai so I was sitting in my desk on the EM trading desk. Even though I was a management person I always felt more comfortable on a trading desk. I'm sure it annoyed all the actual traders to have an ex-trader management guy on the dest but nostalgia is a powerful drug, sitting on the desk allowed me to relive my youth. At the time I considered myself an old salt, having traded through the Russian default crisis, the LTCM collapse, the internet boom and bust, September 11th. In a young mans business at 34 I was a seasoned veteran. The guys on the desk were on edge because the VIX, an index of volatility, had popped from 18 to 36 in a day. I could remember a time when it stayed above 40 for months at a time. Yep, I had seen it all (rueful smile.)

All that summer I had been telling people that things felt a lot like they did in 1998 during the Russian Default Crisis and the LTCM debacle. The internet collapse was different, everyone knew it had to happen they just didn't know how far it would fall. In the summer of 2007, unexpected things were happening all the time and people were generally worried. They knew there was a problem and though they did not know how big it was, they knew they did not know. Then on September 18th, something that seemed normal happened, the Fed jumped in with an aggressive rate cut and language saying they would supply all the liquidity necessary and the markets absolutely screamed higher. I stayed in the office through the New York close, 9PM in London watching the markets rally. My eyes were popping out of my head. At the end of it the guys and I were just staring at the screens dumbfounded. Knowing what we knew about how deep a mess the markets were in, we simply could not believe the size of the rally but there it was, mocking our “knowledge.”

After the bell rang in the US I stood up and shouted to the trading desk, “Boy, what a relief! I'm sure glad the crisis is over.” The desk erupted in laughter because, in our heart of hearts and no matter what the screens said, we knew it had just begun. Indeed, two weeks later the S&P touched 1575, its all time high and then things came apart at high speed from then on.

I tell this story not to compare recent events in the markets and the Great Crash of 2008. There are a lot of comparisons between the two being made now but I think it best to defer to the principle of Heraclitus: a man never crosses the same river twice because the river is different, and so is the man.

Instead I tell it as a warning of how difficult it is to interpret market moves, especially extremely violent one as we have had these past two days. Monday was had an extremely violent crash that got relentlessly more violent with every bit of news that came out culminating in a vertiginous plunge that began during Obama's remarks. This seemed to present a straightforward vote of no confidence by the markets ini risk assets generally and in the will of the American political system to address itself to the most serious challenge that the Republic has faced in a long while.

Yesterday, the day began with a relief rally that gathered steam until about noon and then lost steam, trading back down to flat into the moments before the Federal Reserve Statement. The Fed Statement was, in a word, grim. First of all, it acknowledged that the economy was slowing appreciably which is most certainly is. It also acknowledged that the slowness is not merely the result of supply chain disruptions from the Japanese earthquake and pressure on consumer spending driven by commodity spikes which are traceable to political events in the Middle East and therefore temporary. It also mentioned that though long term inflation expectations were stable short term inflation had indeed risen from the beginning of the year. This is key because the markets have been cheering for a resumption of Quantitative Easing, something which cannot happen unless long term inflation expectations diminish substantially.

Instead of announcing QE3 then the Fed announced went a bit further in the direction of defining what precisely it meant by “an extended period.” The Fed has been using that phrase for some time to describe how long they plan to maintain their easing stance. They do this to try to give reassurance and yet provide some ambiguity within which the markets can adjust. Yesterday they said that they intended to maintain the current stance until mid 2013. In economic terms that's a REALLY long time. Interestingly there were also 3 dissensions from the policy statement. Meaning that almost half the Board did not agree with the statement. We don't know why they objected, they might have been against the continued easing or simply against the idea of the Fed telegraphing its intentions for so far in advance.

Personally I read this as the Fed being seriously concerned that the economy is slowing, that fiscal stimulus had not only failed but, given the deficit issues the country faces, unlikely to be attempted at least unless and until the 2012 elections provide a meaningful mandate one way or the other. The Fed also recognizes that in the current environment commodity prices have been high for a persistent period and are therefore beginning to be priced into final products and being transmitted into core inflation. This is a major challenge for them because it means they cannot engage in Quantitative Easing without seriously stoking inflation. So they're making the best of a bad position and telling people that though the Fed won't be growing its balance sheet, it also won't be shrinking it any time soon either and you don't have to worry about increases in interest rates for years. As I said, it was grim.

It was actually pretty hard for the markets to digest. The first thing they did was to read the economic prognosis and note the lack of QE and the high level of dissent and dive for the deck. The S&P dropped about 20 points to 1100 or so, down 50 points form the high of the day. Treasuries rallied hard and gold, which was already higher on the day jumped another $30. Actually I think I should just stop commenting on gold, just assume that whatever happens, gold is up $30. OK?

Then something interesting happened. The market turned on a dime and leapt higher by 4%, hung out near the highs of the morning, and then in the last 30 minutes of the day screamed higher by another 3% giving the day almost an 8% range. I think would be fair to call what happened an “Up-Crash.” Do not pass go, do not collect $200 go straight to the moon, the devil take the hindmost and for good measure let's crush the hell out of any lingering short sellers who will panic and get out because they know Asia will follow this rally. The rally was so strong it basically brought us back to where the equity markets opened before the S&P conference call and the Obama statement of the day before. It was as if none of the bad news ever happened.

As an observer its actually pretty hard to know what exactly happened in the last hour of trading. Maybe the markets thought that keeping the balance sheet high and maintaining Fed Funds at Zero through 2013 was likely to provide a similar level of monetary stimulus to QE and so they jammed higher on a sense of renewed monetary easing. Maybe but if that's what happened then its pretty hard to explain why in the last hour of trading gold dropped $40 in the same period of time. At the same time US Treasuries fell out of bed as well.

Yes, it is extremely hard to explain which is why I draw your attention to the rally in September of 2007. Yesterday was an up-crash: a panic rout of buying just as frenzied as the panic rout of selling the day before. It is extremely hard to discern what this means about the future direction of markets. It does speak volumes about the level of uncertainty in the markets that they from day to day they cannot agree as to what the total value of US productive capacity is to the nearest trillion. In the final analysis, the important thing is not what I can tell you about what happened between 3:30 and 4PM yesterday. It's what I can tell you did not happen: in the last 60 minutes of trading on Tuesday the entire global financial system did not rationally think though the implications of the S&P 500 downgrade and decide that it did not matter after all. It does matter and it will take more than two days for all of the implications to be fully explored by the markets.

Things are interesting and they are going to stay interesting.

Tuesday, August 9, 2011

Gotterdamerung: S&P pours fuel on the fire, world leaders struggle to put it out

Sorry for the delay. I hosted a dinner party last night so I could not get straight to writing. I'll just go over the market action yesterday and the major news that drove it.

Of course the top story was Friday's downgrade. As I mentioned in my Sunday night post I did not think that the markets had absorbed the possibility of a US downgrade and it would seem that they had not. So Sunday night the markets in Asia started us off with a respectable sell off and, once the CME overnight trading portal (GLOBEX) opened, T-bonds sold off as well and the Euro rallied though both of these moves had reversed themselves by the London open.

The ECB Counter Attack

So, as I mentioned in my post of last Friday, after the European close on Friday the Italians announced that they had negotiated a package of reforms with the European Central Bank that would push forward thier fiscal consolidation, would free up the labor markets and amend the Italian Constitution to balance the budget. This, it was theorized, would enable the ECB to add Italy to its program of bond buying. Indeed, yesterday morning the ECB leapt into the European bond markets with guns blazing.

Buying Spanish and Italian government bonds in $50 million clips the ECB was able to jam the yields on both of them to around 5.5%, well under the 6% danger zone that most investors consider unsustainable and where they have recently been. This encouraged markets in the European morning and they actually rallied off the Asian lows. London actually opened higher but the joy was short lived. While it was true that the ECB was able to jam Spanish and Italian bonds below a 6% yield, German bonds remained remarkably well bid.

This is important because German bonds in Europe are considered the local safe haven. In order for things to return to “normal” it is not enough for Spanish and Italian yields to drop, money has to come out of Germany and into the riskier economies. The stubbornly low German yields indicate that investors are not selling out of Germany and are therefore not following the ECB into Spanish and Italian paper. Even more disconcerting was the divergence of France from Germany. France and Germany are considered “Core” Europe. Those crazy sun addled Mediterraneans and the Guinness besotted Irish may indulge in absurdist levels of debt to GDP but France and Germany are viewed as above the fray. Well, once the US went over the AAA cliff on Friday, investors have been taking a hard look at France and do not like what they see. So while the ECB counterattack against the speculators in Spanish and Italian bonds was a major tactical success, at the strategic level things remained touch and go. Not a good sign.

The S&P Conference Call

Yesterday morning S&P held a conference call to discuss the US downgrade from Friday. S&P has come under some criticism for its downgrade. The US remains the most solid credit on Earth. This could be seen by the fact that within a few hours of the GLOBEX open USTs had reversed their decline and were headed higher. There is also the widely reported “$2 trillion error.” On the face of it, it's not hard to laugh at S&P's assertion that the error is not material because well, 2,000,000,000,000 is not a small number. The really depressing fact is that when thinking about US indebtedness it actually is a small number. The difference turned out to be whether the US would have a 86% or 92% debt to GDP ratio in 2022. As it turns out, either number is high enough to cast serious doubt on the long term credibility of the US and would easily justify the ratings cut so S&P is actually right in this case.

Even so, they were VERY aggressive on their conference call. Yesterday they downgraded several thousand other borrowers who are dependent on the US Treasury for income including Fannie Mae and Freddie Mac, the real estate holding companies backed by the Feds. They also downgraded Israel because, believe it or not, the US guarantees Israeli sovereign debt. This would have been grim enough news on its own but they went further than that. They said that they were many other AAA and AA+ credit in the world with a view to reorienting the worlds risks given the lower rating they assigned to the US. They did this with particular reference to US States, specifically US states which are heavily dependent on federal spending and transfers. There was a Q&A session in which many of those on the call attacked the S&P methodology. S&P was dismissive of it's critics and very assertive about its decision to downgrade the US, to keep it on negative watch and to look deeply into all its other ratings in light of the US downgrade.

This is of course a fiasco for two very specific sets of borrowers: European countries and US states. To have the ratings agencies reconsider all Europe in light of the US downgrade in the middle of a speculative attack is a serious blow. The idea that no European country at the AAA or AA+ has a safe rating is a shot across the bow of “core” Europe. Remember the mechanics of the EFSF, it functions essentially as a wealth transfer from the “Core” European countries to the periphery but calls on ALL European states for contributions. It in effect blurs the balance sheets of all the European countries and many of the commitments are so large that, if fully drawn down, they would significantly worsen the debt to GDP ratios of all Eurozone states. In addition to this, the level of cooperation that will be necessary at the EU level in order to fully fund or amend the functioning of the EFSF will be so fraught it will make the US debt ceiling debate look like the instant consensus of philosopher kings in comparison. This is likely to make the respite bought by the ECB counterattack remarkably brief.

In addition they put the US states on notice. This is a pretty serious problem. It is well known that the pension obligations of the US states are absolutely massive and that generally the financial position of many US states is extremely precarious. This is very interesting because, unlike municipalities, there is no bankruptcy code for states. In the event that a state went into default it would have to negotiate with its creditors almost as a sovereign but within the confines of federal law. Congress considered writing such a law but decided against it because it thought a significant number of states would file for bankruptcy immediately if such a law existed and this would raise borrowing costs for all states.

S&P downgrading a state on the back of the US downgrade would have immediate and serious consequences. The US sovereign has had its borrowing costs lowered because it is still the safest borrower on Earth and so has benefitted from a quasi-paradoxical flight to quality in the light of the downgrade. Will the same effect occur if California or New York are downgraded? Hell no. Their borrowing costs go up immediately which would have the effect of widening the fiscal gaps which drove the downgrades in the first place. What's more is that the states are, like Europe, looking at multiple simultaneous downgrades. This means that investors will not be able to switch from one state to another with confidence and may simply flee the municipal bond market entirely selling the safe and the risky, raising the funding costs for all.

In the event that there is a downgrade cascade that leads to a default cascade the US will be plunged into a VERY interesting but also VERY serious political crisis. It is widely assumed that the Federal government would step in to rescue the states in the same way that it did the banking system. I think this is unlikely to happen and that, if it comes to it, the State defaults will be extremely messy. This is because such a bail out would be extremely politicized. First of all the fiscal gaps the states are facing over time as their pension and health obligations increase with the retirement of the baby boomers are, across all the states, on the order of hundreds of billions of dollars. Trillions if you go out far enough in your calculations. Given the massive battle that just went on you can imagine the appetite in Washington for taking on more debt from the states is nil. Then you have to consider the opportunity that a cascade of state bankruptcies would present the Republican party.

The largest expense of any state is the salaries and benefits of its public employees. These employees are, by and large, unionized. Therefore they collect dues and use them to finance political campaigns of pro-union politicians, that is to say, Democrats. Public sector unions contribute over $100 million a year to the Democratic party at the federal level and several times that at the local level. A cascade of state bankruptcies which forced the states to seek funds from a federal government in which the House of Representatives are controlled extremely financially conservative Republicans presents an incredible opportunity to destroy a major source of Democratic campaign finance. Do I think the GOP is willing to play politics with this? Given that they were willing to put the country into default over much less, there's not a doubt in my mind.

Obama's speech

Naturally the United Sates can't take the downgrade lying down so Barak Obama planned to make a statement at 1PM. This was delayed until 1:30. It's a sign of how rapidly the markets are moving that the S&P 500 dropped a percent and a half during the delay. In the event the markets were not comforted by Obama's remarks.

Obama said that the US is still a AAA country and he quoted Warren Buffet as saying that there should be a AAAA rating and the US should have that. He then said that the main issue was not whether the US could pay or whether there were ideas about how to cope with the deficit but that the main issue was the political infighting. He said that all that was necessary was to make minor adjustment to medicare and to make the wealthy pay their fair share. He then called for unity and said that America would get through this and then made a reference to the deaths of the Navy Seals over the weekend in Afghanistan. The moment he said the words “Tax reform that will ask those who can afford it to pay their fair share and modest adjustments to health care programs like Medicare” the markets started dropping and plunged two more percent, had a last gasp rally and then closed on their lows.

When interpreting something like this it is very hard to speak for the markets without actually speaking for yourself. At this point I should admit that my market analysis is heavily formed by my own views. I think the markets sensed that Obama does not understand the depth of the problem he is facing. The markets are now fully alive to the scale of the US debt crisis and it is massive. Under the optimistic CBO projections which include the repeal of the Bush tax cuts and the end of the wars in Afghanistan and Iraq the federal debt grows by $10 trillion in the next ten years. If you look out over the next 30 the fiscal gap is in the high tens of trillions. This can not be solved by “asking those who can afford it to pay their fair share” or making “minor” adjustments to medicare. Think of it this way, this year the deficit is $1.6 trillion. The US collected around $1.1 trillion in income taxes, $650 billion of this came from the top 10%. So if you DOUBLED the taxes on the top 10% of income earners, which by the way not even the Democrats are actually suggesting, you close only a third of the deficit. That is to say, the problem is vastly greater than the simple solution of raising taxes on the rich.

Do you notice how in the debates no one ever actually refers to the data? They prefer comfortable sounding phrases like “make the wealthy pay their fair share.” That is, yes Mr. & Mrs. John Q. Public, there is going to be some pain but it won't be borne by you. The markets no longer buy it. To actually solve this problem is going to require very real pain across the whole of society. The debt ceiling debate showed how difficult it is to get a trivial amount of deficit reduction passed. In my opinion Obama's insistence that there isn't really a problem with the rating, and that what problem there is can be solved relatively painlessly if people agree to cooperate doesn't hold water. The reason people cannot cooperate is that the pain that will have to be borne is very real and they don't want to bear it. Until the politicians admit this to themselves and then to the voters we are going to continue to struggle.

And though we may get a relief rally today I don't think the fallout from the US is over by a long shot and my next few posts will describe what think will unfold in the coming weeks.

Sunday, August 7, 2011

Don't worry darling, AA+ is the new black.

Of course the big news for he coming week is the S&P downgrade of the United States long term credit rating from Aaa to Aa+ with a negative outlook. To hear the financial press tell it, this is no big deal. AA+ is the new AAA, the new flight to quality assets are the old flight to quality assets or, as they say in fashion, black is the new black.

The arguments in favor of this take several forms. One is that the markets have largely priced this in. Another is that, the credit rating notwithstanding, the vast majority of holders of US Treasuries will continue to do so. Thus there will be no panic sell off in the US Treasury market and the impact on the funding costs for the US government may be muted. They also point to the example of Japan, another country which lost its AAA rating without a significant impact on its borrowing costs.

I think these arguments have some merit but I think the conclusion they reach is far too sanguine. I think this is the beginning of what will be a systematic repricing of risk assets which will demand higher returns and thus push asset prices lower.

I think the argument that there will not be a fire sale of US sovereign securities is correct. The largest holder of Treasuries are the government “Trust Funds” for Social Security and Medicare which should themselves be the subject of a blog post. Once the government realized that it would in no way be able to pay for future entitlement programs on a pay as you go basis on account of demographic changes it decided to try to minimize the burden on future taxpayers by charging an excess to current taxpayers. A reasonable idea except that the Trust Funds are mandated to be invested fully in US Treasury securities. That is to say the government lent the money it is saving back to itself to pay for programs today. Who has to pay these loans back? The very future taxpayers the government was trying to spare excess taxation in the future, more specifically, if you are a US national in the prime of your working life: YOU. Nonetheless, the Trust Funds are unlikely to sell their Treasuries.

The second largest holder is the Federal Reserve which owns a lot of Treasuries as a result of its program of Quantitative Easing. It won't be selling either. The next batch of Treasury holders are foreign Central Banks the largest of which manage their exchange rates vs. the dollar by sterilizing capital flows between the countries in order to enhance the competitiveness of their domestic manufacturers. These banks are sure as hell not going to sell their Treasuries because it would mean their industries would have to compete on a level playing field with the United States, they have no intention of ever letting that happen. Next in line are world financial institutions who hold Treasuries as part of their securities portfolios and often pledge them as collateral to their own central banks or to the various clearinghouses around the world which intermediate the financial system. This weekend the Federal Reserve said that it would not adjust the risk weighting on Treasuries which would have forced all the banks in the world to raise capital. Finally there are the worlds money market funds. They will not be forced to sell their T-bills because the short term US credit rating is unchanged. The only people who will be forced to blow out of their US Treasuries monday morning, or rather Sunday night when Globex opens will be money managers with a hard AAA mandate that cannot change it in time to allow them to continue to hold US Treasury securities. Within the universe of $11 trillion in outstanding US paper, these are not a lot of guys.

So the argument that there will not be a wave of forced selling in US government paper holds water. The idea that the markets have this priced in I think is a lot harder to take. It's actually pretty hard to speak for “the markets” but given that longer dated T-bonds jumped about 10% in the past week I certainly get the sense that investors were thinking that the US government was a lot safer a bet than virtually anything else they might have put their money into. As you could see from the market action on Friday the markets have been far more focused on the sovereign issues in Europe than in the US.

I also think the Japan analogy breaks down both on the fundamentals and the timing. Japan has a very high savings rate and virtually all JGBs are held domestically. As a result Japan is reliant on relatively tame domestic buyers to fund its debt and deficit. This is not even remotely the case for the US where around half of our debt is held by foreigners and, because of our extremely low savings rate we are very dependent on the marginal foreign buyer to fund the deficit and maintain the price of Treasuries. Then of course there was the context of the Japanese downgrade. This was back in 2001, true we were in a recession brought on by the collapse of an asset bubble but the banking system had not had a recent near death experience. There were not also multiple simultaneous speculative attacks against major OECD sovereigns. No, I think the US downgrade is likely to have a substantial impact.

It may just be that the impact is not on US Treasuries themselves. As the optimists in the financial press have been quipping the downgrade of US Treasuries might lead to a flight to a quality into... US Treasuries. As mentioned, black is the new black. That may well be but it is cold comfort for what S&P has just done is make it official that the US Treasury can no longer be regarded as a proxy for the risk free rate. It may well be the least risky thing out there but all that is saying is that every other asset in the world is also riskier than it was when Treasuries were risk free and therefore should be paying a higher return. If they should be paying higher returns that means that they should be priced lower. This is what I think will happen, a systematic repricing of risk assets the world over to take into consideration that the US Treasury, and therefore the anchor of the global financial system in general, is actually much riskier than has been assumed for most of the past 60 years or so.

I expect this to manifest itself in renewed, and far more aggressive, speculative attacks in the Eurozone, and not just the periphery. If the US is not AAA then surely France, Germany and the Netherlands, the core of the Eurozone are on shakier ground than was originally thought. If they are on shakier ground then what hope can there be for Italy and Spain, who will be reliant on them in the event of a major fiscal problem. If Spain and Italy are in trouble what hope can there be for Greece, Portugal and Ireland. I think there will be a renewed speculative attack across the Eurozone periphery and perhaps an attack on the Center itself. In the event that such an attack succeeds, the European banking system will take a major hit to its balance sheets at the same time as the Eurozone governments are under attack from their bondholders. Keep in mind that the European banks are all much larger relative to their governments than are US banks. A European style TARP would be almost impossible to initiate so a sovereign crisis in Europe that spread to the banking system could not be contained and would quickly spread to the rest of the world.

A major and durable correction in risk assets would probably also deter both consumption and investment decisions in the US which may well tip an already fragile economy into back into recession. Bond markets will also have to begin to wonder about the credit worthiness of all US corporations. After all the rhetoric is that the way to plug the fiscal gap is through increased taxation on businesses and capital which will systematically raise the costs on American business. Whatever impact this may have on future profitability there is only one direction for equity prices to go in order to take this additional risk into consideration: down. Additionally, the fiscal problems facing state and local governments are going to become much more acute as their ratings are also going to be in trouble and while there is no precedent for a US sovereign default there is a LOT of precedent for municipal default. Municipal default can also cascade if investors generally flee municipal securities.

So in short, the financial press may be right. AA+ may well be the new black. The finances of the US Government may not be too affected in the end. The problem isn't really there. The problem is that if what was once considered riskless no longer is, then everything risky should be paying more than it was. I think it will take the markets a period of weeks to absorb the new risk paradigm and in that time the instincts of the market will be to flee risk assets and reprice risk generally. The timing of this is not particularly helpful because of the multiple speculative attacks in Europe and the fragile US economy. So the US Treasury may not wind up paying higher rates, at least initially, but everyone else in the world may and this is manifestly not helpful.

AA+ may be the new black, but we had better prepare ourselves for the mean reds.

Friday, August 5, 2011

Todays Rally-Crash-Rally-Unchanged brought to you by THIS GUY

Yet another fascinating day in the markets.

So, this morning before the bell we got the employment report. The economy created 114,000, of which 154,000 were private sector jobs (the government net fired people.) This allowed the unemployment rate to tick down a point to 9.1%. Not a great report but it did beat expectations and, given the massive crush of selling into the close yesterday the market opened with a very healthy pop. Immediately after the open the S&P was up 17 points or about a percent and a half. This was as high as it was to go however as investors quickly remembered that employment is a backwards looking number while the other negative data from the week, ISM manufacturing and non-manufacturing were forward looking and very weak. Also, there was no news out of Europe and though the European credit spreads were easing a little, taking the pressure off the troubled governments on the Southern rim, there was still no policy news that would put the market at ease. Add to this that there is still a lot of doubt as to whether the US will maintain its AAA rating and investors decided to take advantage of the employment bounce to get out while the getting was good.

In the first 20 minutes of trading the S&P dropped 30 points or just over 2%, a small move compared to the disaster of yesterday but a large move on any other day. The market then alternately drifted or plunged lower until about 12 noon New York time, at which time it bottomed at 1169. Treasuries which opened lower after yesterdays spectacular rally also traded up almost immediately after the open. Keep in mind that when Treasuries trade higher, they imply lower interest rates. Gold also spiked up about $20 as investors continue to fear all sovereign risk and consider gold the last best safe haven.

Then, a little before noon New York time, a bit of news came out of Europe. As I mentioned in my post of yesterday when Silvio Berlusconi gave a speech Wednesday night he announced no new policy measures. Then the markets crashed. After the bell in Europe Friday, Italy reversed this policy. The Wall Street Journal reported that Italy and the ECB were in negotiations the result of which was that the Italians would agree to a broader package of reform and to speed up their fiscal consolidation. In return the ECB might add Italy to its bond buying program. As mentioned, one of the things that Trichet had left out of his comments on Thursday was any indication that the ECB would intervene in the Italian Bond markets. Now it seems as though the ECB may help break the speculative attack on Italy and Berlusconi will use his parliamentary majority to push through reforms that would go a long way toward cleaning up the fiscal issues that enabled the attack in the first place. Among these, no doubt to the delight of the Tea Party, was a balanced budget amendment to the Italian constitution.

As an aside, I wrote a post a year ago about how I would thwart the speculative attacks in Europe, and a helpful primer on the role of CDS in launching speculative attacks if you are interested.

The markets loved this news and rallied stocks from 1168 to 1210 in about 45 minutes, the markets went straight up the whole time. Once they had gotten back to roughly flat on the day however the markets could not make any additional headway. They bounced up and down around the closing level of yesterday to finish just about where they left off yesterday with the S&P 500 at 1200. All in all it was a truly amazing day, it's not very often that you have the S&P 500 move up and down 5% in a day to close unchanged. So what does it all mean?

Well, I think it means a lot of things. For one thing it means that there is a HUGE amount of uncertainty in the markets right now. A few years ago the S&P would move 6% in a year, now its moving that in a day, day after day. To be fair there are a lot of things which the markets should be concerned about. If the world economy tips back into recession, the debt laden Western countries will struggle to use fiscal stimulus to attempt to jump start the economy. Exogenous shocks and previous monetary easing have raised inflation expectations to the point where further monetary stimulus is not likely to be forthcoming. Despite all the kings horses and all the kings men trying to put the European fiscal balance back together there remains a very real possibility of a successful speculative attack on the Eurozone which would then be transmitted into the European banking system, from the European banking system into the real European economy, and from there to the rest of the world. Such a disaster would be on a scale no one has seen before so no one really knows what to expect.

So what should you expect? Here's what I think will play out. I think the speculative attack on Italy will fail, I think the new package for Greece will hold so I do not think the Eurozone armageddon event will occur. The trouble is that the markets will take quite a lot of convincing and its not the kind of thing that can happen over night. Italy can default in a day, it cannot prove that it will never default in a day, it has to do that by not defaulting over a long enough period of time that people get used to the idea that it will not default. Another complicated aspect of this is that there are likely to be a lot of fractious arguments among the European governments about how to move forward, as with the debt ceiling debate in the US, these arguments have the capacity to unsettle the markets. So I would expect the European concerns to gradually fade out over time but punctuated with episodes of panic like the one we have had this week.

I think the US economy will get stronger in the second half and but I think the markets will respond unusually to the news as it comes out. The only thing the markets love more than real growth in the economy is a sign that the Fed may embark on another round of Quantitive Easing. So you might see markets paradoxically rally on news that the economy is weak, and more specifically, that inflation is in check in the expectation that this will encourage the Fed to print more money and thus raise all asset prices. I think it is also possible that, now that Congress has some time to work, that there might actually be meaningful progress on the fiscal front here in the US. I don't think that is the most likely outcome but I think they'll be talking with the rating agencies about what the minimum they need to do to keep the AAA rating and they'll do that. If the ratings agencies confirm the US AAA then it should be off to the races for risk assets again. If not, look out below.

Thursday, August 4, 2011

Look! In the sky, it's a flaming risk asset about to crash into the SS Europa: An analysis of todays market action

I'm going to take a day off of my explanation as to why the Progressives are just as wrong about the fundamentals of public finance to talk about what went on in the markets today. First, what went on:

First of all, what happened?

1.) Global equity markets fell very sharply. The US benchmark the S&P 500 fell 60 points or about 4.7%, that is a HUGE move. The stock market is now back where it was in early December of 2010. The stock market is now down about 12% from its highs for the year, it has dropped about 140 points or ten percent since July, 25th, this is a big big move.
2.) Money poured into the US Treasury market as it has since the debt deal passed. This pushed the yield on the ten year bond down to 2.42%, this is VERY low by historical standards.
3.) Money poured into, and then out of gold. On the open gold was up about $30 and then during the day dropped $40 to close lower.
4.) The Euro fell sharply against the dollar losing 1.5% of its value in a single day. This is a big move and it is also a continuation and acceleration of an ongoing trend
5.) Crude oil also fell out of bed. Brent Crude dropped 5% to $107.58 a barrel. (I prefer Brent as a measure because West Texas Intermediate largely reflects the dynamics of storage in Cushing Oklahoma but WTI was down 5% as well.)

Why did this all happen?

This is a good question first I will list the news items that have come out in the last 24 hours and then put them into context.

1.) Silvio Berlusconi gave a speech to parliament last night on the issues surrounding Italian sovereign credit. In the speech he reiterated earlier comments he has made about the soundness of Italian finance, reminded the markets that Italy has passed an austerity budget, and in any case he has a majority in parliament if he needs to do anything else. He blamed the recent financial turmoil in Italian markets on fickle markets and a lack of confidence. He did not announce any new policy measures to attempt to deal with the markets but rather pointed out that the Italian primary deficit is very low and therefore very manageable.
2.) Jean Claude Trichet held a press conference this morning at which he announced that the European Central Bank would continue its two main liquidity measures: a bond buying program, and unlimited lending against solid collateral to the end of the year. The ECB was not expected to announce whether or not it would extend these measures, originally put in place during the Greek fiasco in May of 2010, until September. He came out early with the announcement early in order to assure the markets that there would be ample liquidity for the banking system. He also made a number of hawkish comments about inflation.
3.) Spain held a bond auction. The auction went will with twice as many bids as there were bonds for sale but the rate the Spanish had to pay was 80 basis points (0.80%) higher than they had to pay at a similar auction in June, highlighting the stresses on the market for Spanish government paper.
4.) US weekly first time jobless claims came out at 400,000 a little less than expected but still a significantly high number.

First I need to put these events in context. Six weeks or so ago the EU put together a new rescue package for Greece to supplement the one agreed a year ago. The negotiations over this were tense but they were finally resolved. All seemed quite until a few Fridays ago there was a run on the stocks of the Italian banking sector, that is to say a lot of people came in and started selling short Italian banks. It was, and is, widely perceived that this is a speculative attack on Italy. It is actually not easy to borrow and short sell Italian bonds and the CDS market in them is thin. A large proportion of the assets of Italian banks are claims on the Italian government is bonds. Therefore you can get short the Italian government by shorting the banks and this is what has been going on.

There are a few interesting things about Italy. One is that it does indeed have the second highest (after Greece) debt to GDP ratio in Europe. It also has one of the most anemic economies in Europe, with almost no real growth in the ten years preceding the 2008 financial crisis and not a great record since then. On the other hand the Italian primary deficit is only about 4.6% of GDP or about a third of ours. Also Berlusconi, love him or hate him, does indeed have a parliamentary majority, unlike the Socialists in Greece. This means that, if necessary, he can with ease pass additional measures with which to tighten the deficit further. So, if you ask me, Italy is in trouble, but it has plenty of resources with which to defend itself against the speculative attack should it choose to do so. I think Berlusconi was trying to make this point last night and express confidence by not actually announcing any new measure. As you can see, the markets have their doubts.

The reason the speculative attack on Italy is so significant has less to do with the probability that it will succeed than with the consequences if it does. The European Financial Stability Fund (EFSF) that was established to rescue Greece and which has since also assisted Ireland and Portugal is probably ample for the needs of those countries, it may even be large enough to support Spain. Italy has $1.4 trillion of debt outstanding. Not only is it too large to be assisted by the EFSF, it is probably too large to be helped by anyone except the United States and even then it would be touch and go.

What this means is that if a speculative attack on Italy were to succeed in shutting Italy out of international capital markets there is no organization in the world large enough to support it and so it would be forced to restructure. If Italy were to restructure the European banking system would suffer an enormous blow. This is because not only Italian banks but all banks in Europe have substantial holdings of Italian bonds. If they were forced to recognize losses on those bonds it would eat into their capital and shrink their balance sheets along the lines of what happened in the US when the banks had to write down their investments in residential real estate. This would most likely force a major economic contraction in Europe, MAJOR. Even if this is a low probability event the consequences are so dire that many investors are preparing themselves for that possibility. They are doing this by selling risky assets (stocks generally, assets in Europe and therefore the Euro itself) and putting them into extremely safe assets.

During the budget debate a lot of these assets went into gold because there was some concern about whether or not US Treasuries were the optimal asset to be holding. Once the deal was done money has been flowing into treasuries hand over first. US treasuries have gained about 10% this week, that is also a HUGE move. This is a good thing for the US government because it lowers the cost of funding the deficit but it is not good news for the economy as a whole. This is because the spread between the two year and the ten year US Treasury yield is a good predictor of the financial performance of the financial sector. What is the business banks are in? They take in deposits and they make loans. Deposits are usually short term and loans are long term, so the difference between short term rates and long term rates is the primary driver of banking profitability. The government has been trying to help the banks recover from the housing crisis by keeping short term interest rate VERY low and leaving longer term rates relatively high. When every frightened investor in the world panics and pours their money into long term US Treasury securities like they are now the spread between the short term and long term interest rates narrows and reduces the profitability of the banking system. Lower profits in the banking system mean a longer time to recover from the 2008 recession and thus generally less credit available to the “real” economy.

The real economy in the US is also a point of major concern. Todays jobless claims number was sort of ho-hum, no reason to sell off the market 5% but there have been other problems lately. Last Friday the Q2 GDP number was released. The markets expected the economy to grow at 1.9%, not a great number but respectable. Instead the number came out at 1.3% and worse the Q1 number was revised down from 1.9% to 0.4%. These are truly terrible numbers for the real economy, in order to recover employment from the 2008 fiasco we need to be growing much faster. Those numbers were bad but the ISM manufacturing number on Monday was worse as it came out much worse than expected and showed that the manufacturing sector, the sector which has been leading the recovery as banking and real estate have been on the ropes, is just creeping along.

The uncertainty about the real economy is compounded by uncertainty as to what the policy responses will be. It seems from the data that the fiscal stimulus has been a failure. Whether you agree with Paul Krugman that it should have been larger or with me that it was doomed to failure because rational expectations of higher future taxes to fund the borrowing required deter the kinds of investments which would grow the economy, the data are pretty clear. What's more, even after the hand wringing in Washington about how to trim the deficit, the ratings agencies, and through them the markets, think the US is so deep in debt and has such crushing future obligations that it may not deserve its AAA rating. This, and the fact that there is a significant group in Congress opposed to all spending increases means that there is unlikely to be a second round of fiscal stimulus.

Then there is the question of quantitative easing. In both of his press conferences Bernanke has gone to great lengths to show that, as long as inflation expectations remain elevated, he does not have room for a third round of quantitative easing. This is bad news for the markets because they LOVE quantitative easing. QE2 took the S&P 500 up 30% between July 2010 and February this year. The Fed has said it is willing to engage in QE3 but the bar will be set high. That is, in order for them to intervene the economy needs to be slowing significantly, (which it may be but we won't know for sure for a while) and inflation expectations need to be low (which, right now, they are not.)

To this soup I would add the issues that the potential downgrades of US sovereign debt bring to the financial systems. As I have mentioned in a previous post, the global financial markets have been using the US Treasury as a proxy for the risk free rate. If in fact there are significant risks that the US defaults, every other asset in the world should be yielding more than it is given the risk it implies. As this sinks in it may well force a general shake up and reshuffling of the worlds asset allocations and it is possible that the first stage of this would be a global flight from risk which would look a lot like what we are seeing.

So here is what the markets are looking at: a potential fiasco in Europe, a slowing US economy (which will begin to shrink for certain if there is a financial crisis in Europe,) no fiscal stimulus, and very likely no monetary stimulus as well as serious questions about whether or not they are getting paid to take the risks they are taking in all financial assets. This is an environment in which many people would prefer to run home and hide under their beds which is what happened today. Add to this that the US unemployment figures come out tomorrow and there was no reason to go home long anything so there was not even a buy the dip rally at the end of the day, we closed on our lows.

What to expect going forward.

Personally I am a bit more optimistic than the markets are. I think that the odds of a successful speculative attack on Italy. I think Europe will muddle through and I think the US economy will not go into a double dip recession. Yes growth is anemic but I think a lot of what you are seeing in the numbers reflects the exogenous shocks of the Tsunami, the Arab spring oil spike, and jitters around the Eurozone. That said, speculative attacks can acquire a momentum all their own and for the time being, they seem to have the upper hand. If we get a disaster of an unemployment number tomorrow we are going to be in for another very rough day.

Tuesday, August 2, 2011

The Budget Battle is Over: The good news is we're not going bankrupt tomorrow, the bad news is, we're still going bankrupt

So, today the Senate passed bi-partisan legislation to lift the debt ceiling by $2 trillion or so averting the risk of an instantaneous default. The bill had $1 trillion of discretionary cuts over the next ten years and empowered a panel to suggest an additional $1.6 trillion by year end otherwise severe cuts in other discretionary programs as well as defense would be automatically triggered for 2013. For a total theoretical savings over the next ten years of $2.6 trillion. Woo hoo!

Alas, the markets did allow either side any time for chest pumping about all they have achieved or finger pointing at the nefarious people across the aisle who had made all this “compromise” necessary in the first place. No, the ink was barely dry on the bill and the champagne was barely wet on the tongue before all hell began to break loose in the markets. It began with more negative economic data but really got serious when Fitch and Moodys put the US on negative watch AFTER the bill had passed.

This must be somewhat bewildering to Progressives because they've been told that it was simply the Republican brinkmanship that was the reason for the potential downgrade. As Obama memorably said: “for the first time ever, we could lose our country’s Triple A credit rating.  Not because we didn’t have the capacity to pay our bills – we do – but because we didn’t have a Triple A political system to match it.” And now those dastardly ratings agencies are saying just the opposite. That there is no way the US can pay its bills if things continue as they have. This must be frustrating, and I want to help. In recent days I've written some articles attacking the delusions of the Tea Party, notably the idea that US sovereign default is not unprecedented or that such a default would not constitute a major disaster. Well, now I'm going to provide the same public service for those on the left and try to debunk some of the false impressions under which Progressives have been laboring in a series of posts.

Before I do that however I want to take a moment to address some issues of terminology and reference. Throughout the debate when people have described cuts, or deficits or revenues those numbers are aggregated over the next ten years. The deficit they seek to address is that contained in the CBO Baseline Outlook for 2011-2021. This is a trick of terminology to make things sound a lot bigger than they are, $1 trillion in cuts sounds like a lot but it's really just $100 billion a year for ten years and the government is borrowing $1.6 trillion this year alone. If you crack open that report you'll see that under the baseline scenario the government will borrow an additional $9.2 trillion over the next ten years. It is also important to note that the underlying economic assumptions are somewhat optimistic. They assume that the US economy grows 3.1% this year, 2.8% next year, then at 3.4% until 2016 and at 2.4% from 2016 to 2021 this growth is constant with no recessions. Given that the actual data coming out show that the GDP is growing much more slowly in 2011 (1%,) it is likely that many of the revenue estimates will turn out to be on the high side with correspondingly higher deficit numbers.

So, todays common Progressive misperception is:

The main reason we are even in this position is the Bush administration. If we just roll back the Bush Tax Cuts and end the wars in Afghanistan and Iraq the problem is solved.

You may have seen your progressive friends posting these charts from The Atlantic and The New York Times up on the internet which purport to show that the deficit is the result of the policies of the Bush administration. The New York Times chart shows that at the end of the Clinton administration budget surpluses were projected as far as the eye could see until the wicked Bush Administration took over and began deficit spending like there was no tomorrow. Then President Obama takes over having inherited this fiasco he adds merely a trickle to the flood of red ink.

To begin with the NYT chart is internally inconsistent, on one slide Obama is responsible for $187 billion of additional spending, on the next it's over a trillion. Interestingly she forgives Obama's shortfall in revenue due to the recession but does not recall that Bush also came into office in the middle of a recession caused by the collapse of an asset bubble and instead assigns all revenue shortfalls to the pernicious Bush tax cuts. She then makes the argument that by far the largest contributor to the deficit is the Bush Tax cuts and that if they were repealed we're on a trajectory to sustainability. I wonder what the CBO has to say about that, stay with me, friend reader.

In the Atlantic, James Fallows makes more or less the same point. He goes to great lengths to say he's not interested in being partisan and then like the NYT lays all the blame at the foot of the Bush Administration, its wars and its tax cuts. Fallows also projects forward the surpluses of the Clinton era. He also assigns all the responsibility revenue shortfall to the tax cuts rather than the combination of tax cuts and decreased tax revenue during the 2001-2002 recession. Obama can claim a weak economy Bush, no dice. I do however appreciate Fallows' citation as “an analysis based on CBO data.” Rather than use the CBO data directly he manipulates it to make his point reclassing some of the revenue shortfall as tax reductions in order to magnify the effect of the tax cuts for Bush while he magnifies the effect of the recession for Obama. (Of course there is also this chart which is totally nonsensical, he has the Obama stimulus package ending in 2013 but the recession goes on to 2019, not to mention the wars.)

I only wish that these estimable journalists had kept at the CBO data coalface once they were done assigning the blame for the current predicament to the Bush administration. The CBO is a veritable cornucopia of interesting data including projections as to what the deficit will be. In fact, as mentioned these are the very projections referred to by both sides throughout the debate. Let's just have a closer look in here... wait what's this? The CBO projects revenues to go from $2.228 trillion in 2011 to $3.442 trillion in 2014? How can that be, an increase of 55%? GDP is only growing at 3% during that time, where is all that revenue coming from? Oh, wait a minute, the CBO baseline INCLUDES ALL CURRENT LEGISLATION. Thus it assumes the Bush tax cuts expire, and for that matter, the Wars in Iraq and Afghanistan end on schedule. But wait a minute, even with the expiration of the Bush tax cuts and the end of the wars the government still winds up $9 trillion deeper in debt at the end of it?

Yes it does. As it turns out, the press has done a disservice to the debate by attempting to show that the Bush tax cuts are responsible for the deficit problems that the Tea Party Republicans are trying to solve. The Bush administration is guilty of a great many fiscal sins, and doubtless the current debt would be lower had be been more fiscally conservative, but even after all his policies are withdrawn we still have to borrow $9.2 trillion over the next ten years to fund the government. Sorry Progressives, the problem is in the future, not the past, and because we are reluctant to face it, we are being punished by the rating agencies.

Tomorrow: The Keynesian Endpoint