As we started writing this European morning, “another non event day”, we were unfortunately proven right. Trading is very dull, despite the rumors coming out of Europe. The latest being Europe will run joint rescue funds. News flow is now getting pathetic. Market is rallying some, but with the lack of volume we see, it is hardly statistically significant moves we see.
Some charts below, and note how the Dax is underperforming the Stoxx 50.
- In this New Normal economic environment of slow economic growth, high volatility and enormous macro risks — some identifiable, but many unidentifiable — we don’t believe ignoring major downside risks is prudent for equity investors.
- We believe investors are best served by employing a combination of three strategies to actively manage downside risk in equity portfolios to hedge against the risks they can see, and equally importantly, the risks they can’t see.
- Risk management is often a tradeoff, decreasing some risks while increasing or concentrating others. Being humble enough to admit what we don’t or can’t know is important.
Investors were quite excited last week when central banks announced a coordinated reduction in the interest rate for U.S. dollar swap lines. It’s interesting that the more arcane an intervention is, the more excited investors get – maybe because complex-sounding interventions allow Wall Street’s imagination to run wild and substitute for actual understanding.
Very simply, what happened last week was a liquidity operation – essentially, European banks can now borrow dollars for a fraction of a percent less than they previously could. This prevents transactions denominated in dollars from “freezing up” across Europe (since European banks are no longer willing to lend to each other). But it does nothing to address the sovereign debt crisis. It does nothing to make European banks more solvent. All a “swap” is, really, is a loan of X dollars, in return for some number Z euros. At the end of the period, the borrower pays back X dollars, plus some interest, and gets back exactly Z euros. Notably, it doesn’t matter what the actual value of the euro is at the time of repayment. X and Z don’t change. So the Federal Reserve, for example, doesn’t take on any foreign currency risk in this trade. The euros are really nothing but collateral for what otherwise is a simple loan of U.S. dollars.
Meanwhile, we’re seeing various proposals for more complex ways for some institution to buy distressed European debt. The most recent iteration looks for the IMF to buy the debt. But when the IMF buys debt, it takes a senior claim to all other bondholders, and imposes conditions to make sure that their tranche of debt gets repaid (the IMF is emphatically not in the business of providing loans that it doesn’t think it will get back).
A Euro Basis Swap is simply a derivative product that allows the holder in the case of a Euro swap the ability to swap EUR for US dollars.
In simplest terms the more negative the value the greater the demand for USD. As witnessed by the rapid decent the central banks were forced to act when they did to facilitate those no longer able to access USD through normal market operations.
The central bank swap lines allow banks to now work directly with their central banks who in turn swap currencies with each other. Below is a chart that shows the correlation with the Euro basis swap and the USD. Data is limited to one year but you can see the trend is highly correlated (thanks to reader grogan for the Euro data).
For the sake of repeating what needs to be a daily theme we are in a credit driven event that equity will be forced to acknowledge. Watch the EUR and USD for signs of how this trade is developing.
While markets are still trading in a no trend fashion, and the Euro politicians try talking up the market here is a must listen to interview with Rickards, for anyone interested in understanding what is actually playing out in the financial markets. Courtesy Da Silva.
“The likelihood of a collapse[US Dollar, Bond & Financial Markets] is higher than a lot of analysts assume…..therefore we are in very dangerous territory.”
“Ben Bernanke is probably a greater threat to US dollar stability than the Chinese Communist Party,”
and the oops,
“The Fed thinks they’re playing with a thermostat at home–but in reality, they’re playing with a nuclear reactor–and the danger is they melt the thing down”
Full interview click here.
Worries about slowing Asian growth and turbulence in Europe pushed Australia’s central bank to cut its core interest rate on Tuesday, its second reduction in as many months. The Reserve Bank of Australia cut the cash rate by 25 basis points to 4.25 per cent. At its November meeting, the bank also reduced the rate by 25bp, which was its first cut since April 2009. http://www.ft.com/intl/cms/s/0/c1b113bc-1fc4-11e1-9916-00144feabdc0.html#axzz1fdWXUmDY
Commerzbank took steps to strengthen its capital as the German government prepared to reactivate crisis measures that would allow it to inject money into struggling institutions. The bank, Germany’s second-largest by assets, is to generate a one-off capital boost by spending up to €600m to buy back hybrid equity from investors, the first of an expected series of moves to improve its balance sheet that may require government support. http://www.ft.com/intl/cms/s/0/ae81d4be-1f1c-11e1-90aa-00144feabdc0.html#axzz1fdWXUmDY
Wells Fargo, the largest US bank by market value, has sold $1.5bn of five-year senior unsecured notes at 175 basis points over comparable Treasuries, says the FT, underscoring the ability of US banks to secure funding at a time when their European competitors are struggling to raise money. US banks’ cost of funds last quarter dropped 20bp from last year to 0.7 per cent,http://ftalphaville.ft.com/thecut/2011/12/06/781451/wells-fargo-sells-1-5bn-of-unsecured-debt/
Dubai has for the first time raised the prospect of restructuring some bonds next year as the emirate and its state-related companies face a wall of $10bn in debt repayments, writes the FT, citing an anonymous senior government official. The emirate is also pursuing other options, http://ftalphaville.ft.com/thecut/2011/12/06/781551/dubai-eyes-refinancing-10bn-in-2012/
With the EFSF obviously too light to save the Eurozone, the next take needs to be ECB getting involved by expanding the balance sheet aggressively. The ECB needs to get inspiration from the mighty Fed.
The sovereign crisis has spread throughout Europe, and both countries and banks will need to obtain funding. The “normal” market won’t be able to deal with this, so the next step needs to be the ECB getting involved. There is no other way to “fix” the funding of the European mess.
The ECB should provide bilateral loans to the IMF, which would be a part of the bail out package for some the ones who need it (Italy).
So, the IMF (with the help of the ECB, China seems rather silent for now) and the EFSF are to fix the “problem”. Don’t forget, Italy needs to refinance hundreds of billions over the coming few years.
How the credit risk is to be shared, is not clear. One should not expect too much from the EU summit on Friday, especially after S&P’s warning today. The EU leaders have problems solving minor details, and this is simply too big for them to solve by Friday.
The ECB is to announce further measures of how to support bank funding on Thursday. Probably all operations will be extended. With the EU governments not able to agree on much, the ECB’s app 650 billion Euros of liquidity to Banks needs to be increased drastically, short term.
S&P to put all 17 Euro Nations on Downgrade Watch
Goodbye EFSF and welcome a huge expansion of ECB’s Balance sheet, or who’s gonna bail out Europe now?