Moving to NEUTRAL from RISK-OFF: SNB as an indication that next policy response from G-20 is imminent:

 

The move by SNB today to move towards QE is clear warning signal to me that the policy risk has become too big for global policy makers – there are several reasons why I am now neutralizing my negative call from

Mid-May called: No Silver Bullets. (please insert link for me)

-          The move by SNB is key as it will take Switzerland to zero-interest rates and de facto quantative easing. SNB will increase the monetary base by approximately 50 billion CHF and narrow the target rate for 3-mth Libor from 0.0-0.5 per cent to 0.0-0.25 per cent. This is major help to risk-on as EUR vs CHF has become major benchmark and leader for risk on and off

-          The second reason is technical – our internal models for cyclical and relative value is now moving towards neutral to cheap risk. This is indication for us to take profit on the May trade short trade – however we are nowhere near a high-risk rewards trade yet which will need S&P cash at the 1200/1210 area (This morning low in S&P could be close enough, but prefer S&P cash and US trading hours to confirm this)

-          There is high risk reward trade present in US fixed income – on the back of the debt ceiling deal there is ample ammunition for the S&P to downgrade US debt – I think it will happen and ultimately it should be negative for fixed income and lead to higher US interest rates. The cycle and trend of having higher and higher marginal cost of capital is here to stay – this short-term relieve rally was based on the predictable move lower in growth assessments.

-          My very negative view on GDP growth across the G-20 has been confirmed – I see stabilization at this lower level for now – and the mere fact that most PMI's is now below or just above 50 indicates that the policy response is not far behind. Jackson Hole  this month will yet again become key for change in Fed outlook. Expect strong communication on keeping rates lower for longer, the willingness to explore further asset buying (Operation Twist or QE3) and a tone of urgency to be present.

-          Finally, the ECB and Non-farm payroll and the Italian contagion are event risk but as someone who has been pounding the table on the risk of "domestic agenda being the real risk" – I find the moves erratic and too fast for now.

All this added up makes me move to neutral on risk – awaiting further confirmation on stabilization in economic data and policy response. This will be first time since May. Let me stress that I firmly believe all of above is well inside the Crisis 2.0 scenario I have outlines a few times, the trend of ever higher marginal cost of capital will continue to debtors and the credit nations will all, like Switzerland, have to move towards QE in order to curtail the in-flow of capital. The world is serious disharmonious in assets, in social trends and in equilibrium. Being patient and awaiting clarification could be the best trade for this summer.

I am sending out longer note on debt ceiling debt later today where I outline why it could have been a good start but it ended up as always up being an exercise of buying more time.

Non-independent investment research

Steen's Chronicle

Another step towards Crisis 2.0?

We remain with the risk-off scenario. The US economy is clearly heading for zero growth again and the EU’s is showing no ability to create a credible debt-crisis resolution. There are two major premises in politics it seems: Buy time and spend yourself out of trouble. Over the last 24 hours I have a few conservations with fund managers and two important points crystallized from my discussions with them:

The Keynesian endpoint
Since the crisis hit in 2008, world policy makers have basically operated on the idea that creating more debt could create more growth – the basic tenet of classic Keynesian policy.  I am increasingly convinced that we are reaching what some have dubbed the “Keynesian endpoint”, where the failure of this Keynesian approach to turn the economic ship yields to a more balanced approach to monetary- and fiscal policies (rather than bail everything out all the time). This turn will occur not because it makes sense, but because circumstances simply leave no alternative.

Time is up
The second point is the increased likelihood that “time is up”. This idea came from my friend and hedge fund manager Dan Arbess of Xerion Capital : “Here's the thing.  Every politician likes to spend, that's how they get elected.  Republicans don't like taxes, but boy can they borrow.  That game is ending so now, there are no more options for spending without taxing. It's going to get interesting with two totally different worldviews: Democrats tax and spend, Republicans cut taxes and spend...Democrats tend to thing government is the solution, Republicans think it's the problem”. Well put and time is up for the US spending juggernaut, regardless of how it will be stopped.

If we look at key indicators for the EU and the US there is increasingly clear evidence, to which the market has been paying insufficient attention , that time is indeed up and the alarm bells are ringing:

Chart 1: Contagion is on. Spain minus Italy 10 year bond spread



Source: Bloomberg

This chart may be the most important one for understanding the gradual erosion in the EU and the Euro – namely the spread in 10 year bonds between Spain and Italy. Less than three months ago, the inclusion of Italy in the group of nations affected by the sovereign debt crisis was borderline anathema for EU politicians. Now fast forward and we have this spread down at 18 bps – yes, Italy, deemed outside the circle of contagion, now yields almost as much as Spain.

And while we’re on the subject of Spain, a few items crossing the screen  - all of them today:

• Zapatero calls early Spanish election
• Spain faces Moody’s downgrade risk on regional budget concern
• Talks of EFSF fund not being big enough (still at old level of 440 bln. EUR) is hurting Spanish debt

Again, I made this point several times: The real risk to Italy, Belgium, Spain, Denmark and other countries remains their internal domestic economic- and political agenda: zero growth means by definition that the debt burden will increase when you are running a budget deficit. This you can live with in transition periods, but we are well into the 10th year of below long-term trend growth and in many countries barely even making it to positive growth. There is a price for this: downgrades, increased yields to finance the debt and a desperate need to keep a primary balance at zero or positive (the budget deficit before interest expenses = primary deficit).

In the US – deal or no deal – I am sorry to say it makes no real big difference. The budget plans for the next ten years that have been thrown around, whether intended to save $1 trillion, $2 trillion, or even $4 trillion are insufficient to counter the “baseline scenario” of $10 trillion of further national debt accumulation that will take place assuming no behavior change. And that $10 trillion projection is modest, since it would take place in a scenario of 4% growth. What if growth is 1-2% or worse? When looking at US dollar it is important to choose the right currency. The only fair one is CHF – it’s in Europe, has a small open economy, world class companies, and has reasonable taxes. The chart below is one of the USD vs CHF since 1991. The trend? CHF has increased on average roughly 3 per cent per year in the last decade.

Chart 2- The US dollar vs. CHF tells the story of fiat money


Source: Bloomberg

The next few days are important as political events, but the most likely long-term impact is…surprise, surprise: more of the same:

The US dollar will continue to weaken 3-5% per year, the politicians will buy some time into the next election cycle, yields will creep higher and higher for non-core countries, equities will be over-bid relative to bonds as investors are losing faith in governments, and the disparity between the rich and poor will only yawn wider as the latter suffer on the inevitable standard of living declines that are forced upon them by wages that fail to keep pace with cost of living increases.

We have dealt with bigger crises than this before – you only need to go back to your own grandparents – they lived through wars, booms and a depression, and still created wealth beyond anyone’s dream. The big difference? They grew up respecting and expecting hard times, hard work and each other. Today we all want to believe that the last thirty years will be extended by another five to ten years before we start the rebuilding. We are now definitely in Crisis 2.0 early stages, I constantly meet clients and investors who keep complaining I’m too negative – but am I really negative, or am I merely trying to make you aware that the light at the end of the tunnel is not the exit but an approaching freight train?

I hope I am wrong. I really do (and I often am) but a touch more reality would help us all.

Steen's Chronicle: An over-engineered solution for Europe?

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Steen's Chronicle: An over-engineered solution for Europe? by Steen Jakobsen Measured on the scale of convolution, the latest bail-out deal for Greece scores a 10. The deal does mark a new direction for EU efforts to get ahead of the crisis - but there are a number of important potential pitfalls going forward. Continue reading...

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Steen's Chronicle: Serial even risk week; ECOFIN, EU Council, US debt dispute

Steen's Chronicle

Serial event risk week: ECOFIN, EU Council, US debt dispute

This week is "serial event risk week", with the ECOFIN Meeting on Wednesday, EU Council Meeting on Thursday and then the 22 July self-imposed deadline for dealing with the U.S. debt ceiling. On top of this we have the usual agenda of second-quarter earnings, policy speeches (Federal Reserve Chairman Ben Bernanke testifies on the Dodd-Frank anniversary 21 July) and lack of liquidity during the core of the summer months.
This strategy note follows our bullish call from March into May, the correction call:  No more Silver bullets and the update It’s all Greek to me where we pointed out a break of 1301/1306 could lead to a two-three week relief rally. Now it’s time to reassess the risk!
Europe – The most likely result is a diluted deal which allows the European Financial Stability Facility to buy bonds on the secondary market (i.e: Greek bonds) while Germany will insist on some sort of private participation. In order to get ahead of the markets a deal should and could involve some “further commitments” from both Spain and Italy on austerity and willingness to help out. It seems unlikely this Greek bail-out version 2.0 will do the necessary job in terms of securing and containing long-term risk of ever higher funding costs for Southern Europe and as such a “more of the same deal” is the most negative for medium and long-term risk.
The market is finally realising that countries with “HHL – disease” – High deficits, High debt, Low growth – need more than cutting costs and spending in order to move forward. It’s like an automatic transmission in a car. There are three directions: forwards (drive), backwards (reverse) and neutral:
"Drive": would plainly involve acknowledging Europe is one entity: i.e. one credit risk, one monetary policy, one banking system and one fiscal policy. The indirect route to what now seems politically untenable is to issue bonds on behalf of the EFSF, which effectively will mean one creditor and one Europe, as these bonds would be guaranteed by a collective Europe and in reality bankrolled by Germany. The very issuance would be the first step towards this fiscal union. There is no way Europe and any of its countries can afford to let the EFSF or the European Stability Mechanism go bust – hence the indirect route to fiscal union, but the forward gear also needs to involve a plan for growth and productivity.
"Neutral":  is the most likely scenario and involves more of the same, i.e. version 2.0 will deal with Greece’s acute liquidity issues, it may reduce some of the debt burden and it will almost certainly include some buy-back of Greek bond issues, but it will fail to deal with the growing contagion into Spain and Italy. Let me again point out that Spain and Italy are witnessing higher rates not exclusively due to Greece but also due to failing to address their HHL-disease in time.
"Reverse":  is a scenario which only concerns Greece – a pure, buy-more-time deal which will roll the political decisions on into the near future. This is the preferred version for 95% of all politicians, as they seem to live and die by the premise: If the opportunity cost of doing nothing is free, then do nothing. I fear the policy makers still think the opportunity costs are zero, as they continue to live in a fantasy world vis-à-vis Greek default, the need for creating growth agenda et al.
Added to this is the U.S. earnings season which is upon us and the expectation is that companies overall will beat estimates again, if not only because they have massively downgraded their expected earnings in the lead up to the reporting season. Early signs confirm the picture that U.S. companies with overseas earnings will do well based on “currency impact on earnings” while domestic/retail oriented companies will fall below expected earnings expectations. Look no further than to last night’s failure of well-known Borders to find new investors. In the retail space you can move volumes, but margins are depressed as consumers seem to be continuing deleveraging, and unfortunately, stimulus has worn off leaving only deflationary forces in place.
Lastly, in terms of the U.S. debt ceiling, a deal will come. I do not think the U.S. administration will risk debt default, even if only temporarily, so as time goes on President Obama will become more eager to strike a USD 1 or 2 trillion deal. At the end of the day I think the two political sides agree on the need for fiscal prudence. The deadline remains set for 22 July.

Conclusion:
We remain with our call for a test of 1200/1210 for now – this is a correction – before we get a policy response from the Federal Reserve towards QE3 or Operation Twist. The Fed and the U.S. administration will not allow the market to drop more than 10-15 percent from the top before acting – we saw early signs of Fed Chairman Ben Bernanke starting this process last week and it will continue.
In Europe the thing to watch is the interbank market – short-term rates are slightly bid and the European bank stress test results could lead to some lowered money market lines with counterparts from credit-aware banks. Most crises start with the economy and companies having good long-term prospects but no liquidity to get there – a telling comparison to today’s world – the credit cake gets smaller and smaller and hence the need to continue deleveraging.
Keeping the powder dry remains our directional call – with downside potential of 10 percent from here 1305.00 S&P cash index.

Portugal's Prime Minister Pedro Passos Coelho discovers

Portugal's Prime Minister Pedro Passos Coelho discovers 'colossal' budget hole

Portugal's new leader Pedro Passos Coelho has told the nation to brace for further austerity measures after his government discovered a "colossal" €2bn (£1.7bn) hole in the public accounts left by the outgoing Socialists.

Pedro Passos Coelho also appeared to caution the European authorities that his government will not tolerate heavy-handed interference in his country

By Ambrose Evans-Pritchard

8:43PM BST 18 Jul 2011


Yields on two-year Portuguese debt rose to a fresh record of 20.3pc on Monday, reflecting fears by investors that the country would struggle to pull itself out of downward spiral without some form of debt restructuring.

Mr Passos Coelho also appeared to caution the European authorities that his government will not tolerate heavy-handed interference in the country.

"We want to take part in an ambitious European project and make our contribution so Europe can confront its problems in the most ambitious way, but as prime minister I will not stand by and let Europe govern Portugal," he told a party gathering.

There is growing rancor in Lisbon over the term of the €78bn rescue by the EU and the International Monetary Fund, and the sweeping powers of the inspectors as they impose a "structural adjustment" on the economy.

The penal rate of interest charged by the EU is expected to top 5.5pc and risks trapping the country in debt-deflation. At the same time fiscal austerity, without offsetting monetary stimulus or devaluation, may tip the economy into an even deeper downturn.

EU officials are pushing hard for a 100 basis points reduction in rates on rescue loans, hoping to win backing from a reluctant Germany at an EU summit on Thursday.

The revelation of a budget hole in Portugal has echoes of what occurred in Greece in late 2009, when an audit by the new Pasok government exposed a budget deficit twice the level previously declared to the European Commission.

Portugal's government will have to cover the gap with another round of spending cuts, mostly in the civil service and state-owned industries.
The sacrosanct Christmas Bonus is already being slashed, effectively cutting salaries.

Portugal is obliged to cut the budget deficit to 5.9pc of GDP this year under its rescue terms. This looks like a Sisyphean task since the deficit was still 8.7pc in the first quarter, and further austerity will have the side-effect of choking tax revenue. The experience of Greece is that the country can find itself chasing its tail, with the deficit remaining stubbornly high in a shrinking economy. Portugal's central bank said the economy will contract a further 1.8pc next year.

"There are limits to cutting: you can't just cut blindly," said Mr Passos Coelho.
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Early Bernanke comment...important German comment on Greece...

Overall: In line with expectations – indicating we need higher unemployment & stock down before QE3 – or something similar comes into play, but….  He is concerned about EMPLOYMENT – indicating that his /FED's focus changed slightly from deflation to EMPLOYMENT.. .which could mean some policy adjustments.

 

Here our Operation Twist could play role and likewise changes to deposit rules come to mind – in order to force banks to lend….

 

Most interesting thing being that Bernanke failed to say the magic words:  A strong US dollar policy – he talked extensively about the US dollar but failed to mention the normal mantra – this is MAJOR news in my opinion and could have some impact past tonight (weaker US dollar)

 

Also Jamie Dimon, CEO, of JPM Chase was very "rude" asking how BB saw regulation trade off to survival of banks… desperate Mr. DImon?

 

The biggest story though being this from Germany:

 

It will have two impacts:

 

1-      It will make rating agency DEFAULT Greece

2-      It will make Trichet  very hawkish on Thursday – pay back and no longer wanting to do "fiscal policies" for EU.

 

Schaeuble Seeks 7-Year Maturity Extension for Greek Bondholders

2011-06-07 20:49:12.946 GMT

 

 

By Brian Parkin and Alan Crawford

     June 7 (Bloomberg) -- German Finance Minister Wolfgang Schaeuble said bondholders must contribute a "substantial"

share of a second aid package for Greece, proposing a swap that credit-rating companies may term a default.

     Schaeuble told European Central Bank President Jean-Claude Trichet and fellow euro finance ministers in a letter yesterday that maturities on Greek bonds should be extended seven years to give the debt-wracked nation time to overhaul its economy.

     Any agreement on aid at a ministers' meeting on June 20 "has to include a clear mandate -- given to Greece possibly together with the IMF -- to initiate the process of involving holders of Greek bonds," Schaeuble wrote in the letter, which was provided to Bloomberg and reported earlier by Die Welt newspaper.

     The German position clashes with the position of European Commission officials and the ECB opposing anything beyond a voluntary rollover of debt. A swap offering investors terms that are "worse" than those of existing securities would constitute a coercive or distressed exchange, and be considered a default, Fitch Ratings said yesterday.

     With a return to capital markets in 2012 "more than unrealistic," Greece is likely to need additional aid to avert "the real risk of the first unorderly default within the eurozone," Schaeuble wrote.

     While the size of the package can't be assessed until the so-called troika of officials from the International Monetary Fund, ECB and European Commission give a progress report on Greece, it is likely to be "substantial" and must "involve a fair burden sharing between taxpayers and private investors,"

Schaeuble said.

 

                   'Substantial' Contribution

 

     "This process has to lead to a quantified and substantial contribution of bondholders to the support effort, beyond a pure Vienna Initiative approach," whereby western banks active in eastern Europe in 2009 during the financial crisis were encouraged to roll over funding to subsidiaries and inject fresh capital if needed.

     "Such a result can best be reached through a bond swap leading to a prolongation of the outstanding Greek sovereign bonds by seven years, at the same time giving Greece the necessary time to fully implement the necessary reforms and regain market confidence," Schaeuble said.

 

 

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Consensus, buying time aren't acceptable

Steen Jakobsen's Articles

06 June 2011

Steen's Chronicle: Consensus, buying time aren't acceptable

Steen Jakobsen, Chief Economist

"To me, consensus seems to be the process of abandoning all beliefs, principles, values and policies. So it is something in which no one believes and to which no one objects." Margaret Thatcher.
 
There are three major themes this morning: the election in Portugal, Greece bail-out, Part II, and confirmation of slowing US growth.
 
On the surface, the Portuguese election looks like a victory for change as the Social Democrats (PSD) secured 30 per cent of the vote and appear to have a solid majority of 126 seats in the 230-seat Parliament with the support of the Conservative Popular Party. The new prime minister, Passos Coelh, has promised austerity beyond the needed cuts of 3.5 per cent of GDP per annum layed out in the IMF plan.
 
But real change - what change? A good friend of mine, Paulo Pinto of DIF Brokers in Lisbon, said to me this morning: 'This reminds me of when the French moved to the right and Sarkozy won the elections. Everybody thought it was a historical change. This is not about left or right, this is about those being in debt and the few who are not. The parties that signed the agreement with the Troika (ECB, EU and IMF) had 90 per cent of the votes even before the election so there will be illusion but not growth for the next two years and people will be disappointed soon'.
 
This goes to Jakobsen's law of politics: It's not what the policy makers say which is important, but that they do. Clearly, as a long-term visitor and friend of Portugal, I want the best for Portugal. But Portugal has become the poster child of an Entitlement Society – the public sector has extended everywhere and private capital has been crowded out by the need to keep the public sector employment in place. The only solution to Portugal's catch-22 is to create real private sector growth and to cut the public sector down in size. Portugal has one of the lowest GDP growth rates in Europe with a four-year average of -0.7%, and an outlook for -2.1% in 2011 and -1.5% for 2012, according to the ever too optimistic OECD. Even more importantly than GDP growth rates, unemployment will rise to 11.7% and then 12.7% over the next two years from present 10.8%! That's a recipe for a social upheaval.
 
This is the huge national dilemma – Portugal has gone beyond the point of no return – the problems facing the country are not merely those of "challenges", but massive, structural intractable problems. Even if Portugal did the "right thing" – curtailed the public sector, refinanced the banks, and created a pro-business, pro-growth agenda, it would take years, not months before Portugal again starts moving forward. My issue, as always, is not with the people or the individuals of Portugal, but with the system. The Portuguese entitlement society began collapsing years ago, and the only reason the situation has been allowed to limp along until this year was due to the artificially low rates generated by the ability to ride German credit rating for years.
 
It is time for Portugal to move forward – I hope the new prime minister is not merely a man of words but also of action. Portugal has always played a unique role in history and could do so again for better or worse.
 
The Greek drama continues – basically no one has a clue how to solve the issue of giving Greece more money when the funding runs out next spring. The "re-profiling" of debt (extending duration and the like through a "soft restructuring"), the Vienna solution and the new path of creating ratings default but not a CDS default event are all too complicated for me. My mentor always told me: if it takes more than one minute to understand your arguments, you have no arguments. Clearly, using Greece as the benchmark for how the EU will face down the sovereign debt issue, the EU institution is critically challenged, and Greece is even more so.
 
For starters, we have to shake our heads at the fact that, the EUR 327 billion in outstanding Greek debt, more than 90 per cent is under Greek law (source: Citigroup), whereby Greek bonds have no collective action clause (CAC). This would mean that a voluntary debnt restructuring requires 100 per cent of investors to accept the terms to avoid triggering a default. As bad as that sounds, I'm not naïve enough to believe that this is major issue for the EU, which has proven that they will do everything within their power to find an extend and pretend "solution" for the problem by addressing a solvency issue with more liquidity.
 
Here's another critical issue: Standard & Poor's explained their methodology for determining a default this past Friday: Issuers rated Single-B, like Greece, would be in default if: creditors receive securities with terms less favorable than are available in the secondary market. This is a rather high watermark, since 2- and 10-year Greek debt trades at 22.1% and 15.7% respectively right now. Furthermore, the ECB continues to object to any sort of debt restructuring as it would blow a hole in their own portfolio and create a moral hazard. Good luck to EU trying to resolve this before the June 23-24 summit. 
 
How low can we go on US growth? The status quo is maintained and extended in the USA – as the fortunes for Main Street and Wall Street continue to head in opposite directions. The Bernanke cocktail of lower rates for longer has only made Wall Street richer and Main Street poorer. There are two well known and oft used rules of thumbs in US economics: Consumer spending is roughly 70 per cent of US GDP and labor has received two thirds of the overall national income. However, this is no longer the case: Labor's portion of income has now dropped to 57.5% (source: David Rosenberg) – the lowest level in sixty years! This means that Main Street is as poor as ever before. The Financial Times published a piece this weekend under the headline: China Investors: Beware of inequality. The article points out that over the last 30 years, the top 1 per cent of the US population's share of total income rose from 8 per cent to 16 per cent. During the same period, US median incomes have barely grown in real terms. Again confirmation that the social tension, or the inability to create inclusiveness could become the topic not only in the US election but also across Europe as protests grow in size in Greece and we continue to see youth unemployment of over 40 per cent in Spain.
 
Where from here? We have our most likely scenario as one called 'QE to Infinity' but it may need to be changed to QE and Operation Twist to Infinity. Operation Twist is the new buzzword in political and central bank circles as Bernanke mentioned it in his "famous" deflation speech from 2002: "Deflation: Making sure 'It' does not happen here" - the very same speech which was academic reasoning for QE and QE2.

Mind you, this time the Operation Twist is merely a footnote – specifically footnote 11: "An episode apparently less favorable to the view that the Fed can manipulate Treasury Yields was the so-called Operation Twist of the 1960s, during which an attempt was made to raise short-term yields and lower long-term yields simultaneously by selling short end and buying in the long-end. Academic opinion on the effectiveness of Operation Twist is divided. In any case, this episode was rather small in scale, did not involve explicit announcement of target rates, and occurred when interest rates was not to close to zero" .

The bold text is my work – as it clearly indicates Bernanke thinks it's only a matter of size and objective to do what could not be achieved in the 1960s. As it happens, Operation Twist not only failed but became the Great Inflation of 1965-81. Fed rates were 3.0% (wow! What a coincidence!), and were supposed to go back to 2.5% but ended at 6.0% before the Fed of the 1960s gave up.

The purpose was explicitly to flatten the yield curve – helping the housing market while supporting the US Dollar. Clearly, now you only need to replace a falling US Dollar with commodities and it is all nice and dandy for Chairman Bernanke and his effort to find 'justified' new instruments in the keeping rates lower for longer. We believe 2.0% is likely in 10- year rates merely on the talk of Operation Twist. All research shows, unfortunately, that all benefits gained from QE and Operation Twist come from the anticipation rather than the implementation.

We remain bearish the market as per my earlier note: "No more Silver Bullets" and I have increased the Crisis 2.0 odds from less than 10% to 25% as the amount of troublesome issues continue to rise day-by-day.