A Wandering Mind

By: Michael Ashton | Mon, Oct 17, 2011
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It is very hard to write a comment these days, at least about market events. While there are plenty of market events to write about, ostensibly, none of them is one-tenth as important as what lurks behind door # 3. The news on Friday that the U.S., in a rare display of backbone from the Treasury Secretary, was staunchly opposed to proposals to double the size of the IMF as a partial response to the European debt crisis, probably ought to be a big deal. As the primary source of funding for the IMF, the U.S. Administration really does get a vote in any European plan that involves increasing the IMF's role, and this certainly cools that possibility. Germany over the weekend, and again today, also put a damper on rising expectations that a Grand Plan will emerge at this weekend's summit mee ting - again, this ought to be important, and of course it is at some level.

But we all know that until the announcement is made about just how Greece is going to default - whether there will be a 20% recovery, or a 40% recovery; whether she will resign from the EU or the EU itself has a constitutional crisis; whether it will be done in such a way as to prevent CDS from triggering (I'm not sure why it seems the Wise Men of Europe want to cause worse losses at banks that have bought protection for their bond portfolios, but they seem bent on it); whether the Ireland and Portugal situations will be resolved immediately or remain part of the multiple Swords of Damocles hanging over the market; whether Germany or France will be dragged down with the drowning swimmers or somehow escape; until we have the answers to these questions, the rest is commentary.

So what if Empire Manufacturing was a little weak today (-8.48 vs expectations for -4.00). So what if Italian yields are back to the highest levels since the spikes of July and August. So what if stocks fell 1.9% on light volume, but bond yields only declined 5-10bps. All of this is commentary.

I have no special insight as to when we will finally find out about what is going to happen, in the end, with Greece and the banks whose solvency currently rests on the fiction that Greek bonds will redeem at par or at worst experience only 20% impairment. There might be a resolution this weekend, but I doubt it. Big solutions tend to take big time, and my personal belief is that the length of a meeting grows exponentially with the number of participants entitled to speak. We might be in this holding pattern for some time.

It is a positive that the conversations about the denouement seem to be converging on reality. Greece will have to default in some form, banks will need to be recapitalized in some way, and central banks will have to print money...or, as an alternative to that three-step plan, we can all grab our seats and let the fallout happen, and pick up the working pieces once the grand flushing has occurred. It seems more politicians are recognizing that those are really the only options, and most of the silly promises for a painless solution during some big summit are merely delaying tactics that almost no one believes any more. I continue to think that when a Greece default is actually announced, stocks will rally and yields will rise (maybe after a brief wiggle in the other direction), even though nothing approximating the worst case or even a likely bad case has been priced into the market.

However, a negative to recent developments is that the longer it takes to get to a reasonable solution, the bigger the probability that the default will happen in thinner financial market conditions that will prevail starting the second or third week of November and getting worse for the six weeks thereafter. The default announcement will be scary; we need all (liquidity) hands on deck when it happens. It is better if it happens soon. One year's seeding makes seven years' weeding.

But since we're still waiting, my mind wanders. I saw recently the statement that U.S. debt (and probably developed country debt) is higher as a percentage of GDP than at any point other than a major war. I am not asserting the truth of that statement, but it did make me wonder - what if we get a major war?

That's not a completely absurd proposition. I am a little surprised we haven't seen more market upset, at least in the energy markets, over the rising tensions with Iran. The accusation by the U.S. that Iran was plotting to assassinate a Saudi diplomat and blow up embassies in Washington is surprising in that it was made public. What is the point of making the accusation public? To shame the Iranian leaders? This seems unlikely to be effective. Suddenly, we see Democrats who couldn't figure out why we would fight a war after 9/11 arguing that this constitutes (in the words of Dianne Feinstein (D-CA)) "an escalation." Rhetoric about how close Iran is likely to be to completing a nuclear weapon - which is certainly not news - has also begun to rise and it is being reported in unlikely places. The New York Times on Sunday noted that "President Obama is pressing United Nations nuclear inspectors to release classified intelligence information showing that Iran is designing and experimenting with nuclear weapons technology" and its 'Topics' section on "Iran's Nuclear Program" (updated today) says that "Official American and Israeli estimates suggest Iran would not be able to produce a bomb until 2012, or more likely several years after that."

Again, consider the source. The New York Times, and this Administration, openly guffawed at the notion of an "Axis of Evil" that included Iran, and wanted to engage that regime in talks. Now they're beating the war drums?

Let me say that I agree that Iran's leadership is a threat to peace and stability in the region and I am concerned about the possibility of nuclear weapons in their hands. I've worried about that for a number of years, like many people have; so, I support virtually any action the Administration of this country, or of any other country, wants to take to forcibly disarm that leadership. While I am cynical about the timing, I point it out here because of the market implications. This is one of those stories the reaction to which is being held in abeyance due to the elephant in the room (that is, Greece). If this had happened during the Arab Spring, or when there was otherwise no big news, I think energy prices would surely have reacted more than they have. NYMEX Crude prices remain below last month's $90 highs. Keep a bookmark in this story, lest it become one that commands more attention than the sorry state of the global economy.

 


 

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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