Recriminations And Repercussions

By: Michael Ashton | Wed, Aug 10, 2011
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It's the Europeans!

It's the shorts!

It's the short Europeans!

I suppose it isn't surprising that the angry recriminations have already begun. But it is always so distasteful to me to watch investors who were over-extended, operating without a margin of safety, in an over-valued market, try to blame their losses on some capricious deus ex machina. It was always going to be hard for all of us to hit the exits at the same time and actually make it through the door. We should remember this the next time we want to keep riding momentum when value has deserted.

Early today, when the stock market was clearly going to have a bad day, the financial networks (the big one, in particular) started to play the blame game. The market was being driven down by "rumor mongers" or by "Europeans who are scared" or worse. A rumor circulated early in the day - a rehash of a rumor from several days ago - that "one or two" French banks were in trouble. Of course they are. All European banks are in trouble; it's just not clear exactly how much trouble. Some of the rumors highlighted Soc Gen, reported to have big exposures to sovereign debt. And this, we are supposed to believe, is the reason stocks were down 3% or 4% in the early going.

CNBC stated unequivocally that "speculative attacks" are happening on Soc Gen and other stocks. Really? Who in the world these days has enough capital to engage in a speculative attack? That's a risky endeavor. And who would do that on a company that is fundamentally sound? That sounds to me like a recipe to lose a lot of money. The head of Soc Gen called into CNBC late today to call the sellers "idiots" and generally to sound like an arrogant CEO (if not an arrogant SOB) to the people listening.

The comparison of the Soc Gen or BOA downtrade with Lehman, often made today, doesn't sound the right note. The short-sellers on Lehman turned out to be right - the firm wasn't only illiquid, but insolvent, and probably un-salvageable. The Fed didn't have to let it collapse on its own, but it wasn't a question of shooing away the speculators. The firm had to be wound down. It wasn't that the bear raiders caused Lehman to collapse! They didn't need any help with that.

I really should keep CNBC off during the day. Another journalist speculated that "maybe the computers are causing the volatility," and that theme reappeared regularly throughout the day as well. Huh? Most of the computers are off. You can look at the screens and see there's no liquidity. Markets that used to be 500x500 are now 50x50 with twice the bid-offer spread. In the e-mini, the market for 1000 contracts is probably 2 points wide at least rather than 0.25. I am sure that people are using computers to make trades, and to arbitrage cash and futures markets by transacting quickly, but the high-frequency trading they're talking about isn't a big participant here I don't think. It just doesn't work well in illiquid environments. I'd be interested to hear from someone associated with a HFT firm who can confirm or refute my suspicion.

The carnage on the day managed to reverse the entirety of yesterday's rally. On Monday, the S&P closed at 1119.46; today it closed at 1120.76. The Dow closed lower today than it did on Monday. Bonds rallied further, with the 10y yield down 16bps to 2.09%. The 10-year TIPS bond out-rallied its nominal counterpart again - a real rarity in a seriously rallying market - as yields fell 22bps to -0.18%. There is now no TIPS bond that yields as much as 1% real yield, even at 30 years. The net of the two rallies implied higher inflation expectations, and 10-year inflation swaps are back up to 2.75%.

The DJ-UBS Commodity Index rose 1.3%, with energy up 3%-4% on sharp draws in crude, gasoline, and products. Also rising were grains, softs, and (of course) precious metals. Gold crested above $1800/oz today, closing slightly below.

The VIX is back up, albeit shy of the Monday highs. Volume remains very heavy, although today's volume was a bit short of yesterday's.

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I want to clarify something I said in yesterday's article when I discussed the Fed. Several people have pointed out that technically, what the Fed said in their statement was:

"The Committee 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."

Is this a guarantee? That is the question.

Linguistically, it's a mess. They said "likely to," which is a statement of probability, but then "at least," which is an absolute limitation. An English teacher would annotate in the margin something like "which is it? Is it 'at least' or may it change?"

For our purposes, we don't need to grade the English. Fortunately, no one does that when I write! But we can make a couple of observations. First of all, from the perspective of equities it doesn't really matter which they meant. If they meant the statement to be their estimate, then there was no content at all other than their forecast (and since when was the Fed forecast particularly useful?), and in particular no easing at all when the market was desperately seeking it. If they meant the statement to be a promise, then they bound themselves as I noted yesterday, and will stand idly by if their forecasts prove incorrect (as is quite likely). The second observation to make is that analysts very clearly interpreted the statement to be a promise. The Fed is usually very precise with its language, although it has become less so as the years have passed.¹ It has not previously mentioned a specific period of time in the statement, and moreover for the last couple of months Fed speakers have discussed a "promise to keep rates down for a defined period" as a possible policy gesture. There is little ambiguity here, even if there is ample imprecision.

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And in other inflation-related news, let's not forget the Swiss National Bank, which today said that it would "significantly increase" the supply of liquidity to banks and to the money market. The SNB believes its currency is "massively" overvalued, and is fighting back by increasing the supply of Swiss Francs (CHF). Euroswiss contracts from September 2011 to June 2013 closed above 100, indicating that the market is clearing at negative interest rates for Swiss Francs for nine months.

This is a sign of the demand for CHF against all of the debt-ridden currencies. Investors are willing to take a guaranteed nominal loss to hold CHF in preference to other currencies. I can hear the textbooks being re-written as we speak. This is a rational decision in an international financial system as long as you believe the CHF will appreciate against other currencies, since even though you'll have nominally less Swissy when your deposit matures it may exchange back into weaker dollars (for example) or Euro. But it's weird, because many of the models written to value options and other things tend to assume that rates are bounded by zero. (For example, Black Scholes lognormal volatility is useless if the distribution can be negative, since there's no such thing as the log of a negative number). There are lots of theoretical pricing problems with the current models if you have to take into account negative interest rates!

But the significance for investors fearful of inflation is the same as I pointed out the other day: the currency wars are beginning.

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On Thursday we will get more economic data, including Initial Claims (Consensus: 405k from 400k) and the money supply figures after the close. These are not expected to have a market impact. With liquidity even thinner than is normal in August, position flows will have a big impact on where we trade throughout the day. I will, as I mentioned the other day, buy a teensy bit of stocks as the market continues to decline. When I last ran my "Bargain Basement Stocks" equity screen (that tries to emulate the Value Line criteria), there were only a handful of names on the list. When I ran it today, there were two hundred. Most of them are not bargains at all, but at least there are starting to be names to choose from that may not be complete disasters from day one.

 


¹ When I entered the market, the Fed was still saying things like "somewhat greater reserve restraint would, or slightly lesser reserve restraint might, be acceptable in the intermeeting period." This had a very precise meaning: by using "would" or "might" and "somewhat" or "slightly," the Fed gave very clear parameters about where they wanted the Fed funds rate to trade, without actually saying so. You had to speak the language, but the language was very precise.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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