Macro Man

Macro Man breathed a sigh of relief this morning when he saw the cover of The Economist. It would appear that the trend of dollar weakness has at least another week to go; more importantly, it's nice to see the magazine focus on a life and death type issue that has unfortunately been ongoing for the better part of two decades.

The dollar continues to trade on the back foot, meanwhile, as markets slide into the end of the quarter. Word on the street is that take-up for recently launched investment trusts in Japan has been paltry, thus giving the yen a small boost this morning. Meanwhile, even erstwhile whipping-boy the Taiwan dollar has gotten into the act, with USD/TWD now trading at its lowest level since mid-January. If the greenback starts losing ground against the Zim dollar, however, then you'll know it's probably time to start covering.

Macro Man wonders what is more unpleasant: the chart of US new home sales, now down 40% + from its peak, or the frustration of housing market bears that their favourite issue has not resulted in lower stock prices, as measured by the indices, in the US? That the SPX is up this week despite a pretty unambiguously poor set of macro data (yesterday's jobless claims notwithstanding) is a testament to the importance of liquidity and globalization in driving asset prices.
Macro Man wonders if there won't be plenty more juice in the emerging theme of large caps (many of whom derive income from foreign operations) outperforming small caps (which tend to have a more domestic focus.) He intends to do some more thinking and investigation, and may establish a position next week.

For now, it's hold onto your hats (and hopefully, your P/L) time; only a few hours left to make (or keep) money this month and quarter. Good luck.

After last week's eventful developments, market interest and activity appears to be pausing for breath, at least until tomorrow's quarter-end. While certain enterprising retail establishments may already be gearing up for the Christmas/holiday season, one can only hope that financial markets are not sliding into their usual late-year lethargy.

Given the strong October seasonality and continued uncertainty over America's economic and monetary trajectory, there would appear to be little danger of market stagnation over the next few months. Indeed, a few interesting nuggets have emerged over the last day or so that warrant mention, as they once again suggest that de-coupling, at least financial de-coupling, does not appear to be happening:

* Warren Buffett to buy a stake in Bear Stearns? Rumour has it that the Oracle of Omaha and some Chinese banks, among others, are looking at taking a chunk of Bear. Such a transaction could ignite a rally in the financials, which have badly lagged the SPX recovery to date. (Disclaimer: Macro Man owns a bit of BSC p.a.)

* UK house prices have risen 0.7% this month, according to Nationwide Building Society. This was more than expected and should help calm, at least temporarily, fears that the UK housing market is set for a lemming-like leap off the white cliffs of Dover. Meanwhile, nobody took the BOE up on its recent offer to lend £10 billion at the penalty 6.75% rate.

* On the flip side, yesterday the ECB lent €3.9 billion to an unnamed bank at a punitive rate, suggesting that turbulent undercurrents continue to swirl below the apparent calm in money markets. Month end could provide a few fireworks as banks try to tart up their balance sheets...then again, maybe it won't . We'll know soon enough, however.

Given the relative quiet, Macro Man thought it might be interesting to review the situation in a country where he has significant market risk but has, alas, taken a rather laissez-faire attitude towards his positions. The clue is in the title of the post, as he is of course referring to Japan.

This week saw the annointment of Yasuo Fukuda as prime minister, an event which, by all accounts, places the reforming vigour of Junichiro Koizumi more firmly into the rearview mirror. While Fukuda has retained a majority of Abe's Cabinet ministers, that is not necessarily any great thing. And his appointment represents, from everything Macro Man can tell, a return to the factional, behind-closed-doors dealmaking politcal environment that dominated Japan in the decades prior to Koizumi's election.

In any event, Macro Man has sigificant alpha portfolio risk in short JGBs, with a bit of long yen and long vol risk as well. Of course, the beta portfolio is short yen, so all-in directional FX risk is a moveable feast. That being said, it's worth reviewing the macro situation.

BOJ governor Fukui's term ends next spring, and it is widely believed that he would like to hike rates at least one more time before his departure. To date, CPI inflation has prevented him from doing so, as both headline and core CPI have been negative y/y for most of the year. However, as energy price base effects recede, it is perhaps possible that we see CPI back positive soon. This could be all a trigger-happy Fukui requires to hike another 25 beeps.
Certainly underlying price pressures would appear to be greater than suggested by CPI. Wholesale prices and corporate services prices are both rising, with the rate of change steadily increasing over the past several years.

Of course, the actual output data has been pretty miserable. Q2 real output fell 0.2%, and H1 growth was the worst of the G3. So much for de-coupling... But beneath the surface, some portion of the weakness is probably attributable to an inventory correction, which appears to have run its course. Machinery orders have picked up, and Japan's leading indicator has surged over the last couple of months.

Of course, the flip side to an inventory correction has been a sharp drop in import growth. Coupled with a hyper-competitive yen (against the euro, for sure), this has driven Japan's adjusted trade surplus to new cyclical highs. While Macro Man has previously argued that the small size of Japan's trade surplus was an argument for yen weakness, or at least no yen strength, that argument no longer appears to hold water. Recent trends in Japanese trade would appear to suggest a fundamental rationale for yen strength.

As an aside, this development will make it much harder for Japan to justify massive FX intervention to its G7 partners if they come in anywhere near the levels that have triggered MOF/BOJ dollar-buying over the past decade.

So how are we left? In a situation where Japanese growth and inflation may be poised to surprise to the upside. But this is a fairly low-conviction view, and Macro Man is keen to avoid selectively asserting this view simply because his positions would benefit from it. What is clear is that he really dropped the ball on the short JGB position, turning a tasty gain into an irritating loss over the past couple of months.

Macro Man is keen to avoid repeating this mistake. There's quite a bit of data to be released over the next week; from here on out, the JGB short will have a considerably shorter leash than it has in recent months. As for the yen, it has been driven lower this week by the houswife branch of the DOTW and by half-year-end flows into investment trusts. While there are stories circulating of the post office switching enormous sums of money out of bonds and into equity (some of which will be foreign), that is unlikely to drive near-term price action. USD/JPY above the 116-117.25 region may prompt a re-think, but for now Macro Man cannot help but think that the balance of risk lies in favour of a moderately stronger yen, at least against the buck.

Elsewhere, the nominal P/L has eked back into positive territory on the month, though there's still a crucial period of trading to come. USD/GCC appears to be undergoing a bit of short-covering after yesterday's SAMA non-event, and it seems reasonable to expect that that may continue until next week. Macro Man will look at layering shorts then. Markets still need something to talk about, though, so revaluation focus as switched to Hong Kong. Plus ca change...

So will this be the week that The Economist slaps the dollar on the front cover? Macro Man certainly hopes not, as he is positioned for further dollar weakness and would prefer not to face such a formidable obstacle to further profits. The euro-centric DXY came within tickling distance of its all-time lows yesterday, though it has subsequently backed off a smidge.

Some market technicians are now calling for a respite, given that the buck appears "oversold." And while a pause in dollar weakness, particularly one that keeps The Economist focused on other things, may certainly be refreshing, it would appear unlikely if Macro Man's reading of the current market environment is correct.

Simply put, he does not feel that the market has the short dollar trade on in meaningful size-certainly not in the same magnitude that existed in 2003-04. Part of that is a result of current low-volatility environment, which encourages relatively rapid profit-taking. Indeed, there has been plenty of evidence that some euro longs have been taking money off the table this week. More strategically, however, dollar weakness hasn't really resonated as a thematic macro trade, other than in brief pockets, for the past couple of years.

After all, if you're a macro hedge fund, why screw around with a currency that trades on a 5% or 6% annualized volatility when Turkish or Brazilian equities can move that much in a day? Macro Man's sense is that that may be changing, and that once month- and quarter-end passes on Friday, these funds may be prepared to expend more of their risk budgets on giving George Washington a smack.

And while history may not repeat, it quite often rhymes. Macro Man has observed an interesting phenomenon in EUR/USD which suggests that any near-term pullbacks may be very shallow indeed.

In 2003, when EUR/USD posted its first weekly close above 1.10, it rallied 9 figures in more or less a straight line before stalling.
Later that year, when it registered its first weekly close above 1.20, it ended up rallying another 9 figures in a straight line before losing ground.

In late 2004, EUR/USD registered a weekly close above 1.30 and rallied above 1.36 without registering another weekly close below 1.30.

Last week, EUR/USD registered a weekly close above 1.40. If history repeats, or at least rhymes, then we could see 1.45 or higher in fairly short order.

Focus this morning is on an announcement from SAMA. To say that Western analysts and fund managers, including Macro Man, have no special insight on this would be an understatement. Indeed, the banks that Macro Man speaks to cannot even agree whether this is a regularly scheduled announcement or something extraordinary.

The last few years (China, Russia, Kuwait) suggest that a change in currency regime is not announced in a scheduled press conference, but rather comes as a surprise announcement or simply via market operations.

Macro Man certainly hopes the Saudis do nothing; any profit-taking on SAR longs as a result could provide an interesting entry opportunity. Short USD/GCC offers very attractive option-like payouts, and Macro Man would be remiss in not slapping some on when the negative carry (e.g., the option premium) is low.

Every so often, Macro Man is accused (often by friends and family) of being a know-it-all. As regular readers will have no doubt deduced, he does tend to have strongly-held opinions, and is often less than subtle in his manner of expressing them. But one thing that he takes special care to avoid is overconfidence, and a willingness to admit that he does not know something has saved him from loss and embarrassment on a number of occasions.

As Macro Man scans the world around him, he sees plenty of cause for confusion and head-scratching. Among the things that he does not understand are the following:

1) What, if anything, is the C&I loan data saying? Amidst the "worst crisis in 25 years", commercial and industrial loan growth has soared. Some of this no doubt represents a substitution effect (i.e, bank borrowing rather than CP or bond issuance), but the very fact that banks have been willing to lend suggests the fears of a financial system implosion were overstated. Indeed, current y/y C&I loan growth is the highest in-you guessed it-25 years.

Given the braodly cyclical nature of loan growth, that would appear to suggest that the US economy is as far from recession as you could get. Yet the indicator appears to be a lagging one; in the last economic downturn, for example, loan growth didn't turn negative until July 2001. So is the C&I telling us about the cycle, liquidity, or just the substitution of bank borrowing for issuance?
2) In the aftermath of the first bank run since the 19th century, how can the UK Government be so popular? Regardless of where one sits on the political spectrum, it is hard to escape the notion that the Northern Rock fiasco could have been handled better. Normally, scenes of lengthy queues outside of banks would spell disaster for the current government. Yet Labour, led by the heretofore intensely uncharismatic Gordon Brown has, if anything, seen its approvals ratings rise, to the degree that Gordo is contemplating an early election. How has this happened?

3) How has the Ireland rugby team become so bad, so quickly?

4) Why, on the day that Goldman Sachs reported blow-out earnings ($6.13 versus $4.35 expected) and Bear Stearns reported awful earnings ($1.16 versus $1.71 expected) did GS stock fall $1.97 while Bear stock only declined by 18 cents?

5) What are GCC countries waiting for? Kuwait has revalued the dinar by another negligble amount this morning, yet other Gulf countries have remained steadfast in their dollar pegs. What are they waiting for before they float/revalue? The current policy regime is pretty clearly highly suboptimal, and as things now stand the macroeconomic impact is only going to get worse. With oil at 80 bucks, it's not exactly like the Gulf countries are going to run out of cash any time soon, so why wait? Is it because they wish to avoid speculation on their domestic currencies?

If so, the permit Macro Man a derisory snort, given that Middle Eastern institutions are among the more predatory speculators in the G4 currency markets.

6) Why are short-dated inflation breakevens in the US so low? In case you hadn't noticed, commodity prices are en fuego recently. And these tend to be the primary driver of changes in headline CPI. The weak dollar has attracted a bit of attention as well., and we know that China is no longer exporting deflation. So why are short-term breakevens (proxied below by the 1 year inflation swap) near their lows of the last six months?

7) Why, when Macro Man's normal morning train has been cancelled, do the railway workers not announce this until the following train (which offers an indirect service into London) has come and gone, thereby stranding passengers for half an hour? Is it really that difficult to tell us in time to catch the next train?

Sigh. And so the long dark winter is upon us. When Macro Man left the house this morning, it was absolutely pitch black for the first time since last March. Although the weather remains reasonably mild (it's warmer in late September than it was in late July), the onset of autumn is well and truly here. Once daylight savings is reversed in October, daylight will be for lunchtimes and weekends only.

Whether the winter proves to be one of happiness or discontent remains to be seen, of course. Financial markets are busy developing historical analogies to the current environment. Is it the aggressive asset price reflation of 1998? The recession/stock market rally of 1991? Or perhaps even the 'Fed behind the inflation curve' episode of April 2006?

At this juncture it is difficult to say, for of course history may rhyme but it rarely repeats verbatim. What does seem clear, however, is that there is currently a disconnect in financial markets. Now, disconnects are strange animals. They can occasionally be sources of rich opportunity in what Macro Man jokingly refers to as Heinz trades (Heinz--> ketchup-->catch up, in which an outlier eventually returns to 'correct' pricing.) But they can equally be a source of intense frustration, because there is no guarantee that the ketchup comes out of the bottle, so to speak.

What is striking now is the degree of easing priced into the eurodollar curve, and by extension that short end of the Treasury curve, with the "gas on the fire" response of risk asset markets both before and since the Bubble Boy's 50-beep gift last week.

If we compare the eurodollar strip with last Friday's three month LIBOR fixing, we see that the strip is discounting three month interbank rates more than 0.75% lower by the middle of next year. Some of that no doubt represents a compression in the spread between LIBOR and Fed Funds, but some of it undoubtedly is pricing in further rate cuts.
Now, if you believe that the housing market is a black hole at the centre of the universe which is

Indeed, the euro crossover index, erstwhile barometer of all things wrong with credit-land, is back within hailing distance of its tights despite the apparently obvious deterioration in the fundamental backdrop. While this index has its flaws as an indicator, it certainly captures the prevailing theme of collapsing risk premia. It is now not terribly difficult to mount an argument that current levels inadequately provision for likely defaults.

The equity picture is well known. The 'lambda' and the 'W' might as well be consigned to the Linear B alphabet, because as scenarios they are extinct. The chart below shows MSCI World, but could you really pick it out of a lineup when presented against charts of the SPX, DAX, FTSE, et al?

Commodities, meanwhile, began rallying soon after the Fed's initial discount rate cut and haven't stopped since. Now, part of this rally may be down to the continued resilience of China, et. al. as an independent driver of global growth, but at least some of it, in Macro Man's view, represents the inflationary consequences of an overly-lax global monetary policy. BB's cut has only exacerbated the issue.

So credit, equities, and commodities are saying that the cut was unneccessary and represented gas on the fire. The yield curve and breakevens are saying inflation is going up. Yet fixed income is pricing for more rate cuts ahead. How credible is this?

Not, in Macro Man's view, though there is of course no guarantee that these markets will "normalize" any time soon. But the fact that US household net worth continued to rise in Q2, despite the weakness of housing, is telling; it suggests to Macro Man that the residential black hole is not at the centre of the universe. While one could argue that the impending creation of CIC could have a supportive effect on risk assets, Macro Man finds it difficult to credit that CIC will exert much, if any, influence in the near term.

Macro Man's bias, therefore, is to look to fade the eurodollar strip...though he plans to wait a coupleof days to hopefully allow implied vols to fall a bit. The one thing he is on the lookout for is an abrupt about-face from the Fed, a la May 2006; if BB takes a look at things and believes the market is "dissing" his credibility (steeper curve, surging breakevens, exploding risk assets, collapsing dollar), he may feel compelled to defend his honour. And if the Fed chair does indicate that he gives a hoot about preserving the purchasing power of the currency, then the resulting squeeze could be very nasty indeed.

On a portfolio housekeeping note, SPY went ex-div on Friday. The dip in the stock price this month will be added back in next month via the payment of the dividend.

All of a sudden, markets feel like they've had enough. The dollar has tried and failed to extend losses this morning, and equities are drifting higher after yesterday's weakness. 10 year bonds across markets remain on the back foot, though a set of execrable PMI data from Europe have arrested the decline for the time being. After an enormously eventful week, it seems as if Macro Man isn't the only one content to go quietly into that good (hopefully, should Ireland beat France tonight) weekend.

The benefit of quiet days, of course, is that they allow us to take stock of big picture views and developments. Over the last couple of days and weeks, Macro Man has articulated his growing disillusionment with the dollar and expressed fears that the next bubble will be one of dollar weakness.

While the current shellacking of the buck does not yet represent anything like a bubble, it has certainly taken a number of exchange rates to interesting levels. Yesterday, Macro Man noted that the EUR/USD rate is now "bigger" than the USD/DEM rate. Soon after, another historical threshold was reached. For the first time since America's bicentennial year, a Canadian dollar is now worth more than its US counterpart.
The chart above doees not include the current quarter, else you'd see the last candle below 1.00. How sustainable the uber-loony is remains to be seen, though Canadian policymakers have, to date, played down the impact on domestic manufacturing. The recent recommendation of a commission in Alberta to raise the royalty taxes on tar sands developments has attracted some attention, but the sort of extra revenues expected to be raised (some $2 billon per year), while non-trivial, are hardly on a scale that will dissuade investment, particularly if oil continues its march on $100/bbl. The next obvious target is the post-Bretton Woods low of 0.96.

Another financial market price at historical levels is of course gold. Macro Man has highlighted the importance of the $730 level on a couple of occasions, and the chart below offers a belated demonstration of why. The first gold future bounced hard off of $730/oz in both 1980 and 2006. It has now breached this level, and technically it's clear sailing from here to $870. Given sentiment, the pace of the move could prove to be quite explosive.

A final point of interest is the condition of the money market in China. Macro Man expects markets to re-focus on China in coming weeks, what with the formal launch of CIC nxt week and the 17th CCP Congress starting on October 15. The last reserve requirement hike from PBOC takes effect on September 25....could it be that policy is finally tightening?

Recent developments in China's money market have been little short of remarkable. One month SHIBOR has shot up from below 3% at the end of August to more than 7% now. Word on the street is that this is largely due to technical factors, and it is the case that interbank rates at longer maturities, while higher, have not shown the same sort of spike.

So it's probably premature to conclude that policy is finally and legitimately being tightened in China. Nevertheless, these developments are curious in the context of the recent inflation data; clearly, policy does need to be tightened. Whether this comes via higher interest rates, a higher exchange rate, or, more likely, both, remains to be seen.

Nothing like a complete breakfast of cereal and toast.....

Toast. Not only is it a wonderful breakfast food- tasty with honey, jam, marmalade, butter, or even dry-but it is also a pretty accurate description of the current parlous state of the US dollar.

Macro Man has long been more favourably disposed to the buck than many. His disavowal of the "dollar must go down forever" thesis is one of the reasons that he (unfortunately) didn't delta hedge his powerball strip. However, even his patience has its limits. A few weeks ago, he noted that any aggressive gesture from the Fed to bail out turd-holders and reflate asset markets would force him to turn structurally bearish.

That has now come to pass, and in what Dennis Gartman might refer to as a "Watershed" moment, Macro Man has lost faith in George Washington. Simply put, if the Fed doesn't give a crap about protecting the purchasing power of the dollar, why should anyone hold it?

We've reached a rather interesting juncture in EUR/USD, at least if you are a fan of arcana like Macro Man. Not only has EUR/USD breached 1.40 for the first time, but it is now trading "above" its implied USD/DEM equivalent (on the basis of the EUR/DEM conversion rate of 1.95583) for the first time. This might only interest a finance geek like Macro Man, but he still thinks it's telling.
Impetus for the dollar's latest downturn has come from panic-monger extraordinaire Ambrose Pritchard-Evans, who highlights in this morning's Torygraph the growing risk that Middle Eastern countries abandon their dollar peg. While the headline might be straight out of the Sun or New York Post (the author must be short dollars p.a.), the theme is a very real one.

Inflation in the Middle East is rising due to three factors: "Dutch disease" oil revenues, artificially low rates resulting from the dollar peg, and the weakness of the buck in foreign exchange markets, particularly against those regions from which the Middle East imports most of its goods. The trend in UAE inflation, while perhaps more dramatic than in other countries, is neverthless emblematic of the problem at hand.

They had 9% inflation last year, which will almost certainly print double digits this year. Why, then, are rates at 4.7% and the dirham allowed to slide down the toilet? The obvious solution is to break the peg....which, in the case of Saudi Arabia, could disrupt a source of large price-insensitive capital flows into the US.

The trend seems clear, therefore-at least until The Economist puts the dollar on its cover. Rallies should be used as an oppurtunity to add to dollar shorts. In the meantime, however, gold may offer the best risk/reward opportunity. $730 is a massive level in bullion; a break should target $850 in fairly short order. Macro Man will therefore stop into longs at $742 in the Dec futures contract, adding to the exposure he has from options.

Finally, Swervin' Mervyn has testified before the Treasury Select Committee today. In a shocking, SHOCKING development, King has defended the bank's actions and blames the apparent inconsistencies on other people/organizations. Sorry, Merv: you've blown it.

And for what reason? NRK continues to head lower, and rumours are swirling that HBOS and Alliance and Leicester are preapring to step up to the BOE's liquidity milk-teat. Please, everyone....form an orderly queue.

Finally, today's equity action is likely to be driven by Goldman and Bear Stearns earnings. So far Lehman has beaten estimates whil Morgan Stanley missed. But the real action should be today: Bear was at the epicenter of the subprime earthquake, while GS has both a superior reputation and more proprietary exposure. Still- things are unlikely to be that bad. A Goldman friend of Macro Man's mentioned on the train this morning that he hopes GS misses earnings...so that his bonus allocation (paid in GS stock) will be at a lower price level...

Well, that was an eventful night. No, not the Fed cut and the concomitant risk asset orgy that followed; Macro Man covered that in his last post. Rather, he's referring to some of the things he saw and heard when he went out to party afterwards.

It's a bit of a tradition that after staying late to follow markets during periods of extreme importance, one goes out to paint the town. You know, to decompress, let off some steam, and hopefully celebrate a profitable evening's trading.

So Macro Man and a few buddies made their way to a karaoke bar in Soho, looking for an evening's entertainment of firewater and off-key vocalizing. Imagine our shock and surprise when we got there and found Alistair Darling and Barney Frank knocking back tequila shots and monopolizing the mic! Who knew that those two were such rowdy friends.

In any case, neither one is much of a singer, especially after emptying the better part of a bottle of Cuervo Conmemorativo. Most of their singing was pretty garbled, but Macro Man did manage to understand one Rolling Stones song that they performed. Perhaps due to their consumption of tequila, though, they altered the lyrics. Here's what they were singing:

Under my thumb
The bank that once had me down
Under my thumb
The bank that once pushed me around

It's down to me
The difference in liquidity
Down to me, the change has come
It's under my thumb

Ain't it the truth man?

Under my thumb
The hard-ass bank that's just had its day
Under my thumb
Now they've cut rates and so changed their ways

It's down to me, yes it is
The way it just does what it's told
Down to me, the change has come,
It's under my thumb
Ah, ah say it's alright

Under my thumb
An inflation-fighting man
Under my thumb
I've just made him throw down his hand

It's down to me
The way it cuts when it's spoken to
Down to me, the change has come
It's under my thumb
Ah, money's easy babe
Yeah

It's down to me, oh yeah
The way it cuts when it's spoken to
Down to me, the change has come
It's under my thumb
Yeah it feels alright

Under my thumb
Its views are just kept to itself
Under my thumb
I can make it bail out someone else

It's down to me, oh that's what I said
The way it cuts when it's spoken to
Down to me, the change has come
It's under my thumb

Say, SPUs are up 40 now...

Says it all...
Says it all...

Money's easy babe
Money's easy babe
Feels alright
Keep it, keep it easy babe

As if that wasn't shocking enough, imagine Macro Man's surprise when he encountered the Deputy Governor of one of the regional Feds. This gentleman, kitted out in some rather natty casual threads, seemed rather emotional about the aggressive Fed move.

Macro Man managed to corner him and ask him if the Fed viewed saving the leveraged buyers of crappy credit as the rationale for easing. Did they realize who they were saving via this provision of liquidity? Here's how he responded:



All this is in good fun, of course, but the reality is that the aggressive Fed easing, with a veiled promise for more, ignites the "kick the dollar" scenario that Macro Man has been contemplating. Why buy US financial assets? Other stock markets are cheaper. Other bond markets offer superior real yields and safer credit. Other central banks provide a clearer commitment to protect the puchasing power of the currency.

Global investors largely shunned the US market in July as the recent crisis was beginning to percolate. With CIC coming into existence at the end of this month, what odds that the formerly reliable inflow of capital from China becomes a little more selective? Such is the stuff of dollar shellackings.

What's interesting is that the back end of the US yield curve actually sold off after the rate cut. Part of this may have been due to the placement of curve steepening trades, but some of the rise in yield must surely represent a risk premium against the Fed throwing gas on the inflationary fire. For headline CPI, base effect Nirvana will morph into base effect Hades in Q4, and it is eminently possible that we'll see a 4 handle before the year is out. Negative real yields on two year notes, anyone?

Macro Man finds it very interesting indeed that the Fed has cut rates and eased its inflation concern even as 5y/5y inflation breakevens have shot higher. This measure will probably provide a good barometer of Fed credibility (or lack thereof) moving forwards; a continued rise will be bullish for gold and very, very bad indeed for the dollar.

That's what it is.

Macro Man covers his ESU7 short at 1501 and buys another €20 million at 1.3925 spot basis.

Let the good times roll.......hangovers are for suckers, worriers, and the sad bastards who don 't live under the warm embrace of friendly central banks.

Damn the torpedoes, full speed ahead!

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!

Markets have opened up the new week in edgy fashion this morning, spurred on by weekend scenes of the UK's first bank run in more than a generation. The news makes fairly grim reading, with some £2 billion of Northern Rock's £12 billion deposit base withdrawn since Friday morning. London dealers are asking themselves this morning whose fortunes have collapsed more swiftly: those of Northern Rock or the England rugby team?

Regardless, the chart of Northen Rock is beginning to resmble that of another mortgage lender that suddenly found it difficult to obtain market financing for their loan book. Although many expect a white knight buyer to emerge for Northern Rock, would it really come as much of a surprise if they went the way of New Century?
This week should prove to be very tumultuous indeed, what with the Fed announcement tomorrow and Lehman, Morgan Stanley, Goldman, and Bear all reporting Q3 earnings. There is clearly scope for plenty of volatility, particularly with the S&P 500 perched just a few points from its high since the "crisis" began. Macro Man would not be suprised to see fairly quiet trade today as markets wait nervously for the newsflow to begin in earnest tomorrow.

Those tempted to do a bit of reading in the meantime may turn to Alan Greenspan's new book, The Age of Turbulence, which is published today. The Maestro's legacy has become a bit tarnished recently, with many laying the blame for the subprime debacle squarely on his shoulders. There has been some suggestion that The Age of Turbulence was prompted by Greenspan's desire to engage in a little historical revisionism to preserve his legacy as the Maestro.

Is this in fact the case? Judge for yourself. Macro Man 's contacts in the publishing industry have provided him with access to an initial version of the galleys, reprinted here on an EXCLUSIVE* basis. Enjoy!

Greenspan on....

the housing crisis: In the spring of 2003, it started to become clear to me that the US housing market could begin to start suffering significant distress in 2006, with a concomitant decline in the price of mortgage derivative securities in 2007. I therefore acted promptly, authorizing a 0.25% cut in the Fed funds target rate to 1%. While many on the Committee did not agree with this move, my argument in favour of pre-emptive action against an economic downturn in four years' time eventually carried the day.

irrational exuberance: It is a widely-held fallacy that I used the phrase "irrational exuberance" in reference to stock markets in late 1996, just as they were set to register stunning gains for the next three years. In fact, what I said to the American Enterprise Institute that night was "But how do we know when irrational antipathy has unduly depressed asset values, which then become subject to prolonged and justified appreciation over the next several years?"

In March 2000, I determined that equity markets had, at last, become irrationally exuberant, and described them as such in meetings with the Administration and Congress.

fiscal policy: I was occasionally stunned by the inability of politicians from both sides of the aisle to understand the appropriate use of fiscal policy. Although I eventually developed a working relationship with the Clinton and G.W. Bush administrations, it came only after the painstaking effort of lecturing the executive and legislative branches on how to use fiscal policy.

I recall a meeting that I had with Gene Sperling in early 1993. Sperling articulated the new Clinton administration's intended economic program, which included a substantial increase in spending along with targeted tax cuts. Given that the Fed funds rate was set at an already-accomodative 3%, this was a clearly inappropriate setting for fiscal policy.

"Gene," I said, "let me explain to you what the role of fiscal policy is. When monetary policy is easy and I do not wish to be blamed for taking away the punch bowl, it is the job of fiscal policy to begin tightening the strings on the economy. Only after it is clear that the economy is resilient enough to absorb policy tightening is it appropriate for the Fed to adjust its monetary stance.

"By the same token, when it becomes clear the the economy is slowing, it is appropriate for the Fed to slash interest rates quickly so as to provide a needed boost to activity. Only after monetary policy fails to engender an economic recovery (no doubt because the government ovecooked the fiscal tightening previously) is it appropriate to cut taxes or raise spending.

"In a very real sense, monetary and fiscal policy must work together as a 'good cop' and 'bad cop.' Because of the nature of transmission mechanisms, it is imperative that the Federal Reserve, as an unelected agent, fulfll the role of the good cop."

his recommendation that mortgagees take out adjustable-rate mortgages (ARMs) during the early stages of the tightening cycle in2005: In early 2005, the Economic Club of Cheyenne invited me to Wyoming to make a few remarks. Knowing the local predilection for hunting, I made a casual reference to the forthcoming end of deer season and called on the attendees to "go take out arms" to try and bag one last large-antlered buck before the season ended. This was subsequently misinterpreted in the financial press as a recommendation that homebuyers use exotic and dangerous mortgage products. In reality, nothing could be further from the truth.

the stock market crash of 1987: Half an hour after after the opening of the New York Stock Exchange on October 19, 1987, it became clear that the stock market was in significant distress. Two months into my tenure as Chairman of the Federal Reserve, I was about to meet my first great challenge.

At approximately 10.30 a.m., I took a phone call from Treasury Secretary James Baker. The Secretary asked me what I planned to do about the stock market decline.

I replied that I planned to do nothing, as my Objectivist background had taught me that government agencies should not play a role in private markets and in no way should save "looters" from the consequences of their own economic decisions. I told him that I did not wish to grant markets a "put option" to insulate them from price declines.

Mr. Baker was not impressed. In his inimitable Texas drawl, he said, "Boy, I don't know much about them there put options. But if you don't do something quick, I'll give you another kind: you can have the option of whether I put my left boot or my right boot up your be-hind."

After deliberating for a few minutes, I concluded that shoring up confidence in the financial system was, after all, a worthwhile goal, and thus provided liquidity to markets. And that was the genesis of the policy tool that eventually became known and loved as the "Greenspan put."

Bob Woodward's biography, Maestro: A number of friends and colleagues told me that I should be flattered by my portrayal in Woodward's book, but frankly I found it all to be a bit embarrassing. Woodward left out numerous examples of my policy-making genius, and left the reader in doubt as to whether the entirety of world economic growth was down to my decisions, which of course it was.

Macro Man is sure you'll agree that Greenspan has outdone himself....

Well, it didn't take long for the governor of the Bank of England to remind us why he is known is some quarters as "Swervin' Mervyn." A day after Merv appeared to drop the hammer on bail-outs and "the world owes me a living" financial risk-takers, news has hit the tape that Northern Rock, a prominent UK building society, has borrowed "a substantial amount" from the Bank in an emergency operation.

As of yet, official details- the amount and the rate- have yet to be officially confirmed. That hasn't stopped the press from characterizing the operation as exactly what King stated would not be forthcoming: a bail-out.

Now, in his TSC statement, King did suggest that the Bank has a role to play as lender of last resort to ensure financial stability:

"In addition, central banks, in their traditional lender of last resort (LOLR) role, can lend “against good collateral at a penalty rate” to an individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent. The rationale would be that the failure of such a bank would lead to serious economic damage, including to the customers of the bank. The moral hazard of an increase in risk-taking resulting from the provision of LOLR lending is reduced by making liquidity available only at a penalty rate."

The problem, of course, is that the current standard BOE "penalty rate", 6.75%, is actually lower than the current interbank borrowing rate. So conceivably, Northern Rock could borrow from the BOE and lend in the open market and lock in a small profit- exactly the sort of behaviour that King decried in his statement.

Macro Man is willing to withhold final judgement until the details emerge. But if NR really did borrow at the standard "penalty" rate just before announcing that a) they expect to earn £500-540 million this year, and b) they expect new lending volumes to increase, it will be difficult to avoid the conclusion that Swervin' Mervyn has committed the grossest hypocrisy. (Interestingly, there are a number of anecdotal reports of large queues outside of Northern Rock branches, so perhaps NR's cure was worse than the disease!)

Of course, puzzling behaviour is not confined to the BOE. Serial whingers the Swiss National Bank have provided numerous reasons to scratch one's head over the past few years, and this week is no exception. The SNB hiked its LIBOR target rate by 0.25%, surprising some observers but earning a hearty "Bravo!" from Macro Man. Yet this morning the SNB set the 1 week repo at 2.08%, a whopping 0.21% lower than yesterday. So on Thursday, they hike rates (fully justified, given their currency concerns), but on Friday they cut rates?!?!?! SNB: WTF?

The continued strength of equities, carry currencies, and other non-CP risk assets is also prompting Macro Man to ask WTF. We are swiftly moving towards a scenario wherein a 0.25% Fed easing will be seen not as as a disappointment, and thus a reason to sell stocks, but as a provision of unneccesary liquidity, and thus a reason to buy. Macro Man was filled on his sale of ESU7 at 1490, so if this scenario plays out he may be stuffed. That the central bank of Turkey felt sufficiently confident to surprise markets with a rate cut yesterday- which was followed by a rally in TRY- is pretty clear evidence that contagion risks have, for the time being, subsided. It's just another brick in the wall of Macro Man's view that a Fed easing would be a mistake.

Today sees the release of a really interesting piece of data in the US. No, not retail sales, industrial production, current account, or even consumer confidence figures. All of these will be interesting, to be sure, but the cyclical data is less significant than usual, as Big Ben noted last week, while the confidence data is, in the short term, little more than a proxy for the stock market. No, the figure that Macro Man is really looking forward to is the import price number.

Specifically, the figure on import prices from China. When Macro Man talks to his colleagues about inflation, articulating his view that it is a large and growing problem for the US, he draws a lot of quizzical looks. One tenant of his view that real-world inflation (as opposed to the core PCE deflator, a measure that nobody pays) is that the deflationary impact of the BRICS has been replaced with an INflationary impact.

As has been documented previously, US import prices from China are now rising y/y: 0.9% at last count. On a more high-frequency basis, the 3 month annualized rate is up nearly 3%. What's particularly interesting is that both the y/y and high frequency import price data bear a startling resemblance to China's headline CPI. All the more reason, therefore, to take the recent acceleration seriously and disregard thos analysts who seem to think that food prices don't matter. All of this, of course, is an argument in favour of allowing the RMB to appreciate more quickly. To a degree, this is occuring- against the dollar. EUR/CNY, on the other hand, is back close to its post-reval highs.

Regardless, if an acceleration of non-oil import prices is met with Fed easing, it provides another reason to question why anyone would buy dollars any more. While EUR/USD remains near all-time highs on a spot basis, at longer maturities (such as those used by some sophisticated European exporters), this is not yet the case. Might they start getting sucked in to take advantage of current "value" before long?

Perhaps, though Macro Man is wary of talking his book too much. (And Brad, to answer the question you asked in the comments section a couple of days ago: I'd actually prefer PBOC to bugger off entirely. But if they are going to screw around and set the exchange rates of countries whose capitals are not Beijing, I'd just as soon they did it in my favour than not!)

For now, Macro Man is now going to wait: wait to see how the equity dynamic plays out, wait for an oppounity to sell more dollars, and wait to see who is bailing out whom.

Calm continues to prevail as equities tread water, some CP is being rolled over (albeit at shorter maturities), and the dollar continues to tank. The buck has reached yet another significant low against both the euro and, somewhat more surprisingly, the Canadian dollar this morning. One might have thought that a severe dent to US economic growth expectations might negatively impact its neighbour to the Great White North, but for now strong energy prices, stretched resource utilization, and advantageous positioning have propelled the loony higher. It may not be long before USD/CAD shorts convene for a "parity party."

A refreshing breeze swept through financial markets yesterday, courtesy of the Bank of England. The Old Lady of Threadneedle Street has long prided itself on its market savvy and awareness, and like other major central banks it takes an active role in surveying the state of financial markets in real time.

In advance of next week's testimony before the Treasury Select Committee, BOE Governor Mervyn King released a statement setting out the Bank's views on the current state of play. The message contained therein was reminiscent of the Seinfeld Soup Nazi: "No bail-out for you!"

The entire statement, linked above, is well worth a read. But among the choicest quotes were the following:

"But the source of the problems lies not in the state of the world economy, but in a mis-pricing of risk in the financial system."

"If, in the wake of a shock to the financial system, the terms on which the financial system extends credit to the private sector become less favourable, then borrowing and overall demand would weaken. Other things being equal, that would lower the inflation outlook. Of course, other things are not equal. When the Monetary Policy Committee meets each month it reviews all the evidence on the outlook on inflation before reaching a judgment. The August Inflation Report implied that some slowdown from recent strong rates of economic growth was needed to meet the inflation target."

"the provision of such liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behaviour. That encourages excessive risk-taking, and sows the seeds of a future financial crisis. So central banks cannot sensibly entertain such operations merely to restore the status quo ante. Rather, there must be strong grounds for believing that the absence of ex post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in the future."

"If central banks underwrite any maturity transformation that threatens to damage the economy as a whole, it encourages the view that as long as a bank takes the same sort of risks that other banks are taking then it is more likely that their liquidity problems will be insured ex post by the central bank. The provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises."

Strangely, short sterling continued its recent rally yesterday, with the March-June '08 contracts up 7-8 ticks. Markets keyed on one comment suggesting that the BOE would take the appropriate action; however, the above excerpts would strongly imply that the current mindset of the BOE is that the appropriate action is to do nothing!

What is ironic, of course, is that unlike in the US or Eurozone, monetary policy in the UK is pretty unambiguously restrictive. Markets are happily selling sterling this morning after the RICS house price balance tilted negative- could this be the real economy spillover required to prompt a BOE rate cut?
In the fullness of time, perhaps, but certainly not yet. The scope of the rollover has been modest in comparison with past episodes, and remember: it was just last month that the MPC judged that economic activity needed to slow to preclude further tightening. Now, Macro Man has disliked sterling all year, so he has sympathy for those selling it now.

But those doing so on the expectation of an imminent rate cut should be warned. The BOE is clearly not in the mood to provide a free lunch to banks and speculative turd-buyers; unlike the Fed, the Old Lady is not for turning.

Elsewhere, in the comments section to yesterday's post, reader Corey noted the confluence of factors that could produce an explosive move in gold. Now, Macro Man has avoided commodities since the disastrous GG and oil spread trades earlier this year, but has to admit that the idea has merit. Combine a weak dollar with an unneccesary provision of financial market liquidity (money markets might appear to need it, but it seems clear that other markets don't), and it would appear to be a perfect setup for a higher gold price.

Macro Man decided to run a simple study to see if these two factors have much of an explanatory power over gold, and sure enough, they do. A simple regression of y/y changes in gold with y/y changes in the DXY and global money growth yields a reasonable r^2 of 0.43. The t-stats of both factors are statistically significant.

While the model failed to identify the speculative boom in gold in late 2005, it has captured other broad trends in the yellow metal. Intriguingly, the model suggests that the gold price should be roughly 10% higher than it currently is. Projecting further decines in the DXY and rises in money growth would provide a further impetus.

Whether it's crisis fatigue, an Indian summer in the UK (during the daytime at least), or just plain myopia, markets are happy and risk assets are trading on the front foot this week. It's crunch time in terms of ABCP roll-overs, but markets seem to be taking the attitude that "that's for those money market blokes to worrry about; nothing to do with us." Nothing, that is, until bonus time, when a number of people may find themselves the recipient of a "Number 3 all over" haircut.

Both in the real world and in finance, the last few weeks and months have begun to seperate the wheat from the chaff. Consider the variant fortunes of the following persons. Who would you rather be?

* Shinzo Abe, Prime Minister of Japan. Actually, not any more. Abe has committed political seppuku after the economic and reform momentum of Koizumi has ground to screeching halt. Indeed, the only thing that seems to have increased under his watch is political scandal. The likely replacement as PM would appear to be Taro Aso, LDP Secretary General. Cue the Dukes of Hazzard theme song ("Just a good old boy/Never meanin' no harm/Beats all you ever saw/Been in trouble with the law/Since the day he was born.") It seems safe to assume that Japanese politics is switching back towards the bad old days of pork barrel spending.

* The new graduate intake at Goldman Sachs. A vicious rumour is circulating around the City that the new grad intake at Goldman have all been funnelled into Operations. Imagine the ignominy: expecting to take their first steps towards becoming Masters of the Universe, these poor souls now find themselves chasing third-party valuations and sending SWIFT messages. It's almost bad enough to make them wish they'd taken that job at Lehman.....

*Mohammed El-Erian. After just two years at Harvard, Mr. El-Erian has returned to the fold at PIMCO. While Mr. El-Erian claims that he's left Harvard for family reasons, the fact that he's been named co-CEO and co-CIO is no doubt a coincidence. Not a bad round-trip, is it? Harvard, meanwhile, is now left looking for a CIO for the second time in two years. If anyone from Harvard's administration is reading, Macro Man would be happy to entertain any offers....

Elsewhere, the dollar bear market appears to coalescing even faster than Macro Man had envisaged. Everyone in the known investment universe now seems to be bearish, though Macro Man's investigations suggest that positioning (at least against non-EM currencies) remains light. If this is the case, then pullbacks should be relatively limited. 80 in the DXY is an obvious level that the market can key on.

If the "incipient dollar down-bubble" thesis is correct, the market will end up chasing it after failing to get filled on hopeful dollar sell orders over the next week or so. Stay tuned.

Yesterday's US trade data came out broadly in line and continued to suggest that prior dollar weakness is having an impact. In both nominal and real terms, exports continue to outstrip imports by a healthy margin. It may be a coincidence that Ben Bernanke spoke on global imbalances yesterday, but his comments on the US current account deficit ("unsustainable") are reminiscent of Fed comments in Q3/Q4 2004, a period which saw an aggressive weakening of the buck.While the "savings glut" explanation may have a degree of truth to it- FX reserve accumulators have clearly had an excess demand for dollar assets- one has to query whether the same will hold true in the future. The evolution of SWFs and shift towards a more proft-oriented investment strategy would certainly argue for an asset allocation with a lower dollar weighting than that currently held by China or even Russia; a clear renewal of the dollar downtrend may make VIG, RIG, et al. even less enthused about holding dollar assets. And if Japan ever does revamp its reserve management, as has been suggested recently, one would imgaine that they'd have a few bucks to go as well.

What's interesting to note is that China's trade with Europe is taking on an increasingly prominent role, which might argue in favour of upping the euro's weight in China's FX reserves. China now exports more to Europe than to the US, and the level of the trade surplus is now almost as high with Europe as with the US. At current levels, the monthly trade surplus with Europe ($13.7 billion) must be approaching the monthly allocation of FX reserves into European currencies.

The P/L has been hit by a change in the pricing model for the Powerball strip. While the higher strikes have declined in value quite substantially, the lowest strike has actually increased in value. Macro Man has the quants on the case, but for now it's costing him a pretty penny....

Markets are remarkably subdued so far this week, perhaps suffering from "crisis exhaustion" after last Friday's payroll data. The investment bank earnings releases that had originally been scheduled for early this week (Bear and Lehman) have been pushed back into next week. Perhaps that's an ordinary occurrence, or perhaps it's a sign that they're struggling to fit the pieces together in a SarbOx-compatible fashion. If the latter, it's not exactly a ringing endorsement that the worst is over, is it?

As is generally the case, China marches to a somewhat different drumbeat to the rest of the world. So while the West has been snoozing, it's been all action in China with the release of a (yet another) higher-than-expected CPI report and a 4.5% decline in equities. While the latter is but a blip, the former has now reached its highest level in more than ten years, and thus merits some attention.

As has been the case throughout the year, food prices account for the bulk of the rise in CPI. Non-food-price inflation remains fairly steady at around 1%, which has encouraged many China watchers to presume that the current bout of inflation need not be met with aggressive policy tightening. Just as Clara Peller asked "Where's the beef?" in the 1980's, the question here appears to be "Where's the pass-though?"
Is that the right question, though? After all, a number of non-food items (energy, most conspicuously) fall under the aegis of price controls and thus should not be expected to show a price rise. And given the number of Chinese citizens living on a subsistence or quasi-subsistence basis, it is surely not in the best interests of a regime focused on stability to see food inflation (which has now hit 18.2%!) foment unrest in the hinterland.

And even relatively well-off urban workers must feel the pinch of food prices. Hell, the price of bread exceeding £1 per loaf made front page news in London! But the ease with which many seem to disregard food prices makes it seem as if Chinese workers don't have to eat. In fact, nothing could be further from the truth; food comprises a much higher proportion of living expenses in China and other developing economies than in the developed world. As such, food price inflation should be more likely to feed through into wage demands in these countries than one would expect in the US, Europe, or Japan. And higher wages could, ultimately, overwhelm productivity gains and generate higher unit labour costs from erstwhile disinflationary producers. Perhaps it's already happening, given recent trends in US import prices from China.

Further evidence that the inflationary dynamic in China may be more potent than commonly believed comes from the Baltic Dry Index, a well-known measure of freight costs. The rise of the last eighteen months has been little short of parabolic. In a sense, it doesn't matter how little it costs to produce something in China (or Vietnam, or India.) If it costs an arm and a leg to ship it, that's what the price will be in the destination market.
It may seem foolish to fixate on Chinese inflation when the Fed has finally ceased to care about US inflation. But if the Chinese authorities decide to meaningfully tighten macro policy after the October Party Congress, Asia might not be as bullet-proof as commonly supposed. And if Chinese unit labour costs do begin to rise in a meaningful way, the inflationary consequences of a weak dollar bubble could be that much more extreme.

Macro Man's systems have gone haywire, so no P/L today.

After a weekend of sober reflection (well, sober until the first bottle of vin rouge was cracked open), Macro Man's interpretation of Friday's employment report is largely unchanged. While the figure does not represent or guarantee a recession, it does seem clear after the revisions that the trend of payroll growth has decelerated. Henceforth, Macro Man may not even look at the "timely" payroll data, and instead concentrate his energies on analyzing the revised, presumably more accurate, prior data.

The extent of the rally in fixed income certainly tells you what the market wants to believe; namely, that the US economy is barrelling forward headlong towards recession. While rates at the short end obviously reflect some of the distress in credit markets, the break of yield support at the long end suggests that it's not all down to LIBOR issues.

A bull steepening of the yield curve, which the US has seen over the last couple of months, is not particularly positive for the buck. Specifically, at the short end, US govvy yields no longer offer a premium over those of the Eurozone. As the chart below illustrates, the US-German 2 year spread is back at par for the first time since Q4 2004. And that was a period in which the dollar was under very significant pressure indeed.
While USD/JPY has justifiably received most of the headines, the buck is showing weakness against a broader range of currencies. In contrast to price action observed during August, USD/CNY fell "sharply" overnight, declining by 0.25%. And EUR/USD is back up near all time highs. Macro Man belatedly bought some on Friday, though gains have thus far been limited (perhaps due to the defense of a 1.38 barrier, rumoured to roll off today.) Nevertheless, the buck (as proxied by the DXY, which itself is little more than a proxy for EUR/USD) is breaking some absolutely critical levels.

In the history of the DXY, 80 has been something of a "no fly zone". While the index closed below that level in August 1992, the ERM crisis the following September helped propel the greenback higher. Otherwise, the index has rejected 80 pretty forcefully on each of its prior visits to the level.

As such, last week's close just below 80 raises a red flag that perhaps Macro Man's view of dollar weakness forming the next financial bubble could occur sooner rather than later. Macro Man is therefore switching to high alert.

One data point does not make a recession, today's payroll data were pretty poor. In addition to the headline reading of -4, the first negative month since August 2003, prior months were revised down. As the chart below illustrates, downward revisions have been the exception recently. And experience suggests that one generally only sees downward revisions in, surprisingly enough, a downturn.

Is it payroll day already? It's come up quickly, or so it seems to Macro Man. Expectations have been marked down on the basis of Wednesday's ADP report; while the Bloomberg consensus looks for 100k, the street price is probably more like 85k. Macro Man has taken 137 in the office pool. While many seem to think that this is an unusually important data release, Macro Man takes the opposite view: the Fed will do what it wants to do on September 18o, regardless of how today's figures pan out.

Yesterday's central bank meeting fest played out more or less in line with Macro Man's expectations. The BOE offered some explanatory guidance while leaving rates unchanged, which some have interpreted as suggesting a rate cut next month. While Macro Man reckons that the BOE probably should cut, he thinks it highly doubtful indeed that they do.

As it is Friday, and both the Rugby World Cup and the NFL are starting, Macro Man has decided to have a little fun. Stealing shamelessly from this NFL season preview, Macro Man gives you the world of finance as seen seen through the lens of Star Wars:

Anakin Skywalker: Ben Bernanke. Has the power to do great good, but also the power to do great harm. No one much likes his boss.

"This is like deja vu all over again."

-Yogi Berra

Another month, another European central bank Thursday. While neither the ECB nor the BOE is expected to move policy, the ancillary information provided with the announcments will provide valuable insight into what the world's central banks are thinking.

The BOE may be a total non-event; after all, they usually don't issue a statement when they leave rates unchanged. But after yesterday's measures aimed at calming the money markets, the BOE may perhaps be tempted into clarifying the steps that it means to take.

More interesting, of course, will be the ECB press conference. At last, M. Trichet has been hoist on the petard (incidentally, what is a petard?) of his own word games, as the September tightening "promised" last month is unlikely to materialize. Perhaps Trichet will maintain that the ECB is vigilant both on inflation and on the proper functioning of money markets! Reardless, here's hoping that a journo or two asks probing questions on the severity of the current cash squeeze and its potential impact on the real economy.

Speaking of which, last night's Beige Book had a little something for everyone. While admitting to the continued severity of the residential housing recession, the survey nevertheless suggested that economic ouput continues to expand at a moderate (2% handle) to modest (1% handle) pace. Moreover, the survey suggested that while motor vehicle sales were sluggish (was it the CIA buying all those GM sedans?) , non-residential construction remains robust and that the economy continues to add jobs. However, inflation got short shrift. So if they want to cut rates, they can point to housing and inflation. If they don't, they can point to the lack of contagion. All in all, pretty neutral (or indeed beige!)

Elsewhere, Macro Man is left wondering why Rupert Murdoch enjoys such a dismal reputation as a press magnate. Even The Sun comes across as a bastion of even-handed, measured analysis compared to some of the rubbish coming out of the Daily Telegraph recently. After last month's story on China's potential pursuit of a 'nuclear' sale of US Treasuries, the Torygraph follows up this morning with a story suggesting that China is selling Treasuries.

As proof, the author points to the Fed's custody data, which does indeed demonstrate a decline in holdings of Treasuries since late July. Of course, what the article ignores is that holdings of Agencies continue to rise apace; indeed, even before the recent drawdown in Treasury holdings, CB Agency holdings had been rising at a faster pace this year. If China were going to sell off its US bondholdings, why sell Treasuries but not Agencies?
Moreover, if a Big Kahuna like China started to whack the Treasury market, don't you think word would leak out? Or if SAFE really did sell $45 billion in Treasury bonds, wouldn't the price have gone down/yield gone up? In point of fact, the entire yield curve shifted lower between the date of the peak in Fed custody holdings of Treasuries and the latest datapoint. And Macro Man has yet to hear word one of Chinese Treasury sales. If SAFE really is dumping bonds, they've managed to do so in an incredibly quiet fashion-and silence hasn't exactly been a hallmark of SAFE's investment activities over the past few years.

So what is going on with Treasuries, then? Why has the Fed's custody holding gone down? Macro Man believes that his original theory remains correct. As he articulated in comments on Brad Setser's blog (though he cannot remember which thread), and alluded to in this space, his view, based on conversations with people close to SAFE, was that China had been focusing for a while on buying Treasury bills and other short-dated paper. The rationale was to let that paper mature, and then take the cash and give it to CIC.

1) July pending home sales collapse, but August vehicle sales surge in the US. Could it be that erstwhile purchasers have decided to buy Winnebagos instead?

2) Macro Man is an idiot, as he did not get filled on the S&P futures sale. Learn from his mistakes, boys and girls, and just execute when you see a good setup. Greed, to contradict Gordon Gekko, is not always good!

We are swiftly tilting towards "put up or shut up" time for Macro Man's W-shaped risk asset price forecast, and indeed for those expecting a lambda as well. The next week will give us Beige Book and ADP today, ECB and BOE (who this morning took minor action to ease the liquidity squeeze) tomorrow, payrolls and services ISM on Friday, and then Lehman and Bear Stearns earnings early next week. If bad news is going to shake things up a bit, it shoud happen soon.

Risk asset shorts must be pulling their hair out (if they haven't lost it all.) The recent levitation of the S&P 500 has occurred on pretty thin volume, as the SPY chart below indicates. Any technician will tell you that such a rally is not to be trusted.....and yet it keeps drifting higher. Firm bank lending data suggests that distress in the CP market has not disrupted the credit mechanism for non-turd-buying enterprises.

Technically, meanwhile, the SPX is entering territory where it needs to start faltering if the W is gonna happen. The chart below overlays the 2007 price action (in red) with that of spring 2006 (blue.) While the day-for-day overlay has broken down over the last several weeks, the overall shape of the lines remain very, very similar. In early July 2006, the SPX attemtped to breach the 55 day moving average, but ultimately failed. This proved to be the (technical) catalyst for the buyable dip.

Yesterday, the SPX closed above the 55 day moving average for the first time since the crisis started. If the index doesn't get back below in a hurry, it will appear that the W has indeed morphed into the least popular forecast from the recent poll, the V.

For now, though, the jury's still out, and fortune may favour the brave. The risk/reward of selling stocks near current levels is excellent. Macro Man will therefore look to sell 400 ESU7 at 1490 with a stop loss at 1515, above the Wave B high. The future's currently down in early trade this morning, but would you rule out another early-session low-volume rally?

It's a day of returns today. The US workforce is returning to work from a long Labor Day weekend. Macro Man's kids are returning to school. And financial markets are returning to fully-staffed trading desks and, one would presume, more normal trading volumes.

One thing that has not returned to normal is the money market, where rates and uncertainty both remain high. Markets are abuzz with talk of the enormous CP rollovers to be done this month and left wondering what will happen if there is no bid. The widely held conclusion, of course, is that the Fed will cut rates to ensure that there is a bid.

There is plenty of "real" news this week as well. The US sees ISM, the Beige Book, and payrolls. Weak readings will cement the notion of rate cuts, while strong readings...well, will strong readings mean anything at all? At Jackson Hole, Big Ben noted that economic data will offer less guidance than usual, given the uncertainty of the times. He may as well have just queued up the old Rolling Stones song, ably covered by the Soup Dragons: "I'm free to do what I want/ Any old time".

Of course, it's not all about the US. An early warning signal of how seriously CBs are taking the current market turmoil may be observed from the BOE and especially the ECB meetings on Thursday. The BOE should be a non-event, though the turmoil in the UK money market is just as pronounced as in the US. No, the real info will come from the ECB.

A month ago, Jean-Claude Trichet used his little word games to signal a rate hike this month. And while the ECB subsequuently issued a statement suggesting that the outlook had not changed, at the same time the ECB has provided mammoth amounts of money market liquidity via short and medium term repos over the past few weeks. What would be the use of providing liquidity with one hand and then withdrawing it with another? An unchanged decision would appear likely. The really interesting bit is likely to come in the press conference, where for the first time since the crisis began a central banker will field questions directly from the fourth estate. The degree of medium-term (or lack thereof) concern over the functioning of markets expressed may give us an insight into what the Fed is also thinking behind closed doors, given that the world's central banks confer closely during times of financial distress.

Macro Man retains the view that easing rates would be a mistake for the Fed. Yes, house prices in some markets are falling, in a few cases precipitously. But in most of those cases, these markets are drastically unaffordabe relative to local incomes, and a degree of normalization should not be the end of the world. Yes, some householders will suffer a hit to their wealth. But policymakers (in aggregate) cannot complain about the unaffordablity of housing on the one hand and then act to buoy prices as soon as they start falling! (Well, they can, of course, but not if they wish to maintain internal consistency.)

Moreover, Macro Man would view the current turmoil in the ABCP market as a long-overdue normalization. The chart below shows the amount of CP outstanding by issuer type. Note the explosion in ABCP over the last two and a half years; can there really be any doubt that this represented a bubble? It seems quite clear (as it did in real time to many people) that the expected excess returns to be generated by the assets purchased by ABCP had dwindled to the point of being negative.

A reduction in the "issue short term paper to buy long-term turds" business model is not an event that will cause Macro Man to lose much sleep at night, he has to say. What's interesting to note is that the amount of non-financial, non-asset backed CP has barely budged thoughout this event. If there's contagion, Macro Man doesn't see it here.

Similarly, the yields on CP suggest that markets are charging a higher rate for crap (ABCP and low-quality non-financial CP), while yields on high-grade CP not backed by turds have not budged.

Now, Macro Man will readily admit that credit rationing, should it occur, would prove detrimental to the economy. But he has yet to see evidence that it is occuring. In addition to the steady rates on high-quality CP, borrowing rates for corporates of decent but not sterling credit quality are also showing zero signs of distress. While it's true that spreads have widened since the early summer, that widening has all come from the rally in Treasuries.

The actual borrowing cost of investment grade corporates, proxied below by the Moody's BAA yield index, actually fell in August and is near its lowest level since the beginning of the summer. If there were real signs of the real economy being denied access to credit, shouldn't we see at least some rise in these yields, rather than a modest decline?Finally, and as most readers probably know very well indeed, global equities aren't exactly on a straight line to zero. Of the 18 equity indices on the Bloomberg WEI default page, exactly two are negative year-to-date: perennial basket case Japan, shunned by Mrs. Watanabe for the "safety" of online FX punting, and Italy, which cannot be enjoying the drastically overvalued euro.

While there's certainly no guarantee that equities are properly discounting future macroeconomic developments, that they have yet to fall anywhere near as much as in prior "financial accident" episodes must surely raise the question as to why a monetary tonic is so desperately needed.

So what should the Fed do? For starters, it could cut the discount rate to the level of the funds rate, so at least banks can lock in positive carry by borrowing from the Fed to lend in the interbank market. It could reduce the haircut on asset-backed collateral- or is that 60% margin the Fed's way of saying what that stuff is worth?

Macro Man will humbly offer a prediction here. In 1998, the third Fed rate cut after the LTCM mess helped spur an equity rally of such vehemence that it swiftly morphed into a bubble. When equities collapsed, Greenspan and co. eased rates so aggressively (even before 9/11) that a housing and, ultimately, credit bubble emerged in place of the equity bubble.

If the Fed moves to cut rates by, say, 0.50% of more by the end of the year, Macro Man is pretty sure that this will, in the fullness of time, be seen as the genesis of the next financial-market bubble. And in Macro Man 's view, that bubble could take the form, at long last, of widespread and catastrophic dollar weakness.

After all, if America's greatest export turns out to have, ahem, quality control issues, why should anyone in their right mind, including VIG, RIG, et al., show a bid?

Well, that was an interesting month! To say that a bevy of (black) swans descended on financial markets would seem to be something of an understatement, what with the implosion of the money markets and the explosion of some quantitative investment strategies, most notably in equities.

And yet...the simplest of strategies, buy and hold a 60/40 mix of equities and government bonds, would have yielded positive returns in both the US and Eurozone. That the S&P 500 and DAX both finished higher in a month when markets drastically shifted their monetary policy expectations towards easier conditions as a result of financial distress is a testament to how bizarre August really was.

August was a good month for Macro Man- his best of the year in both the blog portfolio and, more importantly, the real world. His 2.88% return, while probably not comparable to those positioned aggressively short certain segments of the credit market, nevertheless was quite a pleasing development. To have made money last month, on top of solid profitability earlier in the year, demonstrates the importance of remaining flexible in one's approach. While Macro Man has many flaws, he is fortunate that a reluctance to change his mind is not one of them.

In line with the peformance of the SPX and DAX, Macro Man's beta portfolio registered a modest positive on the month. While the equity beta plus strategy is technically a quant model, it is an exceedingly simple one. In developing quant models, portfolio managers have two options: make it as sexy as possible, and run the risk of data mining (and incur the associated 26 standard deviation negative event), or pursue a KISS strategy: keep it simple, stupid.

While KISS leaves a lot of potential information on the table, in Macro Man's view it is also less likely to end up with a convoluted portfolio and a false sense of security. There is of course no guarantee that a KISS strategy will not incur a disastrous left-tailed return; then again, Macro Man knows that and acts accordingly in his alpha portfolio. And in a month of noise and sexy-model dislocation, the KISS beta plus portfolio returned 0.80%.

Strangely, the equity alpha portfolio lost money on the month. While there was a fortuitously-timed sale of SPY and DAX option expiry, the return on the Brazilian equity position was sharply negative. This was slightly galling, because the original trade construction proved to be correct (hedging EWZ with $/BRL calls), but Macro Man neglected to roll his FX option position, leaving him with a naked long Brazilian equity exposure. This was a costly price to pay for lethargy. All in, the equity alpha portfolio dropped 0.23% on the month, leaving the overall equity P/L positive on the month.

The swift collapse in risk-asset strategy returns since mid-July should convince you of two things: