Operation Damp Squib
The FOMC failed to surprise the markets, with predictable results – a major sell-off in stocks and commodities ensued once the statement was digested. It is noteworthy that the three dissenters that were first heard from in August could once again not be persuaded to support even the fairly modest new easing measures the FOMC decided upon (they are not modest in their overall scope, but we call them modest because they won't add to the money supply). In other words, the 'palace revolt' continues to be a thorn in the side of the money printers. We suspect that this is the main reason why the 'Evans gambit' has been shelved for now.
Instead the FOMC opted for the well telegraphed 'Operation Twist' – an alteration of the term structure of its balance sheet – as well as a decision to reinvest the proceeds from maturing mortgage backed securities in other mortgage backed securities – specifically, agency debt, i.e. securities issued by the de facto bankrupt GSE's (instead of reinvesting such proceeds into treasuries as has been the case hitherto).
The statement can be read in its entirety here. It contains the usual non-committal vacuous palaver about the economy and its prospects (weaker than they thought, but expected to improve) and 'inflation' (expected to moderate, natch) and so forth. Below are the pertinent passages regarding the policy measures:
“To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.
To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auction.
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools as appropriate.
If they thought this would be enough to goose the stock market, they thought wrong (even though most Fed officials will of course deny that the Fed is targeting the stock market, we have it from the horse's mouth that it does). Hence the threat to 'employ tools as appropriate in light of incoming information'. The next incoming information could well be a significant stock market decline.
It seems to us that the probability has now increased that the 'unlikely crash count' we presented previously could turn out to be correct after all (only the intervening corrective wave has become slightly more complex), as the new measures announced by the FOMC are likely not sufficient effect a change in sentiment – as mentioned above, they won't increase the money supply. This would only happen if commercial banks were suddenly eager to expand their lending and putative borrowers were eager to expand their borrowing, both of which appear unlikely prospects. Previously the federal government jumped into the breach and the combination of deficit spending and debt monetization by the Fed held up both the amount of total credit market debt in the economy and served to increase the money supply by leaps and bounds. However, this occurred in the face of market forces that are clearly deflationary, as over-indebted households continue to retrench and deleverage. Federal deficit spending is now likely to be throttled back as well, due to the administration's cohabitation with a Republican Congress. The Republican party always rediscovers its commitment to fiscal probity in these situations (it is different when the administration is Republican as well – some of the biggest spendthrifts in history were in fact Republican presidents, beginning with Hoover).
We should also remind here that the most recent sharp increase in US money supply measures was apparently mainly a result of dollars fleeing euro-land banks and being deposited in US banks.
One of our readers from Quebec (thank you Bernard) mailed us the following chart today that shows a putative wave count of the triangle in the DJ Transportation Average:
'The triangle is about to break', so our reader – and indeed, it looks as though that is now happening – click for higher resolution.
This was precisely the same thought that struck us when contemplating the S&P 500 index after the post FOMC equal opportunity massacre. On Monday we showed this chart with two possible paths for the S&P 500 indicated. Both were essentially bearish views, only one of them accounted for a possible 'FOMC bounce' – alas, this was not to be. The wave of selling continues in Asian markets as we write this, and in some instances the declines are very large. For instance, Hong Kong's HSI Index is down by over 800 points or 4.3%, breaking an important level of lateral support. It seems therefore likely that European stocks will also weaken further, making the below interpretation of the S&P chart's wave position more likely as well. Note that the only positive we can at the moment detect is a recent notable increase in short term bearish sentiment. This does however not preclude further declines in a global financial crisis situation – bears must only be aware that large and swift retracement rallies can always happen while a larger scale decline plays out.
Two possible wave count alternates if indeed another bear market leg has begun. Note the green dotted lines which denote support and resistance. A break of resistance would indicate that these counts must be discarded, a break of support would confirm one of them. Note the alternate count continuation in red which allows for an even more complex corrective wave. Corrections are notoriously difficult to count – click for higher resolution.
Germany's DAX index has so far been unable to overcome the down-trend line that forms the upper boundary of what looks like a bearish running correction – click for higher resolution.
Why the Fed thinks that the economy can be helped by lowering the already extremely low sub 2% yield on the t-note further shall remain a mystery. As far as we can tell the empirical evidence suggests that plunging long term yields and a flatter yield curve are go hand in hand with weaker stock prices, declining economic activity, a growing deflationary psychology and an increasingly negative social mood.
After all, the main reason why demand for US government debt has been so strong is that investors still regard the government as the one debtor in the economy who is least likely to go bust. Evidently no-one lends out money at 1.8% because the return on capital is so great. The motive is an entirely different one: ensuring the return of capital is the goal. Naturally the market also 'knows' that money supply inflation has been rampant and that if Ben Bernanke has anything to say about it, will be ramped up even more in the future. Alas, as long as this is countered with a rising demand for cash balances by economic actors, the effect the money supply increase has on prices will remain subdued. There are of course more factors to the 'money relation' puzzle, such as the population's judgment regarding the future developments on the inflation front (which could eventually lower the demand for money), but also the economy's capacity to produce goods and services. This latter factor is weakened by credit and money supply expansions, as capital tends to be malinvested. As Dr. Jim Walker reminded us in an Asianomics missive today, US corporations are exercising a large demand for money, but they have been barely investing in new capital – a reflection of the enormous uncertainty about future economic conditions. This uncertainty is furthered by government deficit spending which will eventually result in higher taxation as well as the regulatory environment, which remains inimical to business.
Back in early August we wrote:
“It [the 10 year treasury note yield] has come very close to the major support from late 2008 now – and this was a very big move in a very short time. Alas, in 1942, this yield was at 1.5%. We would not be surprised to see this level eventually revisited.”
Color us therefore only mildly surprised at what yields have been doing lately, although the decline has happened even faster than we thought it would.
The ten year treasury note yield's recent progression looks almost exactly like the 'running correction' in the German DAX. Since t-note yields have led the stock market lower since February, this is an ominous sign for the stock market. Funny enough, speculators were either net short or flat treasury note futures across the maturity spectrum going into the FOMC announcement – a sign that further declines in yields may be imminent – click for higher resolution.
A composite chart of the net speculative position in treasury note futures shows that expectations of a further decline in yields were rather subdued of late – contrary to what happened prior to 'QE2' – click for higher resolution.
We originally thought the US dollar would perhaps make one more new low before beginning to rally, but evidently the rally has now begun and so far it looks quite convincing. Here are the charts of the dollar index and the euro with our proposed future paths that we posted on July 4 (see 'Could the Dollar Be Ready to Rally Soon', which contains an extensive discussion of the topic). All in all not too bad a guess so far (not that it was very difficult to make that guess).
The chart of the dollar index continues to look bullish after a successful retest of lateral support and the 200 day moving average – click for higher resolution.
Euro-Area Banks – The Troubles Aren't Going Away
We recently mentioned that the balance sheets of the three biggest French banks amount to some 250% of French GDP. It should be noted in this context that the entire French banking system holds assets worth 400% of France's GDP (at least that is the stated book value of said assets, which is probably somewhat dubious).
In other words, 'bailing out' these banks if push comes to shove will be a very difficult task (we are not advocating such bailouts, we merely take it as a given that the big banks will always be bailed out if possible). Such large bank balance sheets can only be supported when confidence in the system is high. Essentially, all the governments of the regulatory democracies of the West are bankrupt, as it is impossible to pay their debt back (in theory it could be done by confiscating a large chunk of their citizen's wealth, assuming it can then be sold for the prices it is currently valued at and assuming that citizens will sit still and allow it to happen). In short, the system of 'eternal debt' only functions as long as confidence is high enough to enable a constant rolling over the existing debt stock. This same debt is however a major asset in the books of commercial banks.
For instance, French banks are exposed to Greek debt (both public and private) to the tune of € 40 billion. Should Greece not only default but reintroduce the drachma, then one can probably expect an enormous haircut on this exposure. Since a Greek withdrawal from the euro would likely spark a major crisis and contagion elsewhere, the exposure of banks to debt of other euro area nations would be similarly subject to impairment. It is not very difficult to see that this could wipe out a good chunk of their capital. It is also not too difficult to see that a major bank run would likely ensue.
The exposure of European banks to Greek debt in US dollar terms. Evidently, the French banks were the biggest 'yield hunters' in Greece – click for higher resolution.
In the September issue of the Elliott Wave Theorist (which we find always a very interesting read, even though we don't always agree with its conclusions), Bob Prechter made two remarks that are well worth quoting in this context:
“Global credit deterioration is objectively real; but disaster will strike only when it becomes subjectively realized”
“In 2008 there was a credit crisis. The next five years will bring on the credit crisis.”
As it happens, the thin thread of faith by which the whole system hangs becomes more threadbare with every passing day. Readers may recall that we have occasionally mentioned that Germany's banks are actually the most highly leveraged in all of Europe in terms of the ratio of their assets to tangible book value. Consider though that neither the value of these assets nor this 'tangible book value' are actually fixed magnitudes. As the value of collateral and assets declines left and right, banks are faced with what we have termed the 'moving target problem'. Even if they raise a lot of capital as the US banks have wisely done when the getting was still good, they are soon back at square one if the value of the collateral backing their loans keeps falling. This phenomenon is especially pronounced in nations where enormous real estate bubbles have collapsed, such as the US, Ireland and Spain. In Europe the plunge in the value of sovereign debt has added a widely unexpected new twist to the situation, as banks were, and still are, not forced to keep any reserves against such assets. This means that any losses that will eventually be realized (and there will be such losses) will directly impinge on their capital positions without taking a detour through loan loss provisions.
So how far along are we on the road to a 'subjective realization' of the credit deterioration? In this context we only need to consider the never-ending barrage of bad news hitting euro-area banks in recent weeks. We have already discussed the fact that US money market funds are busy cutting back their vast exposure to euro area banks. However, one should keep in mind that said exposure remains a threat, as it is estimated to still exceed $1 trillion.
Then came news that the trading with several European banks (reportedly with the big French banks that were recently downgraded by Moody's). Another unnamed Chinese bank concurrently halted interest rate swaps trading with euro-land banks.
This was followed by news that Germany's ten biggest banks banks are thought to require € 127 billion in additional capital (good luck with trying to raise that amount in the present situation). This was followed by a rumor – (and therefore probably true) - that Siemens had withdrawn € 500 billion from French banks and 'parked the money with the ECB', where it is thought to 'shelter up to € 6 billion' according to the FT. Note that Siemens actually has a banking license, so it can indeed deposit funds with the ECB (back in the early 1980's when we first traded German stocks, Siemens was widely known as 'the bank with the loosely affiliated electrical goods department').
On Wednesday it became known that Lloyds of London has pulled its deposits from European banks.
The ECB has meanwhile allotted another $500 million in dollar liquidity to a European bank in a weekly tender (this is probably a rollover, but still a sign that dollars are hard to come by).
And in an additional clear sign that the crisis is taking a dramatic turn for the worse, the ECB has just suspended a number of eligibility requirements for bank collateral in repos, i.e., it has opened its doors wide for all sorts of toxic waste for which no market exists:
“The European Central Bank (ECB) has today published an updated consolidated version of “The implementation of monetary policy in the euro area: General documentation on Eurosystem monetary policy instruments and procedures”. The version published today mainly includes changes on 3 aspects:
First, the Eurosystem has abolished the eligibility requirement (Sections 188.8.131.52 and 184.108.40.206) that debt instruments issued by credit institutions, other than covered bank bonds, are only eligible if they are admitted to trading on a regulated market. At the same time, the Eurosystem risk control measures for marketable assets (Section 6.4.2) have been amended. Specifically, the Eurosystem has reduced the limit for the use of unsecured debt instruments issued by a credit institution or by any other entity with which the credit institution has close links. Such assets may only be used as collateral to the extent that the value assigned does not exceed 5% of the total value of collateral submitted (instead of 10%, as previously stipulated).
Second, the introduction of a common minimum size threshold applicable to all eligible credit claims throughout the euro area has been postponed to 2013 (Section 220.127.116.11).
Third, in order to stress the importance of counterparties’ compliance with existing national anti-money laundering/counter terrorist financing (AML/CTF) legislation, a provision has been introduced (Section 1.4) stating that all Eurosystem counterparties are deemed to be aware of, and must comply with, all obligations imposed on them by legislation regarding AML/CTF.”
The ECB might want to reconsider the third point, if the rumors that drug money kept US banks afloat during the Lehman crisis are actually true (this was claimed by the chief drugs and crime advisor to the UN; we see no immediately obvious reason to assume that he wasn't truthful).
So we can already state that a bank run is underway – in addition to the bank runs that have bedeviled peripheral nations like Greece, Ireland and Portugal for many months already. The latest examples are in fact happening in the euro-area's 'core'. Banks will become more and more reliant on funding from the ECB as a result (hence the change in collateral eligibility rules).
The IMF also keeps contributing to the souring mood, this time by releasing new estimates as to the losses euro area banks will likely face as a result of the sovereign debt crisis – the latest estimate is for $410 billion.
Meanwhile, the split at the ECB deepens, as Buba president Jens Weidmann meets with his allies on the bank's board in his quest to get the ECB to abandon intervention in euro-area's government bond markets. While the ECB is unlikely to follow this line, the evident split will serve to increase investor uncertainty further.
Euro Area Credit Market Charts
Below is our usual collection of charts of CDS spreads, bond yields, euro basis swaps and a few other charts. Prices in basis points, with both prices and price scales color-coded where applicable.
Sovereign CDS spreads continued their relentless march to new highs on Wednesday.
5 year CDS on Portugal, Italy, Greece and Spain – CDS on Italian debt are at a new high of 522 basis points – click for higher resolution.
5 year CDS on Ireland, France, Belgium and Japan – the rally continues. Note that CDS on the 'gray swan' Japan are at a new high – click for higher resolution.
5 year CDS on Bulgaria, Croatia, Hungary and Austria – all are at new highs – click for higher resolution.
5 year CDS on Latvia, Lithuania, Slovenia and Slovakia – as we have said, these triangles are bullish formations – click for higher resolution.
5 year CDS on Romania, Poland, Slovakia and Estonia – ditto – click for higher resolution.
5 year CDS on Saudi Arabia, Bahrain, Morocco and Turkey – no respite in the Middle East either – click for higher resolution.
5 year CDS on Germany, the US and the Markit SovX index of CDS on 19 Western European sovereigns. A new high for Germany – click for higher resolution.
Three month, one year and five year euro basis swaps – still moving in the wrong direction. Dollar funding problems continue to be a drag for euro-land banks – click for higher resolution.
10 year government bond yields of Ireland, Greece, Portugal and Spain – yields keep moving higher – click for higher resolution.
10 year government bond yields of Italy and Austria, UK Gilts and the Greek 2 year note. Italy's yields are well on their way to challenging their highs of August – click for higher resolution.
5 year CDS on Australia's 'Big Four' banks – still in a triangle – click for higher resolution.
From the FT: charting cross-border bank exposure in the euro area – click for higher resolution.
Charts by: Bloomberg, The Financial Times, StockCharts.com, Reuters
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