Monday, October 24, 2011

The Real Contagion Risk

Around here we like to track things from the outside in, as the initial movements at the periphery tend to give us an early warning of when things might go wrong at the center. It is always the marginal country, weakest stock in a sector, or fringe population that gives us the early warning that trouble is afoot. For example, rising food stamp utilization and poverty levels in the US indicate that economic hardship is progressing from the lower socioeconomic levels up towards the center -- that is, from the outside in. That exact pattern is now playing out in Europe, although arguably the earliest trouble was detected with the severe weakness seen in the eastern European countries nearly two years ago.  Because of this tendency for trouble to begin at the periphery before spreading to the center, here at headquarters we spend a disproportionate amount of our time watching junk bonds instead of Treasurys, looking at weak sectors instead of strong ones, and generally spending our time at the edges trying to scout out where there are early signs of trouble that can give us a sense of what's coming next. In this report, we explore the idea that Europe is the canary in the coal mine that tells us it is time to begin preparing for how the world might change if the contagion spreads all the way to US Treasurys (which is mathematically inevitable, in our view).

EURUSD Soars To 1.39 As French-Bund, EFSF Spreads Surge To New All Time Highs

Uh, what is going on? Are French banks selling everything USD-denominated, promptly dumping the USD proceeds, and converting everything into Euros? Someone clearly knows something and is not happy with France, and hence EFSF spreads, as both the OAT-Bund and EFSF spreads have just surged to new records... but it sure isn't the ES which, oblivious as always, just trades with 1.000 correlation to the EURUSD which continues to telegraph precisely the opposite of what most believe. Oh well.

The Miracle On Ice

I am not sure how high stocks can go on the basis of more debt being piled on more debt by the same people who have too much debt. Maybe this round of "all-in" fiscal and monetary irresponsibility will take us to new highs. In any case I don't think we will have fond memories of the "Miracle in Cannes" since no proposals so far do anything to fix the cause of the problem. In fact as those people in society without stocks and without assets realize the government is doing everything it can to push those prices ever further out of their reach, and doing nothing to punish those who were wrong, the disillusionment may give rise to stronger emotions. The "occupy" movement may not know what it wants, it may even disappear after the first snow fall, but more people do have to question a financial system that claims to be managed properly, but is never tested. I heard one great line with the market cap of Hermes passed that of SocGen earlier this year. And that was the fact that SocGen might have a smaller market cap than Hermes, but their employees don't need a discount to shop there.

Another U.S. Sovereign Downgrade Likely By 2011 Year End, Says Merrill

Peripheral And Core Eurozone Yields And Spreads At Widest Since October Equity Lows

Stocks are not the only thing to surge since the October 3 lows. As the chart below shows, yields (and spreads to Bunds) of all Eurozone bonds, both in the core and the periphery, have followed the equity Risk On sentiment diligently (if inversely), and are now at the widest they have been in the past 3 weeks. In other words, contrary to expectations of a mitigation in sovereign risk exhibited by a drop in spreads or yields, or both, following the CDS ban, we have seen precisely the opposite as sovereign risk has soared. But at least it has been accompanied by what continues to be an epic short squeeze, and has thus been masked by the overall market noise. In fact, one can make the argument that in many ways we are seeing the same response that we saw back in the US in advance of various monetization episodes, as it is becoming increasingly clear that it is the sovereigns themselves that are the risky assets, while corporates across the board must be saved at all costs by the ECB, the Fed or both. To purists wondering how it is possible to have a risk transfer of this magnitude in a continent in which the central bank does not have the same market levitation capabilities as the Fed (the ECB essentially needs a Bundestag approval for all its decisions going forward) we wish we had some insight.

Copper Jumps More Than 3 Standard Deviations On Largest 2-Day Rally Since March 09

Presented with little comment - aside from a snark nod to Trichet's much-heralded price-stability platform - Copper (at current levels) looks set to make its largest two-day rally since MAR09 with a shift well over three standard deviations from long-run means. Its hard to comprehend a higher USD and still falling SHCOMP along with the perspective that China is a little hot and may need more tightening with this ramp-fest, but then again applying sense to these markets is now nonsense anyway.

GSEs Expand Housing Subsidy Refinance Model Further, Making It Eligible To Virtually Anyone

Earlier today, the FHFA announced yet another expansion to its attempt to make near-record low mortgage payments a pervasive concept (via the Home Affordable Refinance Program or HARP), and pad retailers' bottom lines courtesy of subsidy bailouts of the GSE capital shortfall payments. The core of the announced transitions to HARP revolve around allowing borrowers to refinance mortgages regardless of how underwater homes are. Of note is the "enhancement" which removes "the current 125 percent LTV ceiling for fixed-rate mortgages backed by Fannie Mae and Freddie Mac." In other words, one can have negative equity equal to the full amount of the loan or more, and still be able to refinance into current record low mortgage rates (something which last week's near record drop in MBA refi rates of -17% may not be too optimistic on). That said, considering HARP's abysmal success record to date, with just 894,000 borrowers having refinanced using this subsidy program (considering anywhere between a third and half of all US mortgages are underwater), and since it is far more economic to be delinquent on one's loans than to refinance and actually have to pay something out of pocket in these here USS of A, we expect even this latest revision to be a massive failure. In fact, the only data that matters is the public announcement on November 3 and 4th of how many tens of billions in retail "top line" the GSEs will need to be funded for by the US Treasury, because at this point one thing is all too clear: the nationalized US mortgage industry, in which ever fewer people actually make any cash payments, is nothing but a massive subsidy pass thru vehicle for domestic retailer operations.


EMU: A Flightless, Awkward, And Bumbling Region

As usual, JPMorgan's Michael Cembalest cuts to the wick of the problems facing European leaders. This time with a rather sad analogy to that head-in-the-sand abomination of a bird called the emu. The Economic & Monetary Union (EMU) and its plethora of finance ministers, leaders, and bankers appears more and more similar to its aviary analogy. Cembalest notes, Europe’s long-awaited sovereign and bank bailout package will soon attempt liftoff; we will know more after yet another summit on Wednesday. There are flaws that may weigh this emu down, as annotated in the picture below. Why is this so important? Bank recaps in Sweden (‘92), the US (’92, ‘08), Japan (’99) and Asia (’98) were close to marking the bottom of the equity market cycle….but were not designed using the equivalent of the “Goal Seek” function in Microsoft Excel.

Why you should want the Federal Reserve to fail
"We have seen this plan again and again the past three years..." 


The Ron Paul "Meet the Press" interview you shouldn't miss
"When you give an Austrian/libertarian the chance to explain his case, it's a beautiful thing..." 

Top economist Hussman: Stocks are prepared for the coming recession
"Recession-linked bear markets don't end before the recession even begins..." 

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