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Flim-Flams Can Work For A While

The thin trading conditions continue to lead to wild swings in these last couple of weeks of the year. In some years, markets just float sideways, with investors more or less content with current allocations. This clearly has not been the case this year. The month of December has already been wild and today’s 3% rally in stocks did nothing to change that trend.

The immediate trigger for today’s rally was a stronger-than-expected Housing Starts number (685k versus expectations for 635k), but in normal times such data would not have as dramatic an effect – especially given the fact that the absolute level of Housing Starts, even with today’s second-highest-print-in-three-years figure, is drastically below the levels of a few years ago (see Chart).

Yay! Big spike in Housing Starts! Right?

German manufacturing data was also strong, in contrast to much recent data off the continent, but also not something that would ordinarily move mountains much less markets.

Bonds sold off sharply (10-year yields up 11bps to 1.92%), while inflation-linked bonds were roughly unchanged (10-year TIPS yields at -0.15%). This produced an impressive 11bps rally in 10-year inflation swaps and breakevens.

And therein lies the hint about what is really behind today’s action, if it has any external motivation at all and is not merely the twitching of a market in coma.

Increasingly, it is dawning on market participants that the recent move by the ECB to offer unlimited quantities of 3-year money to banks to buy domestic sovereign bonds is just the crazy scheme that might work. The effect of it, if it works, is to (a) push the day of reckoning for the EU, which will still come as surely as the sun rises, off by a period of time up to three years, (b) ease the transition from the Euro back to distinct national currencies (because if every bank has loans and assets from their own nation rather than from the whole of the EZ the breakup will be less traumatic for those institutions), and importantly (c) print money, since the ECB giving money to a bank to buy bonds is no different than the ECB directly buying the bonds. Admittedly (c) is only true if the ECB doesn’t sterilize the loans.

And so, after working this through, you get inflation-linked bonds outperforming their nominal counterparts by 11bps.

Now, it is true that the new ECB President has taken pains to declare that “the treaty forbids monetary financing” of governments by the ECB. There seems to be some debate on this topic, but what I have learned over the course of my career (and everyone has been reminded, in spades, over the last few years) is that people in power are all too happy to bend rules or to look the other way when they are being bent, if they believe the ends justifies the means. It looks to me as if by funding banks that then fund governments, Draghi has created enough distance that politicians who want to look the other way anyway, but had previously made strident statements that were hard to back off of, now have some cover to do so. Frankly, it’s nauseating but not surprising.

I have a weird feeling that this idea is just crazy enough to work, because in principle it can’t be pressured too much from external forces. The ECB sends money to banks, who buy high-yielding sovereigns that they pledge to the ECB. The sovereigns continue to sell their bonds to a new and ready market for them, and don’t have to worry about funding themselves in the short-run. The banks increase their leverage still further, but also increase their interest margin and, if they match-fund the sovereign bonds with ECB loans and don’t mark the bonds to market, they won’t have any more earnings volatility than they had. The ECB prints without sounding like it is printing. And everyone is happy, as long as no one blinks.

Cartels are difficult to maintain because there tend to be big incentives to cheat. (OPEC has survived as a cartel mostly because for many years – although it’s questionable if this is still true – the low-cost producer was willing and able to police compliance.) Where are the incentives here? Obviously, the ECB won’t cheat, and the sovereigns will have increased pressure on them to honor their covenant with the banks and work on getting their finances stable since in three years they may really have to raise money on their own merits rather than on the bank of a scheme. What about banks? Here is where I have some mild concerns. If it is good for a bank to take in 3-year funds and buy 3-year sovereign bonds, then is it better for a bank to take in 3-year funds and buy 6-month sovereign bonds ‘just in case’? And I am sure there are other ways for a bank to try and extricate itself from this diabolical compact. Still, it is pretty easy money if everyone in the club plays along.

Spanish 10-year yields have abruptly fallen back to near 5%, which is as low as they have been in 13 months. Italian bondholders are less-impressed (perhaps because the ratio of bank balance sheets to sovereign debt isn’t as good), but 3-year yields are back to 5.58% and 10-year yields at least haven’t gone any higher.

It has been a long-shot bet all year that the EU would find a way to delay this train wreck. They failed in Greece and failed to build a firewall to prevent other countries from circling the drain dramatically and publicly. But it has also been a long shot for many, many years to bet that “the system” would collapse. By rights, after the equity bubble burst in 2000 the country and the world should have entered a deep and prolonged recession to unwind the excesses of the 1980s and 1990s. It didn’t happen, because institutions act to protect themselves (selfish memes!) and so we got outlandishly easy money rather than dealing with the consequences of the years of plenty. In 2008, many of the same institutions acted to avert what they considered disaster, and this time it required cutting some corners such as the central bank guaranteeing and financing toxic waste by means of the creation of a pair of off-balance sheet entities. Hmmm. But I don’t mean to be a scold; I’m just pointing out that it is hard to bet on the ultimate collapse because as the stakes get higher, the scruples of the people tasked with the rescue get lower.

I have a funny feeling we might have reached that moment where the crisis turns aside for a few years until the next, and probably larger, crisis hits. It is harder for me to tell that from where I sit, outside rather than inside of these institutions – in 2008, it was crystal clear exactly when the system had passed the critical point if you were sitting on or near the bank’s funding desk. It is more of a guess for me now.

That being said, it does not imply that it is time to jump into equities – although I am sure some will read my words that way and we could well get a melt-up if my read of the situation is accurate. But stocks remain expensive and the outlook for future earnings if banks are locked in a zombie embrace with their regulators and central bankers is not good. It does seem to support the reflation trade, since part of the deal from the central banks must be that they will keep rates low (the Fed has already promised explicitly to keep them low for two years).

On Wednesday, the main economic data is the Existing Home Sales data. The consensus is for a selling rate for November of 5.05mm units (annualized), but the real story is that the entire series is being revised, and being revised by a large amount. It seems that this is another case where the Cassandras were right. The National Association of Realtors (NAR) has apparently been overstating the sales for years, double-counting sales and making many other “mistakes” (which all turn out to be errors in the direction of increasing the sales count). As much as people complain about government statistics, they are generally compiled by bored civil servants who get no direct benefit it the numbers they produce are high or low. The statistics you should be naturally suspicious of are the ones produced by industry groups. This is a case in point. Flim-flams usually come to light eventually.

The actual numbers are thought to be as much as 20% or more lower than the numbers originally reported. Although this has been reported now for a few days, the data may be shocking and today’s trends may well reverse on the news. It’s what they do after the initial shock that should draw your attention. In thin markets, impulse moves tend to follow through since there aren’t as many ‘value’ players leaning against the prevailing price action. If after an initial selloff in equities (and rally in bonds) on seemingly awful housing numbers the markets reverse, then respect the move…at least, as much as any move in December can be respected.

Categories: Europe
  1. MT
    December 21, 2011 at 4:21 am

    There is no difference in practicality between the Fed’s QE and the ECB’s 3y money. The results are the same, and I’m pretty sure it’s going to at least buy time for growth to pick up, for the Euro countries to sort out who’s in and out and under what terms, and for institutions to prepare for that. This is exactly what was needed and I applaud the ECB for finally figuring it out.

    Don’t be surprised if these 3y loans become rolling loans every 3-6m, and then the proximate cause of current stress is relieved for the foreseeable future.

    I don’t know that I’d be so quick to judge the ‘morality’ or integrity of the various players involved. Did anyone jump on the Fed’s morality for QE1 or QE2 (other than long TIPs traders)? It’s just trickier with the ECB given the factions they have to navigate.

  2. Jim H.
    December 21, 2011 at 8:13 am

    Very insightful commentary! I posted an excerpt at Naked Capitalism, in a comment to the pertinent article ‘Europe Braces for Long Winter.’

    On Monday, with the 30-year T-bone yield briefly falling under 2.80%, I was sorely tempted to short it — weren’t you? After all, the chart said that if the yield couldn’t break the early October low, it had to go the other way. Now we know.

    Coulda, woulda, shoulda. Being an inveterate believer in Santa Claus, I at least had an equities position to benefit from Draghi’s hundreds of LTROs of distilled spirits, which turned a black-crepe wake into a chandelier-swinging holiday wingding.

  3. Lee
    December 21, 2011 at 4:30 pm

    Thanks for sharing your thinking. My brain now thinks that the game will for a lengthy time be almost entirely in treasuries – until we find new, useful stuff to build.

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