Does Germany Get The Yoke?

By: Michael Ashton | Wed, Nov 23, 2011
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If you missed Monday's comment, "Door-Buster Deals," you can find it here.


It has been an interesting couple of days, and I suspect I am probably not alone in worrying about what could happen in the world when the U.S. markets are closed for Thanksgiving and mostly-closed (because liquidity will be abysmal) the day after.

Let's hope that we continue to call November 25th "Black Friday" only because that's when retailers go into the black for the year, and not for other reasons!

Traditionally, institutional investors try to get near to their index in the final month or two of the year, and especially don't want to be underinvested (even more so when cash pays nothing). This minimizes relative performance risk; if the index sells off or rallies, the manager will participate in line with the index. This year, though, I think there should be another concern: investors should position themselves going into the illiquid time of the year by attempting to ensure that they will not be in a position of needing to demand liquidity. If there is a crisis, many managers will be in the position of needing to raise cash for redemptions whether their performance has been good or not - as we saw in the 2008 crisis, many managers were redeemed simply because they offered more liquid terms. With the exception of hedge fund managers with long lock-ups, every manager in my view should be running with significantly more cash than usual in this last period of the year. You really don't want to have to be liquidating into a liquidating market, even if it means sacrificing some return if your index abruptly rallies for some reason.

An 'abrupt rally' seems unlikely at this point.

Equities have been soft for a few days and were again today. We don't have to look far for the reasons. Here are a few:

  1. Unrest in Egypt, which we thought ended when Mubarak resigned, has begun again.

  2. Former AAA credit Eksportfinans (a Norwegian company) was downgraded from AA to junk in one fell swoop. This turns out to be concerning mainly because Eksportfinans was used as a platform for banks to issue structured notes. The way this works is that a client approaches a bank wanting, say, a note that pays off par plus 35% of the S&P 500 price return, but no worse than par. The client, however, doesn't want to face the A- financial company, so the bank approaches Eksportfinans (or a Home Loan Bank, or one of a few other issuers) with a deal: the issuer pays the coupon to the investor and the bank does a swap whereby it pays the coupon to the issuer and receives, say, Libor minus 25bps for 2 years. The issuer no longer cares about the structured payout because it is hedged by the bank; it has merely obtained cheap funding at L-25. (Of course, no one funds at L-25 anymore, but top credits like Eksportfinans used to fund at that kind of level when issuing 1-2 year structured notes). The buyer of the structured Eksportfinans bond of course faces possible losses if it defaults, but the risk here is that collateral calls from the bank swap counterparty could accelerate the firm's demise in the same way, and with similar (albeit much smaller) effects as, the failure of AIG played out. And banks don't need that to happen again.

  3. The Fed issued instructions to a score of large banks ordering them to submit annual capital plans associated with stress tests, declaring that banks would not be able to pay dividends or other distributions unless they would be well-capitalized even in the worst stress-test cases. Unlike the toothless EU tests, the stress scenarios here include a 13% unemployment rate associated with an 8% decline in GDP and a 21% drop in home prices, plus sovereign default shocks. Now we're actually talking about stress tests that involve stress, although it likely means the end of dividends from the banking sector for a while. I suspect there are not many banks that can survive that sort of downturn without being pressured, unless there are some quirky assumptions being made about how markets will behave in such a circumstance and what would happen to firm revenues and credit losses.

  4. The FOMC minutes released yesterday didn't give the clear signal that many expected to see that QE3 or some sort of Evans Rule implementation was imminent. There was a lot of talk about "price level targeting" and "nominal GDP targeting," and a "new policy framework" that would entail new risks for the central bank in managing monetary policy. Disturbingly (to me, although not for most other people), there was almost no skepticism evident in the minutes that monetary policy can affect unemployment at all in the short-term. Previous Fed Chairmen, in particular Greenspan dealt with the 'dual mandate' question by noting that in the long run, there is no tradeoff of inflation and unemployment, so employment is maximized when inflation is made low and stable. The only tradeoff is in the short run. Now, I don't even think that there is much of a tradeoff in the short run either, but the peculiar obsession with affecting a variable in the short run with policies that work against the optimization of that variable in the long run is disturbing. Shouldn't someone be raising this question? Especially since, as the minutes state: "The recent low rates appeared to have only a modest effect on the pace of mortgage refinancing, as tight underwriting standards and low home equity continued to limit the access of many households to the mortgage market." Faced with such a direct observation of monetary policy ineffectiveness, is it surprising that the stock market is beginning to lose confidence in the Federal Reserve's ability to make everything all better?

  5. Germany held a 10-year note auction today, and when the bids were tallied they didn't have enough bids to have all of the bonds spoken for. In fact, the bids totaled only 65% of the auction size. While it is not unheard of for German auctions to be undersubscribed, no one can remember a miss this large. It hardly needs to be noted that all of Europe's hopes start and end with Germany; and increasingly, all of the world's investors' hopes start and end with Europe.

While equities have been weak (the S&P closed -2.2% today and are now -7.3% on the month) and are rapidly approaching an area where buyers have previously kept the market supported, bonds have been sturdy with the 10y yield down to 1.88% today. My bond shorts have long since become an awkward embarrassment. But still, they've hardly been spectacular performers - today the rally was 4bps on a 2.2% fall in stocks - and one gets the sense of an uneasy tension between investors' desire to own Treasuries as a safe-haven security and investors' desire to avoid the next market where other investors rush to the exits. Germany's failed auction raises an interesting question. What would happen if U.S. auctions began to fail, or merely began to get scanty coverage?

Bond investors are clearly addressing this question with some deep introspection. Today the worst European bond market performances were turned in by Italy...and the triple-A countries of Germany, France, and the Netherlands!

While Germany is not about to start crying about 10-year yields around 2.15%, this is more than just a one-off scare. Look at the chart below, which shows Germany's 10-year yield alongside the yield of a AAA member of the European Union which is notin the Eurozone: Sweden.

Germany's yields are diverging from Sweden's as the former implicitly shoulders more of the EZ yoke
Germany's yields are diverging from Sweden's as the former implicitly shoulders more of the EZ yoke.

As you can see, until late September and even as late as a couple of weeks ago, Germany traded at a fairly tight spread to Sweden. The spread is now about 50bps. And that actually means that the condition of the Eurozone countries is worse than we thought, because while lots of focus has been on the widening of spreads versus Germany, Germany herself has been behaving less and less like the top-quality credit of the EU. (Switzerland, which isn't in the EU either, beats them all with a 10-year yield of 0.83%). And that's concerning, because as I said before we all know that the hopes of Europe now start and end with Germany.

What about Germany's hopes?

I am not sure what yield, or spread over Sweden, or other indicator will awaken Germany to the peril of being the Continent's sugar daddy. But the market seems to be saying that Germany faces a choice between being a prime credit, and saving the Euro. Which does she want? To financially annex other nations and their rotten banking institutions, running their policies from Berlin, in order to establish German hegemony in Europe? Or to preserve the well-being of her own citizens, and trying to be a peaceful and helpful neighbor? I don't know that there is a middle ground any more.

I am still of the opinion that it is worth buying some stocks if the S&P drops back below 1100, which is looking increasingly likely. I am considerably underweight my 'neutral' allocation, and not unhappy about that; however, if the market declines appreciably more than it has already then I will do some bargain shopping and get closer to neutral. I continue to hold my bond short, but only because it isn't a large position. I may add to it after the long weekend. I remain overweight in commodity indices.

Happy Thanksgiving!



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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