Been There, Done That

Yes, I recognize the deja vu. About one year ago I began reallocating assets to reflect a more inflationary posture. That posture lasted only a few months. Last summer's debt ceiling debate coupled with the EU debacle squelched my incremental inflationary expectations, and I peeled off risk positions in favor of a more balanced posture.

Fast forward to now. Once again I find myself adding long exposure in lieu of a tape that seems to be taking the Fed's "0% till 2014" promise to heart.

Will this action once again prove temporary in a world that's drowning in a debt bubble that wants to deflate? Not sure, but currently my actions need to express a perceived uptick in the odds of Big Inflation on the horizon.

position in SPX

Portugal Debt Hammered Again

Portugal credit spreads are widening significantly this am. Ten yr CDS now pricing in over 70% chance of default.

For better or worse, I kicked much of my long exposure (mostly precious metals) last Friday and entered today's session about 10% net short via equity index ETFs.

position in silver, SPX

Treasury Yields Not Following Stocks

Usually, when market participants are ready to take on risk, they sell bonds and buy stocks. When bonds get sold, their yields go higher. Thus, higher stock prices and bond yields are often positively correlated.

Not this time--at least so far.

As stocks have lifted over the past few weeks, bond yields have not done the same. Ten yr Treasury yields are approaching mid December lows at ~1.8%.

This suggests that there is still lots of deleveraging behind the scenes--investors are swapping risky assets (perhaps assets grounded in Europe) for the safety in US Treasuries.

Stock bulls will argue that this is a positive. "Imagine what will happen to stocks when this pocket of 'de-risking' is past. Demand for stocks will swamp supply!"

Stock bears will argue that this is a negative. "Imagine what will happen to equities when this pocket of stock buying is past. Supply of stocks will swamp demand!"

And so it goes...

position in SPX

More Gold Weakness

Action in precious metals continues ugly. New lows for the move today. Peering thru a longer time horizon lens, however, finds the yellow metal just now touching its multi-year uptrend line--a defined risk set-up for bullish traders.

One apparent takeaway from a macro perspective is that gold is not buying the thesis that the financial system is reliquifying--particularly w.r.t. the EU. Instead it is behaving like a wave of deleveraging, deflation in in the cards.

position in GLD

Euro Rumblings

Am continuing to pick up chatter like this that the situation in Europe is worse than appears. The EU version of TARP, the Long Term Refinancing Operations (LTRO), has seen a commensurate jump in bank funds with the ECB Deposit Facility to a record high half trillion euros.

The implication is that interbank lending in Euro is largely frozen. Banks are instead choosing to keep funds w/ the central bank.

Deja vu pangs here, as this is very reminiscent of the risk averse behavior we saw stateside in 2008.

Which probably shouldn't be surprising. After all, the situations are largely the same. Risk seeking behavior and easy credit ran up massive debt and leverage. Now risk appetites are waning. And price declines threaten leverage systems with insolvency.

position in SPX

Hypothecation and Re-Hypothecation

The MF Global meltdown has brought the words 'hypothecation' and 're-hypothecation' to the forefront. Hypothecation is the relatively common situation where a buyer pledges collateral to secure a debt. The borrower retains ownership of the collateral, but in the 'hypothetical' case that the borrower defaults, then the creditor can take possession of the collateral.

In the US, the right of a creditor to take ownership of collateral if the debtor defaults is called a lien.

The lion's share of home mortgages reflect hypothecation. The home 'buyer' pledges the property to be purchased as collateral to secure a mortgage from a lender. Until the house is paid off, the creditor retains the right to take possession of the property if the borrower fails to keep up with mortgage payments.

Re-hypothecation occurs when financial entities pledge collateral that has already been posted by clients to support their own borrowing and trading. If a broker dealer such as MF Global puts up assets held by clients in 'margin accounts' as collateral to, say, speculate in Euro sovereign bonds, then this broker dealer would be engaging in re-hypothecation.

The immediate consequence of re-hypothecation is that it increases systemic leverage. More assets can be borrowed and controlled with less amounts of underlying equity.

As we noted many times on these pages, leverage becomes problematic when price moves against you. The higher the leverage, the smaller the change in price necessary to wipe you out.

Thus, when Euro bonds tanked over the past few months, MF Global was wiped out.

In the case where leverage is built on re-hypothecation, then the question becomes one of property rights. Whose property is lost when MF Global was wiped out? If re-hypothecation is in fact a legal aspect of a contract (e.g., a client of MF Global agrees that a condition of maintaining a 'margin account' at the firm is that holdings can be re-hypothecated for MF's own trading endeavors), then it is the client, not the firm, that is on the hook.

Thus, clients of MF Global may be out billions of dollars...

More Bass Thoughts

A couple of interviews w/ Kyle Bass that I have yet to chew fully thru. Similar themes to recent commentary. The end of ponzi in Japan, EU on fire, dysfunctional US govt. One new dimension was his bullish take on Canada--which is tempered by his bearishness elsewhere which will spill over in a negative way to the Knucks.

Interesting stat: value of bank assets worldwide: $87 trillion. Value of bank assets in Europe: $40 trillion. Euro bank balance sheets are 3x levered as the US.

When asked why ECB won't just print the debt whole, Bass said "Your question should be do they print before or after they default. In my opinion, they have to just print afterward because the number that they're going to have to print is so large that they all know this going in."

Not sure I understand exactly what he's saying here. Perhaps the transcript that I'm reading is out of context, and I'll know more once I watch the actual interview.

Hussman's Hard Negative

Another weekly letter by John Hussman that contains several nuggets of insight. Right off the bat, he makes it clear that conditions have turned decisively negative, in his view.

The current situation is "characterized by an extremely unfavorable ensemble of conditions across valuations, sentiment, economic factors, and other conditions. Current conditions cluster with periods such as May 1962, October 1973, July 2001, and December 2007, all of which produced 10-20% market losses in extremely short order."

Dr J notes the increasing disparity between the leading indicators that his firm and ECRI tracks, which now signal an extremely high probability of US recession, and the prognostications of mainstream forecasters and pundits.

He notes some exchange between a Bloomber interviewer and ECRI's, Lakshman Achuthan:

Bloomber interviewer: [ECRI recently made] a recession call. What happened?
Achuthan: It's happening.

Suggests significant cognitive dissonance out there regarding recession chances.

He also notes that the EU summit last week did (and can do) little to avert the central condition of credit crisis: solvency. Solvency is a shortfall between money owed and the resources needed to credibly repay it. Emphasis on 'credibly.' Printing money to pay back debts in devalued currency is not a credible strategy--at least in the eyes of creditors...

John suggests that perhaps one credible means for relieving stress in the EU is for countries to issue convertible sovereign bonds as they roll debt. The bonds would be convertible into the currency of the issuer at the option of the issuing government. Those countries with shaky fiscal houses would be required to pay a significant premium in order to compensate bond buyers for the commensurate risk.

Over time, John suggests, convertible debt might relieve the acute pressure that has built in the EU system. EU members would need to achieve sufficient financial credibility to remain in the EU system, lest they be subject to huge premiums on debt issued. The need for questionable bureaucratic enforcement mechanisms would be reduced. John suggests, "If the system can be saved, it will be saved" under such an arrangement.

One problem, of course, is that the significant discount that many EU countries currently enjoy by issuing debt under the implicit backing of the EU umbrella would vanish. Those countries would be forced to pay up and/or get their fiscal houses in order.

Market forces hate moral hazard...

position in SPX

Gold Moving Lower

Never got off a comment last week on the head-and-shoulders (bearish) pattern setting up in gold. This morning gold is down nearly $50, which essentially validates the 'dandruff.'

Why the thrust downward in the yellow metal? Not sure, cookie, as there is no 'obvious' gold-related news on the tape. Over the weekend, however, there were some rumblings that last week's EU summit outcomes 'did not go far enough' in resolving the debt crisis. Swap spreads are generally widening today, with Greek spreads crossing the 10,000 bps mark--implying a 100% chance of default.

Am starting to sense that gold may be a leading indicator of another round of 'risk off' in the markets. Added to my short equity position this am, and may do more in the upcoming sessions depending on how things unfold.

position in GLD, SPX

Kyle Bass Macro Discussion

After a very interesting exchange last year, Kyle Bass returned for another insightful panel discussion this year (the actual discussion starts about 3 mins in).

I follow my fair share of macro discourse. I find the thoughts presented here as among the most interesting that I've heard. Bass' grasp of the sovereign debt and leverage situation is on a different level than most.

He is convinced that a EU crack up is imminent. From a silver lining standpoint, he suggests that, after observing the pending Euro collapse from front row seats, US policymakers might actually be stunned enough to proactively reverse course. Interesting thought.

On the other hand, he notes that capital flight into US Treasuries might lull policy makers into thinking that there is actually no crisis in our future.

In any event, this 1+ hr dialogue is worth your time. Personally, I plan to take it in a couple more times in the next few days.

position in USD, SPX

Bail Out Mentality

Another sage letter by Dr J. In the front half he makes a compelling argument for a recession given the position of his forward looking indicators.

In the back half he discusses the EU situation given last week's 'coordinated' move by central banks. He reminds once again that the issue is one of solvency rather than of liquidity. Last week's coordinated dollar swap program is a short term measure aimed at boosting liquidity.

To remedy the solvency problem, it is likely that either banks fail or non-bank holders of EU debt must take haircuts. Thus far, no one wants to do that.

John ends with a section called "We represent the Lollipop Guild." His thoughts here are so wonderfully collected that I want to capture them here in their entirety:

"Frankly, I am concerned that Wall Street is becoming little more than a glorified crack house. Day after day, the sole focus of Wall Street is on more sugar, stronger sugar, Big Bazookas of sugar, unlimited sugar, and anything that will get somebody to deliver the sugar faster. This is like offering a lollipop to quiet down a 2-year old throwing a tantrum, and expecting that the result will be fewer tantrums.

"What we have increasingly observed over the past decade is nothing but the gradual destruction of the ability of the financial markets to allocate capital for the benefit of future growth. By preventing the natural discipline of the markets to impose losses on the poor stewards of capital, and to impose interest rates high enough to force debtors to allocate the capital usefully, the world's policy makers are increasingly wrecking the prospects for long-term economic growth. The world's standard of living (what we can consumer for the work we do) is intimately tied to its productivity (what we can produce for the work we do). That productivity requires scarce savings to be allocated to productive physical capital, and to productive human capital (primarily education).

"Nietzsche famously said, 'What does not kill me makes me stronger.' The corollary is 'What constantly rescues me makes me weaker.' The world will only stop looking for bailouts when policy makers stop handing them out."

Re-read until you understand.

The Infuence of Today's Events on Inflation

As noted in this morning's post, central banks got out the bazookas today in an attempt to blow away systemic deflationary forces that are driving Euro and US banks toward insolvency.

On the surface, the concerted central bank actions are clearly inflationary.

This post on zerohedge w/ Peter Schiff comments captures it well. The snippet at the end of the post REALLY captures it well:

"...this is merely the beginning as more and more inflationary actions have to be undertaken by central banks to save banks from being crushed by untenable debt loads. Whether they succeed in overturning the deflationary tsunami is unknown. What is certain is that they will bring fiat currencies to the [brink] of viability (and beyond) in trying."

As the snippet notes, the big question is whether this collective action will work. In late 2008, the Fed got out the fire hose of liquidity to stem the Lehman blowup. After a sharp relief rally on the news, however, markets resumed their downward path as the deflationary forces were not to be denied.

Hard not to wonder whether the same set up might not be in play here. Yes, the collective bazooka exceeds the power of the Fed's firehose. But the deflationary forces are more global in nature this time around.

Peter Schiff suggests that this is the time to load up on gold. That may turn out to be the case. Heck, gold popped 40 handles today.

But the other side of the trade is that the market forces pressing against the intervention are deflationary in nature.

And it's generally not nice to fool Mother Nature.

position in SPX, gold

Central Banks Announce Coordinated Measures

This morning central banks around the world announced coordinated measures to enhance global financial system liquidity. Coordinated measures like this imply that central bankers see something severely wrong with the global financial system.

Their perceptions of systemic probs are correct, although as usual they are behind the curve.

Unfortunately, the planned approach--i.e., 'more liquidity'--does little to remedy the underlying problem, which is one of insolvency.

Nonetheless, the news jacked markets around the world. Domestic stock markets have opened about 2% higher. Gold jumped $30 on the money printing spectre.

My inclination is to 'fade' (read: sell) this news and will be looking for an opportunity to add to short side exposure.

position in SPX, gold

Durable Rally, or Short Term Relief?

If we were to assign news-related causes to today' 2-3% stock market rally, it would probably be a blend of better than expected Black Friday sales plus the spectre of (another) Euro bailout. Of course, we learned today that a) the IMF had no Italian bailout program in motion, and b) last week's retail sales numbers may be greatly exaggerated.

So perhaps today's move is just one more rally to blow off some near term selling pressure.

Technically, an upside move 'works' to SPX 1220.

Other technical evidence, however, is not in synch with a sustained upside move. After an early move lower, Treasuries recovered most of the day's losses. Bank stocks gave up a big chunk of their early gains. The dollar also closed near even after early selling. Oil closed near its lows.

Hard not to view these 'divergences' with some skepticism about the prospects for big upside from here. Time will tell, of course.

Personally, I did a whole lot of nuttin' today. Will likely put back on some of the incremental short exposure ditched last week should prices continue higher toward 1220. Other than that, I continue to be active in the physical metals market, buying both gold and silver.

position in SPX, gold, silver

Bid Wanted Bunds

Germany experienced a 'bids wanted' situation in their bond auction last nite. The country could not get off more than 1/3 of its 10 yr notes.

Now that the best house in a bad neighborhood is having trouble getting credit, hard not to wonder how distant a Euro might implosion be...

Flag Pattern Resolved

Last week's question about which way the pennant pattern in major market indexes would break has been answered. The pattern has resolved to the downside.

The reason being assigned to the rhyme this morning is the budget supercommittee's (gotta like that term) failure to come to an agreement over $1.2 trillion in spending cuts. No deal inked by Wed means across-the-board cuts of like amount commencing in 2013.

This sets up the 2012 elections as a referendum on Big Govt.

Of course, other issues are weighing markets as well. Europe is still on fire, and fallout from the meltdown of MF global is wreaking havoc in commodity markets.

Personally, am leaning slightly net long--about 5-7% of liquid assets. In other words, the value of long positions (primarily commodities) outweights the value of short positions (SPX index short) by a small amount.

Should stock slippage continue another 30 SPX handles or so, I'll start looking to cover some of my short position (support resides in SPX 1120-1140 range). With precious metals getting slapped around today (gold and silver both off 3-4%), am itching to add to those positions as well.

positions in SPX, gold, silver

Widening LIBOR Spreads

Credit default swap (CDS) spreads have been widening in the LIBOR market. The gray line below constitutes CDS spreads of banks participating in the interbank lending markets.

Levels now exceed Lehman 2008 levels.

The gist: acute concern about the solvency of LIBOR centric banks.

More Italian Turmoil

Turmoil is increasing in Italy. Yesterday a major London clearing house raise margin requirements on Italian sovereign debt, sparking a wave of bond selling. Longer dated Italian sovereign debt is marking new lows this am. Commensurately, Italian swap spreads are blowing out.

Italy PM Berlusconi is rumored to be stepping down soon. My buddy Fil shares some thoughts on the consequences.

Markets around the world are listening to some chin music as a result. Stateside markets have opened down a coupla percent.

position in SPX

Pressure Rising in Italy

Italy continues to look like the next EU hotspot. Italian sovereign debt is marking new lows this am. Chatter is getting louder that the Italian prime minister Berlusconi and his administration are on the way out.

Contacts from my network that know the situation suggest that income administrations are likely to make Berlusconi look like the austerity king...

Last Week's Euro Plan Explained

Wondering about the plan hatched last wk in the euro zone? This explains it pretty well.

Another 'debt w/ more debt' proposal...