A Time To Refrain From Embracing

By: Michael Ashton | Thu, May 10, 2012
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Today's bit of wisdom comes either from Ecclesiastes, or from The Birds (depending on your religious background): to everything there is a season, whether for casting away stones or for gathering them together, whether for embracing or for refraining from embrace.

This too is good market wisdom - and in the current circumstance, it appears it is a time to refrain from embracing. Two sovereign wealth funds have apparently stopped buying European sovereign debt, according to stories out today. One is China's CIC (which is interesting: I suppose they figure that their pledge to the IMF is more than sufficient exposure to the region! If that is the case, then surely this falls in the category of an unintended consequence!). The other is Norway's $610bln oil fund, which will actually divest holdings of Eurozone sovereigns. It had held 50% of its total bond holdings in Eurozone sovereigns and has cut (or maybe will cut - the story is unclear) its exposure to under 39%, according to this story on Reuters.

Frankly, if I was another sovereign wealth fund, I would read these stories and wonder whether it is time for me to cut my exposure as well, since I surely don't want to be the last one out. As I said, perhaps this is a time to refrain from embracing.

That being said, as I wrote on Tuesday "I think it's likely that European prices will rise at least as fast as US prices" and opined that "I think Europe is going to be catching up to the U.S. in the monetary-profligacy race." I wrote that, and today a story appeared in Der Spiegel: "Breaking a German Taboo, Bundesbank Prepared to Accept Higher Inflation." The ECB is already losing its "Bundesbank DNA" since being taken over by Mario Draghi. Now it looks like the Bundesbank itself is losing its singlemindedness when it comes to inflation.

This is a game-changer, obviously, when it comes to inflation in Europe (German inflation carries about a 25% weight in the calculation of Euro inflation) but also when it comes to inflation globally. I noted yesterday that Euro M2 accelerated to a 3.1% pace in the year ended March, and that that was the highest pace since September of 2009. I can't imagine these two things - an acceptance by Germany of potentially higher inflation, and faster Euro-area money supply growth - are unrelated.

This may or may not be an error. If Germany is acceding to higher inflation because she believes that faster inflation will be a result of faster Euro-area growth, it's an error since inflation derives from money growth, not real growth. But if Germany is allowing inflation to rise in Germany relative to the rest of the Eurozone, as a way to 'rebalance' her economy relative to the Eurozone, then it's not a bad idea; the only problem is that since Germany doesn't have a lever to pull on monetary policy that's separate from the ECB's lever, I don't see how they can raise Germany's inflation rate relative to the other nations. Between countries with flexible currencies, this adjustment happens through the money supply and currency. How do you effect such a 'rebalancing' in this case? I don't know.

Speaking of errors, JP Morgan announced a whopper today after the close. About a month ago, a story circulated about a trader at JP Morgan who had amassed positions in corporate credit-related derivatives that were so large they were affecting the indices of credit risk. Today, JP Morgan revealed that the unit where the trader works (the chief investment office, which is meant to hedge firm-wide risks rather than to take positions) had lost $2bln on synthetic credit instruments. JP Morgan CEO Jamie Dimon said on a call today that the losses could 'easily get worse,' implying that the positions remain open for now.

There will be many questions about how the bank amassed a $2bln loss in the short time that has passed since quarter-end, especially given relatively sedate trading in the credit markets. There are both positive and negative fact sets that could apply. On the positive side, we could posit a smart risk-management officer that read those earlier stories and investigated whether the book was being marked at levels that were being affected by the trading of those instruments by the book, or whether they were fairly considering the likely loss in the event of liquidation. Discovering that they were not being marked conservatively, Risk Management and the CEO decided to disclose the loss as soon as they knew it should be. If that is what happened, it would be hard to fault the bank's disclosure even if you could fault some of their controls. But Dimon is also a pretty crafty fellow, and I can certainly imagine a circumstance where the bank figured "if we announce the loss on the credit hedge now, then when the gain on the other side shows up in the regular earnings we might be able to persuade analysts to treat this as an 'item.'"

So what I'd want to know if I was a regulator, or a reporter, or an investor, is whether the error here was that the chief investment office departed from its hedging function and made some bad prop trades. If the answer is yes, then I want to know how that happened in large size without senior approval. If the answer is no, then the next question is whether this loss was offset by a gain somewhere in the bank, since it must be a hedge. If the answer to that question is no, then we simply have some stupid hedging. If the answer to that last question is yes, then I want to know why an announcement was made at all because the hedge worked! Sometimes hedges lose money, after all...when the thing being hedged shows a gain.

On Friday, Dallas Fed President Fisher is speaking on the topic of "Too-Big-To-Fail." How timely.

Also due out on Friday are Michigan Confidence (Consensus: 76.0 from 76.4) and PPI (Consensus: 0.0%/+0.2% ex-food-and-energy), neither of which is an important release. Have a nice weekend.



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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