The end is nigh?

As an old Scandi government bond trader my heart beats a little faster today as Danish 10 years are trading through bunds by about 25 bp’s – Swedish 10 years, having traded through Germany for a little while are now a whopping 60 bp’s through bunds. Norway is lagging and still offers a pick-up, but that can’t last long. Even gilts traded through bunds yesterday – at the time of writing they are neck and neck with bunds.

This brings me to why? Things are certainly not brilliant in the UK or Denmark (and in Denmark’s case the currency is effectively linked to the Euro) so why now? Well, as the solutions being put forward to sort the current crisis out once and for all (i.e. something that lasts more than a week) involve one of two things: 1) ECB prints, or 2) Fiscal union of some sort, or 3) both!

I can already hear George Osborne (or David Cameron) crow about it being the result of the UK government’s fiscal plan and the savings (locally known as cuts) they have introduced, that gilt yields are so low. 

But as Martin Wolf writes in the FT today the public and the private sector cannot reduce spending and reduce their balance sheets at the same time without the risk of the economy collapsing – something the Chancellor either doesn’t know, or doesn’t want to admit to. Instead there is a lot of rhetoric about reducing the balance on the nation’s credit card trying to compare the nation’s budget to a household budget – this might help get the point across with the electorate, but it is out of the George W Bush school of communication and indeed completely inaccurate as the nation’s economy is completely different from the household budget.

And while I belong to one of the ‘anyones’ who could have told the PM that the accelerated austerity measures were a risk to the economy (indeed I did so on the Today program on radio 4 in August last year) while my erstwhile opponent Andrew Lilico was going on about the economy would be expanding 1%+ Q/Q at this time and RPI would be close to double digits – I guess in economics there are always more than one view and nobody knows in advance who will turn out to be right.

Instead of harping on about the basics of how the public and private sector work together in a modern economy of a certain size I suggest you read Martin Wolf’s excellent piece here: Link to Martin Wolf

I do caveat the above with the size of the economy, because the UK cannot be compared to a Baltic state or to what Denmark did in the late 80’ies and Finland and Sweden did in the early 90’ies. Small open economies have the luxury of running a two speed economy where you can have a domestic recession and all the growth comes form the export sectors – the UK is not in a position to do this at the best of times and most definitely not in one now, with the Eurozone bordering on a recession which could turn into a depression. The US and the rest of the world may be in a marginally better position, but I stress marginally. In the words of George W: “This sucker could go down”.

QE(III) with a twist?

As the markets are starting to contemplate a new helping hand from the Fed with the upcoming symposium at Jackson Hole being a potential launchpad (as it was last year) I thought about what they can do apart from just buying more treasuries…

I have long argued that in the US the economic problems are not over before the housing and job markets stabilize. This is more than in part due to the fact that the drivers of the economy have been consumption (70% of GDP) and a lot of that was financed by increasing ‘wealth’ stemming from the housing market.

With this process now firmly in reverse, house prices declining, repossessions at very elevated levels even if they are currently subdued do to an administrative backlog. House building is at historic low levels – and all the economic activity that comes form people moving houses, doing them up, hiring contractors etc has also come to a virtual standstill.

So perhaps instead of targeting the S&P500 as some have suggested is what the Fed is really doing, perhaps they should focus on the housing market?

There are added benefits to stabilizing the housing markets as a stable housing market would make the banks healthier – it wouldn’t necessarily get the off the hook for previous misdemeanors and outright fraud, but it would help the banking system as a whole. It would enable them to start lending to prospective buyers – and prospective buyers would be more willing to buy if the fear that what they are buying shortly depreciates even further in value. Houses in many local markets are ‘cheap’, but as we know cheap don’t mean it can’t become even cheaper. This is part of the mentality – the other part is that ironically now the market has fallen banks have tightened their lending criteria, so it has become very hard bordering on impossible to get a mortgage, certainly one that isn’t FHA sponsored.

Of course the whole US mortgage market needs to be re-developed along the Danish balance principle model, but that is a topic for another day.

There are some 1.7 million houses in various stages of foreclosure and a total of 6 million mortgages that are delinquent in some form. Falling prices makes this even worse as even homeowners who can afford to pay their mortgage make tactical defaults when they give up hope that their house ever will be worth what they owe on it – and they walk away, because they can.

This is a very vicious circle, which needs intervention on a large scale just to stabilize the current levels of house prices – something that only the Fed, or the government can do.

As the US government has underwritten the GSEs who have assets (and liabilities) on a scale of the US government, so any assistance that would require less tax-payer assistance in the future would clearly be beneficial in several ways.

What would it take? Who knows, but a quick back-of-the envelope calculation suggests that $500 billion would buy 2.5 million houses, or more than are currently in the foreclosure process. This would in my opinion stabilize the market to a degree and make private buyers more comfortable committing.

Maybe the market would improve without all this capital being put to work? Parts of the mortgage market would benefit and this would help as well, both for banks with their existing lending, but for new lending as well?

What would the Fed do with the houses? Alan Greenspan suggested something along these lines which included tearing them all down, as in to help re-start the house-building industry. This may be a solution in some cases, but simply renting them out, perhaps even to people who were foreclosed on, if they can afford to pay some rent would be another option.

Exit strategy is another common question as the Fed embarks on ‘unusual’ programs? Turn the whole thing into a REIT, float it on the stock market and let the Fed be the senior lender until private lending can be arranged, with 20% equity and 80% debt. There are a lot of investors around the world who think that US property is cheap, but do not buy for various reasons: financing is not available, management and maintenance is difficult from afar. Some do buy for cash and for their own use, but many more would be potential investors if most of the hassles were removed and the ticket size reduced (it’s difficult to buy less than a whole house) and it’s much safer to buy a well diversified portfolio as opposed to just one or two houses.

I think there are so many advantages to this approach over buying another stack of treasuries, that it should be something the governors should consider.

Pear Shaped…….?

Watching the on-going saga in Europe with Greece on the edge of the cliff I can’t help but think of September/October 2008.  The similarities between the situations, while very different, are at the same time incredible!

If you throw your mind back to the week-end of 13^th/14^th September Lehman Brothers was on the edge – the stock had fallen from $16/share to $3.65 over the course of the week – rumours about them were abundant – it was the no 1 story on CNBC and so on. Much like Greece right now.

Similar to what has been going on in Europe over the last 12 months; Bear Stearns had failed, but had received a bail-out orchestrated by the Fed and the Treasury. Guarantees were issued to JP Morgan, which made the takeover possible, and no creditor incurred a loss. While Lehman’s stock price was tanking, the market (me included) still believed that some sort of solution would be found. The NY Fed even called banks on Friday afternoon to tell them that a solution would be found over the weekend. Risk assets had a moderate recovery into the close.

Now we have politicians and central bankers telling the market that no euro-zone member will ever default and that everything will be fine, while every astute market commentator will argue that Greece will default – it’s just a question of time as the debt levels are simply too high to be sustained, let alone repaid.

Bond holders are being asked to roll over their maturing Greek government bonds (GGBs), but not at market yields, so while their very short term bonds will be redeemed at par the holders are being asked to buy new issues with a coupon much lower than secondary market yields, which range form the high 20’ies to the mid-teens depending on the place on the yield curve. Credit agencies say this will constitute a default, which the politicians and the ECB are desperate to avoid. Holders of Greek CDS may, or may not be compensated, which in itself may become a huge problem for certain investors who thought they had purchased insurance against their bond holdings.

It is of course ironic that we live in a world where banks can book gains when the value of the banks own debt falls in value, but at the same time can carry e.g. Greek government bonds at cost (i.e. no mark to market) so some of the most profitable banks at the moment could be Greek and Portuguese banks as the value of their own liabilities are reflecting the assets they hold, but these assets are not being marked down in these banks financial statements!

So what will happen? The most likely is probably that Greece will be funded by the euro zone and the IMF until a time when a restructuring can happen with the vast majority of the debt in the hands of the ECB, EMSF, IMF etc and the need to recapitalize French and German banks will be much smaller and hopefully everything will be much better then and of course it will be someone else’s problem……this is a typical politician’s vision: Things will be better in the future. But what if they are not, or what if we don’t even get to the future? I think this is not as un-likely as the market has been believing!

Further Greek assistance is dependent on further austerity measures being introduced and these are certainly not popular, judging by the protests in the streets in Athens. Nor is further assistance popular with many of the voters in the countries, which are meant to foot the bill. Can this balance be achieved? Maybe, maybe not. There are a lot of variables that have to be observed:

• ·      Austerity measures have to be passed by the Greek parliament. The main opposition party have indicated that they will vote against these;
• ·      Politicians/voters in Germany, Holland and Finland have to be placated so the austerity measures cannot be watered down;
• ·      The next tranche of the IMF support package cannot be released if there isn’t a clear 12 month funding plan;
• ·      Private investors have to be strong-armed into rolling their maturing bonds over into new ones with sub-market coupons and yields. This will result in instantaneous losses of approximately 50% (depending a bit on maturity);
• ·      Default is to be avoided or GGBs will no longer be eligible as collateral with the ECB and the result would be that Greek banks would be illiquid and another bank run would ensue;
• ·      ISDA would need to accept this so a credit event is not declared;
• ·      Losses incurred by holders of GGBs would not be covered by CDS so they would presumably lose twice i.e. the GGB loss + the premium on the CDS, which in itself might prove worthless;

There are probably a few more things I haven’t thought about, but all this is not easy to accomplish.

Is the market ready for a default? Probably not!

What will happen? Greek banks will be instantly bankrupt and will need to be recapitalized/nationalized. Greece will of course have to leave the Euro and reintroduce the drachma.

Some French and German banks may need to be re-capitalized. The inter-bank market, which hasn’t recovered from the events of 2008/09, will freeze. The pressure on Portugal and Ireland, which is already intense as their 10 year government spreads are at EMU-time highs, will become much worse, closely followed by the ones which are too big to bail-out; Spain and Italy. This is of course why everyone who has political capital invested in this is afraid of ‘contagion’.

Then it may be all over – the euro zone experiment may have ended 12 ½ years after it begun.

So while the politicians and central bankers thought a solution would be found for Lehman over that fatal weekend in September 2008 it wasn’t. Greece may have a little more time than Lehman did, but if a solution hasn’t been hammered out by early July it may truly be all over!

Inflation, Inflation, Inflation……

So now everyone is on the band-wagon with inflation going up because of rising commodity costs, which are rising because of QE2, which is the Fed’s undoing of all things good….,or is it?

Woody Brock and David Rosenberg have both just penned great pieces on this topic so I will keep it short.

Headline inflation (CPI) in the UK is now 4%, but at least 75bps is a direct result of VAT going up to 20% from 17.5% according the National Statistics Office and this analysis was done for the month of January. One could argue that the effect is larger now – the CPI indices without taxation (CPI-Y) and with constant taxation are running at or around 2.7%, so the ‘truth’ is somewhere in between the two (2.7% - 3.25%). Is this runaway inflation? No! Is it high considering the recent movements in the oil price which in £ terms went to all-time highs? No, not at all.

One of the other commodities feeding into CPI, which has gone up in spectacular fashion is Cotton. Cotton has risen from around 75c/lb to more than $2/lb before retracing back to $1.78/lb. This has caused major pain for the producers of items made of cotton and for retailers. Hennes & Mauritz reported 30% lower earnings in Q1 as they absorbed the price increase rather than passing it on to their customers.

So far so good. Then I took a look at the futures curve……I don’t recall EVER having seen anything like it: It’s not just in backwardation which means that prices are lower the further out the curve you go – they are a lot lower! May 2012 is 80c lower than May 2011, so while futures prices are not really a ‘prediction’ of where prices will be in the future they are certainly a point at which the manufacturers and retailers can purchase the Cotton they will need for some of their future production.

Of course inflation only ever really becomes a problem when the so-called second round effects take hold and the whole thing becomes a vicious cycle with everything going up and workers are able to ask for higher wages to reflect the higher prices etc.

So if Cotton is a good predictor of future inflation then I’d say we have seen the worst.