Not The Weakest Link

By: Michael Ashton | Tue, Sep 13, 2011
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Equity markets remained buoyant with anticipation today, but I have begun to lose track of what it is anticipation of. By definition, we can't wait for something that won't happen, so we can't be waiting for Greece to not default. By the same token, we haven't priced the damage that is likely to follow if Greece does default. Ergo, we are either waiting for Greece to announce that it will not default (but they have already done so, and everyone who is going to believe it already does), or we're waiting for something that has nothing to do with Greece, Portugal, Ireland, Italy, or Spain. But I can't think of what that might be.

Surely it won't be PPI and Retail Sales. Those figures are released tomorrow (consensus on PPI is 0.0%/+0.2% and consensus on Retail Sales is +0.2%/+0.2% ex-Auto). Thursday is much busier with CPI, the Empire Manufacturing number, Industrial Production, Initial Claims, and Philly Fed. But does any of that really matter if the Greek 'bond exchange' fails?

I actually think my speculation above isn't far wrong. Credulous investors are waiting to jump aboard any positive announcement, however far-fetched. For example, stocks rose today when German Chancellor Merkel today said she's "very optimistic" that Finland will get its special collateral as part of the bailout package. If I assumed the package was going to get done then by definition I'm optimistic about that too, since the package fails otherwise. She said nothing about the fact that most other EU countries will, reasonably, demand treatment similar to Finland's, and that such a system of 'compensating balances' make the whole deal untenable - so the content of what she said was, at best, empty.

For those who are confused by the term "compensating balances," it is a banking term for a practice that inflates the effective interest rate a bank receives on a loan. The banker sometimes will demand (actually, I don't know whether this is a common practice any more or not) that on a commercial loan of (for example) $1mm at 6%, the borrower must keep at least $100,000 in its non-yielding deposit account at all times. The effect, of course, is that the bank actually lent $900,000 but is receiving $60,000 per year in interest, so the effective interest rate is really 6.67%. In the case of Finland, though, they are demanding that Greece provide collateral equal to the loan. A compensating balance of 100% is essentially the same as not making a loan at all, since all of the funds must be kept on deposit. I would call this a clever scheme to cause Finland to appear to be participating while not actually taking any risk, except that it is about as subtle as a defensive lineman.

Greek Prime Minister Papandreou will hold a conference call with Merkel/Sarkozy tomorrow, mainly I am sure because announcing such a conference call is seen as being good news. I don't understand why that is, but it seems that every time the names "Merkel" and "Sarkozy" appear together in a news story the stock market rallies.

Markets also reacted positively to a back-and-forth on BNP. In a Wall Street Journal op-ed today, Nicolas Lecaussin claimed that someone inside of BNP had told him the bank is no longer able to borrow dollars in the market. BNP came out with something that sounds like a denial, saying they can finance the dollar-based part of their balance sheet "directly and through foreign-exchange swaps." That's not as strong a denial as saying you can fund your entire balance sheet directly in the market; if you're having to borrow in Euro and then conduct a swap through the ECB and indirectly through the Fed (for example), then it's not quite the same as having free and unfettered access to dollar funding. To the layperson that difference may not be obvious. I expect that that subtlety is fully the intention of the person writing the denial.

I don't have any reason to think that BNP, normally considered a very strong bank rated Aa2 by Moody's, has a bigger problem than any other European bank. They are probably very well-capitalized if PIIGS debt and bank crossholdings are valued at par, and probably thinly capitalized if they are valued at market. But I think we already knew that. Ordinarily, markets drag down the weakest link, and I don't think BNP is it.

I understand that there isn't much to this comment, and that is because there wasn't much to this day. But implied volatilities remain high and volumes remain above where they were earlier in the year. I don't think the market is about to go back to sleep. I expect stocks to resolve lower, and bonds higher (but not a lot higher unless a disaster occurs in fact rather than merely in prospect), and I don't expect that resolution to take very long.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

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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