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A Time To Refrain From Embracing

Today’s bit of wisdom comes either from Ecclesiastes, or from The Birds (depending on your religious background): to everything there is a season, whether for casting away stones or for gathering them together, whether for embracing or for refraining from embrace.

This too is good market wisdom – and in the current circumstance, it appears it is a time to refrain from embracing. Two sovereign wealth funds have apparently stopped buying European sovereign debt, according to stories out today. One is China’s CIC (which is interesting: I suppose they figure that their pledge to the IMF is more than sufficient exposure to the region! If that is the case, then surely this falls in the category of an unintended consequence!). The other is Norway’s $610bln oil fund, which will actually divest holdings of Eurozone sovereigns. It had held 50% of its total bond holdings in Eurozone sovereigns and has cut (or maybe will cut – the story is unclear) its exposure to under 39%, according to this story on Reuters.

Frankly, if I was another sovereign wealth fund, I would read these stories and wonder whether it is time for me to cut my exposure as well, since I surely don’t want to be the last one out. As I said, perhaps this is a time to refrain from embracing.

That being said, as I wrote on Tuesday “I think it’s likely that European prices will rise at least as fast as US prices” and opined that “I think Europe is going to be catching up to the U.S. in the monetary-profligacy race.” I wrote that, and today a story appeared in Der Spiegel: “Breaking a German Taboo, Bundesbank Prepared to Accept Higher Inflation.” The ECB is already losing its “Bundesbank DNA” since being taken over by Mario Draghi. Now it looks like the Bundesbank itself is losing its singlemindedness when it comes to inflation.

This is a game-changer, obviously, when it comes to inflation in Europe (German inflation carries about a 25% weight in the calculation of Euro inflation) but also when it comes to inflation globally. I noted yesterday that Euro M2 accelerated to a 3.1% pace in the year ended March, and that that was the highest pace since September of 2009. I can’t imagine these two things – an acceptance by Germany of potentially higher inflation, and faster Euro-area money supply growth – are unrelated.

This may or may not be an error. If Germany is acceding to higher inflation because she believes that faster inflation will be a result of faster Euro-area growth, it’s an error since inflation derives from money growth, not real growth. But if Germany is allowing inflation to rise in Germany relative to the rest of the Eurozone, as a way to ‘rebalance’ her economy relative to the Eurozone, then it’s not a bad idea; the only problem is that since Germany doesn’t have a lever to pull on monetary policy that’s separate from the ECB’s lever, I don’t see how they can raise Germany’s inflation rate relative to the other nations. Between countries with flexible currencies, this adjustment happens through the money supply and currency. How do you effect such a ‘rebalancing’ in this case? I don’t know.

Speaking of errors, JP Morgan announced a whopper today after the close. About a month ago, a story circulated about a trader at JP Morgan who had amassed positions in corporate credit-related derivatives that were so large they were affecting the indices of credit risk. Today, JP Morgan revealed that the unit where the trader works (the chief investment office, which is meant to hedge firm-wide risks rather than to take positions) had lost $2bln on synthetic credit instruments. JP Morgan CEO Jamie Dimon said on a call today that the losses could ‘easily get worse,’ implying that the positions remain open for now.

There will be many questions about how the bank amassed a $2bln loss in the short time that has passed since quarter-end, especially given relatively sedate trading in the credit markets. There are both positive and negative fact sets that could apply. On the positive side, we could posit a smart risk-management officer that read those earlier stories and investigated whether the book was being marked at levels that were being affected by the trading of those instruments by the book, or whether they were fairly considering the likely loss in the event of liquidation. Discovering that they were not being marked conservatively, Risk Management and the CEO decided to disclose the loss as soon as they knew it should be. If that is what happened, it would be hard to fault the bank’s disclosure even if you could fault some of their controls. But Dimon is also a pretty crafty fellow, and I can certainly imagine a circumstance where the bank figured “if we announce the loss on the credit hedge now, then when the gain on the other side shows up in the regular earnings we might be able to persuade analysts to treat this as an ‘item.’”

So what I’d want to know if I was a regulator, or a reporter, or an investor, is whether the error here was that the chief investment office departed from its hedging function and made some bad prop trades. If the answer is yes, then I want to know how that happened in large size without senior approval. If the answer is no, then the next question is whether this loss was offset by a gain somewhere in the bank, since it must be a hedge. If the answer to that question is no, then we simply have some stupid hedging. If the answer to that last question is yes, then I want to know why an announcement was made at all because the hedge worked! Sometimes hedges lose money, after all…when the thing being hedged shows a gain.

On Friday, Dallas Fed President Fisher is speaking on the topic of “Too-Big-To-Fail.” How timely.

Also due out on Friday are Michigan Confidence (Consensus: 76.0 from 76.4) and PPI (Consensus: 0.0%/+0.2% ex-food-and-energy), neither of which is an important release. Have a nice weekend.

  1. onebir
    May 11, 2012 at 1:55 am

    “I don’t see how they can raise Germany’s inflation rate relative to the other nations.”
    I think the relatively centralised wage bargaining structure in Germany would make this possible, if the employers federations & unions can be persuaded it’s in their interests.

    • May 11, 2012 at 6:18 am

      True, but I guess I should be a little more explicit. They could do a wage-and-price-controls thing that artificially pushes prices higher – along the lines of what you suggest. But Nixon tried that, and it didn’t change underlying inflation…it just moved it to the period when the caps were removed (in this case, the floors). Didn’t we learn anything from the failure of the USSR when it comes to trying to run a command economy? It just can’t work in the long run.

      • onebir
        May 11, 2012 at 6:35 am

        Wasn’t Nixon going the other way (repressing wages in the face of high inflation?) Surely that’s a bit harder than pushing up everyone’s wages, and letting prices catch up… (Even in Germany!)

      • May 11, 2012 at 6:58 am

        Yes, he was repressing both prices and wages. But I’m not sure there’s much asymmetry. The bottom line was that the real economy said “based on the amount of money out there, prices should be higher,” and they adjusted rapidly once the controls were removed. I suspect that you’ll get a similar result in this case – unless Germany actually becomes less productive in real terms, I doubt they can make a lasting change in the relative terms of trade…of course, that’s just a guess. But what drives the terms of trade ultimately is are relative costs, and if you can’t permanently change the currency it seems to me you’d have to either keep the controls on forever, or change something fundamental in Germany to make it worse.

        By the way, essentially this means that German companies ought to get killed, right? Their costs will go up and they’ll eventually have to raise prices or lose margin, and in the process they’ll lose market share since there will not be an offsetting currency adjustment. Just seems an odd policy.

      • onebir
        May 11, 2012 at 7:09 am

        Isn’t the required asymmetry (downwardly sticky wages & prices) pretty well documented?

        “Just seems an odd policy.”
        Indeed. But that didn’t stop politicians in the peripheral countries basking the fruits of basically just this policy for a decade or two…

        So unless the German public &/ corporate interests are *remarkably* perceptive and long-termist, if the machinery exists for pushing up nominal wages in Germany – of this I’m not sure, since I don’t know the degree of political intervention in the bargaining process – this might something that the politicians could get through. If they really, really want to save the Euro in close to its present form…

      • May 11, 2012 at 7:27 am

        Oh I think they will get it through. Just don’t think it will do anything other than push prices up, at least in the medium-term. And I’m not sure the Euro will last long enough to have it matter, anyway.

        By the way, according to Blinder in “Asking About Prices: A New Approach to Understanding Price Stickiness”, the notion that prices are sticky on the downside is a theory that isn’t supported by econometric evidence (he said Okun first noted this in 1981). In Blinder’s book, he concludes one chapter by saying “In conjunction with the survey results on lags presented in chapter 4, and the paucity of econometric evidence in its favor, it appears that the common assumption that prices are stickier downward than upward should be rejected.” (!!)

        Although it may still be true that wages, at least an individual’s wages, are sticky on the downside, it doesn’t necessarily follow that wages IN AGGREGATE are sticky since you can always fire high-wage workers and higher low-wage workers, although restrictions on this practice certainly slow the process (e.g. unions). But I think there’s a better case for wages than prices.

      • onebir
        May 11, 2012 at 7:49 am

        Germany pushing up its prices while the periphery is in deflation, ought to correct the trade etc imbalances across the Euro area – given time. Which I agree they probably don’t have anyway…

        The book you quoted seems to be… unappreciated (esp given the author!) & well worth a look. I wonder if the emphasis on survey and interview data doesn’t partly explain that. Macroeconomists, policy makers etc seem to distrust ‘surveys’. (Never mind the fact that GDP aka ‘hard data’ is partially concocted from them…)

        Anyway, thanks (especially as the preview on google books looks fairly complete. 🙂

      • May 11, 2012 at 9:27 am

        I tend to be skeptical of surveys as well, but they seemed extremely careful in the construction of this one, and they were administered face-to-face. It’s an interesting book, anyway, … at least for an econ geek. 🙂

  2. Jim H.
    May 11, 2012 at 10:37 am

    Mike — ‘wisdom from the Byrds’ … with a ‘Y’! Perhaps it goes to show that if you remember how to spell bands from the Sixties, then you weren’t there! 😉

    ‘We could posit a smart risk-management officer that read those earlier stories and investigated …’

    Oh man … so JPM’s chief risk officer found out about its derivatives loss the same way we did — by reading about it in the news? All too plausible! After all, that’s how members of Congress find out what they actually passed in those 2,000-page bills, after they’re signed into law.

    • May 11, 2012 at 11:31 am

      Funny, I had a feeling that didn’t look right, but when I did a quick Google search on the lyrics the first result was “The Birds…” I should have looked at the SECOND result too!!! 🙂

  3. bixbubba
    May 11, 2012 at 10:50 am

    Looks like the Michigan Survey had a pretty big impact on the market after all. We’ll see if it holds.

    • bixbubba
      May 11, 2012 at 2:39 pm

      not so much

  4. Lee
    May 11, 2012 at 8:43 pm

    Is JPM the tip of the iceberg and is the iceberg why the Fed-Treasury carry trade exists if it still does?

    • May 12, 2012 at 12:53 am

      I don’t know…hard to tell how prevalent that punting still is. Most shops seem to be discouraging punting. But there seems to have been an awfully lot of hubris there, and some measure of daring the Fed to call shenanigans (recall that they just barely passed the ‘stress test’ in a way that made it look like the stress test passing grade was ‘curved’ so that they would pass). I just think that while JPM may have been one of the strongest banks at one time, it’s certainly not as invulnerable as people seem to think. It’s a long way from JP Morgan and much more Chase these days.

      • Lee
        May 12, 2012 at 1:41 pm

        Thank you. I guess I’m having a hard time understanding how a hedge could get so far out of whack that you call it an egregious error.

      • May 13, 2012 at 2:40 pm

        Fair point! You have to almost put on a hedge the wrong direction to lose that much money (and to call it an ‘egregious error’)!

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