All My Rowdy Friends Are Coming Over Tonight

At last, the waiting's over and the big day is here. Investment bank reporting season kicks off with Lehman Brothers before the New York open, and the most eagerly-awaited Fed announcement in years hits the tape this afternoon (EDT)/evening (BST.) So after a month of biding time, shuffling positions, and waiting, it's time for financial markets to enter the crucible. In the words of the legendary Bocephus, it feels like all my rowdy friends are coming over tonight.

As an appetizer, however, we have the rather unedifying spectacle of Bank of England independence and credibility withering before our very eyes. The market is rife with rumours that the section of Mervyn King's statement on the Bank's potential Lender of Last Resort status-quoted in this space on Friday-was shoehorned in at the last minute after the Treasury notified the Bank of the problems with Northern Rock.

That the Treasury has taken the unprecedented step of guaranteeing all Northern Rock deposits raises the moral hazard stakes even further, and asks the question of what the end game will be. While there is clearly a utility to be had in shoring up depositor confidence throughout the banking system, Northern Rock has surely lost its right to exist as an independent entity. Its business model was essentially identical to that of an SIV-type vehicle: it funded long-term assets (its mortgage book) via short-term liabilities (interbank borrowing.)

Yesterday, other UK building societies saw their share prices collapse late in the session (the chart below shows the intraday price action of Alliance and Leicester.) It was probably this panic that encouraged Alistair Darling to create the emergency guarantees for Northern Rock.

Macro Man was amused to see Goldman Sachs and HSBC reduce their price targets for Northern Rock from somewhere around 1000p to somewhere around 300p (yesterday's close was 282.) Uh, thanks fellas. Macro Man hereby offers a price target of his own: zero.

In the meantime, Mervyn King has remained silent since his statement last week. The BOE has offered an emergency repo this morning, while the FT reports that the penalty rate on the Northern Rock credit line will be 7.25%, assuaging some of Macro Man's moral hazard fears. Yet the market is now focusing on the fact that Mervyn King's term as BOE governor ends next summer, and wondering if he was strong-armed into the NRK bailout under threat of non-renewal. Either way, it's a sordid situation that can only damage the credibility of the Bank. On the plus side, Newcastle United, the football team formerly sponsored by Northern Rock, has managed to secure a new sponsorship deal:
At the end of the day, NRK's business model, financing long-term assets (its mortgage book) with short-tem liabilities (interbank borrowing) is indistinguishable from that of a number of exploded hedge funds and insolvent SIV-type vehicles. While it may be appropriate to disintermediate depositors from this mess, there should surely be no question that NRK and its shareholders should be left holding the (empty) bag. Other banks may have a similar asset-liability mismatch, but it appears that NRK was particularly egregious in inflating its balance sheet.

And what of US investment bank shareholders? Lehman reports today, which will be our first real taste of how this summer's fireworks have impacted Wall Street. Ominously, Bank of America issued a statement yesterday suggesting that the credit market dislocation will have a "meaningful impact" on earnings. Many, however, expect the IB's to window-dress earnings via non-recurring cashflows and/or mark-to-model valuations.

Macro Man is not an equity analyst and doesn't plan to sift through the minutae of the statements. But he cannot shake the notion that the better the announcements sound on a headline level, the worse things may well be under the surface. We all know July and especially August were crap; the more transparent the banks are about this, thequicker we can all move on without fear of ex-post revelations of hidden turds.

And of course, we have the Fed. Much can and has been written about today's decision elsewhere, so Macro Man will keep his comments relatively brief. While he thinks that the Fed should do nothing, he does live in the real world and acknowledges that that ain't gonna happen.

His impression is that bond and currency markets are expecting 25 bps from the Fed funds rate and similar on the discount rate. That is, his expectation is that the people involved in those markets expect 25/25. Looking at where the US yield curve and some high-yielding currencies are currently trading, one could argue that 50/50 is actually priced.

Equities, meanwhile, look set for 50/50 all the way. One would have to suspect that a 25/25 would be construed as a disappointment, unless it was accompanied by a (highly unlikely) promise of much more.

So it would appear that "risk trades" are vulnerable in the event of a 25/25 or perhaps even a 25/50 outcome. This was the very rationale that encouraged Macro Man to sell 1500 calls in the first place. Of course, it's a touch simplistic to look at the actual rate decision in isolation. What if the Fed does 50/50, but then says that they view the action as sufficient to support the economy, and thus that their primary concern has reverted to inflation?

One would suspect that risk assets would perform poorly. Macro Man's base case expectation is 25 on the Fed funds rate, though he has a sneaky suspicion that they might do 50 on the discount rate. The statement, he believes, will offer some vague assurance that the Fed will take appropriate action on the basis of new developments.

Ultimately, this should stoke another downleg in risk assets, if for no other reason than that expectations need to be re-set. While Macro Man still holds the view that the dip is meant to be bought, he reserves the right to change his mind in the event of fresh developments.

Good luck!