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

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

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

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...

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...

Greece Balks on Deal

In a move said to have 'blindsided' many, the Greek government has called for a referendum (a.k.a. a vote of confidence) on the bailout plan recently hatched by EU officials.

The word is that the 'voluntary' 50% writedowns on Greek debt may have been palatable to many external holders of Greek debt, but those inside Greece holding their own country's bonds, including Greek banks, don't want to take the haircut. For one, it would render some Greek banks insolvent.

The theme from Wall Street types in my personal circle is that, while they were largely skeptical that the plan put together last week would hold up, they are surprised by how fast it is unraveling.

That surprise is being reflected in markets worldwide. Sovereign debt of many Euro countries like Greece and Italy is getting crushed today. Stock markets are listening to chin music as well. The SPX is down about 2.5% in early trading.

Seems to me that domestic stock markets are in a precarious situation currently. Shorts have been squeezed out, hedgies have been buyin' 'em after feeling 'underinvested, and there has been a general movement toward more 'risk on' out of euphoria that the EU didn't collapse in early Oct.

Perhaps the collapse was merely postponed by a month or so.

From where I sit, if the SPX can't hold 1220 support, then it looks pretty vulnerable for a downside whoosh.

position in SPX

New EU Bailout Scheme

The idea de jour in the EU crisis is to have governments borrow money from the ECB to buy assets (such as Greek bonds) from struggling banks. The vehicle for doing this is the EFSF (European Financial Stabilization Facility), which is a special purpose vehicle (SPV) established in 2010 and backed by EU country guarantees. The EFSF provides assistance to eurozone states in financial difficulty. The EFSF would essentially borrow using their country's assets as collateral.

The size of the borrowings necessary? Perhaps $1-2 trillion...

If this sounds like a version of TARP, then you'd be somewhat correct since the focus would be buying 'troubled assets.' In the case of TARP, however, government funds bought troubled assets from private sector banks. Under the latest EU plan, government money would be levered up with ECB money (more government money) to buy bonds from the same governments on the hook for the EFSF and ECB money to begin with.

How long before Mr Ponzi enters this discussion?

The only way such a program could be marginally effective is if Germany and France absorb an outsized share of the risk--well beyond what they have currently committed to contribute.

Which brings us back to the conclusion we've been reaching for months (here, here). Should Germany decide not to participate, then it all crumbles, cookie.

For today, anyway, markets were willing to look at the glass half full side of the story, with domestic markets up a couple of percent or so on the prospect of a $trillion EU bail out.

position in SPX

Long Bond Yields at All Time Lows

Below is monthly chart of the yield on a ten year Treasury note over the past 20 years. Earlier this month 10 yr yields dropped below 2% for the first time ever.

After the Fed announced Operation Twist this past wk, yields broke lower yet again. They now reside at about 1.8%.

The Fed is trying to buoy economic activity thru borrowing--particularly w.r.t. housing. But anyone with a pulse recognizes that interest rates, which have been at generational lows for months, do not constitute a binding constraint on economic activity here. Economies around the world are already choking on debt and have little appetite for more. The Fed is thus pushing on a string.

Two groups are especially hurt by Fed policy here. Retired people and other savers are having trouble making ends meet as it is becoming impossible to make ends meet by making 1-2% off modest principal. Savings are being gutted by Fed policy. Moreover, low returns on savings are nudging more people into risky assets such as dividend-paying stocks.

Keep in mind that, over time, savings are the driver of higher standard of living as resources set aside are invested in productivity-enhancing technologies.

Pension funds are also significantly impacted by long bond rates. Pensions funds are built on bond portfolios, and these portfolios are returning less and less. Lower bond yields increase pension fund assumptions about future liabilities, thereby creating funding gaps. To close these gaps, pension fund managers can take more risk increasing their allocation towards stocks, or, in the case of corporate pension funds, have the corporate parents write checks out of retained earnings to fund the shortfall. Those checks in turn reduce earnings...

By discouraging saving and encouraging risk taking, current Fed policy serves as a major drag on standard of living.

position in SPX

Long Bond Yields and the Fed

The chart below displays yields on the 10 year T-note over the past 200+ years.

If we were to calculate the standard deviation of interest rates for the first half of the series, and then do the same for the second half, which standard deviation would be higher?

Answer: the second half by a mile. Long bond rates have been significantly more volatile during the past 100 years than during the previous 100.

A key difference between the two periods is the presence of the Federal Reserve. The Fed came into being in 1913, and has been getting progressively more intrusive in markets since then.

Ironically, a primary justification for the Fed was that a central bank was needed to stabilize economies and markets that purportedly were too volatile in their free unregulated states.

The interest rate data above suggest just the opposite. The Fed's presence increases, rather than decreases, volatility in credit markets which, because of credit's centrality to economic activity, spills instability into the entire economic and financial system.

Stated differently, credit markets unhampered by central bank regulation are likely to be more stable, rather than less, stable. How can that not be a boon for economic activity?

no positions 

Widening Euro Credit Spreads (Again)

On the back of failing talks between Greece and EU/IMF officials (and maybe even today's weak US job report), credit spreads are blowing out again in Europe. Greek CDS spreads are once again at records, and Italian and French bonds are also getting hammered.

While it is easy to get distracted by talk of QE3 and the potential for new stimulus packages here in the US, I continue to view Europe as ground zero for synchronized global market probs.

Still adding short side hedge in order to manage risk.

position in SPX

Widening Corporate Spreads

Below shows the current spread between 10 yr B corporates and 10 yr Treasury note. Spread haven't been this wide since early 2009.

Widening spreads imply lower risk appetite (buyers less willing to pay up for lower grade corporate bonds relative to 'risk free' Tresuries).

no positions

Record Low Treasury Yields

Yesterday, 10 yr Treasury yields dipped below 2% for the first time. Investors want out of risk, and are currently seeking perceived safety of longer dated Treasuries (despite the recent US credit downgrade).

In a vaccum, this is deflationary action.

Technically, hard not to wonder whether we're putting in a double bottom here.

Seemingly, if we knife decisively below 2%, then it's a brave new world...

no positions

Big Move in Treasuries

Wow, you don't see moves like this in long bonds every day. Long dated Treasuries are up about 5% in a couple of days.

Suggestive of investors who want to get out of risk in a hurry.

no positions

Strong Treasuries

Largely lost in the drama this week was the rally in long bonds. On Friday, 10 yr Treasury yields hit a new low for the move.

Technically, it appears that a two month head and shoulders pattern has resolved lower.

Bonds could be strong for a number of reasons. One is that bond market investors are not very concerned about a default or about a US credit rating downgrade (otherwise bonds would be selling off). Another is that investors are seeking safety in the midst of domestic and EU fiscal turmoil.

Of course, an alternative view is that domestic bond markets have been so manipulated that no interpretation is possible...

no positions

Old Age and Sovereign Debt Default

Interesting discussion of the negative relationship between the age of a country's population and propensity for sovereign debt default. What many people don't understand about sovereign debt is that it is usually unsecured, meaning that there is no collateral for lenders to claim if the borrower defaults. This is unlike other debt instruments such as mortgages or corporate bonds which are typically backed by real assets.

As such, lending to countries is pretty much dependent on the creditor's assessment of the borrower's ability, or perhaps more importantly the borrower's willingness, to pay.

It is likely that old age reduces willingness to pay. Paying back debt might cut into entitlements that older segments of the population enjoy, such as State provided health care and retirement benefits. People may be less willing to forego those benefits in lieu of using those economic resources to pay back loans.

If the country is too leveraged, however, then the point may be moot. Socialistic systems require ever more economic resources to keep the wheels on the wagon. Credit will be cut off, either thru default or by bond market shut down.

This is the central message of Reinhart and Rogoff (2009).

Reference

Reinhart, C.M. & Rogoff, K.S. 2009. This time is different: Eight centuries of financial folly. Princeton, NJ: Princeton University Press.

A Bubble in AAA Ratings?

Wow, this observation really struck me. From 1990 to 2009, assets with the highest credit rating increased from 20% of all fixed income to 55%. Sovereign debt comprises more than half of all AAA.

This bids an obvious question. In a world where debt and leverage have been dramatically increasing, how is it that more than half of all fixed income can be stamped as essentially risk free?

Perhaps we have outsourced our brains to the ratings agencies.

Personal Asset Allocation Update

Current personal liquid financial asset allocation as we head into the second half of the year. (Haile Fund AA can be found here)

cash 60%

equities 21%

alternative assets 15%

fixed income 4%

Alternative assets include short equity 11% and commodities 4%. Fixed income is short duration.

21% equities + 4% commodities - 11% short equities = 14% net long risky assets

US Money Market Exposure in Europe

Learned via Bill Fleckenstein today that Jim Grant, in his most recent newsletter, has observed that US money market funds have substantial fractions of their assets invested in European bank debt. Many money fund managers have been extending themselves abroad in search of yield, given the Fed's suppression of short rates to essentially zero.

The five largest domestic money market funds (three at Fidelity, one at Vanguard, one at Blackrock) with about $400 billion under management have about 45% of their assets in Euro bank paper.

If a credit crisis commences in Europe on the back of sovereign debt probs, then the spectre is raised that collapsing Euro bank paper could pressure net asset values of US money market funds to the point where they could 'break the buck' (fall below the $1 unit value). This occured to a small degree two years ago here in the US.

The implication is that US investors should make sure that they understand the nature of their cash holdings. Some funds may be FDIC insured. Current insurance amount, which was raised during the recent credit crisis, is $250,000 per depositor per insured bank.

For cash holdings that exceed the insurance limit or that are not covered, then the strategy should be locating the safest principal preserving vehicle possible. For those who are capable, this might mean parking cash in 1 to 3 month T-bills. They yield next to nothing but likely reflect the surest bet on preservation of principal.

Some believe that the US government would intervene should US money market funds begin to feel stress. Based on history, that may be a good bet. It is also one of the reasons why moral hazard is so high among bank depositors. As a class, depositors are largely clueless of the issues discussed here since they figure that the government has their back.