For the week, the S&P500 surged 5.4% (down 3.3% y-t-d), and the Dow jumped 4.7% (down 0.6%). Technology was especially strong. The Nasdaq100 rallied 6.6% (up 4.0%), and the Morgan Stanley High Tech index jumped 6.9% (down 9.3%). The Semiconductors surged 9.6% (down 7.3%). The InteractiveWeek Internet index gained 5.6% (down 5.7%). The Biotechs increased 3.8% (down 8.1%). The S&P 400 Mid-Caps rose 5.2% (down 4.5%), and the small cap Russell 2000 jumped 6.0% (down 8.8%). The Banks rose 6.8% (down 25.9%), while the Broker/Dealers gained 7.3% (down 26.4%). The Morgan Stanley Cyclicals rallied 5.5% (down 16.8%), and the Transports recovered 6.7% (down 8.7%). The Morgan Stanley Consumer index increased 3.6% (down 4.5%), and the Utilities gained 4.6% (up 8.0%). With bullion sinking $44, the HUI gold index fell 3.3% (up 6.0%).
One month Treasury bill rates ended the week at negative one basis point and 3-month bills closed at zero. Two-year government yields were unchanged at 0.17%. Five-year T-note yields ended the week up 12 bps to 0.92%. Ten-year yields rose 13 bps to 2.05%. Long bond yields rose 7 bps to 3.31%. Benchmark Fannie MBS yields jumped 15 bps to 3.26%. The spread between 10-year Treasury yields and benchmark MBS yields increased 3 to 121 bps. Agency 10-yr debt spreads narrowed 3 to one basis point. The implied yield on December 2012 eurodollar futures declined 1.5 bps to 0.50%. The 10-year dollar swap spread declined about 2 to 18.75 bps. The 30-year swap spread was little changed at negative 28 bps. Corporate bond spreads narrowed. An index of investment grade bond risk dropped 6 bps to 125 bps. An index of junk bond risk sank 65 bps to 665 bps.
Investment-grade issuers included Intel $5.0bn, American Express $1.3bn, PNC Funding $1.25bn, Bank of New York Mellon $1.0bn, GATX $650 million, Xylem $600 million, Textron $500 million, PSEG Power $250 million, Progress Energy Carolina $500 million, Exelis $250 million, Southern Power $300 million, AGL $300 million, and O'Reilly Automotive $300 million.
Junk bond funds saw inflows of $209 million (from Lipper). Junk issuance included Omnicare $500 million.
I saw no convertible debt issued.
International dollar bond issuers included Nordea Eiendomskreditt $1.0bn and Rio Tinto $2.8bn.
Greek two-year yields ended the week down 132 bps to 51.73% (up 3,949 bps y-t-d). Greek 10-year yields rose 66 bps to 20.19% (up 773bps). German bund yields rose 9 bps to 1.86% (down 110bps), and U.K. 10-year gilt yields jumped 22 bps this week to 2.28% (down 103bps). Italian 10-yr yields rose 10 bps to 5.50% (up 68bps), and Spain's 10-year yields jumped 14 bps to 5.28% (down 16bps). Ten-year Portuguese yields added 2 bps to 10.89% (up 431bps). Irish yields were down 4 bps to 8.40% (down 65bps). The German DAX equities index rallied 7.4% (down 19.4% y-t-d). Japanese 10-year "JGB" yields added one basis point to 1.01% (down 11bps). Japan's Nikkei gained 1.4% (down 13.4%). Emerging markets were mostly higher. For the week, Brazil's Bovespa equities index gained 2.6% (down 17.5%), and Mexico's Bolsa rallied 3.9% (down 8.7%). South Korea's Kospi index increased 1.5% (down 10.3%). India’s equities index gained 0.4% (down 17.4%). China’s Shanghai Exchange dipped 0.6% (down 11.6%). Brazil’s benchmark dollar bond yields jumped 12 bps to 3.72%, while Mexico's benchmark bond yields added 4 bps to 3.44%.
Freddie Mac 30-year fixed mortgage rates were down 3 bps to 4.09% (down 29bps y-o-y). Fifteen-year fixed rates slipped 3 bps to 3.30% (down 52bps y-o-y). One-year ARMs declined 3 bps to 2.81% (down 59bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates unchanged at 4.80% (down 56bps y-o-y).
Federal Reserve Credit expanded $3.6bn to $2.844 TN. Fed Credit was up $437bn y-t-d and $555bn from a year ago, or 24.3%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 9/14) declined $2.4bn to $3.475 TN. "Custody holdings" were up $125bn y-t-d and $265bn from a year ago, or 8.3%.
Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg – were up $1.650 TN y-o-y, or 19.2% to a record $10.229 TN. Over two years, reserves were $3.024 TN higher, for 42% growth.
M2 (narrow) "money" supply increased $21.5bn to a record $9.591TN. "Narrow money" has expanded at a 12.4% pace y-t-d and 10.5% over the past year. For the week, Currency was unchanged. Demand and Checkable Deposits increased $12.8bn, and Savings Deposits rose $9.5bn. Small Denominated Deposits declined $2.6bn. Retail Money Funds increased $1.9bn.
Total Money Fund assets declined $16.5bn last week to $2.633 TN. Money Fund assets were down $177bn y-t-d, with a decline of $181bn over the past year, or 6.4%.
Total Commercial Paper outstanding dropped another $22.6bn (9-wk decline of $193bn) to $1.043 Trillion. CP was up $72bn y-t-d, or 8.6% annualized, with a one-year rise of $7bn.
Global Credit Market Watch:
September 16 – Dow Jones (Tom Fairless): “Three years to the day since Lehman Brothers collapsed, the European Central Bank has dusted off yet another of the tools it used to fight that crisis as it seeks to stem Europe's worsening debt woes. The decision… to pump dollars into the euro-zone banking system via new three-month funding operations--the first since May last year--shows how seriously the ECB is taking the latest bout of money-market turbulence. It also leaves the ECB with just one main tool in its crisis-fighting toolbox--the 12-month liquidity tender. After that, the bank will be in uncharted waters.”
September 15 – Bloomberg (Carol Matlack and Jeff Black): “‘Everything must be done to keep the euro zone together.’ That was Chancellor Angela Merkel speaking on German radio on Sept. 13 as she denied reports that Germany was preparing for Greece’s exit from the monetary union. That the leader of Europe’s biggest economy must dampen speculation of a breakup shows the rising unease about the common currency. Two years ago most politicians and investors believed firmly that the euro area was indivisible. As the finances of Greece, Portugal, Ireland, Spain, and Italy have fallen into crisis, that has changed.”
September 15 – Bloomberg (Radoslav Tomek): “Greece should default on its debt and abandon the euro as further loans won’t solve its crisis, a Slovak lawmaker whose vote in parliament may decide whether the country backs a bailout package for the currency area said. The Freedom and Solidarity party, a member of Slovakia’s coalition government, will vote in parliament against the European bailout system, founder and parliamentary speaker Richard Sulik said… His party, known as the SaS, wants member states to ‘keep to the rules’ guiding the euro and ‘start saving money.’ ‘The first step is, Greece has to go bankrupt,’ he said… ‘There is no possibility that’ Greece ‘not now, not in the future, not in 50 years, will’ pay back ‘the loans. My personal opinion is it would be better for Greece to leave the eurozone.’”
September 13 – Bloomberg (Eliana Raszewski and Camila Russo): “Greece should default on its bonds to stop a deterioration of the economy, said Mario Blejer, a former Bank of England adviser who took the reins of Argentina’s central bank after its 2001 default on $95 billion. ‘Greece should default, and default big,’ Blejer, who was an adviser to Bank of England Governor Mervyn King from 2003 to 2008, said… ‘You can’t jump over a chasm in two steps.’”
September 16 – Bloomberg (Charles Penty and Emma Ross-Thomas): “Spanish regions’ debt burden surged to a record in the second quarter as administrations struggled to rein in spending amid a slump in tax revenue. The 17 semi-autonomous regions’ outstanding debt burden rose to 133.2 billion euros ($183.7 billion), or 12.4% of gross domestic product, from 11.6% in the first quarter… Spain’s regions are key to the nation’s efforts to cut the euro area’s third-largest budget deficit as they manage more than a third of public spending, including health and education. Fitch Ratings downgraded five Spanish regions including Andalusia and Catalonia this week, saying debt levels are climbing and the weak economic recovery will undermine revenue.”
September 13 – Bloomberg (Keith Jenkins and Esteban Duarte): “A measure of banks’ reluctance to lend to each other in Europe held within 2 bps of the highest level in 2 1/2 years amid concern U.S. money-market funds are shutting off funding to French banks. The Euribor-OIS spread, the difference between the three-month euro interbank offered rate and overnight index swaps, fell to 82.8 bps…”
Global Bubble Watch:
September 15 – Bloomberg: “China is willing to buy bonds from nations involved in the sovereign debt crisis, National Development and Reform Commission Vice Chairman Zhang Xiaoqiang said…”
September 13 – Bloomberg (Jim Brunsden): “The European Union is considering listing ‘specific examples of strategies using algorithmic trading and high-frequency trading’ that should be banned and punished by regulators as market manipulation. The measures to increase investor protection and reduce volatility are part of plans to clamp down on market abuse in the European Union, according to a draft of the proposals… ‘There are particular automated strategies that have been identified by regulators which, if carried out, are likely to constitute market abuse,’ the document says. ‘Further identifying abusive strategies will ensure a consistent approach in monitoring and enforcement by competent authorities.’”
September 15 – Bloomberg (Tommaso Ebhardt, Andreas Cremer and Ola Kinnander): “Maserati SpA’s new sport-utility vehicle was one of the most sought-after models at the Frankfurt car show this week and Ferrari SpA predicted record sales as executives said ultra-luxury remains recession-proof. ‘If you go to the Ferrari stand, there aren’t any customers worried about the recession,’ Fiat Chief Executive Officer Sergio Marchionne said… The last Ferrari customers I saw at the show weren’t crying.’”
Currency Watch:
September 12 – Bloomberg (Lukanyo Mnyanda and Anchalee Worrachate): “Slowing economic growth around the world is punishing investors who bet on Australian and Brazilian assets using money borrowed in dollars and yen with the biggest losses in more than a year. A UBS AG index tracking the performance of carry trades where investors sell currencies with low interest rates to buy ones in 24 markets with higher yields has tumbled 2.6% this month after losing 2.2% in August and 3.1% in July, the biggest back-to-back monthly drop since May and June 2010.”
The U.S. dollar index declined 0.8% this week to 76.60 (down 3.1% y-t-d). For the week on the on the upside, the Canadian dollar increased 1.9%, the Japanese yen 1.1%, the Danish krone 1.0%, the euro 1.0%, the Swiss franc 0.9%, and the New Zealand dollar 0.9%. On the downside, the Brazilian real declined 3.4%, the South Korean won 3.1%, the South African rand 2.8%, the Mexican peso 2.7%, the Taiwanese dollar 1.2%, the Swedish krona 1.2%, the Australian dollar 1.0%, the Singapore dollar 1.0%, the British pound 0.6%, and the Norwegian krone 0.5%.
Commodities and Food Watch:
September 15 – Bloomberg (Elizabeth Campbell): “The month before cotton reached its highest price ever in March, Brad Heffington bought a 7760 John Deere picker for $500,000 to help get as much ‘white gold’ as he could out of his 6,000 acres in West Texas. Seven months later, the harvester is for sale. The 43-year-old farmer’s crop is wilting… At least 65% of his crop is gone as drought crushes growers’ chances of benefiting from record prices…”
September 16 – Bloomberg (Andrew Roberts): “Emanuele Carminati Molina’s latest beef is the cost of leather. The chairman of Valextra SpA, an Italian maker of high- priced handbags and luggage, says the unblemished cowhide his company uses is becoming an ever more precious commodity: The price of calfskin, the king of luxury leathers, surged 21% in the first half on top of last year’s 43% increase… ‘There’s less top quality leather in circulation and it costs a lot more,’ Carminati Molina said… ‘This has an impact on the price of all the products.’”
The CRB index declined 1.4% this week (down 1.0% y-t-d). The Goldman Sachs Commodities Index fell 1.0% (up 3.4%). Spot Gold dropped 2.4% to $1,812 (up 28%). Silver fell 1.9% to $40.83 (up 32%). October Crude gained 72 cents to $87.96 (down 4%). October Gasoline added 0.5% (up 13%), while October Natural Gas dropped 2.7% (down 14%). December Copper declined 1.8% (down 11%). December Wheat sank 5.7% (down 13%), and December Corn fell 6.0% (up 10%).
China Bubble Watch:
September 13 – Bloomberg: “China’s money-market rate dropped to a two-week low on speculation the central bank won’t seek to tighten monetary policy after cash supply expanded at the slowest pace in at least six years. The broadest measure of money supply, M2, rose 13.5% in August from a year earlier… That was the slowest pace since at least January 2005…”
September 15 – Bloomberg (Jasmine Wang): “China slashed spending on railway construction 50% last month as it slowed building work following the nation’s deadliest high-speed train crash. Spending in August plunged to 33 billion yuan ($5.2bn) from 65.5 billion yuan a year earlier…”
Japan Watch:
September 16 – Bloomberg (Aki Ito and Masahiro Hidaka): “Bank of Japan board member Sayuri Shirai said she hasn’t ruled out any monetary stimulus tools as European and American economies slow and an appreciating yen threatens Japan’s post-disaster recovery. ‘There’s a lot of uncertainty about the outlook,’ Shirai, 48, the newest member of the central bank’s board, said… ‘There are many ways to ease policy. In regards to these options, there isn’t anything I’ve excluded,’ she said…”
India Watch:
September 15 – Bloomberg (Tushar Dhara): “India’s food inflation rate exceeded 9% for a sixth straight week, maintaining pressure on the central bank to raise interest rates tomorrow.”
September 16 – Bloomberg (Kartik Goyal): “India’s central bank raised interest rates for the 12th time since the start of March 2010, breaking ranks among the so-called BRIC nations that have either cut or held borrowing costs as the global recovery falters. The Reserve Bank of India increased the repurchase rate to 8.25% from 8%...”
Asia Watch:
September 15 – Bloomberg (Kathleen Chu and Makiko Kitamura): “Marriott International Inc., the largest publicly traded U.S. hotel chain, said it’s planning a record number of hotel openings for Asia in 2013 to cater to growing demand in the region. The Bethesda, Maryland-based manager of brands including Courtyard and Residence Inn plans to open about 27 hotels in Asia, the most in a year since it started operations in the region in 1989… ‘We have relocated our resources from Washington D.C. to this part of the world,” Smith said… ‘We’ve doubled our offices here in Asia. There is quite a bit of room to grow.’”
Latin America Watch:
September 13 – Wall Street Journal (John Lyons): “Brazil is booming amid a tectonic shift in global investing toward the developing world that has lifted its stock market, strengthened its currency and provided financing for new ports and World Cup soccer stadiums. But while foreign investment is mostly a good thing, there are downsides. The abundance of cash has helped fund riskier bank loans and fueled a potential real-estate bubble. By some measures, the Brazilian real is now the world's most overvalued currency, and many local factories aren't competitive in global markets. Daily life has become so expensive that movies, taxis and even a can of Coke cost more in São Paulo than in New York. Rio de Janeiro apartment prices have doubled since 2008, and office space in São Paulo is suddenly more expensive than Manhattan.”
September 13 – Bloomberg (Ben Bain and Jonathan J. Levin): “Mexico is seeking to step up overseas borrowing in 2012 after raising $3 billion this year from international offerings, more than any other country in Latin America. The government is asking Congress for authorization to boost net external debt by $7 billion in 2012, up from the $5 billion increase it was granted for this year…”
Unbalanced Global Economy Watch:
September 15 – Bloomberg (Jennifer Ryan and Emma Ross-Thomas): “The European Union cut its growth forecasts for the second half to reflect a worsening outlook on the sovereign-debt crisis and warned the euro-area economy may come ‘close to standstill at year-end.’ The 17-nation euro region will expand 0.2% in the third quarter and 0.1% in the fourth, down from an estimate in March for 0.4% expansion in both periods…”
September 13 – Bloomberg (Alex Duff): “Most U.K. soccer clubs are freezing player wages as a sluggish economy hurts ticket and jersey sales, accountancy firm PKF (U.K.) LLP said, citing a survey of the financial directors of 41 teams. Only a fifth of the clubs intend to increase payroll this season and none plan to increase squad size…”
September 15 – Bloomberg (Sharon Smyth): “Spanish home prices fell for the 13th quarter as unemployment remained above 20% and a reduction in mortgage lending crimped demand for property. The average price of houses and apartments declined 6.8% in the three months through June from a year earlier…”
September 13 – Bloomberg (Alena Chechel): “Oil at $60 a barrel may halt Russia’s two-year economic expansion next year, triggering a ‘substantial’ devaluation of the ruble, the Economy Ministry said, according to a document obtained by Bloomberg. Gross domestic product may shrink as much as 1.4% next year under a negative scenario that projects a ‘world recession’ cutting the average price of Urals crude by almost a half from the current level…”
U.S. Bubble Economy Watch:
September 13 – Bloomberg (Catherine Dodge): “The U.S. poverty rate rose to the highest level in almost two decades and household income fell in 2010, underscoring the lingering impact of the worst economic slump in seven decades. Data released by the Census Bureau… showed the proportion of people living in poverty climbed to 15.1% last year from 14.3% in 2009, and median household income declined 2.3%. The number of Americans living in poverty was the highest in the 52 years since the U.S. Census Bureau began gathering that statistic. Those figures may have worsened in recent months as the economy weakened.”
September 13 – Bloomberg (Tomoko Yamazaki): “Nassim Nicholas Taleb, author of the best-selling book ‘The Black Swan,’ said he’s more concerned about prospects for the U.S. than Europe because the country lacks awareness of its fiscal woes. ‘The difference between Europe and the U.S. is the consciousness of the problem,’ Taleb…said… ‘There’s no consciousness in the U.S.’ about the fiscal deficit, he said… Jacques Attali, a former European banking official, told reporters… that the U.S. is in a worse state than Europe because of factors including political paralysis over its debt burden as well as unemployment. ‘I’m quite pessimistic about the future of the U.S. economy for quite a long time,’ said Attali, who advised French President Francois Mitterrand in the 1980s and later became the first head of the European Bank for Reconstruction and Development. ‘The U.S. economy is in very, very bad situation.’”
September 13 – Bloomberg (Bob Drummond): “Borrowers defaulted on federal student loans at an 8.8% rate for fiscal 2009, up from 7% a year earlier… The rate at for-profit colleges… rose to 15% in fiscal 2009 from 11.6% a year earlier.”
Real Estate Watch:
September 15 – Bloomberg (Dan Levy): “Default notices sent to delinquent U.S. homeowners surged 33% in August from the previous month, a sign that lenders are speeding up the foreclosure process after almost a year of delays, RealtyTrac Inc. said. First-time default notices were filed on 78,880 properties, the most in nine months…”
Central Bank Watch:
September 13 – Bloomberg (Scott Hamilton and Jennifer Ryan): “Bank of England policy maker Adam Posen said the central bank may need to expand its bond-purchase program by as much as 100 billion pounds ($158bn) to support the recovery. ‘We should start with a minimum of 50 billion pounds in gilt purchases in secondary markets, titled toward the longer- end of the maturity spectrum, over the next three months,’ Posen said…”
Fiscal Watch:
September 15 – Bloomberg (Jason Arvelo): “The profitability gap between U.S. Postal Service employees and those at FedEx Corp. and United Parcel Service Inc. is the widest since at least the late 1990s. The Chart of the Day traces net income per employee, a gauge of how efficiently labor is used, for the two biggest U.S.-based package delivery providers and the Postal Service, beginning with their 1998 fiscal years. In 2010, the average net loss for each postal employee grew, compared with gains in net income for FedEx and UPS employees. The gap between Postal Service and UPS workers reached $21,369.”
September 13 – Bloomberg (Brian Friel): “Construction spending by U.S. agencies may fall 7.6% this year, ending a building boom that had tempered a three-year drought in private-sector construction spending. The Census Bureau… projected the first drop in annual federal construction spending in six years as cleanup from Hurricane Katrina, construction in Iraq and Afghanistan and stimulus-funded projects all wind down. Federal construction appropriations for the fiscal year ending Sept. 30 were $18.7 billion less than for the previous fiscal year, according to an estimate by the Associated General Contractors of America.”
Speculation Watch:
September 16 – Bloomberg (Christine Harper): “Goldman Sachs… will shut its Global Alpha fund after clients pulled money from the quantitative trading pool that was once the firm’s largest hedge fund… The fund, which managed $11 billion of assets in 2007, had less than $1.7 billion at the end of June…”
Delta One:
The ECB and leading global central banks implement additional emergency (dollar) liquidity operations; UBS reports a $2bn loss from a “rogue trader” operating within its “Delta One” derivatives trading unit; and the S&P500 surges 5.4% during “quadruple witch” expiration of equity options and futures. Just another week in the markets.
The Federal Reserve released the Q2 2011 Z.1 “flow of funds” Credit report today. Total non-financial borrowing expanded at a 3.0% annualized rate to a record $36.517 TN. Total system Credit ended the quarter at $52.554 TN, having doubled since the beginning of 1998.
There are myriad problems associated with protracted Credit booms. It is certainly no coincidence that heavily-indebted U.S. and European economies are all today suffering from stagnation. Such economic maladjustment is a textbook “Austrian” consequence of rampant “money” and Credit excess. But this week I’ll focus more on Financial Sphere distortions and fragilities.
Years back, I often referred to my fictional “town on the river” when pondering derivative-related market distortions (“writing” fiction is hard). I used an analogy of a waterfront community (“A Derivative Story,” CBB 3/31/00) that enjoyed a spectacular boom after the introduction of inexpensive flood insurance. An extended drought had altered the perceived risks associated with selling/writing insurance. The commencement of a lending, building and general economic boom ran concurrent with a spectacular Bubble in the newfound flood insurance marketplace.
As more splendid riverfront homes were built (and additional mortgage Credit extended) and existing home prices were inflated, the size of the insurance market expanded exponentially. And as the drought persisted, there was no more profitable endeavor than to hawk flood insurance to eager homeowners. Not unsurprisingly, the “easy money” insurance market turned increasingly speculative. Everyone had to have a piece of the action. Many would simply write the insurance and immediately “book” the full profit (models projected the probability of flood-related losses at near zero). Most players would hold minimal-to-no “reserves,” choosing instead to rely on the flourishing reinsurance market in the unlikely event protection was deemed necessary. After all, reinsurance was cheap and readily available. Curiously, when the amount of insurance in force started to balloon the price of insurance began its collapse.
The main point of the analogy was an attempt to highlight how the evolution of the insurance market became the critical factor fostering Bubble Dynamics within both the financial and economic spheres. Readers may be stunned to learn that my little fictional tale did not have a happy ending. When weather patterns changed and torrential rains eventually arrived, all hell broke loose. Rushing to acquire reinsurance, the speculators quickly confronted a market closed for business (i.e. “illiquid” or “seized up”). And when the so-called “100-year flood” unfolded, it was a scene of panic and mass devastation (fortunately, no loss of life other than a few insurance traders). At the end of the day, market distortions and the evolution of the “insurance” market actually ensured catastrophic economic and financial losses. The value of at-risk assets had inflated dramatically, while the true reserves backing the insurance coverage were minimal. And it all seemed to work so miraculously - until it didn’t. To be sure, the community would have been much better off had the flood come sooner (or, better yet, that misperceptions in the marketplace had been recognized by participants or regulators before catastrophe struck).
This week, “Delta One” prominently entered the financial vernacular (“delta” refers to the change in the price of an option contract per unit price change of the underlying market security). Details remain sketchy, but an employee involved in UBS’s business of selling (and hedging) client derivative products (apparently mostly exchange-traded funds/ETFs) is being blamed for $2bn of losses. And while we’re on the subject of derivatives, it is worth noting that, according to J.P. Morgan, 40% of outstanding equity options – amounting to $800bn of notional contract value - expired today. The SPY S&P500 “spider” ETF traded 1.5 billion shares this week.
With European banks in freefall and global de-risking and de-leveraging at full force, there has been no shortage of reasons to hedge myriad market risk exposures (in vulnerable equities, Credit, currencies and commodities markets). It is worth noting that, with the this week’s big market rally, enormous value was extracted from bearish hedges in the final few sessions of the September contract period. Perhaps coincidently, this week’s concerted central bank move to provide dollar liquidity to troubled European banks had a similar effect on hedges as did the extraordinary concerted currency intervention during this past March’s “quadruple witch” expiration.
Policymakers have orchestrated a huge dilemma. The ongoing simultaneous global expansion of debt and marketable instruments, along with the policy-induced reflation of global risk markets, has created an unprecedented accumulation of market-related risk. At the same time, a financial monstrosity has evolved that is in the (what had been highly-profitable) business of writing market insurance to protect against declining stock, Credit, sovereign debt, currency and commodities prices. The business of peddling ETFs, listed options, Credit default swaps (CDS), “swaps,” “swaptions,” and countless varieties of over-the-counter derivatives to protect against market risk has been booming. And the more authorities intervene to ensure unending Credit expansion and the ongoing inflation of global risk markets the greater the amount of market risk to hedge - and the grander the profit bonanza available from trafficking in market “insurance.”
From the timing of increasingly vocal outcries against “high-frequency trading,” one might get the idea that these players sit back and become active only when they develop a hankering to see the market get wacked. From my perspective, I assume these players are among the most sophisticated, best informed and keenly opportunistic traders in the marketplace. Throughout the policy-induced rally that commenced in 2009, they likely garnered huge long-side profits buying (“squeezing”) heavily shorted stocks ahead of an enormous unwind of bearish hedges and bets (I don’t recall any protesting). They will gravitate to wherever they can garner a trading advantage (“front running”) ahead of the crowd. But mostly, I believe the “high-frequency” contingent is immersed in a game of extracting trading profits from this monstrous business of structuring, selling, hedging and managing market (“flood”) insurance. Call it “front running,” savvy or despicable market manipulation.
In my little “town on the river,” I didn’t grant market participants the ability to dictate the weather. Local authorities weren’t allowed to stop the torrential rains and instantaneously reduce the river flow - with a simple press release. As they say, sometimes "truth is stranger than fiction.”
Part of my thesis is that the unfolding sovereign debt crisis is different in kind to previous private debt crises. Aggressive (“activist”) monetary and fiscal policies now suffer from increasingly short half-lives. But, at times, well-timed policy measures can appear as powerful as ever.
This week’s move to provide dollar liquidity to European banks will have essentially no impact on the unfolding sovereign debt crisis. But the ECB, in the week following the resignation of German Juergen Stark, showed ongoing resolve in its aggressive crisis response. A bearishly positioned marketplace was forced to run for cover. Authorities, once again, dodged a bullet with today’s expiration of huge amounts of equity market insurance. Fortunately for the marketplace, those that had written these contracts were forced to buy back securities that they had previously sold to hedge their exposure (as the market declined and put options traded “in the money”). With so many “put” option contracts outstanding, the market could have been in serious trouble had the market broken to the downside – with those having sold insurance forced to sell aggressively into a falling market as they “dynamically hedged” their derivative exposures (i.e. attempting to offload flood insurance risk during exuberant downpours).
Another part of my thesis is that, increasingly, policymaker market interventions will do more harm than good. Is it mere coincidence that UBS’s (the old Union Bank of Switzerland) “rogue trader” left “need miracle” on his Facebook page last week as Swiss National Bank intervention led to an incredible 10% decline in the Swiss franc? One thing’s for sure, UBS will now rein in risk-taking in its “Delta One” operation and throughout the organization. And other firms will tighten risk parameters, as global de-risking and de-leveraging dynamics continue to gain the upper hand.
For a long time now, I’ve believed that inexpensive and readily available “flood insurance” was the key to ongoing Credit and risk market Bubbles. Cheap insurance distorts market perceptions and the overall marketplace, in the process promoting risk-taking. The derivatives marketplace would be a very different place today had it not been for repeated government interventions. The world would look differently today had AIG been allowed to fail back in 2008, with the collapse of their derivatives book reverberating throughout the global risk-intermediation daisy-chain. With a lot of friendly help from global policy makers, the markets bounced back and the hedging and financial speculation businesses came back as powerful and enterprising as ever.
Increasingly, I ponder to what extent the marketplace will continue to trust both the fairness and soundness of risk hedging markets. If sophisticated traders are operating in the marketplace specifically to extract profits from those buying derivative hedges, doesn’t this in reality greatly increase the cost of this market protection? Their trading strategies certainly incite volatility and general market instability. And if timely policy maker intervention reduces the probabilities that hedging protection functions as prescribed, doesn’t this also boost the true cost of market insurance? And doesn’t governmental policy intervention distort the marketplace, incentivizing those writing “flood insurance” to presume that fiscal and monetary policies can manipulate the weather?
It’s all become a very dangerous – and offensive – game: the myth of a functional marketplace for market insurance. The bottom line is that Credit and market risks are not “insurable”. They are anything but random and independent events – in contrast to auto accidents and house fires. Credit and market losses come in especially non-random and non-independent waves. And unlike property and casualty insurers that employ actuaries and build generally sufficient reserves for generally predictable future losses, those on the selling end of Credit and market insurance utilize self-reinforcing “dynamic hedging” strategies. That is, they must sell securities – often in a falling market environment – to hedge the “insurance” they have written. These strategies rely on the dubious presumption of “continuous and liquid” markets. And as these markets have become so enormous, there is also the reality that the marketplace cannot offload market risk.
One of these days, the selling required to hedge market protection written may overwhelm the market’s capacity to absorb derivative-related selling. We’ve appeared on the brink of this scenario more than a few times. Or, perhaps, the issue will be a loss of confidence in the integrity of the derivatives marketplace, with participants resorting to the liquidation of actual securities positions to mitigate risk in an extraordinarily risky environment.