Wednesday, August 10, 2011


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.

1 comment:

Anonymous said...

Sehr gut, mein Herr.