Risk assets are green across the board from the policy actions announced after the EU summit. Short term it is obviously quite bullish and buys more time for further action that are needed to truly solve the European crisis. However, new details being released makes it seem the status quo is still in place. Take for instance the suspension of the subordination clause in relation to the bond buying by the ESM or EFSF. Simple answer is investors are still getting subordinated, if the ESM is used to buy bonds. Also, the collective action clause is still in place. If the ECB does the purchasing, they will still subordinate everyone else. This new proposal does nothing to deal with the fear people have about buying peripheral bonds and getting subordinated.
The suspension of the subordination clause was rather meaningless because it only applies to the money used to bail out the Spanish banks. Since they removed the bailout cost of the banks from the Spanish balance sheet, it didn’t matter whether the subordination clause was removed or not. A bail-in clause still might apply. Equity holders and some bond holders may still take a huge hit once the bailout actually occurs. According to the Bank of International settlements, the Spanish banks owe 40b to German banks. Give Spanish banks 100b and take 40b of it for your own banks. You can’t help but laugh at some of this shit.
The only good piece of news is the direct recapitalization of banks. This will significantly relieve the contagion fears. Direct bank recap does sever the link between the sovereign and the banks.
Side note: A monkey wrench could be coming at 11 or 12 EST today (whatever is 5 pm German time). German parliament needs to ratify the ESM. Supposedly there is already backlash, but it will likely pass anyway.
Three main things coming out of the EU summit:
EU will not subordinate Spanish debt.
ESM can directly recap banks without putting the balance onto the sovereign. ECB will be granted supervisory power.
Something about EU opening bailout fund ( Not sure what this does as of yet)
Markets all going crazy towards risk. S&P futures is up around 10 pts or so.
Not to put a damper on all this exuberance, but Merkel is pissed. Merkel left the summit without giving a statement. A big problem is the German parliament has not ratified the ESM. The Bundestag is suppose to ratify the ESM today. Good luck with that one. Going to be a volatile day.
That was one hell of a ride after the announcement . Bernanke is going to hold a press conference at 2:15. Don’t expect too much from him. He’ll say the same thing as he did during the June 7th testimony. Nothing new will be added and again markets will be disappointed. He’ll repeat the line extreme financial stress over and over again. Blah blah blah. Don’t expect anything from the Fed until Jackson Hole. I think it occurs at the end of August. Not too sure. Very tired at this point.
Could be tilting at windmills at this point by fading QE expectations, but I am going to stick to my macro thesis. Portfolio has been risk neutral since the last shift. It has gone risk off. New FX exposure will tilt the exposure to risk off. The trades will be asymmetric with tight stops put in place. Gold is getting crushed and USD/JPY is pushing towards the upside. Both are signalling no qe or at best a twist is coming. It could just be confirmation bias, but willing to accept the risk reward with the trades. Also, may write a call option on EQR at 65 or 62.5.
Update: New positions are in the money and time for a free roll before the Fed. Stop losses all moved to free.
ECB rumor of buying bonds was false; however, this new rumor of the EFSF and ESM will be used to buy bonds is more probable. ECB never wanted to buy bonds using the SMP mechanism in the first place. When they did buy the bonds, they always wanted to shift the potential loss burden onto the EFSF. This occurred on the Greek bonds they bought. It has to do who takes the losses. ECB is a quasi-private corporation owned by quasi-private central banks like the Bundesbank. There are shareholders for these central banks and they don’t like taking losses. The Fed is a private corporation too. (Not trying to spin conspiracy theories. Just trying to distinguish the difference between the entities being used and why it matters.) The ESM and EFSF buying bonds will subordinate all bond holders. If these two entities do take a loss, then the loss will be taken directly by the taxpayer of each nation. On the other hand, the losses taken by the ECB are not as direct.
The plan is for the EFSF to buy 200b and the ESM buying 400b Euros of bonds from Spain and Italy. The dry powder the EFSF has left is about 250b and the ESM has 500b Euros. The 100b Euros supposedly pledged to the Spanish bailout has not been counted. Like I said in a previous post, the money was never really going to be released to Spain. Now that the independent audit has been delayed until the end of July, it seems even less likely the banks will get this money. Replacing the bailout will likely be the banking union. Supposedly in a text message the PM of Spain Rajoy said they needed 500b euros to truly recapitalize the banks of Spain.
The French may have won a battle against the Germans. The French wanted crisis solving measures first before fiscal rules and the Germans wanted it the other way around. This plan could be meaningless because the ESM has not been fully ratified by everyone yet. Most importantly the German Parliament. This plan does not solve the problem, but it will relieve the market tensions significantly.
All this news around Europe dealing with their problems, it seems even less likely that the Fed will do another full scale QE tomorrow. An extension of twist or nothing at all is the most probable outcome. The Fed will keep their powder dry at this point. (Explained the scenarios on QE in another post) Also, most asset classes participated in today’s rally except gold. Gold market is not expecting QE at this point. Looking for the market to stay range bound established after LTRO II and the low of May to hold for a little bit longer.
It seems more and more likely the EU banking union will come sooner rather than later. Comments from two EU officials today had an interesting twist to them. Barraso said a banking union would not require a treaty change. Van Rompuy hinting at a road map was on its way and will be discussed in the June summit. Also, he mentioned banking union proposals will come this autumn. Along with the supposedly “secret” leaked document that outlines the roadmap for a bank union in yesterday’s Telegraph, seems like a banking union is coming down the pipe.
The supervisory authority will likely be the ECB. The ECB will follow the footsteps of the Fed and will likely be granted the same powers. ECB will become the lender of last resort. Once a banking union is put in place, it will sever the link between the sovereign and banks. If the banking union is activated, it will be a game changer for the European crisis. It will not solve all their problems, but it will reduce the pressure.
A few of these nations sovereign debt problem occurred after bailing out their banks. Ireland is an example of this. Have you noticed there are no further details about the Spanish bank bailout after the announcement? It seems like it was a head fake and they were never really going to give them the money in the first place. Instead it was a stop gap announcement to supposedly stabilize the market. Well, that was an utter failure. Spanish bonds hit a new high today. A banking union will solve most of these problems. The bailout money will not be placed upon the sovereigns’ balance sheet under a banking union. Bad banks will get unwound and good banks recapitalized. Capital flight will subside. Financials will have a monstrous rally, if a bank union is proposed. As long as you don’t purchase a bank that will be affected by the bail in provision, then it will be a good trade. If financials rally, the whole market will go along for the ride.
If a banking union comes on line fast enough, then they may boot Greece out of the EU. Greece will face a troika review soon and the troika will be pissed on the progress that Greece has shown. Greece will need a third bailout. Yes, a third bailout even though the second bailout has not been fully released. From what the German finance minister has been saying, it seems they are sick of putting good money after bad. They may boot Greece first then right after put in place the banking union to remove the contagion factor. More and more likely Greece will get booted.
This is supposedly a secret draft of a proposal for an European Banking Union. It will likely be the blueprint later on; however, it is rather meaningless at this point. The Germans will not agree until they get fiscal rules in place and the French are refusing those fiscal rules. The French want their sovereignty and money from others. The best description of the current situation was by a Dutch official. He said the Dutch and the Germans are raising their retirement age. The French are trying to lower their retirement age. It is another battle between the French and Germans. Hopefully the French will surrender again.
When the rules of the game are no longer beneficial, change them. This is what will happen when BIS waters down BASEL III. The two changes likely coming will be lowering the capital charge from 3.5 to 2-2.5 and what can be considered high quality liquid safe assets. Banks are rejoicing over these rule changes. They will have a wider pool of assets to choose from to meet the liquidity ratio imposed by Basel III. Previously the pool was essentially limited to cash and government bonds. Now equities and gold are allowed as well. This new rule adjustment will allow banks to raise less capital and they will have less of a capital shortfall than originally planned. It will relieve some tension in European banks as well. An interesting question is: how are banks allowed to speculate on equities and gold in the US, if they supposedly are not going to be allowed prop trade under the Volcker rule? Well, that rule will get watered down of course.
The second story over the weekend was how pensions will be calculated. What happens if you are a corporation, state, or local government facing a massive increase in pension liabilities? Well, you lobby the Federal government to get the rule changed of course. The new transportation bill that just passed the Senate did just that. Instead of having a massive shortfall, the shortfall disappears just like that under the new rules. Especially enjoy how the provision was buried on page 1472 of the bill. Don’t you just love rule changes. It is like the wonderful gift of suspending mark to market. Ignorance is bliss sometimes…
If you want in-depth analysis of what the bill actually did, then read this: http://soberlook.com/2012/06/with-all-talk-about-mark-to-market.html
Full Scale QE occurs only if the Greek election creates no government. Otherwise, this scenario will likely not be relevant. In full scale QE, the fed will purchase treasuries and MBS. Speeches from Evans and Lockhart show they are comfortable with current economic conditions and said no further easing is needed at this time. They attribute it to the safe haven flow that is currently occurring. It is driving the yield on long dated bond down without the Fed. Although their speeches came before the recent CPI and PPI, the numbers came in near expectations. Also, core CPI came in exactly at 0.2 and this was what the market was expecting. The recent decline in oil likely caused the headline CPI to come in at -0.3 without dragging down core CPI. The volatility of headline CPI and core CPI coming neart expectation will likely not force them to implement full scale QE.
It will be difficult to do another round of full scale QE without extreme financial stress in the system. Bernanke, Evans, and Lockhart all had variations of the line “extreme financial stress” in their speeches. The Fed is limited in what they can purchase. Purchasing short term bonds will nullify the purpose behind Operation Twist. Operation Twist was created to combat the “voluntary” capital destruction in the market. Another full scale QE will limit high quality short term quality even further because the Fed will drain the supply with their further. QE exacerbated capital destruction; Dodd Frank added fuel to the fire. Before Dodd Frank, money markets and financial institutions had a larger pool of short term high quality assets to choose from to meet capital requirements. Instead of buying treasuries, they bought CODs that had a higher yield. As we know now, the CDOs were not high quality assets. Post Dodd-Frank, the pool became even more limited due to new regulations on what can be considered collateral. Unless the Fed wants to nullify operation twist, the pool of assets they can purchase will be limited.
They can purchase medium to long dated bonds and MBS. Buying more medium and long dated bonds will increase the duration of their portfolio even further. The Fed is already sitting on nearly 1 trillion dollars of 6 to 30 year and 600b of 3 to 6 year bonds. The two times they initiated full scale QE was when the 10y yield was above 3. Currently, the yield is sitting at 1.59. It would not make sense for the Fed to extend the maturity on their portfolio at this point with the safe haven flow already pushing yields down. The Fed does not lose money on their purchases. How does buying more bonds at these rates make them money? Also, how does the Fed unwind their portfolio later on? Purchasing more of these long dated bonds will make it more difficult because they will be the market at some point. They have shown glimpses of how they plan to unwind in “The Mechanics of a Graceful Exit.” Unless these questions can be truly answered, it will make it difficult for them to launch another round of full scale QE without extreme financial stress to the market.
Truly QE is nothing more than a great way to help clean up the balance sheets of banks and create inflation expectations. If the Fed truly wanted to get inflation going and flood the market with liquidity, then they could stop paying the IOER. The banks would stop holding their excess reserves at the Fed and would actually start lending the money. Before 2008 there was an opportunity cost for banks to hold their reserves at the Fed because it didn’t pay interest. Post 2008 the Fed was granted the power to pay interest on those reserves for the first time in history. Why would banks lend money when their NIM is so low and take on risk? Instead they can receive a risk free interest payment at the Fed.
The monetary base has grown, but the money multiplier and money supply are both very low. So ask yourself this: if the Fed has been printing wildly, how is it possible for the money supply YoY growth to be so low? Compare it to China’s money supply YoY growth over the past few years and you will see a drastic difference. The reason is the money never really left the Fed. IOER was a way to sterilize their purchase and keep monetary inflation from truly getting out of control. QE perpetuated the notion that inflation was being created without inflation actually being created. Instead the expectation of inflation was created. A sterilized form of QE was rumored in March; however, the Fed already has been sterilizing QE with IOER. An announced version of sterilized QE would eliminate the benefit of inflation expectations. It wouldn’t make sense to announce a sterilized QE when they need inflation expectations to combat deflation.
Now that full scale and sterilized QE are eliminated from what the Fed may do. QE lite and an extension of operation twist must be examined. An extension of operation twist will be difficult to pull off. The Fed is only sitting on 180b to 200b of short term bonds (1-3y) compared to 600b when they first announced twist. An extension can be used as a stop gap between now and the elections without too much of a threat to Fed’s independence. However, they may not have a large enough pool of short term bonds to extend operation twist for that long.
The second possible scenario is a twist on QE lite. In QE lite, the Fed reinvested the proceeds of maturing MBS and bought treasuries with it. This time they may do the same or use the maturing MBS proceeds to buy more MBS. Evans mentioned buying MBS was an option. This scenario allows them to keep their balance sheet the same without a contraction or expansionary component to their purchases. Also, it keeps the duration of their portfolio the same.
Germany dashes expectations for action to help eurozone : http://www.ft.com/cms/s/0/ff1f20a4-b574-11e1-b8d0-00144feabdc0.html
Any macro thesis you have for the markets just throw it out of the window. To believe people will act rationally at this time seems futile. The last time true irrationality prevailed was back in 2008. It was when house of representatives failed to pass TARP the first time. The clowns watched as the market cascaded down and still voted NO. This time it is the Germans turn to say NIEN. It is not rational to burn your house down for spite, but that seems to be the logic going around.