Have a break... buy some S*** Schatz

While the market's attention has been focused squarely on QE2 and currency wars, quietly bubbling underneath the surface has been the significant tightening of Eurozone financial conditions, with the EUR TWI up about 7% in the past month and money market rates up about 40bps (in EONIA) over the same period. TMM's arch-nemesis Darth Weber has struck many a blow to those who have been either short EUR or long the front-ends, with his persistent protestations (subsequently slapped down by Baron von Trichet) that the toxic waste dumped by Club Med on the ECB's balance sheet should promptly be sent to Sellafield. At the same time, numerous ECB members have warned that banks should not rely or become addicted to the ECB's liquidity programmes in the form of the unlimited allotments, and so the banks listened, last month's 3m LTRO had no take up. "Hurrah! The European banking system is OK! The crisis is over!", the Eurostriches claimed. But it all looks to TMM to have been something of a fuck up, given the subsequent squeeze in EONIA. Not to mention the 5%-odd contraction in the ECB's balance sheet over that same period...

Now TMM totally get the German strength story, but find it difficult to believe that this will continue as the US is slowing, and certainly not while the rest of the Eurozone is undergoing a large fiscal adjustment. The feedback mechanisms with the banking system are material, and at a time where peripheral bonds still don't look too healthy, a tightening of financial conditions is just going to end in tears in TMM's view. A more realistic reason for these moves, the Team believe, is that the banks behaved liked good little bunnies and didn't bid for cash, then subsequently discovered that there was actually a lot less cash available than they expected, and that they'd have to pay up for it. In addition, the September LTRO matured on Christmas Eve, which is not a particularly great time for liquidity to roll off when the bank's Treasury departments would rather be doing the last minute shopping for the kids. Whatever the reason, it's clear that the liquidity situation has become somewhat dire (see chart below, average current account holdings in the current maintenance period - orange line) and EONIA (white line) has spiked higher, causing something of a sell-off in the front-end.

TMM have learned over the years that trying to pick up positions in the front end of Europe usually ends up with Darth Weber removing their fingers with his light saber, and to this point they have had their hands securely tied behind their backs. But with the October LTRO next week, there are grounds to expect a large take-up: EONIA is high, Euribor is above 1%, and the period of the operation covers the year-turn, a time when funding is often difficult, so Treasury managers prefer to cover their turn-funding in advance. If, as TMM expect, take up is high, then EONIA should begin to fall off and the downside pressure on the European front-end should reduce. Dec10 Euribor (chart below - brown line) is pricing 3m rates at 1.15%, now even if EONIA hits 1%, that puts 3m Euribor at about 1.3%, so the downside is pretty small there. But the juice in Schatz looks to be bigger, sitting at 1% and at the bottom of the trend channel.

A cheeky long in the normally shit Schatz with a tight stop looks like good risk reward to us.

Twenty IFs

It's one of those days today when its hard to get ones thoughts straight and TMM wondered whether a different version of 20 Questions would be in order to lighten our mood so they would like to ask their readers 20 "Ifs"

1. If you had a thousand ounces of gold in coin in your sock drawer would you:(a) gloat, (b) sell it, or (c) debate the size and strength of the sock drawer.
2. If you had to chose the most apt word or phrase from the list below for current markets which would it be: destroy, deal or unleash destruction, unleash the hurricane, nuke ruin, ruinate, bring to ruin, lay in ruins, play or raise hob with; throw into disorder, upheave; wreck, wrack, shipwreck; damn, seal the doom of, condemn, confound; devastate, desolate, waste, lay waste, ravage, havoc, wreak havoc, despoil, depredate; vandalize; decimate; devour, consume, engorge, gobble, gobble up, swallow up; gut, gut with fire, incinerate, vaporize, ravage with fire and sword; dissolve, lyse.
   
3. If a coach breaks down on a three lane highway in London at rush hour do you: (a) quickly tow it out of the way with your police Land Rover, (b) filter traffic past it whilst waiting for a tow truck, or (c) close the whole road down and divert all traffic. (TIP: If you are Kent Police making the choice last night, you go for (c).
4. If you were a central banker, which one would you be? (or ARE you, if you are reading this).
5. If you were a policy maker which one would you be? (and as per above).
6. If you were given a small Caribbean island would you: (a) retire to it, (b) set up an offshore haven for Hedge funds, (c) establish a bank, or (d) try and recreate a Jurassic park (combination of (b) & (c)).
7. If you had to chose between owning a kilo of the following which would you choose: (a) Yttrium, (b) Lithium, ( c) Germanium, or (d) an "A" Class.
8. If you had to take one of the following jobs which one would you chose:(a) banker, (b) estate (realty) agent, (c) Fed Chairman, or (d) road sweeper for a London Local Council.
9. If a face can launch a thousand ships, whose face would you then most like to park them on?
10. If you were a placard waver outside the upcoming G20, what would your placard say?
    
11. If you had to riot in protest over upcoming spending cuts, which country's riots would you choose?
12. If you were are a South east Asian equities fund manager are you currently: (a) on the beach, (b) retired, (c) buying a new house with your wife, or (d) remembering the Asian crisis and absolutely terrified of what happened last time you felt like this.
13. If you were an equity salesperson in Japan (paid in USDs) , once you're done with work you are:(a) living off Raman and cheese given how bonuses are looking for this year, (b) leaving the country, or (c) selling yourself at a gentleman's establishment in Ginza.
14. If you could corner one market, what would it be: (a) silver, (b) rare earth metals, (c) cabbage patch dolls, or (d) cocoa
15. If you were to stretch the surface area of your lungs over a tennis court: (a) they would only cover half of it, (b) they would easily exceed the area of the court, (c) you would die, (d) Health & Safety 13b has a clause forbidding it.
16. If you have a roaring hangover you would: (a) call in sick, (b) come in on time, consume bacon butties and coffee, then do as little as possible telling folks you are working on a special project, (c) arrange a huge lunch with a broker or client and get long again, or (d) you don't get hangovers because you are a reformed alcoholic who is now a workaholic instead and has no tolerance for your staff EVER doing anything but work.
17. If you ran fixed income trading at an investment bank and regulators and clients wanted to move derivatives trading on-exchange to reduce systemic risk and increase transparency, you would: (a) agree, and accept that your business will shrink due to increased competition and transparency, but hey, never mind it's all about having a free and transparent market, right? All in the greater good. (b) Try and confuse the politicians by coming up with some bullshit argument about how banks are in a unique position to provide liquidity, and that it is already a free market and that doing this would actually reduce transparency and competition. We need to keep all the spread business we can. (c) Wait, didn't you work with us before? This is NOT how this is meant to go down. You are screwing this up for everyone, Gary. Or (d) Fuck them, give me my bonus.
18. If you traded OTC markets and a technology company tried to bring together you and others in your product area in order to create a new centralised electronic market for trading your product, would you: (a) say, "Wow, what a brilliant idea, this will improve transparency and liquidity and really improve the market", (b) note what happened to Spot FX traders when EBS came online and think "there's no way they're taking my broker lunches away and replacing them with a computer with no expense account" and utterly refuse to trade on the new system. Or (c) Fuck them, give me my bonus.
19. If you were a hedge fund manager who has had a bad year, you see strikes in Europe are mounting, with the French firing tear gas at school children, the Portuguese can't get agreement to pass their budget and peripheral bonds still trade like Lehman stock. Do you: (a) Sell EURUSD because Europe's falling apart and Europe needs looser financial conditions, (b) To hell with macroeconomics, buy EURUSD because it's trending up and you need to make some cash before Dec 31, (c) shut up shop because you'll never make your high water mark back and start a new fund, or (d) QEQEQEQEQEQEQEQEQE I cant hear the question I've got my fingers in my ears QEQEQEQEQE.
20. And of course.... If you think china will ever stop taking the piss with FX, when would that be ? a) never.

I bought a Chevy Vega, but I want it to be a Mercedes

We have woken up ths morning to find our desks covered in "relax, don't worry, the correction is over" pieces. But TMM think too many technical supports have cracked so we are not jumping on this renewed USD sell fest. There is too much relief at the relief. Instead we are waiting for the still-overweight droids to respond to their rolling momentum models and continue to buy USDs back. Even if Voldemort and his death eaters are currently happy to take the other side. So whilst waiting for the second showing of the "path of most pain" TMM will have a look at a subject we have thus far kept pretty quiet on. The whole Mortgage-gate thing. And this headline yesterday was just too much to let it go:

BOFA CEO MOYNIHAN SAYS BANK WILL PROTECT SHAREHOLDERS AGAINST MORTGAGE INVESTORS WHO SAY "I BOUGHT A CHEVY VEGA, BUT I WANT IT TO BE A MERCEDES"

TMM is led to believe by the mortgage experts that losses related to put-backs could come as high as $100bn, but a good chunk - perhaps 50% of GSE put-backs - of these losses have already been taken. In the grand scheme of things, that is not a particularly large number (anyone remember the time when a $2bn loss would move Spooz 2%...?! How things have changed...), and unlikely to result in further capital needs at the banks. But TMM, like many others, was particularly surprised to see that the NY Fed, along with PIMCO, is attempting to put-back a good chunk of mortgages to Bank of America. Now, this is quite a big deal as far as TMM are concerned, as not only have the two largest buyers of mortgages decided to try and get some money back, but one of them is the Fed. Apologies for the cliché, but don't fight the Fed. BoA is going to take a bath on this. But, as above, that's not the real problem here, as this is just transferring cash from one group to another.

The *real* problem, in TMM's view, is the impact upon the securitisation machine going forward. Now, after the tumult of the past few years, the machine was not really in great shape anyway. TMM suspect that the legal and administrative nightmare that has arisen will result in significant changes to the originate-to-distribute model above and beyond those that have already been implements post-crisis. Securitisation was conceived because it was thought that it would (a) reduce the risk to investors by providing embedded diversification, and (b) allow banks to move assets off balance sheet in order to extend more credit without being exposed to the existing loans. Well it turns out that it has failed on both fronts, both in the form of concentrated losses, and the complex paperwork attached to securitisation resulting in loans coming back on balance sheet at Par. It doesn't look so smart now, does it?

That's not to say securitisation is a bad thing, it has clearly had the intended benefits, just not to the degree to which originally conceived. But going forward, it seems that an additional administrative overhead as a result of Mortgage-gate will be put on the process, slowing the machine down and reducing the amount of credit extended. To TMM, that sounds like the Velocity of Money is going to take a further hit at a time when it has already fallen hard as result of the crisis. TMM have generally been pretty optimistic in terms of the amount of deleveraging needed, and the amount of progress made to date, but this gives cause to re-asses. The below chart shows the logarithm of the ratio of debt outstanding to M2 for Households (white line), Household Mortgage debt (brown line) and Corporate (yellow line). Post DotCom crash, corporates deleveraged aggressively and, as evidenced by the very large amount of cash held on balance sheets, are underleveraged with respect to the long-run trend. As the story goes, households just kept leveraging at unsustainable rates and have a lot to do. Of course, the amount of deleveraging is determined by how much of the financial innovation over the past 30yrs has permanently affected the velocity of money, and how much of that is gone forever more.

TMM can see four potential scenarios, with current market expectations lying somewhere in between numbers 1) and 2):

1. The jump in household leverage post 2001 was purely due to the shadow banking system and related mortgage bubble. If it is only that portion of velocity that is being unwound, then eyeballing the below chart, there is probably another ~10% to go, and the post-Smithsonian Agreement trend (see chart below, green line)) is probably intact. This is the optimistic scenario.
2. The originate-to-distribute model is severely impaired, there is a disintermediation of credit led by banks moving away from securitisation as their primary means of extending credit. The velocity of money falls further and the financial system moves to a hybrid securitisation plus more European-style bank-based one. In this scenario, it is reasonable to conclude that much of the developments in credit markets since the mid-1990s are reversed and the sustainable ratio for household debt moves down towards the pre-1994 trend (see chart below, red line), which implies something like a further 25% fall in household leverage. This is the bearish scenario.
3. On top of the above, households develop an aversion to debt, Glass-Stegal returns either explicitly, or by default as a result of bank behaviour. Virtually all the innovation gains of the past 30yrs are wiped out and the economy turns Japanese. The ratio falls towards its pre-1983 trendline (see chart below, white line), by about 33%. This is the uber-bearish scenario of the Roubinis of the World.
4. But TMM think there is another scenario, that will be music to the Gold Bugs' ears. Prior to the 1971 Smithsonian agreement, the Gold Exchange Standard effectively limited credit extension and the velocity of money. One of the more conspiracy-related extensions of the current chatter regarding a global agreement on currencies is that the QE enacted by the Fed will eventually become a permanent part of their balance sheet. The argument goes that policymakers want Gold to go up to $2500 at which point the Gold on the Fed's balance sheet will be re-valued, and the currency backed by 1/3rd Gold as part of a basket, i.e. - the monetary system moves back to something like it was pre-1971. Now under the rigidities of such a monetary system, it might be expected that the sustainable ratio would have to fall to the pre-1971 trend (pink line), by something like 40%. Of course, as a result of the QE being permanent, much of this adjustment will have been made by the denominator of the equation, rather than the numerator...

...and then TMM took off their Tin Foil Beanies...

Back to Mortgage-gate. TMM think that the ultimate scenario lies somewhere between 1) and 2), but closer to the former than the latter. The trouble is that the repercussions of Mortgage-gate are to move us a little closer to the second scenario. In that respect, at least, scandal is something of a growth shock.

Bubble Bubble Toil and Trouble

There is a *lot* of talk going around the market of bubbles these days. The FT is making a lot of noise about bubbles in EM which frankly we could have written ourselves:

“The degree of euphoria surrounding some emerging economies is already troubling. The Indian and Indonesian stock markets are trading at price earnings ratios of over 40 times, based on ten-year average earnings. You would surely need a hundred years of fortitude to buy Mexico’s recently-issued 100-year bond at a yield of 5.6 per cent. Bubble and bust in China, on which the world is now so dependent for growth and optimism, would likely tank the commodities markets, set off a second round of deflation, and end the emerging markets boom in the most spectacular way possible.”

That, of course, is hardly the only one they are positing, others include:

Gold (here and here),

Farms,

Online gaming,

Etc, etc.

TMM are finding plenty of anecdotal evidence these days from positioning in BRL forwards, AUD and other carry currencies and, conversely, the amount of effort central banks and governments in these countries are putting into vain efforts to slow appreciation here. To wit, look at the efforts of Brazil here, South Africa’s towel throwing here, to say nothing of Korea, Japan and the Panda in the room, China.

That being said, while valuation is often a good guide its generally a shocking indicator for timing. Many equity markets are now historically expensive (Southeast Asia, India, list goes on) and EM local FX yields continue to get ground down by the weight of capital flows. Short of putting a 100% tax on all interest and capital gains from their bonds, it’s hard to see exactly what they can do in a world this starved of carry. Once again, while TMM are leaning

to the short side now this kind of navel gazing doesn’t appear to have an obvious resolution: leaning against the CBs makes a lot of sense and while the equities aren’t cheap so long as you aren’t limit long exporters you won’t have to come into work one Monday, see “Plaza II” on your screens and have 15% of your book facing a world in which their FX is 15% higher and their net income margins just went negative in perpetuity.

To that end, TMM are holding off a bit on the anti-bubble trade obvious positions and going for slightly more subtle and less volatile crosses – short AUDSGD, short EURCHF are a lot less hair raising than USD crosses for now. However, we have found one corner of the market that has now conclusively jumped the shark – rare earth metals.

Rare earth metals have been covered extensively elsewhere, but a wiki is not a bad place to start. The long and the short of this market is this: these elements are crucial in a number of applications for which they make up almost none of the cost. As a result, demand is pretty inelastic and buyers will take what they can for what they can and are not all that fussed about pricing, hence the market is very much a supply side driven game.

The supply side has been in the news a lot because China has recently worked out that it owns about 85% of world production and has decided to start flexing its muscles, particularly with respect to Japan where Hitachi Metals is from. See the production history below:

Hitachi has the patent on neodymium-boron magnets which are used for just about everything and which require neodymium, a rare earth metal. In an effort to move more manufacturing for high-tech products to China and probably due to no small amount of Japan bear-baiting China has restricted exports of these products.

TMM have one thing to say: bad move. Putting on our consulting/industrial organization hats for just one second if you 1) own a market 2) have customers that couldn’t care less about pricing within reason why would you cut them off and give them no choice but to create competitors? This kind of behavior is the quintessence of short term greedy which may work at a hedge fund but hardly makes for great strategic thinking. Cue the ramp in rare earth metals like Cerium seen below:

From what TMM understands has made the likes of the hedge fund / commods trading houses like Trafigura, Glencore, and Red Kite very happy these days. Not that equity punters haven’t had a good time with it, see Lynas Corp, an emerging Australian producer seen below:

The only problem with this trade is this: if prices stay even vaguely close to these levels for an extended period of time then every single prospective mine in this space WILL get built. Additionally, after the Chinese experience it seems that end users of these products are very much inclined to throw in the towel on buying at spot and instead vertically integrate by buying a deposit at an earlier stage of development for less. As most industrial organization and antitrust experts could tell you there isn’t much difference between a monopoly and an oligopoly in terms of pricing especially when their cash costs are much the same. You might not get cut off, but you will get gouged.

To that end, TMM are calling out those who value these companies assuming current spot metal prices for what they are: idiots. The mother of all squeezes for physical in this space does not translate to permanently higher prices and while there are no futures or ETFs for these metals those piling into LYC and the like are asking for trouble. TMM’s informal poll of the Asian metals and equities trader space finds this position to not be incredibly crowded with a large number of momentum monkeys and not the kind of guys you like to see in these trades, i.e,. - the guys who trade physical. TMM instead prefers to play the takeout game and judging by recent price action in the likes of Greenland Minerals and Energy, we aren’t far from wrong.

Big deposit held by junior in need of funding is a much better story than big deposit held by funded mid cap that is already in development for the likes of Hitachi.

As we go to press, China have offered another of their pre-G20 offerings with a rate rise. Now we may not see this do anything more than give them a negotiating feather, considering its effect on commodities and Chinese shares, it may just be enough to help us deflate the rare earth metals bubble.

Rummaging in the Toybox

We might have just set a new record for the amount of time the market has been able to focus on just one subject, but at last the Attention Deficit and Hyperactivity Disorder kids are restless. It's looking unlikely that they will be able to maintain such QE focus for the 2 weeks running up to the FOMC, and they are looking for new toys.

So what's in the ADHD market kids' toybox?

The new mortgage scandals - A new version of an old toy - like computer controlled Lego. This is interesting but not good enough on its own to shock the market. In fact it may well suit policy. You take the banks (who after their disgraceful display of two fingers to the world with their 2009 profits need a public slap) and stitch them up with a "Kerviel"-type financial penalty hanging over their heads. You then either arrange to loosen the noose around their necks in exchange for more responsible behaviour OR you insist that they do indeed empty their coffers to feed the starving populace and then use any further QE as a life-support system for them as they cope with that together with Basel III. This effectively means that any new QE goes to Joe Public end-user instead of getting locked up in corporate balance sheets. Neat, however it is once again the over-profligate borrower who gets bailed out at the expense of the cautious saver.

Plaza 2 - 1980s classic Cabbage patch kids. While the market is rife with chat that November's G20 meeting will yield a Seoul Accord, TMM just cannot see it given that the man who woke up the World's media to the idea of a currency war, Senhor Mantega, is apparently not going to be attending. Now, whether or not this is a US/China/Europe issue, whereby the rest of Asia will just follow China's lead, is irrelevant. The G7 ceded the lead in Global Policymaking to the G20 and, what with the BRIC craze, it seems very unlikely that such a monumentally important policy move would happen without the Brazilian contingent. Of course when the trade wars do boot off, we are waiting to buy every "next door" country possible, as the likes of Mexico fit the last screw in otherwise Chinese goods, label them "Made in Mexico" and ship North. There is no better business than acting as a middle man between rich folks who hate each other.

Europe - last toy to be played with, never properly put away, with pieces now hidden under the sofas and rugs. A pet frustration here is that the eurocrap has successfully been swept under the US QE carpet, but now is a perfect time for someone to ask "what's that smell"? Can the market really ignore 1.2 million people on the streets of France, fuel supplies depleting and Charles De Gaulle airport under threat? Well yes, they obviously can, as the market felt it was Trichet's comments effectively isolating Weber that were more influential. But as we have mentioned before the French students always get an "A" in rioting and are normally forgiven these days with patriotic sighs of "Ahhh, fond memories of 1968, let them have the fun we did." Germany must be wetting themselves in mirth as they see the own goals around them while they go on to print ever more encouraging data.

Gold - The Meccano at the bottom of the box, been there forever, you get excited about building it into something, only to find half of the necessary bits are missing and it collapses. God forbid we say anything on gold. We know what happens. We trust that the FT journos who have been pumping out "gold bubble" stories since Friday have had their names changed and moved to safe houses to avoid the hail of AK47 bullets, tins of spam, beans and bottled water that will be flying their way.

China - Scrabble. Picking real words from random letters. Comfortingly familiar and always good for a rainy day. We sometimes think that Chinese officials just use a "word bag" to come up with their statements. We just tried it and got " Policy Wen yes US higher no FX Chinese interests steady correct". See? Almost a Reuters headline!

But perhaps this market is even more ADHD than even we expected and, after looking in the toybox, gets instantly distracted again and rediscovers the QE game on the floor. Price action so far today seems to suggest this may be the case.

Picture worth a thousand words

As Macro Man referred to his progeny as his Macro boys, so Team Macro Man also have their own pack of brats. Who we will now on refer to as the Macro Minors. We were rather impressed when one of said Macro Minors, with perfectly topical timing (and also possibly an eye on the Frieze Art Fair), created this (click to enlarge):

Good Trips and Bad Trips in Macro

TMM can’t help but notice that with FX moves like this all reasonable expectations or predictions of price levels makes discussing commodity target prices or inflation pretty surreal. It’s a mathematical fact that if the dollar goes to zero then silver in dollars goes to infinity and for the meantime the dollar debasement theme song appears to be Primal Scream's "Don't Fight It, Feel It".



As one astute market observer pointed out in a recent Bloomberg chat “it's like teenagers with a bottle of vodka in the park”. Quite. Despite all the fun of playing this game, certain members of TMM are having a recurring dream where they are on the train on the way to school and fall asleep. When they wake up they are at the last stop and the train is full of Terminators and you are John Connor.


Having played some of the spivvier metals some of TMM are taking their cash off the table since these charts look awfully CTA heavy. Similarly the price action in some previously dormant gold names gives us pause: sure it was a value proposition a month ago, but 40% in a month? Come on.


So if dollar debasement/long gold and precious metals feel a bit crowded where do you go? The problem is that the “lean against Asian Central Banks” trade has run really hard and the legislative action has already ratcheted up. Thailand has imposed taxes on local FX government bonds’ income payments, and look at the chart below: its as if everyone woke up post the euro crisis and decided to load the boat on Asian carry. Indonesian 20 year, Thai 20 year and the Asia Dividend yield index from ze Germans have all done exactly the same thing. Returns that haven’t been realized in FX have been made on yield compression, big time.


While equities still look good to ok they might not all do so if the CBs throw in the towel and these currencies are up 10-15%. There are signs of this happening with Russia moving bands yesterday and MAS allowing SGD to strengthen today.

We are also not blind to other catalysts out there to turn some of these acutely overextended trades around. QE we have discussed extensively but no one seems to think it will do much good for anything except asset prices which might give pause to the Beard, especially given what the theme song of the US house is likely to be post midterm elections. We even now have Bill Gross and Medley (allegedly) weighing in on the issue, But much more importantly Mr T has laid down a marker in Gold, with a landmark interview on Bloomberg.

All we need now is a call on EURUSD from Gisele for a full house.

With Ron Paul and his tea bag/party/Dachau re-enactment society/whatever cousins calling for action on China and less of the monetary easing Ben Bernanke is calling for it may not be the most politically prudent move for the Beard to print here if he wants to keep his job. Even some of those Southern Democrats and Freshwater Economists including Hoenig and Fisher on the FOMC are calling “no more”.

Watch this space. TMM are moving to more liquid positions and keeping an eye on well informed Asian CBs – something is up. If the walls start bleeding and we wake up at that last train stop in a carriage full of killer robots we are going to assume that our good macro trip of the last few months is definitively over courtesy of the Beard and/or some deal, however shoddy, on global imbalances.