Ireland – the solution for the Irish?

At the moment the Irish government and the ECB/EU/MF are hammering out a deal which will see Ireland borrowing approximately €85 bill primarily to bail out its bankrupt banking system – the government is only really in dire straits because it has to bail out a banking system whose assets had grown to 700% of GDP[1]. By comparison the US banking system has assets of roughly 100% of GDP.

If I were an Irish (opposition) politician in the upcoming general election I would run my campaign on a “no” to this so-called bail out and ask: Why should a generation be paying for this? What will stop any able-bodied Irish man or woman leaving Ireland now? The size of the bail-out will increase Irish government debt by 40-45% of GDP in one quick move.

The reality behind the urgency was the markets waking up to fact that Ireland could not afford to keep its pledge to guarantee all senior obligations of its banks, which swiftly brings us to the next question:

Is €85 bill even enough? Who knows? Two (out of four) of the troubled Irish banks actually passed the ECB’s stress test earlier on in the year, which just goes to show how good and reliable they were…..! With €1.4 trillion is assets between the banks how much has actually been/will be lost?

As a would-be Irish popular politician I would say that the bailout is mainly to let the people of Ireland pay for the mistakes made in London, Frankfurt and other financial centres where its actually the mistakes of the holders of the Irish banks senior debt that are being bailed out! Chancellor Merkel is quite keen on making ‘those who profit’ pay when it comes to sovereign debt restructuring – so how about just letting the senior bond holders pay? The banks taking the losses can go to the markets and try and raise the capital they have just lost and if necessary Ms Merkel can underwrite the German banks so they don’t default. Why should the Irish tax-payer pay for a bail out of the UK and German banks?

I would guarantee the domestic deposits and re-incarnate the banks to service the domestic economy (much like they had to do in Iceland) if need be leave the Euro, re-introduce the punt take a devaluation as it’s much less painful than an internal devaluation, which is the result of the current policies and get on with it! Of course I would keep the 12.5% corporation tax rate and negotiate directly with any inward investor who might lose money as a result of the banks defaulting, but paying for the UK and German banks’ mistakes – no way!

Will you vote for me??????

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[1] According to research by Barclays Capital

QE2 came and it’s off to the races, but what’s going on in Europe?

While it looks like the risk-on trade is in full flow with the interesting concept of all assets going up in tandem – something I find unsustainable – but never mind.

In the middle of the euphoria the crisis in Europe is coming back even if it doesn’t get much attention in the media. Irish 10 year spreads just blew out to a new all time high against bunds, €/CHF looks like it could break down and most likely will if 1.3550 is given (it just was so the recovery in €/CHF seems to be over), the Ibex doesn’t look like it’s in rally mode, quite the opposite, so can the rest of the markets just ignore this and continue as if nothing’s happening in the European corner? Somehow I don’t think so…….

The correlation between markets & QE II……..

The markets have become more and more correlated with the risk-on/risk-off trade (interesting article about this topic in the FT yesterday - link here: http://www.ft.com/, but one thing has changed: the equity markets and the US in particular has been able to shrug off bad news while embracing the good news….

This in itself has happened before and in particular it reminds me of the mind-set from the autumn of 2007 where one CNBC market commentator phrased it something like “if we get bad economic data, the Fed will lower rates and that will be good for stocks….” I think he managed, in the same report to say that the stock market was a forward looking market…

So fast forward till the autumn of 2010 - treasuries are approaching all time low yields (some parts of the curve have already traded through the previous lows) because of disappointing economic data and the anticipation of QE II, while the stock market manages to rally albeit not to new highs on the same information. 

Warren Buffett is out again talking about how cheap the stock market is (and how expensive the bond market is) - personally he did that trade in October 2008 - His op-ed was published on 16th October 2008 in the New York Times so for a little fun experiment, I have compared the returns of a US treasury bond index and the S&P 500 from that date till yesterday’s close (7th October) and the results are surprising……...think about it purchase of US equities in the middle of a massive bear market compared to an index of US treasuries. Which performed better? 

Oct 2008 - Oct 2010:       S&P 500                   +22.36%

                                             Treasuries           +22.90%

So in my book they have had the same performance, but think about the difference in volatility and the asset classes - the “riskiest” vs the “safest” - I have put both in quotation marks as it’s not obvious that everyone agrees about the relative risk or safety of either, but at least traditionally that’s how they were perceived. Any money manager would, at least in hind-sight, have kept the treasuries.

The real point I am trying to make is that the current scenario where good news is good news and bad news is also good news (for equities) may come to an end - some members of the FOMC are making their views known that QE II is not a foregone conclusion and any reasonable participant should question the fact that the QE I in large part has just ended up in excess reserves - so why would more of the same work better?

The markets most at risk are perversely, in my view, not treasuries, but gold and equities, which have been rallying on the back of QE II leading to inflation, while treasuries are rallying on a basis of QE II coming, or not, not leading to inflation - all three cannot continue to rally together!

Inflation.....and bond yields!

Following last week’s inflation report from The Bank of England this week’s actual inflation report for July came in much as expected with the headline CPI dropping to 3.1% Y/Y from 3.2% in June.

Because of my recent foray into the media about inflation and the economy I have been paying closer attention to UK inflation and the underlying factors driving it. What no-one seems to notice, or care about, except for the B of E is that CPIY i.e. inflation without indirect taxes and in particular without VAT fell from 1.6% Y/Y to 1.4%. 

This is the measure  we should focus on as the VAT decrease in 2009 followed by the increase in 2010, which will be followed by anther increase in 2011 will make it impossible for anyone to deduct anything from the headline CPI number - anyone who says differently is either stupid or lying, or both! 

This was also the case in 2009 when CPI was much lower than CPI-Y as the effect of the temporary VAT reduction fed through to CPI. What is more interesting is that CPI-Y has continued to fall from the peak of just over 5% in 2008 to the current level of 1.4%, albeit not in a straight line, the trend is clear......lower! 

Even the inflationists favorite measure the RPI, when stripping out the VAT effects etc and looking at the RPIY fell from 3.8% Y/Y to 3.5%.

Elsewhere it is deflation that's staring policy makers in the face - The Fed is clearly worried and it probably won't be long before QE2 light will be replaced by a fully fledged version somewhere between $500 billion and $1 trillion. Philly Fed's survey which was released yesterday at -7 instead of the expected +7 and weekly jobless claims topping 500k again.  

Recovery? Has it been and gone already?

In the bond markets yields are reflecting the very weak economic backdrop (even if the equity market participants are not fully embracing this reality) and with US mortgage yields in deep re-financing territory (all the ones who can will refinance) the negative convexity is playing havoc with duration i.e. If you need/want duration the only place to go really is the back end of the yield curve, which is why it’s starting to flatten smartly and will probably continue to do so as 2 year yields below 50 bp’s hardly provides any protection or yield, 30 years at 3.60-something is the place to be. 10-30’s is still north of 100 bp’s and that could easily come back into the 50-75 bp range during the remainder of this year. It could go even lower depending on the launch of the new QE2 and the scope/weighting of it.

All the bond-bubble alarmists will be hurting emotionally (financially as well if they put their money where there mouths are) as the market will continue to rally and the curve continues to flatten......but the more of them there are the better for the market’s prospects as short covering is a very powerful thing.....! 

If you care for a more thorough trashing of the latest bond-bubble alarmists' arguments then you should read David Rosenberg's daily comment from yesterday.....it's very good reading indeed!

Interesting day....

Having spent the morning appearing on no less then three BBC radio programmes including the Today program as well as the BBC Business Report on BBC World, it has given me  a reminder of how little time general news actually gives to financial/business news.

Trying to debate the Fed’s actions last night  and the implications of QE, the prospects for growth and inflation globally and specifically in the UK in slots of 3 mins or less is very difficult and the generalizations become huge!

So what do I think? The Fed’s announcement that they would keep the balance sheet at current levels by re-investing mortgage backed coupons and redemptions in treasuries is, I’m sure better than not doing it, but is it just rearranging the deck chairs on the Titanic? It could well be, as the base case looks more and more like a double-dip - I out the odds at 50/50 this morning, but even if we don’t technically get a double-dip growth will be very sluggish for a long time.

I did a little digging on UK inflation data last night in preparation of my media appearances this morning and found that CPI-Y (that is CPI without indirect taxes such as VAT) is actually quite stable and currently running at 1.6% Y/Y, which is what the Bank of England should be focusing on when they talk to the markets and the media. Their mandate may be headline CPI, but they cannot be held responsible for, or even asked to take this into account when it is the government that is responsible for half the current annual growth in CPI i.e. taxes.

While the MPC always say they are looking ‘through’ the temporary effects of indirect taxation and the effective depreciation of sterling, why don’t they start talking about the CPI-Y, or the net-price index as I would call it ?????

Well, they can of course start that today at the press conference and if they do I will be taking all the credit!

I had the pleasure of meeting Andrew Lilico from the Policy Exchange before and after our debate on the Today program and while he thinks the economy will be weak in the short term and that more QE is forthcoming as well, but then our views are very different as Andrew believes that growth in the second half of 2011 will take off sharply and inflation will follow. I completely disagree as I see no growth of any significance in a scenario where the government is cutting expenditure aggressively and the banking system is still broken and the shadow banking system has ceased to exist. There can be no growth without access to credit, unless it’s government sponsored.

Bond markets seem to be continuing to take the cue and rally to this new economic reality, but equity markets are completely mis-priced, why on earth they think that corporate profitability can continue to grow in a no-, or low growth economy is beyond me. There are only so many costs and jobs that can be cut - and while these cost saving measures may be good for an individual company’s short-term profitability, they are terrible for the economy as a whole. The difference is that bond markets can be a leading indicator, while the equity market is clueless........!

The Euro’s demise?

A lot is being written about the end-of-the-euro as we know it at the moment - not surprising with the problems persisting both inside the Euro area and on the periphery e.g. Hungary with huge private sector (read mortgages) Euro and CHF borrowing.

Earlier in the crisis there was a big diversification out of the dollar as it got weaker - US investors started investing heavily abroad, international companies (and even sovereign countries) started asking for payment in Euros as opposed to dollars. 

This seems to be reversed, with Iran converting €45 bill of their FX reserves from Euros to US$ and gold and probably a fair bit of repatriation by US investors who suddenly find their non-US$ assets not performing in US$ terms. A US investor who held the IBEX is down 40% YTD is US$ terms!

All this has led to to the Euro sliding against the dollar for six months in a row, seven would be a bit of a record (it’s would be record in the dollar index of which the Euro is a large component), but what would really set the ball rolling (not that the recent sell-off is insignificant) would be if domestic Euro area investors started losing faith in the Euro and started exporting capital en-masse.

What would make this a reality? Well, the recent bail-out package combined with the deteriorating value of the Euro is powerful stuff in particular for the German electorate and savers. But there are ‘savers’ in all countries the question is only when they will get sufficiently nervous and start piling their (Euro)savings into other currencies/assets. Some have without doubt already done that - the SNB’s FX reserves grew by CHF80 bill last month and €/CHF have made new all time lows today.

Gold made a swift recovery yesterday and again has made all time highs against a lot of currencies while just touching the highs in US$ terms.

Frankfurt saw the first gold vending machine last year and while I’ve been skeptical of gold as everyone seems to be long already, there is perhaps room for it to move much higher if we are indeed talking about a dismantling of the Euro from the inside.......watch this space!

Europe.......the saga goes on!

Following up on from earlier in the week the press reports that the EU (not just the eurozone countries), but all 27 member states will agree to a stabilization fund to help weaker members in dire straits. 

So far so good, I suggested the ECB buying Greek, Portuguese, Spanish and Irish debt in the open market in significant size, however unappealing that may be, was the only solution to stop the rot right now. Having the EU guarantee issuance of bonds jointly and severally to then use the proceeds of buying up the debt of the weaker nations a huge spreads - Greece 10yrs at bunds +1000 - would work equally as well, it might not even have the QE stigma, which is probably a good thing.

Here is the rub - the proposed size of €60 bill reported on Bloomberg et al - if that is to be believed, at first glance I thought there was a ‘0’ missing, is completely and utterly insufficient. Have they learnt nothing from the last week’s reaction to the Greek bail-out package? As a €110 bill was deemed insufficient for Greece, why does anyone think that€60 bill will make any difference whatsoever?

If that is indeed what they come up with tonight - press conference to be scheduled at 6pm - then my suggestion is that the € will make new lows against the dollar and the yen and European stock markets will get hammered as well as the club med bond spreads and CDS making new highs.

Having read this month’s GMI which has a great deal of coverage of the Spanish situation (the author lives in Spain) the Spanish housing problem alone could use the €60 bill to bail out the Spanish lenders with them still asking for more. This analysis is my own but as the Spanish banks are not realizing any losses on 1 million empty units, just offering them at the old prices as they cannot afford to take the losses, when repossessed and continuing to keep developers alive that should be foreclosed as in not to show even more property on their own books. A quick back-of the-envelope calculation: 1 mill empty houses and flats at a conservative average valuation of €200,000 mortgaged at 80% or €160,000 with a value of €100,000 (no-one is even looking at property with 30% off so 50% should be the start of getting anyone interested) would equate to a loss of €60,000 per unit or - wait for it - €60 bill. Maybe that’s how they came up with the number? I know some of these properties are owned without mortgages, others are mortgaged less, but probably others are mortgaged more and some developments are completely worthless as they have been constructed without proper building permission and will be bulldozed and the land will be worthless as it will not have planning permission and probably not get it. So as it was a back-of-an-envelope calculation it may not be entirely accurate, but it gives you an idea of the size of the problem. Oh yes, I almost forgot: Spain is out of recession with positive growth of +0.1% in Q1.

What about the UK? With a budget deficit higher than any other larger nation and no government - I know the old team is still warming the seats for whoever may be taking over and that Alistair Darling is in Bruxelles today with the other EU finance ministers discussing the above mentioned bail out fund, but he has no real mandate without speaking to George Osborne and Vince Cable. Is the UK going to be the next in line for some real punishment? Well, if there is no deal between the Conservatives and the LibDems in the next day or two, then I would say that chances are we’ll see gilt spreads (against bunds) already at the highest since 1998 go higher, sterling will get pummeled against the dollar, the yen and the swissie.......

It looks like it could be a fun week!!!!