Europe’s liquidity situation

As we continue to monitor the rolling over of the liquidity facilities in Europe, the FT had a good summary of the ECB’s role in propping up the banks.

The European Central Bank has slowly but surely been replacing the private markets as the main source of cross-country funding in the eurozone.

The ECB is currently lending close to €900bn ($1,098bn, £728bn) to eurozone commercial banks, jumping to near-record levels since the creation of the central bank 11 years ago. This now matches cross-border lending between commercial banks in the 16-nation currency zone, according to JPMorgan.

Although lending between domestic banks represents the lion’s share of the estimated €6,300bn market, the ECB has become essential as a lifeline to the weaker of the 3,000 banks in the eurozone.

To read the full article, click here.

Alert: Oil just moved lower

Oil just went down 1.5% in about 5 minutes. Not sure what the news is out there, but something is spooking the market.

Morning notes

A lot of huffing and puffing around town, but you should have already been positioned:

• Euro is taking out 1.22, on it’s way to 1.20 and lower. 3M Libor is going up, as we discussed a few weeks ago. European lending/borrowing costs will rise, banks will be hurt, and sovereign debt will need to be repriced. Spanish banks are especially vulnerable given the liquidity crunch coming up once European facilities need to be rolled over in July.
• China can’t hide the numbers any longer. Why would they lie? Because THEY”RE COMMUNISTS! Government numbers in general are massaged, but in communist regimes, it’s on a different scale. For those who remember 5 year plans, pictures of stocked Russian supermarkets, talk of the US falling behind on every level, this is just more of the same – in the end, communism and state directed economies fail. Not a value play (yet?) for me.
• USD is getting stronger and weaker: stronger vs. euro (duh) and weaker vs. yen (huh?). Continued unwinding of the carry trade? Domestic yen coming home from international allocations?
• 10 year yields are saying deflation, and they’re saying that the US government has some leeway since investors still think it’s credible. So good so far.
• Are we on the brink of massive quantitative easing on a never-before-attempted scale? Competitive devaluations? Against what – each other? USD? Gold?
• Real estate: how come when I say real estate is vulnerable you don’t listen but when Meredith Whitney says it 6 months too late, everyone is up in arms. And now Barry Ritholtz and John Mauldin are confirming? Nice, but I hope my readers were already out of the space for the time being.

Euro traders are missing the point

Anyone who is buying the euro at this stage might be picking up nickels in front of a $542 steamroller.

On Thursday, the clock runs out on the ECB financing programme – the largest amount ever lent in a single liquidity operation by the central bank – under the terms of the one-year special liquidity facility launched last summer.

The article in the FT.com goes on to point out:

The €442bn ECB facility, which charges interest at a rate of 1 per cent, is not set to be renewed, something that banks in Spain and elsewhere in Europe say ignores current commercial realities.

A special offer of six-day liquidity will tide banks over until the following week’s regular offer of seven-day funds. On Wednesday, the ECB will also be offering unlimited three month liquidity, and further offers of three-month liquidity will keep banks going until at least the end of the year.

For the full article, click here.

Spanish banks have been especially dependent on the lending facility. A certain portion (BarCap estimates $150 billion) will not be rolled over, which in turn will mean reduced lending by European banks. Add to that the newly announced austerity measures, coupled with the BIS annual report that criticizes the US Fed’s zero interest rate policy, and you have a recession coming down the line for Europe. (For a summary article of the BIS report, click here.) While the US may be next, the euro’s current level can’t be sustained. I’m obviously biased, and have been short the euro since late 2009, so take my opinion with some confirmatory-bias-salt, but I believe the next couple of weeks will be key for the euro, Spanish banks, and the eurozone as a whole.

My take on today’s action

Nothing – meaningless, low volume, noise where day traders and HFT were exchanging shares across markets. This doesn’t signal anything. It doesn’t mean anything. I was happy to watch the Brazil game. If you want to read anything, read this.

Fiscal Crises of the States: Causes and Consequences

By Jeremy Gerst and Daniel Wilson

The recession that began in late 2007 severely reduced state tax revenue and increased demand for many public services. In the near term, institutional and political factors limit the options states have for cutting spending and raising taxes. Aid to states in the federal economic program is winding down next year and the situation is likely to get worse before it gets better. Painful budgetary choices lie ahead for many states, though the drag on the national economy should be modest. (Emphasis mine)

Euro down. Yields down. Equity flat. Gold. Oil. Flat. Cigarette makers? That’s the big news? I’m overweight the sector so I can tell you, they won’t lead the market, but are nice fillers with good dividends. That’s about it.

We’re going into month and quarter end, so there’s a real chance of a strong seasonal rally, but I’m not going to participate, since I believe July will be a tricky month, with liquidity coming off the table for the euro. Meantime, CHF, at this rate, will just become a euro proxy. Waiting and watching for now.

Random Thoughts

• 7 year auction comes in at a low bid, but 10 years start selling off? How come?
• Hugh Hendry‘s wants to take Soros down and believes the euro is doomed because there’s a structural problem of maintain fiscal vs. monetary interests. He must be reading The Hard Trade site.
• If financials and energy and retail and tech are all heading lower, who’s left to lead a rally?
• Is the Baltic Dry Index spelling trouble for the CRB space? Does anyone even care that rail traffic is improving?
• Is SNB going to break with their ever-growing euro position? They’re setting themselves up for some trouble down the road – but then again, I’m short the euro.
• Gold continues to hold up as the vent, but silver might be the ultimate winner.
• I’ll admit it, I sometimes like to say “I told you so”. For months we’ve been telling our readers that real estate is not stable, that the numbers are being manipulated by government stimulus, and that the current crop of speculators will be crushed. So, it was with no surprise that the sales numbers came in so low. And we ain’t done – commercial real estate along with residential is still being mispriced on bank balance sheets (and on Freddie and Fannie balance sheets). We continue to stay away.

Month end issues

There are a lot of crosscurrents over the next two weeks that might be game changers. While I’m not as concerned with shorter term moves, we should at least be aware that the next couple of weeks have a lot of crosscurrents:

• FOMC meeting today. We’ll be on the lookout for any changes, but the long bonds will reflect the economy more than the short term, and since I don’t trade the announcement, I’m just watching and reading to see if there are any longer term impacts.
• Index rebalancing is always a big deal. The Russell rebalancing is always a fun spectacle – and dangerous for smaller players or ones without the computing power to be faster than the big guys.
• It’s also quarter end, so look for window dressing by managers.

But all of these are known and out in the open. A much bigger issue is that…liquidity might dry up?

After the Greek crisis, the ECB started a number of liquidity operations, including expanding its unlimited three-month LTROs to coincide with the end of the 12M one, which means that drop probably won’t be as precipitous. But the issue is how much of the 12M LTRO will roll into the three-month operation. Abate reckons there could be a €150bn gap.

This is a must read (click here).

Barclay’s analyst, Abate, expects LIBOR to rise to 75 bps. Central bankers should be working overtime to figure out how to roll over the liquidity operations and provide liquidity going into month end. The good news is that we’ll know one way or the other in less than a week. The bad news is that we’ll know one way or another in less than a week.

For reference, also read the ZeroHedge article from yesterday.

And right on queue: Transports (IYT)

We’ve been discussing the different underlying messages the market is saying, but recently, a lot of the messages have been quite clear:

• We have real estate rolling over as seen through housing numbers. Any uptick in commercial real estate seems like a last gasp as…
• ECRI leading indicators are rolling over. Recession schmecession – it doesn’t matter what you want to call it, but without jobs in the US, there is no growth in consumer spending. We’ll have periodic upticks as built up demand vents in certain weeks or months, but the consumer is retrenching. Now you might have expected all the global stimulus funds to keep the party going for a while longer, but…
• Europe is starting their austerity program. Guess what, they are so structurally flawed that even THAT doesn’t help the euro. However, it will lead to a slowdown in growth in the eurozone, which wouldn’t be that significant, except…
• Europe is China’s biggest export destination. So you’d think the Chinese would just let things be, but instead, they’re tapping on their brakes and NOW decide to make statements about revaluing the yuan? Aside from a political grandstand to show how weak they believe the Obama administration to be, this is probably cutting your nose to spite your face, because they’ll be doubly hurt when…
• US growth slows along with Europe’s and China’s internal markets prove to be fake. Why? As I’ve mentioned before…because THEY”RE COMMUNISTS! Still, the markets looked like they might like the news, except, the rally quickly faded yesterday and today. Throughout, it was pretty surprising that the Dow Transports were holding up…
• And still are, by most measures. But our goal is to move forward and today’s 3.75% might be a harbinger of what’s to come:

  

• So that leaves us with AAPL. What a company?! What a stock?! Can it last? Me thinks not.

All the talk of 200DMA

Where is the 200 DMA now?

Rising rates AND deflation? How?

I have been writing for months about a possible new scenario for economists: rising rates in the face of a deflationary environment. See, most people are either deflationists and believe that rates will go down, or inflationists and believe that rates will rise. What if they’re both half right (or half wrong)?

Foreign ownership of U.S. assets, particularly Treasury bonds, has increased significantly over the last two decades. Foreigners now own 57% of outstanding U.S. Treasurys, up from 37% in 1997. The chart above shows that this growth has been driven entirely by government purchases, notably China’s. In the two years ending in March 2005, official sector purchases accounted for 60% of new issuance, compared to about 40% historically back to 1960. The increasing significance of government participants, whose motivations are not always profit-driven, may help to explain Alan Greenspan’s famous “conundrum” — the question of why long-term interest rates declined in the face of strong economic conditions and rising short-term rates in late 2004 and early 2005. This disruption to the mechanism through which monetary policy normally affects the broader economy may one day work in reverse if governments choose to reduce their exposure to Treasurys back to 1960s levels. The resulting “reverse conundrum” — rising long-term interest rates in the face of weak economic conditions and falling short rates — would be far more unpleasant than the Greenspan version.

Source: Council on Foreign Relations

US Treasuries and US households

From Fortune:

The U.S. household sector bought $147 billion of Treasury securities in the first quarter, the Federal Reserve said in its quarterly flow of funds report. That pushes Americans’ holdings of Treasury debt to $796 billion, the highest level since 1999.

The article goes on to mention…

U.S. banks bought $64 billion worth of Treasurys in the first quarter; the Federal Deposit Insurance Corp. said last month that federally insured banking institutions boosted their Treasury holdings by 53% in the first quarter.

Government-sponsored enterprises such as Fannie Mae (FNM) and Freddie Mac (FRE) went on an even bigger binge, nearly tripling their holdings of federal debt.

Some wonder how strapped consumers can afford to spend billions on low-returning government bonds. One hard-core critic of U.S. fiscal laxity, Toronto hedge fund manager Eric Sprott, has questioned the massive reported purchases by the household sector. He claims the government is manipulating its data for the sake of running a giant “ponzi scheme.”

For the full article, click here.

As my readers probably know, I don’t like Treasuries here, fully acknowledging that the deflationary argument supports bond prices for a while yet. I continue to view bonds as return free risk – a bet that the US government 1. won’t inflate their value away and 2. exogenous forces like a failed auction won’t occur.

More than anything, I’m afraid for the US investor who goes from one fire to the next having lost wealth in pricking of the stock bubble, only to be burned by the crash of the real estate bubble, and now facing the end of the bond bubble, perhaps. All in all, I don’t think there is a lot of room for continued internal financing as long as jobs are missing, savings are missing, and international sources are more and more internally focused and won’t be able to sustain our debt. (We do not make specific recommendations, but are short treasuries.)

Kass and P/E multiple contraction

It’s a slower day for me, so I’m catching up on some reading of academic papers, but thought this would interest you, since multiple contraction/expansion is a large (largest) driver of stock returns. This morning Doug Kass at TheStreet.com wrote about it:

There exists numerous price/earning multiple deflators and non traditional headwinds to growth. These factors don’t necessarily prevent an extended bull market, but they will most certainly deflate price/earnings multiples and put a cap on the market’s upside potential:

• rising taxes
• fiscal imbalances in federal, state and local governments;
• the absence of drivers to replace the prior cycle’s strength in residential and nonresidential construction
• the long tail of the last credit cycle (Greece, Portugal, Spain, etc.)
• inept and partisan politics

To read the full article, click here.

Then, from economicdata.blogspot.com comes this:

Lets take this concept and look at how it fits in over the LONG term (i.e. based on history, do we seem extended). The chart below shows the CAPE (Professor Shiller’s Cyclically Adjusted Price / Earnings Ratio), as well as the twenty year average of the same going back 100 years to 1910 (actually, the 20 year average data goes all the way back to 1890).

Note that in previous cycles we have seen the CAPE move well below 10 at the low, whereas this cycle “only” hit a low of 13 in March ’09. Interestingly enough, that 13 CAPE ratio is higher than each of the three 20 year average lows, seen at each low point throughout the last century.

To see the source, click here.

In general, this is a case of confirmatory bias, because I’m giving it more credibility since it’s something I already believed and wrote about. However, I don’t think it takes away from the general point, which is that valuations are not supportive of the beginning of a bull market.

BP – The clock has already started

What happens if BP goes bankrupt in the next few months? Setting 20 billion aside in a private deal with the White House surely won’t survive a judges review. What about paying out small claims to thousands if not tens of thousands of shrimp boat captains and motel operators? Will they be clawed back? How can they not be? What will that do to the small business owner? And what about all of their bilateral trades? I am not sure people realize just how many trading shops that could ensnare.

I am not a bankruptcy attorney and this is not my area of expertise, but I did trade through a number of counter-party bankruptcies and I know how hairy things can get. I can see it now – Florida vs bondholders vs shareholder lawsuits vs their NYMEX FCMs and banks vs gulf residents – a legal battle royal if their ever was one.

No judgments here – only a question.

Global inflation revisited – IMF working paper

Since the inflation vs. deflation debate rages, I want to bring a new IMF working paper by Joseph Crowley to your attention, which highlights a possible decoupling of inflation trends. On a personal level, I think there has been some decoupling on the inflation front on a relatively short term basis, however, I anticipate that there will be a re-coupling in the next few years as asset prices drive down inflationary pressure. On a longer term basis, emerging markets can face higher inflation pressures as limited domestic resources, tighter currency controls, unstable politics, etc. could provide fodder for inflation.

From the paper:

Abstract:
Inflation followed a strikingly uniform pattern in all countries of the Middle East, North Africa, and Central Asia during the period 1996-2009, falling until about 2000 and then rising. International fuel prices do not help explain this pattern. This conclusion is robust even when different cross sections of countries are tested or when different regression variables are included. The pattern of inflation is explained mainly by past inflation, the strength of the US dollar, US inflation, and—depending on the subset of countries analyzed—monetary and exchange rate policies and nonfuel commodity prices.

The paper goes on to point out some key findings:

Inflation is driven by many factors, and the interest and exchange rate policies that
central banks implement, the money supply growth that they allow, and the exchange rate
regimes that constrain them are ultimately the most important. In the MENACA region,
central bank policy decisions clearly bear significant responsibility for the reemergence of
inflation. Many countries (particularly in the Maghreb) have failed to increase nominal
interest rates in the face of increasing inflation, largely because of the constraints of official
or unofficial pegs to the US dollar. Others, including in the GCC, have increased rates in
spite of the peg, but not enough to keep up with inflation. Often the key policy decision has
been to maintain adherence to an official or unofficial peg.

But the reemergence of inflation around the world was so uniform that it is hard to
attribute it entirely to shifts in the policies of individual central banks. Meanwhile, there were
striking developments in certain global variables, particularly during the period following
2000, and it would be logical to consider global factors in any study of inflation.

Global factors may have a significant impact on inflation and this impact may have
increased in importance in recent years. Borio and Filardo (2007) argue that global factors
are important and since the 1990s have become increasingly important in determining
inflation, even replacing domestic factors in some cases. Rogoff (2004) argues that
globalization, by increasing competition, has changed the shape of the Phillips curve, making
the inflation-output tradeoff less favorable to policymakers who might be willing to accept
higher inflation in return for higher output. Other authors have similarly argued that greater
openness reduces the benefits of unanticipated monetary expansion (Romer 1993) or
otherwise has effects that make narrowing output gaps more costly in inflation terms (Razin
2004). Chen (2004) finds that openness had a downward influence on prices in the EU during 1988-2000. D’Agostino (2007) finds evidence that US inflation is more closely related to global liquidity than to US liquidity. Ball (2006), however, disputes these claims. He provides evidence that the Phillips curve has changed shape, but in the wrong direction to
support the conclusions that are drawn. He also provides evidence that US inflation is not
dependent on output in other countries.

It is hard not to notice that the comeback in inflation coincided with a sharp increase
in food and energy prices, and it is tempting to infer that these increases in commodity prices
drove the resurgence in inflation. The IMF’s April 2008 Regional Economic Outlook (REO)
for Latin America noted that “Rising domestic food prices, reflecting both sharp increases in
world commodity prices and some local supply disruptions, have been widely viewed as a
key element in the uptick in inflation.” In a cross regional paper on inflation in emerging and
developing countries, Habermeier, et al (2009) concluded that the main causes of the increase in inflation were demand pressures and commodity prices, and that the initial impact of commodity price increases was followed by second-round effects. The Economist magazine indicated in May 2008 that a main cause of higher world inflation was higher food and oil prices.

The conclusion that recent inflation has been driven by commodity prices could lead
to the hope that the recent softening in energy and food prices will bring with it reduced
inflationary pressure. The decline in the value of the US dollar has also been tied to
commodity prices and to world inflation, and this raises the possibility that the recent
strengthening of the US dollar could also reduce world inflation. In the case of the MENACA
region, the benefits of lower commodity prices may be limited. A stronger dollar may have a
more important impact.

For the full article, click here.

Yuan all around

Everyone is talking about it, parsing it, and (for now) praising it – but why?

By theoretically lifting the dollar peg (ever-so-slightly) the Chinese have pulled off a strategic political feat. First, they take pressure off themselves as world politicians try to find a scapegoat for their own economic mishandling. Second, they tap the breaks on their own credit induced real estate mania. Third, they give themselves a way out of increasing their treasury holdings.

And there you have it. By devaluing the yen, even a little bit, they open the window to slowing their treasury purchases. At the same time, since the Chinese don’t buy as many goods from the US as the US consumer buys from China, they don’t really risk any increase in domestic prices of US goods. On the other hand, the US consumer might face higher prices from Chinese goods, namely, everything. So the US trade deficit might get better from the fact that imports will go down, but I do not anticipate exports to China to rise substantially. Turns out that the Chinese don’t want to buy anything we produce – including our debt.

So what now? We remain short treasuries. The uptick in equities seems absurd since the cost of capital is rising, China is tapping their economic breaks, and US consumers will buy fewer goods in general (since Chinese manufacturing costs will rise). Not sure where the positive outlook for stocks is coming from, but alas, its there for now.