Archive for April 2008

Nobody knows

Nobody seems to know what to make of this evening's FOMC statement.

Equities are up since the announcement- barely- and are now sitting smack on the boom/bust line of 1400.

The strip has rallied, and Fed funds futures are now once again pricing in a modest chance of a rate cut later in the year....though also continue to price in a chance of a hike later in the year.

The dollar's gone down.....a little.

Of course, the statement itself is curious. Gone are the references both to downside risks to growth and upside risks to inflation. It sounds like the Fed itself doesn't know what to do.

What to make of it?


Macro Man doesn't know.

Month-end fireworks

It's been a slow start to the week thus far, but today could well see an explosion of fireworks. Take your pick as to what could move the market: the ADP survey, giving an early bead on Friday's payroll figures; the Q1 GDP report, which could suggest that the US has indeed slid into recession; the 4 p.m. London fixing in foreign exchange, which should generate some considerable short-term volatility; and oh, yeah, the Fed announcement this evening.

Ultimately, it's the latter of these that is the most significant, with the million- or billion-dollar question being whether the Fed will signal "one and done" or opt for a more open-ended statement. Market consensus is overwhelmingly in favour of the former, at least in the currency and fixed income space; common sense might suggest having thrown his lot in with the reflationist crowd, it would be a bit foolish for Bernanke to close off his options while the economic data is still deteriorating.

Having been relatively constructive on the US economy over the course of 2007, Macro Man has been forced to change his view over the past few months as circumstances have changed. Simply put, the deterioration in the labour market, combined with the rise in the cost of living, has hit disposable income growth to the extent that Macro Man is now looking for the end of the Great Consumer Boom that has characterized the US economy for the past quarter-century.

That the current environment will not mimic 2001-02, despite the aggressive Fed cuts, is apparent from the consumer confidence data. Both the Conference Board and Michigan indicators have plumbed to depths not heretofore witnessed during Macro Man's fifteen year career, a change in circumstance that he is forced to respect.

Yesterday's Conference Board release showed another uptick in one of Macro Man's favourite indicators, the "jobs hard to get" component, which tracks the unemployment rate quite closely. As the chart below illustrates, this data suggests another new high in the U-rate on Friday.
However, you can see that the overall level of the indicator is still well below the peak of the last recession. So why is Macro Man so worried? Well, the Conferene Board survey also contains a less-followed indicator on the outlook for employment six months' hence. The balance between "more jobs" and "fewer jobs" has collapsed over the past several months down to levels not observed since early 1991. What's interesting is that the "more jobs" subcomponent is at its lowest level since the early 80's...the last time there was a genuine consumer recession.
Given that household spending is currently 71.5% of US GDP, it will be a very big deal indeed if Joe Sixpack reins in his spending. Longtime readers may recall a simple consumption model that Macro Man has constructed, which explains nominal consumption growth in terms of changes in disposable income and wealth. (The model would work just as well on real income, but there is a greater data history for nominal income/spending.)

The chart below shows the model output along with actual consumption data. The upshot of the model is that if, over the next couple of quarters, disposable income growth slows a percent and a half and y/y changes in net wealth go to zero, real consumer spending growth will go to flat y/y. And that's with a steady savings rate. Given that it may be reasonable to expect y/y net wealth to turn negative (as indeed it did in 2001) , there should be downside risks to this forecast.
Of course, the coming stimulus check bounty will raise disposable income growth, though higher food and energy prices will sap some of those gains. Of course, there also remains the risk that consumers finally look to rebuild their balance sheets and decrease debt/increase savings. Every single poll that Macro Man has seen on the stimulus checks suggest that a majority of respondents plan to pay down debt or boost savings with their windfall.

The residual of the model above correlates very well with changes in the US household savings rate. This is useful, as it allows us to postulate what a given change in savings will mean for actual spending. If, for example, the savings rate were to rise 1% over the course of a year, it would shave 2/3 of a percent off of spending.
If Macro Man is correct about the state of the US consumer, then the savings rate could rise even more over the course of the next year or two. And that, Macro Man would suggest, would produce a period of sustained low interest rates and high 1970's style inflation, such is the Fed's apparent intolerance of below-trend growth.

Ultimately, this would be a poor environment for both stocks and duration. It's not hard to see the new President, whoever it may be, replacing Bernanke at the end of his term with a 21st century Volcker-type figure.

Exquisite timing

Talk about exquisite timing. Earnings season is winding to a close, and while the figures haven't been great, they haven't been uniformly awful, either. As a result, US (and, by extension, global) equities have enjoyed quite a tasty respite from the early-year bear market.
However, as Macro Man looks at his calendar, he sees that tomorrow is the end of April (and what an eventful one it should prove to be, what with the US GDP release and Fed announcement!); and he cannot help but recall the old equity trading saw that one should "sell in May and go away." Yet lo and behold, what should appear on the cover of Barrons this week but a tan, rested, and ready bull, looking relaxed and ready for some action.

Colour Macro Man skeptical. The S&P 500 has wended its way towards its 1400-1405 resistance zone, but the price action and volume has been less than convincing. The Barrons cover article was revealing; its survey of "big money" managers showed a marked skew towards bullishness, with many appearing to believe that this was a contrarian view. Yoinks!

It appears that these chaps are prepared to trade the recovery before we've actually experienced the recession; Macro Man remains highly wary of this view and outcome. Worryingly, resilience elsewhere in the world is starting to crumble. Dataflow in Europe over the last week has been pretty uniformly awful; it is starting to look like Macro Man himself was guilty of some exquisite timing last week.

Similarly to the SPX, the Eurostoxx is running right into resistance, though chartists might note that a break above would appear to confirm an inverted head and shoulders pattern, thereby heralding further gains. But with the European dataflow turning down so hard and equities nearing resistance, Macro Man finds himself growing more and more bullish fixed income, particularly euro fixed income, every day. He has some positioning there, and has now resorted to sitting on his hands so that he doesn't add too much, too soon.
He can only hope that his timing is as exquisite as he reckons Barrons' cover to be.

Time to do the Humpty Dance?

Today may, in the fullness of time, be seen as a key turning point for financial markets in 2008 and beyond. Not because of any particular market price action or earnings announcement, though both could perhaps be meaningful. No, the font of significance in today's newsflow comes from humbler origins, in data that is rarely at the top of traders' agendas. Ultimately, the most significant news of the day could spring from the usually inconsequential womb of Germany's state CPI data.

Market observers may recall that last November, ECB president Jean-Claude Trichet alluded to a temporary "hump" in inflation that would have to be scaled before the ECB could contemplate changing policy course. Readers of a certain vintage will recall the late 80's Digital Underground hit "The Humpty Dance"; one wonders if Trichet and co. have been waiting until inflation decelerates before performing this jig. If so, it's perhaps time to cue up Shock G. and co., as this morning's state CPI data have shown a marked deceleration in y/y inflation. Perhaps we're about to ride the downside of the hump!

The chart below shows the y/y inflation rates in three of the German states reporting this morning: North Rhine-Westphalia, Hesse, and Brandenburg. As you can see, there's been a sharp deceleration from recent peaks in all 3 states; indeed, NR-W's rate is almost back to the ECB target!
Should the sharp fall in CPI be mirrored for Germany and indeed Europe as a whole, it coud represent a significant turning point for the ECB. While Macro Man stands by his view that current growth data is insufficient to warrant an ECB easing, it would be foolhardy to ignore the sharp decline in business confidence, ostensibly a leading indicator. And given that uncomfortably high (and accelerating) inflation is basically the sole reason that has kept the ECB in hawk mode, signs that inflation is moderating back towards the ECB target will be greeted with relief in Frankfurt.

Will it prove sufficient to generate a rate cut, near-term? No. But insofar as the ECB has been clear that they are focused on inflation, a change in circumstance should, in the fullness of time, prompt a change in tack from the ECB.

And what would the market implications of an ECB capitulation be? The euro, obviously, should lose some its luster....assuming that Voldemort and others don't step in and bid for "your amount" at these lofty levels. The CBs seem to have taken a break from their activities over the last few days, perhaps wishing to give the market a break after jamming EUR/USD up to 1.60. The true test will come on any further dip below 1.55. Will these chaps keep their hands in their pockets or will they be tempted to fill their boots with "cheap" euros? Inquiring minds want to know!

Perhaps the more interesting trade is in European rates. The euro steepener has been a P/L graveyard recently; indeed, the 2-10 swap curve inverted last week for the first time since the inception of the euro. However, it is clear that the euro curve has lagged its traditional follow-on from the US steepening; ex-post, it would seem clear that the high level of inflation, and concomitant ECB hawkishness, is the reason. However, if inflation is easing back and the ECB relents, then the curve should steepen from here. Conveniently (for those who avoided the bloodbath of the last few weeks), positioning in the curve is cleaner than its been for some time.
In the near term, the back end of Europe may be supported by month-end index extensions, which are relatively large this month. However, there would appear ample scope for the front end to rally; not only have German 2 year yields rallied 45 bps this month, but they are now only 17 bps lower than the ECB refi rate. Before the front-end carnage of the last week, which has pushed US 2 year yields above Fed funds, the last time that US 2's were that close to the official Funds rate was thee middle of 2006.

So for the near term, buying the front end of Europe outright could be a better way to play a shift in ECB policy; assuming the rest of the curve follows, the back end could be sold Thursday or Friday morning at better levels to leg into the curve trade.

Front end Schatz vol looks pretty cheap relative to the moves of the last few days, so Macro Man has spent a bit of premium on low-delta calls in the event that today really does mark a turning point in the history of this economic cycle.

No, Mr. Bond......I expect you to die

James Bond: "Do you expect me to talk, Goldfinger?"

Auric Goldfinger: "No, Mr. Bond....I expect you to die."

It's a little-known fact that the above dialogue, perhaps the most iconic exchange in the entire Bond film ouevre, wasn't actually written by Ian Fleming. It never appeared in the Goldfinger novel, and instead was a creation of the film's scriptwriters.

Nevertheless, it is a pretty apt description of the current state of play in financial markets. In addition to the front-end carnage across the globe, bond markets broadly are getting smoked like a Scottish salmon this week.

Consider the price action in JGBs, which have cratered sharply through the uptrend of the last year or so. Sure, Japanese CPI has continued to tick higher, but that hardly explains the butchery seen in the JGB futures market:
The pain has not been confied to Japan, of course. Favourite object of market hatred, the UK, has also seen its bonds get whacked. Perhaps there is a small impact from the recent SLS, but a Q1 GDP print of 0.4% q/q doesn't exactly suggest that Gilt futures should have sold of four points over the last week or so:
Given the hawkishness of the ECB and the high inflation prints in Europe, it's probably unsurprising that Schatz have also broken down:
In the US 10 year future, 115-04 has been a pretty key pivot point over the past 6-9 months. The market has crashed through the level this morning, in sympathy with pain elsewhere.
What's driving this? Supply? Perhaps, as govvy issuance has ticked up in places like the US. Renewed economic optimism? Maybe- the Fed funds strip is now pricing in rate hikes in the second half of the year, having priced in cuts until very recently.
Inflation? Maybe...though breakevens are hardly suggesting that inflation concerns are paramount.

No, from Macro Man's perch this looks to be a good-old fashioned position liquidation screw job, perhaps exacerbated by short gamma-type positions from the mortgage convexity hedgers.

Ultimately, there are some tasty mispricings appearing on Macro Man's screens; he really struggles to see a scenario where the Fed tightens interest rates in H2, particularly given the general election in November.

Of course, in this game, timing is everything, and being early (as Macro Man has in buying the front end of the US) is the same as being wrong. Given his views on inflation, it's hard for him not to have sympathy with the long-end sell-offs; for the time being, however, Macro Man is just trying to be as adept as 007 at escaping Goldfinger's clutches.

The physiology of an 800 lb gorilla

It's sod's law, isn't it? Macro Man writes a piece that attempts to demonstrate why the ECB ain't cutting rates any time soon, and immediately thereafter we get pretty weak business confidence data from Belgium and Germany. (Receiving less press, of course, was yesterday's EU orders data, which showed industrial orders rising 0.6% m/m and 9.9% y/y.) Still, he retains the view that this market is occasionally guilty of cognitive dissonance, ignoring the evidence the runs contrary to its embedded view. While avoiding this pitfall will not necessarily yield a profit (Macro Man has no desire at the moment to make a P/L sacrifice at the altar of Euribor or short sterling), in the current market the avoidance of loss is just as good.

Anyhow, the weak Euro confidence data has unsurprisingly hit the euro while supporting EMU fixed income. Receiving less support, of course, has been US fixed income, where the market now seems keen to trade the economic recovery. This optimism seems relatively misplaced to Macro Man, given that we seem to have jumped immediately from credit crisis mode to recovery mode without ever trading the recession. Now, granted, the consensus is that the US experiences a "mild" recession, partially as a result of the $600 windfall that will wing its way out of IRS headquarters in the next month or two. However, Macro Man believes that the market is ignoring the 800 lb gorilla in the room; the gorilla whose name is "energy."

Now, Macro Man is not an energy specialist, and has no special insight as to what drives short-term price action in that market (other than the dollar effect, which seems to have become paramount recently.) That having been said, he does like to look at it from time to time, particularly when thinking about the macroeconomic impacts of energy prices.

Simply put, Macro Man believes that energy prices have reached the point where they are exerting a critical (downward) influence on discretionary consumer spending, and influence that may only partially be offset by the coming refund bounty. As such, he believes that there is a real risk for the first consumer-led US recession in a quarter century.

The last weekly retail price data that Macro Man can find on Bloomberg suggests an average US retail price of $3.57/gallon. Now, those of us living in Europe would love to pay so little for gasoline; then again, we tend to drive less (and use more fuel-efficient cars) than residents of the U.S. of A. Macro Man's gas price model suggests that current levels of crude and crack spreads should see retail prices climb towards $4.00/gallon in the next few weeks; further rallies in crude and/or a seasonal rise in cracks could mean gas prices rise by even more.

How significant is this? In Macro Man's view, very. If gas prices follow the trajectory of his model, it would take the real inflation-adjusted price of gasoline back towards the all-time high observed in 1980. More significantly, it would also take consumer gasoline outlays as a percentage of total spending back towards the all time high....a period which accompanied the last real bone-crushing consumer recession.
The rise in gasoline outlays naturally acts as a hit to discretionary spending power, as gasoline demand is obviously price inelastic in the short run. Coming at a time when the labour market is weakening and real disposable income growth has dropped sharply towards critical levels, the rise in gasoline prices threatens, in Macro Man's mind, to push the consumer over the edge. Sure, the forthcoming $600 will act as a buffer, and certainly boost incomes in the short run. But if consumers believe that gas and food prices will continue to rise, they may well choose to save more of the windfall than may have been the case a few years ago.
And that, Mr. Bernanke, is why it is worth paying attention to headline inflation as well as core. Some might argue that for a country like the US, rising food and energy prices represent a relative, rather than absolute, shift in prices.

Macro Man's retort is that for those countries that have been the purveyors of low-cost goods and labour for the past several years, these rises represent a boost to the absolute level of prices, and thus have a larger impact on wages/incomes. And that is why we see statistics like a steady rise in US import prices from China, and why Macro Man believes that the ultimate result of the current credit crisis will be a substantial rise in tangible goods and services prices (i.e., CPI/PCE deflator) relative to financial asset prices, which were the primary beneficiary of the shadow banking system that is at the heart of the maelstrom.

Macro Man has taken a look at the physiology of this 800 lb gorilla......and from what he can see, this sucker's an ugly 'un.

What is the ECB smoking?

As the Greatest Financial Crisis Since the Depression (TM) rolls on, complete with continued carnage at the front end of most major yield curves, the divergent views of prominent central banks is coming increasingly into focus. While Fed policy remains extremely easy (as measured by real rates) and the Bank of Canada cut rates yesterday, seemingly not a day goes by without a hawkish comment from an ECB member. Given the apparently universally held view that a) the European banking system is buggered, b) that stuff like Spanish property is in free-fall and requires attention, c) weak sisters like Italy are being crippled by the strength of the euro, and d) as a result, European growth is headed for a massive slowdown, a constant refrain that Macro Man hears from colleagues and counterparties is "what is the ECB smoking?"

Macro Man did a bit of digging to find out. We should recall that the ECB's mandate is to ensure price stability, with the primary definition of this defined as CPI inflation close to, but not exceeding, 2%. Regular readers of this space, or indeed observers of financial markets, will know that the ECB has not achieved this goal in a long time, as demonstrated by the chart below. Now obviously, headline inflation (the object of the 2% target) is being higher by energy prices, and frankly there's not a lot the ECB can do about that in the short term. That having been said, we should recall that the ECB dialed down the rhetoric late last year on the expectation that inflation was experiencing a temporary "hump". Nothing that we've seen so far this year, least of all $119/bbl oil prices, suggests that we're about to coast down the downside of that hump.

More worrying, from the ECB's perspective, is the potential for second-round effects- namely, rising wages that then fed through into broader price rises. In fairness, macroeconomic data on wages has been pretty muted this far. Worryingly, however, core CPI has risen steadily over the past couple of years, and now rests at the ECB's 2% target for headline! If that isn't evidence of incipient second-round effects, Macro Man isn't sure what is.So will second-order effects intensify? One place to look is labour markets to get a gauge of tightness. And there, the message is that European labour markets are very tight indeed. In Germany, the "anchor" or "daddy" of the Eurozone, has seen its unemployment rate fall to the lowest level since immediately after unification.
And what of serial moaners France, who can almost always find something to complain about- be it the level of interest rates or the level of the euro? As one of Macro Man's colleagues observed this morning, the chart below looks like a classic head-and-shoulders formation: a bearish pattern suggesting that the line should head lower. In point of fact, it's a graph of France's unemployment rate, which is at 25 year lows. That bears repeating: French unemployment is at 25 year lows! You can just imagine the memo that Trichet and co. composing a memo to the French Finance Minister. "Dear Mme. Lagarde: Shut the f*** up!"
But enough of the core: what of the periphery? The market is replete with stories of collapsing prices for Spanish coastal properties, which inevitably drag the economy down with it. How valid are these fears? As far as Macro Man can see, not nearly enough to alter the ECB's calculus. Spain's own house price index , recently updated for Q1, has yet to show a quarterly decline this decade. Sure, the price of some coastal properties is falling.....but its hard to see the ECB (whose own Frankfurt homes haven't budged in value over the last few years) having much sympathy for British owners of vacation homes, who in any event are benefiting from the currency move!
And finally, what of Italy, particularly now that Signore Berlusconi, his fake hair, and fake tan are back in charge of Italy's government? It's taken as gospel that Italy is getting squeezed by the strength of the euro, and indeed that Berlusconi will moan about it. On the latter issue, Macro Man has no doubt that Berlusconi will indeed raise a stink. On the former, colour Macro Man unimpressed. The chart below shows the rolling twelve month sum of Italy's trade balance. He cannot help but notice that despite the sharp rise in oil prices over the last couple of years, the trend in Italian trade (supposedly crippled by the euro) has actually improved. Cry me a (Tiber) river, Silvio.

So what are we left with? Prices that are too high and threatening to stick. Historically tight labour markets. Few obvious signs of macroeconomic stress in supposedly vulnerable Club Med countries. Rather than asking what the ECB is smoking, Macro Man can't help but wonder what the market is smoking for thinking the ECB shouldn't hike.

Profits of Doom

Ah, another day in Paradise. LIBOR spreads blow out again, mercantilist central banks ramp EUR/USD higher, and oil prints (yawn) another new all-time high. Pity the poor chaps at Deutsche Bank; these markets aren't getting any easier, and now they can't even treat their customers to an expensive lunch or a "show" after work.

At the risk of flogging a dead horse, Macro Man continues to be intrigued by the dichotomy of opinion on US corporate profits. Over the last week or so, he has received fairly bearish research from Goldman, Morgan Stanley, and JP Morgan. Yet other shops, such as UBS and Lehman, appear to be more sanguine about the outlook for US corporate profits. The low volumes that have accompanied the recent slew of earnings announcements suggest that the market has yet to see enough to make up its mind one way or the other.

Why is it important? The trajectory of corporate profits can help to determine or confirm the trend in a number of macroeconomic and market variables. In 2006-07, for example, Macro Man was fairly confident of a US "muddle through" scenario because of the strength of corporate profits, particularly when expressed as a percentage of GDP. However, recent data points suggest that we've finally reached the top of the cyclical, and perhaps secular profits cycle; a reversion to the mean (in terms of profits/GDP) would appear to suggest either a profitless recovery or declining profits in a recession.
One of the indicators that Macro Man likes to keep an eye on is a quick and dirty proxy for corporate margins, the annual change in producer prices less the change in consumer prices. To be sure, this is not a perfect proxy, as high energy input prices can actually represent quite a fillip for the profits of the energy sector, which has obviously been one of the leading lights of the mid-Noughties rally.

But still, the signs from the indicator are very ominous indeed; the prior three descents into "negative margins" all preceded/accompanied recessions; however, for most of the past several years, this indicator has been in record negative territory. Now some of the "profits anomaly" of consistent profitability (through the middle of last year) despite apparently negative margins may well be down to the energy effect, as XOM, et al rake it in. But can that explain all of the S&P's pre-3Q07 profitability? Perhaps not. Perhaps what we're really seeing here is the impact of "something-for-nothing" type structures like CPDOs, SIVs, et al, which have latterly proven themselves to be more expensive than advertised. Insofar as those avenues are likely to remain closed for the foreseeable future, perhaps profits will re-anchor with the apparently unfavourable margin environment.
And finally, to talk his own book, Macro Man presents once again the evidence that multinationals (typically large cap) are a preferable hold to smalls caps, which have a more domestic focus. Through Q4, the NIPA profits that were derived domestically unsurprisingly fell y/y, whereas foreign profits have been gangbusters. And what have we seen so far this earnings season? International earnings have been pretty darned strong from the likes of IBM, Google, Intel, and even GE.
Macro Man cannot help but think that the party's just getting started for the large cap/small cap thesis.

Four points

Four issues on Macro Man's radar on Monday morning:

1) BOE Buzz cut: The Bank of England announced its version of the TSLF this morning, as had been widely leaked over the weekend. Among the key issues with the program is the size of the haircut; for every £100 of bonds that you tender (AAA rated, backed by UK or European mortgages and/or credit card receivables), you only receive £70 to £90 worth of Gilts. Plus, you have to pay a fee to take out the loan. While this program might be better than nothing, Macro Man wouldn't be surprised to see an uptake similar to that of the TSLF: i.e., pretty patchy.

2) Front-end carnage. Last week, Macro Man highlighted the potential volatility that the LIBOR "scandal" might cause. Well, the volatility has come, all right...but by and large, it's been confined to the fixed income, rather than the equity, space. The front end of th US, UK, and European yield curves got pummeled towards the tail end of last week; Dec Eurodollars, for example, tumbled 79 bps peak-to-trough last week. Ouch! At this point, the market is actually pricing in hikes by year-end; Fed funds futures show an 11 bp rise between August and November. How realistic is this?


Not very, historical precedent would suggest. At the end of the last easing cycle, Fed funds remained at 1%, the terminal rate, for a year before rates finally rose. When Greenspan cut 0.75% in the wake of he Russia/LTCM crisis, rates stayed at 4.75% for seven months...and that was with the Nasdaq going crazy, retail sales up 7%-9% y/y, and the unemployment rate falling steadily. And in the early 90's, rates stayed at 3% for seventeen months. So now, in the midst of the Worst Financial Crisis Since The Depression (TM), rates are supposed to be going up five months after the last cut?

Colour Macro Man sceptical: the front end of the US appears to be a buy here.

3) Equity markets at a crucial point. For the last year, 1400 in the SPX has been something of a pivot point, as the chrt below indicates. After Friday's infuriating price action, the index is knocking at the door of that level now. (Macro Man was long a butterfly centered at 1360 expiring last week; he was thrilled that the market decided that lower-than-forecast earnings and $15.2 billion worth of writedowns at Citi were deemed worthy of a 2% rally. Grrrr)

The driver of the recent rally, good international earnings from large cap stocks, plays nicely into another one of Macro Man's favourite themes, the long large cap/short small cap trade.

4) RMB weakness. Per the usual, USD/RMB has stalled immediately after a G7 meeting that called on China to allow further currency strength. Perhaps it was the lack of follow through. Perhaps it was losses by macro funds on other (long front end? short equity?) positions. But what's clear is that there has been a ferocious short-covering rally in the RMB NDF market, as shown by the three month outright below.

How cheap are US banks?

How cheap are US banks? Recent price action suggests that market's answer to this is "rather." Merrill reports worse than expected (albeit only slightly worse than leaked), and the stock rallies 4% on the day. Today, Citigroup disappointed the consensus and wrote down $15 billion or so. However, this amount was less than the $22 billion leaked yesterday, and de-emphasized in the headlines. (Citi must have bunged Bloomberg's headline writer a few bucks, as the only "red headline" showed a $6 billion writedown.)

The BKX has struggled to break new lows, and Macro Man's favourite technical analyst is lookinbg for a tasty (albeit corrective) bounce in the index.
Macro Man decided to do a crude study of bank valuation. The study was not meant to be exhaustive, and he is well aware of the limitations of his metrics. He constructed an evenly-weighted (i.e., not cap-weighted) basket of a number of US banks- Citigroup, BofA, Goldman, Merrill, Morgan Stanley, and Lehman. Using Bloomberg data, he had a look at how the equally-weighted index of their prices and price/book ratios have changed over the last dozen years:
On the face of it, these stocks look pretty darned cheap. The price index is back at the level of four years ago, and the price/book ratio is at its lowest in the dozen-year sample. On this basis, they look like a scoop, plain and simple. Of course, things are never that simple. Price/book estimates for banks are notoriously unreliable, and the wedge between price and price/book means that book value has spared over the years. Perhaps we'd better look at that.
Oh dear. Book value has risen in a pretty straight line for the entirety of the sample, albeit with a modest downturn recently. When you consider the utter implosion of most banks' assets, and that some are realizing the losses at 90c on the dollar, it's difficult to believe that these book values have troughed.
Indeed, book values have only retrenched back to the levels of last March....which was only three months before the onset of the financial crisis. Now, maybe this is accurate, and that somehow banks have managed to defend book values even as they de-leverage their balance sheets. Then again, maybe not......

Macro Man will let you be the judge....

Not to kick Merrill's while they're down....

...but after another earnings shocker, it would be churlish not to post this screen shot from Merrill's website, which is doing the rounds this afternoon. With an aggregate loss of $17.62 per share over the past three quarters, associating a bunch of Muppets with the name seems very apt indeed.

Uh-oh

Per yesterday's post, June eurodollars contineu to get whacked...
..and more worryingly, 10 year Treasuries are breaking the uptrend support line of the entire bull move.

3 month $ LIBOR set "only" 8 bps or higher, but the carnage continues in fixed income markets. There appears to be a modest, belated reaction from equities, though it is pretty small when the context of another crappy report from Merrill is considered.

Meanwhile, markets were treated to the following repartee:

EUROGROUP'S JUNCKER SAYS MARKETS DID NOT CORRECTLY UNDERSTAND G7 MESSAGE ON FX EUR/USD dumps on this.

Five minutes later, we get

WEBER - INFLATION OF 3.6 PCT IS WORRYING

and then

ECB'S BINI SMAGHI SAYS EASY FOR SOME NATIONS TO CRITICISE ECB BUT DISTRACTS FROM REAL PROBLEMS - TV

Uh, chaps.....I though you wanted to avoid sharp fluctuations in exchange rates?

A funny thing happened on the way to the rally

A funny thing happened today as equity markets left Virgil in the rearview mirror and started partying with Beatrice. Sure, equities were overdue for a rally; it had been what, a week and a half since the prior upmove of 2% or more? And what could possibly be more bullish than the news that JP Morgan broke even last quarter, once you strip out profits that are unrepeatable (the VISA sale) or of highly dubious provenance (the "profit" created by the fact that the value of the bank's debt went down a lot.) But as stock traders were popping champagne corks and riding the SPX to a 30 point up-day, they seem to have missed a rather interesting and, one might argue, salient point: the next leg of the financial crisis has begun.

The British Bankers' Association issued a directive today that it will expel banks that it believes are manipulating the LIBOR fixings by proffering rates that are not representative of where they are willing and able to borrow and lend in the market place. Macro Man touched on this issue last week, but it really hit fixed-income markets this afternoon. Early indications are that tomorrow's 3 month dollar LIBOR will fix 10-15 bps above where it printed today.

Why is this important? Now, Macro Man is not in expert in banking balance sheets, and anyone who is can feel free to correct him here. But his understanding is that lowballing LIBOR has enabled banks to mask the true state of their funding costs on their income statements and balance sheets. A sudden correction to the LIBOR fix could have some rather deleterious consequences for their liquidity status....and we have a rather recent precedent of how quickly a bank that is struggling with liquidity can hit the skids.

The warning signs are ominous. The spread between eurodollar and Fed fund futures has exploded to levels way beyond anything seen even last year; the chart below shows the spread on the December 2008 contracts, which widened by 13 bp this afternoon alone. That's not really a sign that it's time to begin trading the recovery, is it?

Similarly, two year swap spreads have begun widening again today; having made a higher low last month, will they now go on to blast up to a higher high?
After several sessions of pretty blah trade, the stock market was probably due for a bit of joy. Today's post-close IBM results will ensure that the party keeps rolling this evening. But tomorrow is another day, and one that's like to see bad news in terms of higher funding costs for banks; as Merrill Lynch is likely to demonstrate tomorrow, funny things can happen on the road to recovery.

Plus ca change

Macro Man occasionally has a look into his crystal ball, gazing at what the world will look like in the future. When he had a look last night, he managed to dig up a market historian's succinct summary, written in the middle of the next decade, of the current subprime crisis:

The U.S. Subprime crisis of the 2000s was the failure of several financial institutions in the United States and elsewhere. More than 1,000 banks, mortgage lenders, hedge funds, and structured invest vehicles failed in what economist Nouriel Roubini called "the largest and costliest venture in public misfeasance, malfeasance and larceny of all time." The ultimate cost of the crisis is estimated to have totaled around 2.75% of US GDP, about 80% of which was directly paid for by the U.S. government --that is, the U.S. taxpayer, which contributed to the large budget deficits of the late Noughties. The resulting taxpayer bailout ended up being even larger than it would have been because moral hazard and adverse-selection incentives compounded the system's losses.

The concomitant slowdown in the finance industry and the real estate market was the primary cause of the 2007-08 economic recession. Between 2005 and 2008, the number of new -homes constructed dropped from 2.2 million to 1 million, the lowest rate since World War II.b

Seems like a pretty realistic summary, doesn't it? Now compare it with the Wikipedia entry on the S&L crisis of the 1980's:


The U.S. Savings and Loan crisis of the 1980s and 1990s was the failure of several savings and loan associations in the United States. More than 1,000 savings and loan institutions (S&Ls) failed in what economist John Kenneth Galbraith called "the largest and costliest venture in public misfeasance, malfeasance and larceny of all time." The ultimate cost of the crisis is estimated to have totaled around USD$160.1 billion, about $124.6 billion of which was directly
paid for by the U.S. government -- that is, the U.S. taxpayer, either directly or through charges on their savings and loan accounts-- which contributed to the large budget deficits of the early 1990s. The resulting taxpayer bailout ended up being even larger than it would have been because moral hazard and adverse-selection incentives compounded the system's losses.

The concomitant slowdown in the finance industry and the real estate market may have been a contributing cause of the 1990-1991 economic recession. Between 1986 and 1991, the number of new homes constructed dropped from 1.8 million to 1 million, the lowest rate since World War II.

Plus ca change, plus c'est la meme chose...

As Big As Plaza: A Farce in One Act

Dramatis Personae:

Ben Bernanke, a central banker
Jean-Claude Trichet, a central banker
Masaaki Shirakawa, a central banker
Henry "Hank" Paulson, a finance minister
Christine Lagarde, a finance minister
Alistair Darling, a finance minister
Peter Steinbrueck, a finance minster
J.M. Flaherty, a finance minister
Asian Bloke #1
Asian Bloke #2
Middle Eastern Bloke #1
Middle Eastern Bloke #2

All the finance ministers and central bankers are seated around a table in a meeting room in Washington, DC. The blokes are seated quietly in the shadows in a dark corner of the room.

Christine Lagarde (CL): So 'ank, when you say zat you want a strong dollar, what eggzactly do you mean by zis?

Hank Paulson (HP): Well, just what it says on the tin, Christine.

CL: Tin? What is zis tin? I am talking about zee currencies, not zee commodities.

HP: Sorry, it was just a figure of speech. What I mean is that I say what I mean and I mean what I say: I want a strong dollar.

CL: But strong? 'ow?

HP: Well, you know. I really like the dollar to squeeze out 10 reps of 140 kg on the bench press, and be able to squat 250 kg 10 times as well. That's what I used to do down at the Goldman gym.

CP: In France, we do not eat ze cheeseburgers and do not need to go to ze gym. But 'ank, what I want to know is what you are going to do with ze dollar!

Ben Bernanke (BB): Take it for a ride in my new whirlybird!

CL: But it ze dollar is killing La Belle France!

Jean-Claude Trichet (JCT): Have I mentioned recently that I am worrried about inflation?

CL: Tu est un traiteur, Jean-Claude. We are ze G-7! We must do something about ze dollar and ze euro!

Asian Bloke #1 (AB1), on the phone: Euro/dollar, fifty mine!

Alistair Darling (AD): Don't worry, Christine, the Government has everything in hand.

CL: But what can Gordon Brown do about ze euro and ze dollar?

AD: Well, we are having consultative meetings with the banks in the UK, and hope to have something resolved soon.

Masaaki Shirakawa (MS): Alistair-san, why you ask UK banks to cut mortgage rates, when Northern Rock owned by Gordon Brown not cut its mortgage rates?

AD: Errrr........

CL: But we must do something about ze dollar!

J.M. Flaherty (JF): How about nothing?

Peter Steinbrueck (PS): Ja, vee in Germany are doing OK.

CL: But somebody in zis room needs to do something!

AB1 and ME1, on the phone: Buy me two hundred euro/dollar at best, please.

CL: 'ank, we need something bigger zen ze Plaza!

HP: Is Le Crillon bigger? I know the bill is.

CL: Come on, garcons! We are ze G7, we can set ze exchange rates where we want!

ME2, on the phone: Buy me 500 million EUR/USD, please.

CL: Come on, 'ank, what are you going to do? (Starts screaming)

HP: Will no one rid me of this volatile floozy?

CL: Zat is it! Let's mention ze volatile fluctations of ze exchange rates and promise to intervene. Ben and Alistair have ze experience of intervening in ze private markets, and zat's gone well.

BB and AD: Err........

CL: But now ze world will know zat we mean business!

ME1, ME2, AB1, AB2, each on the phone: Buy me five billion EUR/USD at best please: pay up to 1.62.

Exeuent all



Putting Holmes on the Hunt for Cheap Gamma

Market reaction to the G7 statement has been refreshingly rational, as the dollar's grey-zone attempts to surge have been body-slammed so far, taking both the EUR and the JPY to levels virtually identical to Friday's New York close.

Tellingly, reserve managers have been reported as buying up EUR/USD throughout the Asian and European sessions, re-inforcing Macro Man's view that it's more important to pay attention to the people with the money than he people with the microphone.

Indeed, one could easily argue that the "G" that is most influencing markets this morning remains GE, as equities have traded on the back foot following Friday's late-session melt away in the US. Sadly, it remains premature to state that the correction higher is over and the down trend back in force, for the simple reason that volume remains pretty modest. Sure, there was a slight uptick over the 4 days of sideways SPX action, but volumes remain well, well below the levels of February-March.
Still, with a number of bank earnings out this week, it's not hard to construct an argument that the catalyst for fireworks is now in place. After all, the G7 failed to deliver any concrete steps on improving market conditions, banks that demanded more liquidity with no concomitant increase in regulation were told to get back in their box, and the newspapers are full of rumoured rights issues and write-downs.

Macro Man has sent Holmes, Watson, and the Baker Street irregulars out onto the streets in search of some cheap gamma. Sadly, they've drawn a blank thus far, beaten to the punch by the infamous Moriarty. Should anyone encounter any, by all means pass the word. Lestrade of the Yard is offering a shiny gold sovereign as a reward.

The beginning of the end of the dollar rout....or the end of the beginning?

Well, well, well.

The G7 appeared to signal some concern over the decline and fall of the dollar empire yesterday, changing the boilerplate language in their communique:

"We reaffirm our shared interest in a strong and stable international financial system. Since our last meeting, there have been at times sharp fluctuations in major currencies, and we are concerned about their possible implications for economic and financial stability. We continue to monitor exchange markets closely, and cooperate as appropriate. We welcome China's decision to increase the flexibility of its currency, but in view of its rising current account surplus and domestic inflation, we encourage accelerated appreciation of its effective exchange rate."

The new text, shown in bold, can only refer to the dollar. So is this it for the dollar rout? Macro Man has long thought that the endgame for the current dollar downtrend will be a commitment from the relevant authorities to act to turn it around. However, it's far from clear that the G7 are the relevant authorities; after all, it's not Japan or Germany or the UK that is buying billions of EUR/USD every month; it's China and Russia and the Middle Eastern Countries. And Macro Man didn't see their names attached to any document expressing concern.

Moreover, it's worth taking a look back at history to gauge how significant this statement is. In the context of the last 25 years, the language is pretty limp. Compare the above, for example, with the language from the September 2000 communique expressing concern over the weakness of the euro:

"We discussed developments in our exchange and financial markets. We have a shared interest in a strong and stable international monetary system. At the initiative of the European Central Bank, the monetary authorities of the United States, Japan, United Kingdom and Canada joined with the European Central Bank on Friday, September 22, in concerted intervention in exchange markets, because of the shared concern of Finance Ministers and Governors about the potential implications of recent movements in the euro for the world economy. In light of recent developments, we will continue to monitor developments closely and to cooperate in exchange markets as appropriate."

Of course, at that point, the authorities had already intervened in foreign exchange markets. And even then, it was a full 18 months before the euro finally put in a clear bottom against the dollar.

How about the last time that there was a legitimate will amongst the authorities to prop up the dollar, in 1995?

" The ministers and governors expressed concerns about recent developments in exchange markets. They agreed that recent movements have gone beyond the levels justified by underlying economic conditions in the major countries. They also agreed that orderly reversal of those movements is desirable, would provide a better basis for a continued expansion of international trade and investment, and would contribute to our common objectives of sustained noninflationary growth. They further agreed to strengthen their efforts in reducing internal and external imbalances and to continue to cooperate closely in exchange markets."

Observe how 13 years ago, the G7 essentially stated that exchange rates were misvalued and should reverse. That's a much stronger statement than the observation that there have been "sharp fluctuations"; indeed, the latter phrase seems to say more about volatility than direction.

And how about the Grandaddy of them all, the Plaza Accord? Those were the days when men were men (unless they were Maggie Thatcher), and G7 (or G5) statements were bold and forthright:

"The Ministers and Governors agreed that exchange rates should play a role in adjusting external imbalances. In order to do this, exchange rates should better reflect fundamental economic conditions than has been the case. They believe that agreed policy actions must be implemented and reinforced to improve the fundamentals further, and that in view of the present and prospective changes in fundamentals, some further orderly appreciation of the main non-dollar currencies against the dollar is desirable. They stand ready to cooperate more closely to encourage this when to do so would be helpful."

Again, observe the direct language expressing a clear directional bias that is absent from yesterday's communique. The language of the Louvre Accord, essentially "taking profit" on the Plaza, is similarly forthright.

Ultimately, when the history books are written, yesterday's communique may be seen as a small first step to end the dollar's decline. But small is what it is, regardless of whether the dollar stages a handsome rally on Monday. Absent a commitment by the Europeans to cut rates to lessen the euro's lustre (a reticence that recalls the Bundesbank's reluctance after the Louvre Accord, which ultimately helped spark the '87 stock market crash) and, importantly, Voldemort and co. to quit selling dollars in the open market against other free-floating currencies, it's hard to see any dollar rebound enduring, especially given the weakened state of the US economy and financial markets.

The beginning of the end? Nah. But it just might be the end of the beginning.

Old G7 statements can be found at the University of Toronto's excellent G8 resource center, linked to the right.)

Pressure points

So much for traction. Macro Man was just starting to get excited yesterday at lower equities and USD/JPY, then at 3.10 pm London time every market in the world seemed to put in a V (or a lambda.) In the end, the traction that Macro Man and others experienced in the "re-emergence" of Q1 trends resembled that of the chap on the left.

Yesterday, the TSLF was undersubscribed...which must mean that everything is sorted, A-OK, and hunky-dory, right? If banks needed liquidity, surely they would have bid for it?!?!

Not so fast. Macro Man isn't sure what is wrong with the TSLF, but he's pretty sure that something is wrong with it; the participation rates have, in aggregate, been much lower for the TSLF than the TAF. Moreover, this week's TAF was heavily oversubscribed and awarded at a level ABOVE prevailing LIBOR rates. What that means is that banks were so desperate for liquidity that they were bidding for secured borrowing, with a haircut, from the Fed at a higher rate than they could ostensibly borrow sans haircut and collateral from each other. No wonder modern-day accounting is so screwy!

Moreover, there are interesting things afoot in the UK. Sure, the Bank cut rates yesterday down to 5%....but LIBOR isn't moving. Indeed, 3 month LIBOR is indicating today at unchanged from yesterday, and at a tasty 92 bps spread to base rates, the highest since two prior climactic crisis points. So unfortunately for everyone who bought the front end of the short sterling strip on the basis that the UK economy is buggered, while they may be right about Britain, they're still losing money.
The G7 meetings this weekend will no doubt look to address the issue, but at this juncture it's uncertain what they can do. There's a fascinating paper from John Taylor and John Williams on the FRBSF website suggesting that counterparty risk is what's driving spreads, and that the TAF is having no discernible impact. Macro Man stands by his view that the endgame here is the US and other governments writing a bit fat check to buy all the unwanted crap off of banks' balance sheets and holding it til maturity.

Further signs that the worm has turned in the global economy came from China's trade data, which showed a rebound in the surplus....but still left that surplus much smaller than the levels prevailing in 2007. China appears to be getting hit by twin headwinds; not only has demand slowed in their export markets, but their terms of trade has deteriorated markedly. The spread between export and import growth is at its most disadvantageous level since 2004, and export growth on its own is at its lowest level since 2002, when the world was slowly emerging from its last recession.
At the risk of beating a dead horse, by linking their domestic currencies to the dollar at undervalued levels, mercantilists and oil producers are forcing the required USD adjustment to manifest itself in other ways...not only against other floating currencies, but increasingly against commodity prices via the invoice currency effect. At some point, this will become a real public policy issue for China, the Middle East, et al., when they realize that not only is inflation not going away, but that an increasing cohort of their populations are struggling to feed themselves.

Perhaps then we'll finally get the badly needed multilateral buy-in to facilitate the currency adjustments required to rebalance the world and, ironically enough, enrich the developing world.

Financial accounting, ca. 2008

Passed on from a colleague.....

There are two sides of the balance sheet: the left side and the right side.

On the left side, there is nothing right...

And on the right side, there is nothing left.

Easy!

Traction

Are markets starting to get traction again? The last 24 hours have seen many of January-February's popular trades (which were incidentally among March's worst performers) spring back to life in impressive style. What was the catalyst? It's hard to say. Perhaps it was the revelation that Goldman's level 3 assets surged last quarter, or the rumour that Merrill will go to the writedown well once again, this time to the tune of a fresh $6 billion. Perhaps it was the IMF, in a rare bout of relevance, issued a fairly bearish update to its World Economic Outlook.

Overnight, the catalyst was clear: Singapore's MAS, responding to exuberant Q1 growth and uncomfortably high inflation, unexpectedly tightened monetary policy (which in Singapore entails allowing the currency to strengthen. Unsurprisingly, this prompted an Asian currency love-in, no doubt exacerbated by USD/CNY breaking below 7.00.
But consider the return to prominence/threating the recent trend of other erstwhile sacred cows, such as short equities. The SPX is now threatening its uptrend off the lows (though Macro Man has cunningly omitted the trend line.) In fairness, however, volume was not discernably higher than during the recent sideways drift, so the jury must remain out.
However, USD/JPY is also threatening its uptrend , and indeed as of current writing has broken through the line, while EUR/USD has made a new all-time high this morning. It looks like it's game on again for the dollar down trade- will the ECB do anything about it today? (Probably not.)
Meanwhile, the 2-10 yield curve in the US has begun steepening again (by about a dozen bps yesterday) , reversing the horrible correction of March and breaking the flattening trend line.

And finally, and at the risk of descending into shameless back-patting, US small caps got a roasting yesterday. The OEX/Russell 2000 spread, which Macro Man carried in his old blog portfolio (which is suspended for the time being as he builds out his book in his real job), took a sharp turn higher yesterday. To quote Hannibal from the A-Team, "I love it when a plan comes together."
Of course, this could just be a head fake that suckers poor lambs like Macro Man into the abattoir, where carnage and slaughter awaits. He would really like to see volumes increase sharply to suggest that participation is increasing and risk is being re-allocated. There have been some rumblings about risk being deployed in the option space (buying equity index and USD/JPY puts) , which would suggest that conviction remains relatively low.

Another couple days of these trades getting traction, however, and we could the market get seriously re-risked and macro trading become pleasant once again.

Wither Earnings?

Earnings season is just beginning, and low equity volumes and bland price action indicates a lack of interest, or at least conviction. A theme that increasingly interests Macro Man and, judging by his email box, some of the more astute researchers out there, is the seemingly inevitable sharp downgrade of US earnings expectations, which would presumably lead to lower stock prices.

While consensus expectations have been marked lower, they still imply stronger SPX earnings in 2008 than in 2007. How that squares with an inability to procure credit and a nascent shedding of labour is an issue that has frankly eluded Macro Man. What we can observe is that the gap in 12 month trailing earnings and the 12 month forward forecast has widened sharply recently. Now, part of this is the simple mechanical function of the forward "earnings year" shifting from 2007 to 2008...though even smoothing for that suggests a wedge is forming between trailing earnings and the forecast.
Even more remarkably, analysts are forecasting stronger 12 month forward earnings now than they were a year ago. To be sure, the degree of optimism has waned considerably from its peak of a few years ago. But observe that in the last two recessions, y/y forward estimates turned sharply negative, reflecting the substantially lower profit base resulting from the economic downturn. On this metric, there is very substantial room for pessimism to increase and downgrades to emerge.
And if the SPX looks vulnerable to revisions, what about the less-covered small caps? Data is admittedly hard to come by here, and Macro Man is working with the scraps that he can retrieve from Bloomberg. (Any readers with good historical data on Russell trailing and forecast P/Es and who is willing to share, by all means contact Macro Man by email.)

But as the chart below indicates, trailing earnings in the Russell have collapsed over the past couple of quarters, which has pushed the trailing P/E up to nosebleed territory (53.3 according to Bloomberg.) But the earnings estimate data that Macro Man has been able to procure hasn't really budged at all.
If there's room for futures disappointment in the S&P, what should we be expecting for the small caps? Yesterday's survey of US small business confidence plunged to the lowest level in the history of the survey, which goes back to the mid-80's. Hardly a ringing endorsement of the small companies that represent the backbone of the US economy, is it? The large cap/small cap trade that Macro Man tracked in the blog portfolio has taken a step back over the past few weeks, as major indices have taken a breather and nudged higher. If the disappointment which appears to be forthcoming actually does materialize, both the SPX and especially the small caps look vulnerable.

Disclaimer

This commentary is written for entertainment purposes only. Nothing you read on this site is advice or an inducement to buy, sell, or hold any real or hypothetical investment, nor should you construe it as such.