Dislocation, Dislocation, Dislocation

It's said that the three most important things in real estate are location, location, location. Given that US housing was the genesis of the current global financial crisis, it's worth keeping that little aphorism in mind, as the story of yesterday- and indeed the whole crisis- can be summarized as dislocation, dislocation, dislocation.

Wanna see someone getting screwed? You don't have to be choosy in your search. In FX, as Macro Man documented yesterday, USD/MXN completed melted up......and then, in a Wile E. Coyote moment, collapsed right back down. While explanatory rumours swirled, Macro Man has yet to hear a completely satisfactory explanation for the roller-coaster ride.
Fixed income? Look no further than swap curves. One would normally expect that a 50bp easing to steepen the curve, but these ain't normal times. 2 year swap yields are nearly 40 bps higher than they were at 11.59 London time yesterday, while 30 year swaps are close to 10 bps lower. The result? A massive flattening of the 2-30 swap curve: pretty much the opposite of what both the textbooks and common sense would tell you to expect.
While the pain is all too evident in equity indices, you don't have to look too far beneath the surface to see an absolute horror show in single-stock land. Perhaps the most obvious example of the distress in equity land is the distress surrounding Volkswagen stock. While there are a lot of moving parts to the background (a Porsche stake in VW, Lehman facing trades blowing up, etc.) the basic premise of the trade is classic RV. Take two economically-similar share classes...and when the share prices diverge, sell the rich one one buy the cheap one on the expectation that they will re-converge.

When it works, you make a bit of dough. And when it doesn't, you get charts like this:
Ouch!

So where from here? At the time of writing, AUD/JPY is up 8.5% from NY yesterday's close, so normal service has clearly not been resumed. As Macro Man has noted over the past few days, he thought that a coordinated policy response would generate a bounce in stocks. So after yesterday's 50-beeper, he went net long....for about half an hour, then cut his purchases at a tiny profit and resumed normal short service.

It's probably premature to call the policy easing a failure, however. After all, 24 hours after Hank Paulson announced plans for the TARP on CNBC, the SPX was 8%-10% higher than just before the announcement...and we can all probably agree that that didn't ultimately support equities.

The next couple of days may ultimately mark the bottom. With the resumption of short-selling in the US today, the door will once again be open for squeezes. And tomorrow's Lehman CDS settlement auction is an obvious flashpoint; while it could prove to be a disaster, it could also ultimately become the cathartic moment that equities need to rally.

The old magazine-cover indicator is also suggesting that panic may be setting in; certainly the dislocations that are evident across markets are symptomatic of panic. So Macro Man once again finds himself prepared to acquire a net long delta, though at the moment he wants to see how equities digest higher LIBOR fixes. Of course, that view is a flexible one; anyone with skin in the game knows that this is no market for simplistic worldviews or sweeping generalizations.

After all, simplistic assumptions are one of the root-causes of these market dislocations; Macro Man is doing his damnedest at this juncture to keep an open mind and a black P/L.
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vlade
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October 9, 2008 at 10:16 AM ×

Mr.M. I hate to say it, but do you still think that calling for a rate cut makes any difference while the LIBOR market is so dislocated as it is? All we got (in UK), is the spread between BoE rate and LIBOR jumping by 50bp....

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Macro Man
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October 9, 2008 at 10:39 AM ×

vlade, I think the rate cuts were a necessary but not sufficient part of the cure. I suspect that one day we'll wake up and find that the aggregation of everything that's been done will cumulate to "enough", and LIBORS may come down in a hurry. Indeed, I have heard some rumbling that the current squeeze is down to cash hoarding ahead of the Lehman CDS settlement tomorrow.

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Daniel
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October 9, 2008 at 10:55 AM ×

My (perhaps lame) attempt at re-writing an old Oompa Loompa song:

Oompa loompa doompety doo
I've got another puzzle for you
Oompa loompa doopety dee
If you are wise you'll listen to me

Who do you blame when your company dies
Choked out on debt despite liquidity lies
Blaming the shorts is untrue and a shame
You know exactly who's to blame

The company management

Oompa loompa doompety da
If you've put aside cash you will go far
You can exploit opportunities too
Like the Oompa Loompa Doompety do

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gsm_73
admin
October 9, 2008 at 10:57 AM ×

Dear MM:

besides the settlement of Lehman CDS (and maybe couple of forthcoming more CDS settlements) what else would you advise need to be watched other than 'time' which could restore some order.
Am I rite about the latter?

ganesh

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gsm_73
admin
October 9, 2008 at 11:00 AM ×

Dear MM
Your style of writing I like and thoughts have been reassuring in moments of panic.

thanks:

ganesh

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Macro Man
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October 9, 2008 at 11:10 AM ×

I think time is the most important thing, ganesh....well, that and the actual implementation of the measures that have already been announced.

Daniel, very nice. You've won yourself a Golden Ticket. Unfortunately, it's on XL Airways, so your prize is, alas, now worthless except as a souvenir.

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Daniel
admin
October 9, 2008 at 11:18 AM ×

Lol. Even the value of golden tickets is worthless in this environment!

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mikarsky
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October 9, 2008 at 12:02 PM ×

Hi MM
"the aggregation of everything that's been done will cumulate to 'enough'"

Optimist:
I agree, it's probably enough. The measures are designed to address the bottlenecks and should keep the system flowing. More support for troubled banks may be needed but it's manageable.

Pessimist:
I agree, it's probably enough. The measures are embedding the financial crisis into the real economy. The crisis sentiment reaches consumers. As a result they scale down purchases and consumption. This has significant effects on the real economy. Which in turn feed back to aggravate the financial crisis. We're dealing with self-reinforcing systemic relations.

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Sean Maher
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October 9, 2008 at 12:07 PM ×

MM spot on on the Lehman CDS settlement re Libor, Fannie and Freddie went better than expected on Monday, if Lehman follows suit tomorrow, we could see a very fast reversal in risk appetite next week...I've reversed my bearsish stance and gone long equity futures for the first time in months; Nikkei sub book at 9200 looks a steal.

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Anonymous
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October 9, 2008 at 12:19 PM ×

Everyone looking for a bottom, calling fro a bounce and more then likely they will all be wrong. Seems to be how it works in the real world.

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Sundblad
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October 9, 2008 at 12:27 PM ×

Here's a question: a few days ago, the Fed said it would start paying interest on deposits. Will this not make the banks even more reluctant to lend to each other, when they can earn interest at the Fed instead?

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Anonymous
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October 9, 2008 at 1:14 PM ×

Sorry for steering offtopic. Could anyone with a bloomberg tell me what was the low of EUR/RON for yesterday? pls! your help will be much appreciated.

as a side note:

MM, you said that in this market its sentiment that matters. Do you believe that an improved sentiment right now will just prolong the pain and will set up the risk assets for a vicious fall after a short-lived rally? if the rally is only sentiment-based and not based on the real issues improving (like deleveraging imho) will it not generate a steeper fall and then even more panic?

Thanks a 1000 times for your most insightful blog!

humble student

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Arnold
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October 9, 2008 at 1:17 PM ×

Hey, Macroman, didn't you write a post called Nouriel Roubini is a big fat idiot. I wonder who looks like the idiot now?

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Anonymous
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October 9, 2008 at 1:38 PM ×

MM was correct. Roubini was wrong to say that Yen carry unwind would be catastrophic.

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Macro Man
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October 9, 2008 at 1:53 PM ×

sundblad, the Fed paying interest on reserves allows them to turn on th monetary spigot without driving FF below target.

Humble student, 3.8670 is what I see. I am keeping my mind and options open in terms of what any rally might look like. The bear market standard has been 6-10 weeks in this cycle, so I'd look for something similar. It's still a bear market, though.

Arnold, NR's contention was that the yen carry trade amounted to a trillion dollars and would bring fire and brimstone to all who touched it. Speaking only for myself, there was good money to be made in the carry trade last year, and there was plenty of time to get out and even short for anyone with their eyes open.

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gramps
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October 9, 2008 at 2:47 PM ×

Well, a global coordinated cut of already heavily subsidized central bank rates has managed to drive Libor EVEN HIGHER

And now Paulson wants other countries to follow his bone headed policies -- and he is mad as hell that only Japan and Europe voiced any support (Japan already having made the mistakes 15 years earlier)

I don't see a market bottom until after the election -- as long as these clowns are "in charge", extreme caution is the only course you can take

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Mike Sankowski
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October 9, 2008 at 2:57 PM ×

they are going to end up backing Libor with U.S. govt dollars. It is going to happen relatively soon.

This might be through some nationalizations, but I think they are going to go farther than that and actually back Libor from people that can prove solvency. The ones that can't prove solvency will be left out of the market - then they forced into bankruptcy because they are out of the market, and then they will be nationalized. Circular, but realistic knowledge.

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prophets
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October 9, 2008 at 3:08 PM ×

ive a 1% short position in VW ords. pretty much spent all day tuesday starring at the VOW GR chart in complete amazement. i was down 70% at one point.

seems like a no brainer to me. i can wait more than 5 mins to make $...

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Anonymous
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October 9, 2008 at 3:46 PM ×

if we have USD libor and european banks paying 7% for 1m and turn USDs despite all the TAF, CP facility, coordinated rate cuts, etc, what happens when the central banks try to wean the markets off all these facilities in 6 months? Something tells me the "facts have changed". Will be interested to see all the unintended consequences engendered by all this. Who would have thought money market and USD IRS trader would be the best seat on the Street a couple years ago? My oh my how USD liquidity was mispriced...

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Anonymous
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October 9, 2008 at 5:30 PM ×

Libor rates:

Nothing moves today because of stupid decisions made months ago.

When you see as the Times reports that Westminster, Kent and other counties had £ millions deposited with Icelandic banks. People managing cash were happy to earn 50 bps more on a deposit at an Icelandic than say at HSBC when the CDS spread between those banks and HSBC was 500 bps !!!!!!!


All these stupid mistakes made by people who had no clue lead to todays situation. You go from zero risk analysis to 100% paralysis ...

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EM
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October 9, 2008 at 5:45 PM ×

Mr. MM .. First of all I would like to congratulate for your amazing blog ... Really insightful .. Well , just a quickie on what happened to the freaking MXN yesterday ( and same dynamic has been playing out in BRL , as well, for the last few sessions ) ... Pretty much lots of exporters were enticed by eager salesmen to join highly leveraged options trades .. In a nutshell , what was underneath all BS and cutes names was a sweetneer where they would sell high strikes dollar calls .. In other words ,they were the improving the average of their exports while selling the upside naked.. Pretty much they believed that MXN and BRL would be forever trading down towards 0 .... For their amazement they found out thru a very painful experience that CCys trade in both ways .. So they lost fortunes and there was a huge run after the lost vol ... Just for the record , in Brazil Aracruz announced that lost USD 1 bio in fx exposure , Sadia lost $ 400 mio and so on .. I hope that helps ... Cheers

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Anonymous
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October 9, 2008 at 7:49 PM ×

Just read a Reuters article that led off with a reference for the G7 to act to stave off worldwide financial ruin. Has it come to that? Thanks for hanging in with your readers, MM. Your blog is the first thing I turn to in the morning.

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Anonymous
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October 9, 2008 at 8:13 PM ×

G7 to act to stave off worldwide financial ruin

Already been there, already done that.

You just can't fix stupid with rate cuts

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Anonymous
admin
October 9, 2008 at 9:01 PM ×

EM - are you talking about Knock-In $calls embedded in the structures that MXN/BRL exporters sold?

zman

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Macro Man
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October 9, 2008 at 9:18 PM ×

Zman, yes, there have been some truly horrific stories of the TARN structures in Brazil and, to a slightly less extent, Mex. Just filthy. Kinda like this equity market, which I have to confess has surprised me with its horribleness. I've slashed short equity risk and feel naked...

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EM
admin
October 9, 2008 at 9:31 PM ×

Yes ... There are talks that another big company is going to announce losses .. It is a closed company .. But loss would be humungous ...

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Anonymous
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October 9, 2008 at 9:47 PM ×

There was a nice quote in Derivatives Strategy magazine many years ago to the effect of "don't trade anything you can't price yourself in Excel". Corporates might do well to pay attention to that (e.g. United, who hedged out their short jet fuel exposure in 2Q08 and sold $107 strike knock in CL puts as part of the hedge. Doh...)

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mikarsky
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October 9, 2008 at 10:48 PM ×

SANITY WHERE ARE YOU??

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Anonymous
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October 9, 2008 at 11:03 PM ×

"don't trade anything you can't price yourself in Excel"

LOL - I priced everything in the beginning in Excel (with exotic pricers coded in C via DLL)...

Ask the Japanese exporters and insurers (if they actually survived) who sold chained KI $calls in the latter part of 1990's..."hurdles" we called them - they were like current-day US Treasury's printing machine for the desk....$$$

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Anonymous
admin
October 9, 2008 at 11:48 PM ×

What are the VOW GR/VOW3 GR? Common/preferred? Just guessing.

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Anonymous
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October 10, 2008 at 1:59 AM ×

MM, some advice please. My wife and I are US residents, self-employed, looking to move abroad for 5-10 years and then returning. Given our time frame what 3 countries would be your top destinations as a currency trade?

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Anonymous
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October 10, 2008 at 7:21 AM ×

I would not be suprised if G7 would shut down exchanges globally, or introduce a tobin tax, or change any other rule we take now for granted.

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Anonymous
admin
October 10, 2008 at 7:58 AM ×

The cover on the magazine is one signal that panic becomes omnipresent. Another one I observe is when the best/biggest stock give in.
A list of the DJIA stock shows that lately this has been the case.
http://finviz.com/screener.ashx?v=211&f=idx_dji&ft=1&ta=0&p=w&o=ticker&r=1
I doubt the CDS settlement will change anything. It will go well, but the market knows it's only for appearances. Hide what you can still hide!

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MW
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October 10, 2008 at 2:17 PM ×

@ Anon. 1103

http://www.derivativesstrategy.com/magazine/archive/1995-1996/1195qa.asp

I was a little off on the quote (good thing I'm not a market maker) but the ideas was right. Anyway, you might enjoy the article.

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