Friday, May 07, 2010

The Sea-Change

Where to begin? Let's forget the nonsense with P&G, or the supposed fat-fingered futures butchery at Citi ("your tax dollars at work!") Yesterday was a game-changer, a sea-change. Obviously, anyone who saw the SPX melt 60 points in 5 minutes probably doesn't need Macro Man to tell them this, but consider that:

* E mini futures posted their highest volume day (by a huge margin) since October 9, 2008.

* VIX soared higher and is now up on a y/y basis.

*The front end of the eurodollar strip got slammed in a long-overdue comeuppance for the "pennies in front of the steamroller" crowd. The chart below shows the continuous first eurodollar contract...ouch! At one point yesterday, EDM0/EDZ1 had flattened 45 ticks: the former was down 22 and the latter was up 23. Ouch, indeed.

* The day after posting its high print of the year, USD/JPY posted its low print of the year. Unless you're in the first week of January, that's normally not a good sign.
At the heart of everything, of course, is the ongoing implosion in Greece, and the European "response". It seems pretty clear that neither side (the Germans with the money, or the Greeks with the sense of entitlement) really wants to do a deal...and the fact that Greece has hired an investment banker to "advise" on its debt profile should raise a big 'ol red flag to any potential bottom-fishers in Greek debt.

The only centralized body in Europe with any sort of the authority is the ECB. And frankly, at this juncture, it looks like they are in over the heads. Now, perhaps we might wish to extend the benefit of the doubt to Trichet and company until after the Germans vote on the rescue package. Perhaps the governing council took the view that if the ECB acted pre-emptively, the necessary fiscal support would not be forthcoming.

Somehow, though, that doesn't ring true. A central bank that talks of being "inflexibly" wedded to price stability isn't one that sounds capable of quick, credible action. After everything that's happened over the last few years, how the hell can any Tier 1 central bank talk about "inflexibility"? It's asinine.

And if they really, truly didn't even discuss a bond-purchasing program, even in passing...well, then the single currency is going to deserve everything that it gets. Sticking your head in sand and hoping everything turns out OK isn't really an option if you're the custodian of a reserve currency in crisis...and yet that seems to be the policy response pursued by the ECB.

The natural result would be to strip the euro of its reserve currency status. OK, OK, the ECB isn't doing nothing. They're having a conference call, by gum, with some of Europe's largest banks to talk about the state of the money market! They'll presumably be told it's in bad shape...the scramble for dollars has sent EUR/USD forward points screaming to the right (i.e., pricing in higher USD rates than EUR rates.)
They've also publicized a conference call to be held amongst the G7. Leaking news of the call might not have been such a swell idea...because if it doesn't produce anything, what then? Sure, the Fed can re-open swap lines with European central banks, but both the US Congress and taxpayer may justifiably question as to why the Fed should lift a finger when the ECB itself doesn't seem prepared to do so. (And that's before Congress has gotten its teeth into the idea that they'll have to appropriate several billion dollars towards the IMF bailout of Greece.)

So while "risk" is currently enjoying a bounce, Macro Man wouldn't exactly be scurrying to build longs here. After a day like yesterday, he suspects that you're (finally) supposed to sell rallies now.

Alas, one place where a sea-change may not be in the offing is the benighted UK, where a hung parliament has now been confirmed (thereby putting paid to one of your author's non-predictions for the year.) While the Tories have a comfortable plurality of the vote, the vagaries of the UK electoral system (translation: Labour districts are the size of a postage stamp; everyone else's are the size of the Grand Canyon) mean that they are denied a majority.

Noted creature of the underworld Peter Mandelson was pimping the notion of Labour crawling into bed with the Lib Dems before the first result was announced last night, and it certainly sounds like Gordon Brown will need to be forcibly ejected from Downing Street (ed. note: now that, I'd pay to see.)

So even though the Tories will be the largest party in the house by a decent margin, we're looking at a few days of uncertainty at best and another 5 years of Gordon at worst. Ugh. Will the last one to leave Britain, please turn out the lights.....


The Fundamentalist said...

not for nothing, but it's hard to argue for the case that mkts sold off yest. on news that Trichet says no ECB discussion on QE.

I mean the news came out at 12:55 GMT and European mkts hardly budged.

Ditto for the US mkt, basically flatlining for the 1st half-hour of trade.

One only get the sense that the US mktis getting a tad too weak after 10.30am EDT when all the major US econ. data has been released.

Even then there's no inkling that the US mkt would crash. After all, if the European mkt had hardly react to ECB's non-discussion of QE, one would hardly expect the US mkt to lead the way down in a big way.

Macro Man said...

I thought the efficient market hypothesis had already been discredited?

In seriousness, there were obviously a number of moving parts...including, significantly, margin calls (themselves a result of weakness derived from the Greek situation.)

Moreoever, the funding issues are very real, and white eurodollars were down from the moment the ECB did nowt...which was exacerbated once equities plummeted.

Rossco said...

truly one of your best posts - stale bulls need to get with the program after that.

As for the "fat finger" .... yeah ....well ....

jcambria said...


I’m not as negative as you at least not for core European stocks DAX and CAC.

The ECB will eventually get a handle on this and realize that they’ll have to QE or the entire edifice is gone. Inappropriate monetary policy for Germany and France will light a fire to these relatively unleveraged economies.

The Fundamentalist said...

more like late Feb 2007 sell-off to me.

back up the trucks pple.

Our Man in NYC said...

It was also pretty noticeable how quiet fixed income was in Europe, throughout the day -- it was if nobody wanted, or was able, to trade...

melki said...

now now macro, don't let your gut get ahead of your head.

36% is NOT a "comfortable plurality" of anything. 36%*650<<300+. it's the libdems who get screwed again, but as they want to cap bonuses at £2.5k I'm not surprised you're not a fan. still, head before gut.

markets-wise, it's hard to disagree but stranger things have happened. but if 290k jobs can't put a bid under risk, what can?

as for the ECB - monetising the debt is a really, really bad idea. it's been tried before, never succesfuly. liquidity is already plentiful, money creation cannot create solvency. therefore: i) another institution must be created, effectively ushering in fiscal federalism and/or ii) nations must accept a brutal fiscal tightening and/or iii) we're all screwed.

as for leaving britain: where, pray tell, will you go?

Macro Man said...

Uh, melki....7% more votes than Labour is a comfortable plurality. You do understand what 'plurality' means?

The Fundamentalist said...

how ironic, european indices are pulling the US indices down

a total contrast to yest. trading action where US mkts lead the way down.

front-running the G7 conference, we are

The Fundamentalist said...

just another view to chew upon,
gary savage see this crash akin to late-Feb 2007.

Macro Man said...

The obvious difference between now and then is that in Feb '07, there had not been any policy easing; now, there's little room for any more.

k1 said...

Great post MM. Exciting times. I do adore the American media's provincial notion that a trader could fat-finger (truly? m is right hand, b is left, even if you are a 2-finger typist) an order for P&G and move the entire global edifice (again, truly? that spike in U/J?). LOL.

And yes LB, I am indeed short JNK since our conversation early this week. Thanks for noticing.

Tyler said...

I have been outright bullish for a while (although I have not commented in these pages for some time). Thus, I admit I fall into Rossco’s category of a bull (I’ll drop the ‘stale’ portion if you don’t mind; it has a decidedly negative connotation).

Although the natural tendency is to forget prior periods on an ex-post basis, recall that the bullish view was tested in July 2009 and again in February of this year. While those corrections did not come to a head in nearly the same manner as yesterday, they were still a hardy test to stand one’s ground. And don’t forget that it was not easy to turn bullish before then (I recall reading Jason Todd’s analysis on March 31, 2009 and finding his arguments to ‘sell the rally’ so feeble it strengthened my bullish resolve).

I am reminded that conviction and stubbornness are identical twins differentiated only by their outcomes (no I didn’t make that up…not sure where I got it). Until now my conviction has been rewarded. The broad arguments of the bullish stance is still in tact: zero interest rates, cyclical lift, high corporate profits and clean balance sheets as are the broad risks: sovereign issues, inflation and tightening in EMs, regulation uncertainties. As always, arguments for valuations fall on either side.

I believe it was Right Field who commented on these pages that a 10% correction was a gift to the real money players out there. I thought that was an interesting notion at the time and, as you might guess, I agreed with it. (I am pretty sure Right Field became bearish so I am not trying to put words in his mouth, I am intentionally taking him out of context) Well, the market never really gives anything away right? What I mean is that if the bullish side ultimately wins this little tiff and the economy keeps printing nice numbers and earnings keep coming in strong and Europe creates a resolution of some sorts and this rally goes on to new highs…it will not have been easy to say that you stepped up to the plate in early May when it looked like the world was heading into another liquidity crunch and you focused on the fundamentals of a cyclical uplift and 2011 S&P earnings of $100 plus and improvements in employment and blah blah blah.

I’m certainly not advocating that I am right as I have been smacked and humbled. And I fully admit that if another selloff comes my clients and I are going to take it in the piss…but that’s why they call them risk assets, right? And
right now, I think the risk is to the upside and the focus should continue to be on what risk assets can give, not what they can take away.

Sorry about the length. Have a nice weekend. And I agree, great post MM.

Leftback said...

Well, well, well... there was always going to be that "10% correction is a buying opportunity" camp, eh? In fact, we will almost certainly see a modest rally that might last for a week or even two.

As MM points out, in a NORMAL RECOVERY, that would be a great play - as low rates, easy credit and strong growth would all combine to close the output gap in short order. So in this case, we may be looking at the development of an EXIT RALLY for a lot of equity (and esp. commodity) longs who didn't jump ship yesterday afternoon.

k1, nice work, there has been a monster squeeze in HY since 3/09 and those moves only end one way - did you cover after the plummet by 7% yesterday? Any time you need a new fixed income strategist at your fund, LB is open to offers!

RebelEconomist said...

"A central bank that talks of being "inflexibly" wedded to price stability isn't one that sounds capable of quick, credible action."

Not true; such a central bank sounds capable of quick, credible preserve price stability. Euro area inflation is stable, so no action by the ECB is required.

The Greek problem is precisely that, despite the fact that such principles led to the low interest rates that made the euro attractive to join in the first place, the PIIGS believed that, when the principles applied to them, they would be relaxed. This credibility is too valuable to be squandered on Greece. If the politicians consider that Greece should be bailed out, let them do it with hard money, for which the politicians are properly accountable.

Macro Man said...

And so what's the ECB supposed to do when Greece's solvency problem becomes a liquidity problem for half of the remaining countries in the Eurozone?

Embrace the inflexibility of their price stability orthodoxy, which provides their Maginot Line defence against the enemy in the last war?

Allowing the PIGS into EMU was a bad idea and the result of politics rather than sound economics. But they're in there. If the ECB chooses to act as if they're not, well OK, but then don't blame "speculators" when the euro gets tagged and eventually fractures.

Right Field said...

Let me start off with a quote from Keynes: “When the facts change, I change my mind. What do you do, sir?”

To be clear, the 10% correction scenario and “gift” was directed at professionals and not real money. While the broader exercise over the last two days has been about reducing gross exposure levels, I know many large fundamental long/short or multi-strategy professionals buying that “gift”. If correct, it will help level the playing field against real money with respect to underperformance. We will see…

Observation: Over the last two days, I have seen macro traders at their best, i.e. flexible, liquid, very focused on downside risk and adaptive to changing facts and market conditions. Point being, many are making money.

Right Field said...

Apologies if this comes off as a look back option or victory lap (not my intention at all) but I did not have time to post my morning call/note on this on this Blog, just my regular DL. Here is Thursday, May 6th at 9:20 a.m. EST for reference as many read throughs here are still relevant.

Three Day Down Rule...More Unwind of Growth Strategies --------- Risk assets were clearly looking for a crutch, the ECB did not produce one and
the risk reduction now continues into a third day. It is misguided to view policy officials as not respecting the gravity of the current situation but the
pace at which the market demands solutions to a crisis and the pace at which the policy process can respond are different. Point being, the market today is going to highlight that difference in timing with continued weakness in the EUR and any strength elsewhere in risk assets will be sold. The price action and policy announcements between China and Australia are creating an Australasian growth scare. Brazil and Mexico are leading Latin America down that same path. The European deflation story is only growing now. This regional bifurcation is easily noticeable and dollar denominated assets have benefitted. The dollar and US Treasuries may stay bid today (safety) but US equities remain at risk of a large down day. In my experience, the third day of weakness is the most painful due to longs finally capitulating from denial, especially as any real money becomes a seller. All of this remains supportive of Gold as argued yesterday (Wed).

Right Field said...

Fast forward to now:

The SPX has now corrected 8% off the closing high. Clearly investors are asking the question if this has a more legs and can lead to a 2008 scenario where the entire industry is once again severely impaired if Europe goes... And Macro Man is correct like many others, rates are low and stimulus is already high so there are very few bullets to shoot if needed. Conversely, US reflation, earnings, jobs, etc. all are supportive for US equites and the “gift” to buy.

I do not have an answer or that foresight or willingness to make a 2008 analogy call but here are three scenarios that many find themselves in, with possible course of action:

1) Fully invested. This is horrendous no matter how cheap equities now look, i.e. they can always get cheaper which you learned in 2008. If you are still in this scenario, I would sell 25-50% of my longs and put 10% of those proceeds in a vol overlay or short exposure in financials, small caps, or EM.
2) More than 50% cash, 20% short, 30% equities is a good spot and cover shorts when your weightings are getting out of whack. The weightings of your shorts will become oversized when they go your way, so take profits in increments.
3) Net short by more than 15% is a very dangerous position to play against govenement’s no matter how long it takes to respond to noted issues. Remember what happened to that position in 2009.

Right Field said...

Finally, I will leave you with a a cheap tail risk hedge if you missed putting one on and still believe we have significantly further to go:

Idea: Buy CDS protection on Brazil and Mexico

Why: These are the two most liquid EM countries to express CDS views and the risk/reward at these levels to own protection are very compelling. This is three pronged hedge:

1) European deflation and structural breakdown
2) China/Australia growth scare
3) Rising interest rate structure due to inflation

Location and Risk/Reward: Look at both charts are of 5-year CDS on Brazil and Mexico. You are risking a 30 bps tightening against a 150 bps widening or more. That is at least 5:1 with true macro tailwinds in your favor.

Price: These are cheap on stand-alone and optical basis. They are cheap relative to index puts now. They are cheap relative to Financial or highly focused sovereign CDS.

Leftback said...

Right Field:

Too many notes, Mozart !!

It's risk off, dude. You might make money for a few days/weeks on the exit rally but this thing is going down - it isn't about a few sovereigns any more, it's about the entire European banking system.

At the risk of restating the completely bloody obvious, Germany has to decide whether to save DB. Nobody cares about Greece.

RebelEconomist said...

I am not entirely sure what the liquidity problem you have in mind is MM, but if you mean an increased demand for base money, the ECB should take care of this automatically in the course of holding (down) its policy interest rate.

If Greece is forced to default, the standard procedure should be followed, as it should have been in the US when AIG failed - ie if a Greek default bankrupts a German bank, first wipe out the bank shareholders, then if necessary haircut the creditors according to seniority, and nationalise the bank temporarily to allow it to be either closed in an orderly manner or continue in business under new ownership. The bailouts have been getting steadily bigger for years; they need to stop before they take us all down.

The Lab-Rat said...

when do you leave for the us mm?

Leftback said...

Krugman reviews the options for Greece, including those discussed here, and the Argentina solution:

The Options for Greece

In any case, it will continue to be "drachmatic"....

Nemo Incognito said...

Sorry for my absence. View from Asia looks quite benign - too benign in my opinion. Indo fixed income has take a bit of pain but equities just aren't quite there yet. The usual themes are strong though - anything consumery is doing ok and Sing dollar is actually holding up. If this is anything like 08 I just wonder how long the decoupling camp can hold their line and continue to believe. Inflation trades look a lot less interesting if Greece sticks to an austerity program: it makes it much more of an LB/MM type of world.

I entirely agree on the DB point - one of the reasons I left that firm in mid 08 was due to a couple of beers with a friend in the european cmbs biz who basically talked about the Eastern Europe / Southern Europe book like a Vietnam Vet does about the Mai Lai massacre "i've done terrible, terrible things, god will never forgive me, etc".

Though this part of the world seems to be not all *that* affected so far I think the likes of Lai Fung are in for more deucing between the CNY reval risk and crappy export demand. The real subsea methane turd though is whats happening in commods and this China banking bubble thing. If they get this Agricultural Bank thing away it will be pretty amazing.

Bitr said...

hey MM am slightly disappointed in that everybody including you would just continue using Citi as a source of trouble in this... "citing multiple sources.." ???? give me a break... i heard other major names privately too but would never dare to tell any media a particular name of any firm as these are irresponsible accusations unless you got any proof... all that despite Citi saying they know of no such error...

deke said...

Livin' in the USA!
give me a cheeseburger!(steve miller band)

The latest growth data showed continued upward momentum in the USA, now generating net hiring, with leading indicators for employment pointing to more acceleration ahead!

The S&P 500 is down 8.7% from its April 23 high, after the 80% rise through then from the low in March 2009.

The Fundamentalist said...

The night is young, but wow! Futures are screaming higher