Headlines And What They Mean

Posted by on Nov 30, 2011 in Uncategorized | No Comments

The market has decided that we will get IMF/ECB support, ECB rate cuts and QE3.

The headlines continue to be messy at best, but the market has decided that the leaders will “see the light and go for the only possible solution”.  They probably will, though there is scant evidence that it is really a solution and doesn’t just make the problem bigger (if it can even be implemented) and too little time is being spent on offering a real alternative.

ECB rate cuts must be close to a certainty.  It seems like it costs nothing and makes everyone happy.  The last rate cut really did nothing, but since it is mostly symbolic, why not.  German 1 year yields are negative – so clearly not dependent on the ECB overnight rate and maybe the market overly exaggerated the lack of demand for German debt?  Expect them, especially after China moved overnight, but I wouldn’t get overly excited.  Unlike the Fed funds rate, which clearly impacts treasuries and potentially still has an impact on other rates markets, the ECB overnight rate seems to have less correlation to any observable rates.

QE3 seems highly likely.  Most Fed members seem on board with it, and Bernanke believes in it, so seems like an 80% probability.  There remain a couple of hold-outs including Lockhart who is typically more neutral.  The market has priced a lot in as everyone remembers the relentless march higher in risk assets after QE2.  We may not get quite the same benefit as banks in a whole are deleveraging, but European banks in particular are pulling back from the US and are looking for a bid for their mortgage holdings.  It would be great from that perspective if the Fed stepped up, but think money will be returned home to shrink balance sheets and not as much will transfer to risk assets.  This is particularly true if Europe goes ahead with its plan to guarantee bank debt of 1 year or less.  Government support of funding where 90% is short term seems insane to me.  Banks runs are best prevented by having LONGER term funding.  In this time of uncertainty, the flows could be European banks sell mortgages, buy back longer dated bonds, and sell shorter dated bonds.  Some increase in risk, but not to the same degree we saw after QE2.  And that is if we get it.

IMF/ECB “plans to explore”.  With EFSF apparently on the backburner, the entire market has shifted to how the IMF and ECB can save Europe.  Stark warned that the ECB couldn’t lend to the IMF because it is not a member, I think that could be remedied quickly, but it remains unclear how much leverage the IMF can take.  The IMF lives on commitments to fund via SDR’s.  Do those commitments allow the IMF to leverage, and if so, how much?  Is the IMF comfortable leveraging?  They have been relatively prudent throughout this crisis (it was their report that pushed for 50% haircut on Greek debt).

Like so much else, we are back to the planning to plan and exploring options phase.  This was all meant to be done by now, and the EFSF is an abysmal failure so far.  Not only have they not been able to raise money, which given the timeline can be forgiven, but they still haven’t figured out anything real, which is unforgiveable.

One plan on the table is that the central banks of each European nation could enter into bilateral loans with the IMF so that they could lend.  I read that statement about 20 times.  So if the national level central banks can lend to the IMF so that the IMF can lend to the countries?  This strikes me a new level of circularity and if it is possible, what have they been doing for the past 6 months?  What is the central bank of Italy actually already doing?  Maybe somehow they can be part of a “solution” but maybe this will just open up another black hole that investors haven’t focused on.  Remember back when EIB was going to solve the problem, and is now not solving the problem, but attracting some scrutiny itself?

It feels like this may be an attempt to guilt G-20 members into stepping up their support for the IMF?  I do not see how the US can do that easily.  At some point, our IMF commitments must attract attention – clearly they want the IMF to borrow from the ECB so we don’t have to fund our commitment and bump into our debt ceiling.  China and Russia strike me as countries that don’t appreciate being bullied.  The EU seems to have a belief that if they push the BRIC’s into a corner, they will become docile and go along with the plan.  I just don’t get the sense that is how they react, and how quickly has the EU forgotten their unsuccessful appeals for money?

I suspect they will cobble together something. It will have strings attached, won’t be as big as needed, and won’t ultimately get implemented because of too many required approvals, but should be enough to limit the downside of the market for a month or two. If they actually get what they want (I’m not sure they even know that), what will it really do?  Will it really work?  The market hasn’t done a particularly good job of demanding things that turned out to work either.  The politicians have tried to do what the market has asked for, and you can argue about too little too late, but you can also argue that the market only knows what it needs for the next 5%, but has been horrible at demanding good solutions.  This is likely to be another case of that (the market is about 10 for 10 on demanding plans that have failed, so why would this be different?).

Treaty Changes.  Sure, why not.  France, Germany, and the Netherlands want them.  Italy and Greece are puppets so will say yes.  Does anyone else really matter?  Probably not, they will go along with some agreement in principle and then go home and have the task of getting it actually approved.  None of these leaders can unilaterally get anything done.  Sarkozy seems to have the strongest support at home (everyone in France is desperately afraid of their banks) but even Merkel might struggle (though these changes are so likely to be favorable to Germany this case should be easy).  Will Italians really let Monti sell them out?  More and more I think of Monti as Bud Fox in the original Wall Street who is in charge of Bluestar airlines just long enough for his handlers to get what they want.  So some statement about treaty changes or agreements that don’t require treaty changes is almost a certainty next week, but it is almost as certain that 3 months from now nothing will have been done, and the market, if not scared already by then, will get scared.

Market “trading short” or “embarrassed longs”.  After the Grand Plan there was a lot of discussion about cash on the sidelines and performance chasing and SPX 1,400.  Now there is a lot more talk about how the markets are trading short and has gotten too bearish.  I don’t see it.  I’m bearish on any long term solution but am running very small positions, as the opportunities to sell overdone rallies seems easier than being constantly short.  Many of the bears that I talk to seem lightly positioned and the NYSE short interest isn’t particularly short either.  It seems that many investors talk bearish but are positioned long and get longer on any bounce – using the upward price movement as a confirmation that “Europe gets it”.  Investors are scared to sound too bullish right now, as that seems unpopular, but behind the scenes are far more bullish than they appear.

AMR and short end of HY.  AMR December CDS was trading at less than 10 points on Monday.  It is at 80 points today.  That is a big loss.  It follows on the heels of a similar nasty surprise on PMI.  It has pushed the curves on other “story” credits like Eastman Kodak.  There was complacency in the high yield short end.  It may remain isolated to just the story credits, but is worth watching as short end investors typically have the least tolerance for any sort of losses.

Bank Rating Changes.  The S&P downgrades weren’t too bad actually.  Many were expecting some 2 notch downgrades that didn’t materialize.  I am more interesting in the Moody’s decision to create more separation between senior unsecured debt ratings and sub debt ratings based on less government support.  I remain convinced that the only real way out of this crisis is restructuring sovereign debt across the board.  That would impact banks a lot.  The EU leaders know that most of the banks need to survive in order to lead a recovery for the economy, but “need to survive” doesn’t have to mean at current valuations.  Senior unsecured debtholders need to be protected in order for banks to continue to lend.  Sub debt and share price are not a prerequisite for ability to lend.