Stress Testing

This is the way the world ends
This is the way the world ends
This is the way the world ends
Not with a bang but a whimper.


T.S. Eliot, The Hollow Men

Later in life, Mr. Eliot repudiated the ending to "The Hollow Men", quoted above. One would have to presume that if he were alive today and a practitioner of financial poetry, he would be equally averse to claiming that the world would end with a whimper.

Or so we'd have to judge by price action today, wherein all things risky are tracing out an Icarus-like descent, and the only thing preventing a Black Monday-style crash in the US today is that the market is closed. This month has already been a testing one, and on the basis of today's gruesome start that trend appears set to continue.

Where to begin? How about with the monolines insurers, where last week's Fitch downgrade of AMBAC surely spells the beginning of the end in that space. Certainly the stock chart appears to be a re-run of American Home Mortgage, New Century, and Northern Rock. While Macro Man is far from an expert in this field, it would appear to be fairly evident that buying insurance from a non-AAA provider defeats the purpose of insuring oneself; what's the point of merely exchanging one ropy credit risk for another? Should another agency swing the axe on AMBAC's rating, one would have to conclude that the company will cease to exist.While this would appear to be self-evident, it has apparently escaped the notice of some of the analysts covering the stock. One research report that crossed Macro Man's desk this morning downgraded AMBAC from "buy" to "hold", while reducing the target price on the stock from $27 to $19. Now, in Macro Man's world, if you expect the price of something to triple, it is probably a buy. Then again, in Macro Man's world, the price target on AMBAC is similar to his NRK target issued last September: zero. While the frailities of equity research are well known, this report would appear to be a particularly egregious example of failing to realize that the horse has already bolted.

This is actually a great environment to be a (lower case) macro man, your humble srcibe's early-month P/L scuffles notwithstanding. The ability to be short risk assets relatively quickly is useful in times of stress, and it would appear that the macro community is grasping the opportunity with both hands. The rolling 40 day correlation between the S&P 500 and the HFR Macro hedge fund index is now -0.8, the joint lowest reading since immediately after the invasion of Iraq.

What's interesting is that EUR/JPY, a currency pair that owes its lofty status to the compression in global risk premia, is starting to look decidedly ugly. A couple of weeks ago, Macro Man suggested that selling EUR/JPY and its ilk was the real trade to do in the event of a US recession; it appears that the market may have come around to the same view. Clearly markets are now assuming that US recession is a base case, and Macro Man has seen his first 1% Fed funds forecast this morning. Observe that EUR/JPY is now flirting with a three point monthly trendline off of its all-time low below 90. Given that fair value for this pair is probably 125 or so, there appears to be plenty of juice in the trade should a bear market follow on.
While Macro Man is actually long a bit of euro cash via his EUR/GBP positions, his overall euro delta is actually small short, thanks to his powerball strip of downside one touches. The DEM receiver position should also be negatively correlated to the euro FX rate. It's gratifying to see one of Macro Man's cherished tenets panning out, meanwhile; namely, that in times of stress, all financial market implied volatilities should rise.
The chart below shows one year implied voaltility in the EUR/USD exchange rate over the past few years; observe how it's risen nearly three vols since last spring. While the realized vol of the pair has risen, it's almost certainly not enough to justify such a sharp rise in back-end implieds. Then again, those implieds were woefully underpriced a year ago, thanks to structured product related selling. Either way, being long EUR vol as the "cheapest vol on the block" has paid dividends.
Finally, Macro Man would like to give a "smooth shout out", hip hop-style, to one of his favourite analysts. Fred Goodwin, Lehman Brothers' "Mr. Prop" (whose pieces influenced the narrative style of this space) has written his last piece and moved over to the proprietary risk-taking side. Good luck, Fred: you've now left Macro Man as the sole torch-bearer for third-person financial commentary.

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Anonymous
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January 21, 2008 at 9:49 AM ×

Policymakers of the 1930s observed the correlates of the monetary contraction, such as deflation and bank failures. However, they questioned not only their own capacity to reverse those developments but also the desirability of doing so. Their hesitancy to act reflected the prevailing view that some purging of the excesses of the 1920s, painful though it might be, was both necessary and inevitable.

Chairman Ben S. Bernanke
At the Fourth ECB Central Banking Conference, Frankfurt, Germany
November 10, 2006

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Macro Man
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January 21, 2008 at 9:58 AM ×

...which presumably means that he won't make the same mistake. Which is why Macro Man comed down on the "inflation" side of the inflation/deflation divide, and why he is hesitant about buying dollars.

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macro fan
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January 21, 2008 at 10:49 AM ×

Mistake?

Milton Friedman certainly has everybody thinking that it was a mistake. And it would seem from recent quotes in the press that Anna Schwartz will defend this thesis in the face of collapse on the grounds that the Fed has only made more mistakes (Marxists would surely applaud this deft parry!).

But I think what Bernanke is gradually realising is that once a bubble starts leaking from many holes you can blow as hard as you like and all you really get is red in the face.

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vlade
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January 21, 2008 at 11:08 AM ×

Macro fan:
Actually, you can (in Fed's position) inflate the rest of the world so that the bubble's not noticeable anymore.
Or, to put it differently. To bring the bubble to a realistic value, you can either shrink the bubble or inflate the world.
The latter is easier (politically), as people are (strangely enough) less upset by the nominal value of something they own going up a lot than by the same going down a bit. Of course, people who don't have anything to go up in the first place are quite unhappy with the first (possibly more so than the second).

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Anonymous
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January 21, 2008 at 11:58 AM ×

...which presumably means that he won't make the same mistake.

That is exactly what Hank Paulson just said about the housing decline in the US a week ago: necessary and inevitable.

The FED only controls about 45 billion in bank reserves, I find it hard that they can inflate the world. Interest rates are set by the bond market as outlined by Greenspan.
September 17, a commentator on CNBC asked, “Did you keep the interest rates too low for too long in 2002-2003?” Greenspan immediately responded, “The market did.” Rates were not “too low” or the period “too long,” either, because the market, not the Fed, made the decision on the level and the time, and the market is never wrong; it is what it is. If investors in trillions of dollars worth of U.S. Treasury debt worldwide had demanded higher interest, they would have gotten it, period.

If you want inflation it will have to come from fiscal policy not a few FED rate cuts.

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January 21, 2008 at 12:26 PM ×

Anon 11:58,

Note that there's nothing in there that actually states that the market is ever right, either. The question not answered correctly (or perhaps even asked) by Greenspan and others in a decision making capacity was whether the market, rightly, wrongly or blindly, was providing a desireable outcome over a time frame of interest to a sovereign state.

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Macro Man
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January 21, 2008 at 1:14 PM ×

Hoo boy, where to start? I think that money illusion, the gross level of debt embedded in the US economy, and Bernanke's own background make the inflationary outcome both politically palatable and preferable than the deflatonary alternative. While's it's true that the monetary base is a small proportion of broad monetary aggregates in the US economy, it's equally true that the Fed is prepared to use unconventional methods, such as the TAF and the "printing press" that Bernanke himself alluded to in November 2002.

As for Greenspan's comments....well, he's full of s**t. It wasn't the market that farted around with language like "considerable period" or "measured" tightening. It wasn't the market that refused to hike policy rates by more than 25 bps. It wasn't the market that crapped itself in 2003 and cut rates to 1%. It was fairly obvious in late 2003/early 2004 that rates needed to go up. Yet greenspan waited til mid 2004, and then put rates up very, very slowly, ensuring negative real policy rates at a time when the economy was expanding well above trend.

Not that "the market" was faultless, either. Well, actually, the "market" didn't set rates in 2004-2006. It was mercantilist central banks; primarily the BOJ in 2004, and China thereafter. This was well-documented at the time by both the private setor and the Fed. The implication was that short rates should have gone up farther and faster to compensate...yet Greenspan dragged his feet.

There were many people, including Macro Man (in real job guise) who were critical at the time, so this is not a case of Monday morning quarterbacking. of all the people responsible for the current situation, the single most culpable is Alan Greenspan.

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CV
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January 21, 2008 at 1:41 PM ×

Wow,

I think this is what I have to say when I look at markets today. As a derivative of what MM said in the post and as a snap shot from my monopoly money FX portfolio I can see that what once was 'risk' is getting vomitted out like never before. It almost makes wonder about the merits of actually being able to short trade since this is just so much of a one way street at this point.

I take note of a few things ...

EUR/USD < 1.45
EUR/JPY < 155 and counting :)
USD/JPY < 106 or at least it looks as if it will be soonish. What was the mean intervention call from the last post? about 102 or something?

Up here in the Nordic parts of the world we are hearing rumblings on the jungle drums of a crack/bear market in Oslo and the Copenhagen OMX index is not doing any better it seems.

In the Baltics Moody just flashed the whip over Swedbank AB who is holder of many a dodgy mortgage. Now, this in itself is of course peanuts but if they decide to close shop and close off the tap the Baltic economies will basically implode at this point in time. Really, I still think that Eastern Europe will be where the abyss will open first in terms of a real macroeconomic crisis.

And I could go on and on I guess ...

It is interesting how we all become dismal scientists in times like this but then again these really do seem to be dismal times.

Be careful out there


Claus

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Gregor
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January 21, 2008 at 3:16 PM ×

Today would be a good day to buy a cigar in St. James, and then duck through the pedestrian tunnel near Dukes Hotel and talk a walk in Green Park, trying to forget all this.

The ongoing discussion between deflationists and inflationists over the past 5 years, at times uncivil, would have benefited enormously if participants had only made the distinction between pressures, and paradigms. Deflationary pressure(s) does/do not make for paradigmatic deflation, and visa versa. I have remained solidly in the inflationist camp since 2004, and feel my view is strengthened actually by always acknowledging deflationary pressure from Housing, and cheap Emerging Market Labor. (The former is well upon us of course, but the latter actually is fast dissappearing!). Not only do I believe we are in an inflationary paradigm, but, I believe my own country (The US) will successfully repudiate its debt via currency devaluation. The next leg down in the USD will serve to further ease global monetary conditions, and will have implications for already ramping Asian Industrialisation, population growth, and structural shifts in diet/food. A duly chastised American consumer and Housing will continue to pump out deflationary pressure. But, it will be attended to with policy overshoot I think from the FED, ECB, BOE, BOJ. Ben may lack grace under pressure, but there is no doubt where he's headed.

Finally, it remains my view that the USD is the largest long position in the history of the world. If this is not the case, then by saying so I have at least fulfilled my duty as an American to pump up the jams with a good dose of the hyperbolic.

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Anonymous
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January 21, 2008 at 4:11 PM ×

it's equally true that the Fed is prepared to use unconventional methods, such as the TAF


"The key point to take away from this experience with the TAF, however, is that the Fed’s actions to improve liquidity in term funding markets did not involve a change in the FOMC’s fed funds rate target. That is, the TAF did not change the stance of monetary policy. The Fed actually withdrew funds through open market operations as it injected term liquidity through the TAF."

The Economic Outlook and the Fed's Roles in Monetary Policy and Financial Stability Charles I. Plosser President and
Chief Executive Officer
Federal Reserve Bank of Philadelphia
Main Line Chamber of Commerce
Economic Forecast Breakfast

Read it again.

The Fed actually withdrew funds through open market operations as it injected term liquidity through the TAF.

If there is a helicopter drop it will have to come from government fiscal stimulus such as tax cuts, check mailings, or maybe another war.

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Macro Man
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January 21, 2008 at 4:25 PM ×

Naturally, of course, what the Fed has done in the past need not dicatate what the Fed does in the future.

In any event, TAF has done its job to date, as LIBOR spreads have contracted quite a bit.

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throw
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January 21, 2008 at 5:24 PM ×

I worked at Lehman for 5 years and met Fred on one trip through London. I loved his stuff. Good luck Fred.

-Ross

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OldVet
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January 21, 2008 at 5:40 PM ×

MM-Temporary stoic optimism aside and quickly corrected, if you ever need to refurbish that crystal ball, I'll chip in gladly. Brilliant short on DAX and acumen on display with Yen call too. Things are perking up at last for the bears. Finally.

And please ignore challenges on Poe from C, let me revel in Short side pleasure a few weeks longer and prepare for future with more cash in worn pocketbook. :)

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Anonymous
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January 21, 2008 at 5:59 PM ×

How about that er... "de-coupling" then? How about'em apples? There is shite and more shite, just buried a bit deeper. Watch out rest of the world now...

i^i

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Macro Man
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January 21, 2008 at 7:01 PM ×

OV, I am blushing. In this game, minimizing losses when you're wrong is just as if not more important than coining it when you're right. While I perhaps haven't done a great job of being right this month, I think I've done OK at addressing that issue and turning what could've been a bloody awful month into what may turn out to be a moderately profitable one.

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Quarrel
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January 22, 2008 at 3:58 AM ×

Fitting nicely with the themes here for the last few days of Fed Chair bashing and financial poetry challenges a colleague sent me this today:


Columbia Business School Spring 2006 Follies spoof on The Police's "Every Breath You Take" featuring imitation Dean Glenn Hubbard and Fed Chairman Ben Bernanke




--Q

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