Tick By Tick

Merkel and Sarkozy were undoubtedly patting themselves on the back yesterday as they watched equity markets around the world continue their gains based on the optimistic view that the European debt crisis has been resolved by a range of half cut measures.  However, these simple fools need only turn to the bond markets to realise that all is not well in market-land.  Did we see a move in Fixed Income?  Well in the most objective of ways, yes.  But the gains were of such little substance that the real consensus is No.  Has anything changed? Well, not really.  It seems that $2.4tn does not buy you respect in this most hostile of marketplaces.

In fact, what we believe is more likely is that bond yields will continue to grow as investors now doubt the value of the CDS cover that they have bought in order to net off their positions.  As explained on Wednesday, this is likely to have profound effects on distressed sovereign credit globally.  

Looking at the debt markets since, it appears that those "evil short sellers" have decided to pick on Italy as the next country that is set to break into the "danger yield" category, by which we refer to 8% or more (not the widely thought of 6%).   Last Thursday we talked about how Italian yields have retreated from their previous improvements following the commitment by the ECB to purchase bonds in the secondary market.  We also noted that the key number to watch out for would be a 450bp spread between the Bund and BTP.  A figure that currently sits at 379 with improvements being made only on the Bund side of the equation.

"Europas Banken müssen für Griechenland bluten"

or (translated)

"Europe's Banks need to bleed for Greece"

A far cry from "EU reaches Deal of Greek Bonds" published in the UK

I know we keep harping on about it but Leverage is the single biggest threat to the world economy as it stands.  And it looks like the Eurocrats may have just leveraged their banks through their latest act of financial folly.  

To illustrate the situation, we will create a hypothetical example.  It is simplified but please bear with us.  

 Introducing Jeff.  (Hello Jeff!  Hello Everyone!)

Jeff would like to borrow some money to buy a new shed but doesn't currently have the money to pay for it.  However, Jeff believes that by using this new shed, he can start a lawn mowing business that will allow him to pay back the money at a future date as well as create a few jobs.  Great! Jobs.  We need those. 

So we (lets assume 10 of us) lend Jeff the $100 that he needs to buy a shed.  Jeff agrees that he will pay us $1 a year for the next 2 years in interest before giving us the full amount back.  

However, unbeknown to us.  Jeff is actually cooking the books and is using the money to pay his overpaid staff in his window cleaning business.  So now Jeff has spent $100 and not purchased any tangible assets that we could claim if he could not pay.  

Word gets out about Jeff's antics and we are not impressed.  5 of the original lenders want to sell their loans to other investors and offer the debt at 25% discount meaning that the new investors will only pay $75 to the old investors and still receive the $1 interest. 

Only 3 months has passed since the last debt ceiling soap opera and since then, the worlds attention has well and truly been focussed on the actions of Merkel, Lagarde, Trichet and Sarkozy; the rest are merely their for the ride.  There has never been a better demonstration of how not to conduct yourself than the current state of affairs in politics on both sides of the Atlantic, the US resembles a West Side Story kind of situation and Europe is more like a Royal Rumble. 

For those of you who are either too young or too embarrassed to recall the objectives of a Royal Rumble, Wikipedia covers the basics below.  

In simple terms, politicians globally are desperate.  

When one reaches the pure age of around 15, the topics of objectivity and subjectivity are introduced into the educational mix by comparing statements and facts.  From this, we learn that certain things are absolute (e.g. Yes and No) and others a subjective (e.g. I think that a single Monetary Union was a terrible idea) - Oops! I wish my teachers had taught me that example instead of praising the benefits of a singular socio and economic existence.  Anyways, the point is that Politicians deal in subjectivity (or Guess-timation) and markets deal in objectivity.  

A deep rooted issue that is haunting a seminar room in Brussels as we speak.  From the latest we have heard, the "discussions" sound more like a zoo than rational thought, whilst Berlusconi is still  trying to chat up the receptionist (Ok - that bit was "fictional").  Everyone in Finance knows that Europe is skint and no amount of super leveraged hyper sonic bail out package is going to change a thing.  The situation is like saying that Pete Doherty could compete in an Olympic Sprint Final. With the right preparation and attitude, Pete could have made it but now his body is the victim of years of substance abuse and the possibility is impossible.

On the 7th of August, the ECB gave the go ahead for purchases of distressed European sovereign debt in the Secondary Markets via the European Financial Stability Facility. 

The measure was designed to relieve the growing pressure on the government debt market as the effects of European contagion spread.  Driving the yields lower would provide the European Sovereign nations access to credit at lower yields to both fund their existing obligations and their fiscal obligations.  

The move was made as movements in the credit default swaps market and the growing risk of contagion were spooking investors in Spanish and Italian debt, causing a sharp rise in yield.  The key figure that most analysts focus upon is 6%, as at this point, ING reports that Italian interest payments would grow by 18 billion euros by the end of 2015.  The intervention by the ECB caused short term relief in the markets, triggering a 120bp fall in 10 year BTP yields.

The market for Italian debt is the third largest in the world, behind the US and Japan, but the nation has no control of its Monetary Policy.  Italy is effectively Too Big Too Bail if the market was to push yields to unsustainable levels and the likely fall out would bring the world economy to it's knees.  The value of this debt is rapidly approaching 2 trillion euros, 4 times the size of the current EFSF.  

For those well versed in Portfolio Theory and Finance, models and ratios such as the Capital Asset Pricing Model and Sharpe Ratio should be particularly familiar.  They allow an investor to look at a number of factors and determine the risk and return of an asset based on those variables and assess its risk reward pay off when evaluated against other investments.

To quickly explain what we are talking about, we will provide a quick overview:

Capital Asset Pricing Model

Expected Return on Investment = Risk Free Rate + Beta of Investment * (Market Premium)

Sharpe Ratio

= Expected Return - Risk Free Rate/Standard Deviation (Expected Return - Risk Free Rate)

Generally, investors will look for investments with higher Sharpe Ratios and CAPM values.  However, all of these models require a risk free rate; usually the yield on a Treasury Bill or in some cases Bond.  In recent weeks, we have started to question whether such a risk free rate actually exists any more.  

In theory, the debt of any Government that controls its monetary policy is riskless for they are able to print money and pay off the debt if required but historically this has not always been the case.  One must only read Reinhart and Rogoff's "This Time Is Different" to understand what we are talking about.  Or alternatively look at the growth in the Credit Default Swaps market.  

Following the UK September CPI figures published today by The Office of National Statistics, we thought it would be appropriate to bring up stagflation.  Inflations bigger and badder cousin. 

Todays report showed a rise in UK CPI to a record 5.2% that has predominantly been driven by higher commodity prices, especially energy.  To the UK population this is not good news.  Current Economic data points at the following figures:

Stagflation, a term coined by British Politican Iain Macleod, is an economic situation where there is high inflation, high unemployment and slowing economic growth.  Sound familiar.  (Hint: look above)

For a masterpiece discussion on the UK situation we point you to Dr Tim Morgan's work at Tullett Prebon available HERE

LONDON (Reuters) - Britain's economy has stalled and will grow less than expected this year, despite the Bank of England's latest injection of 75 billion pounds to try to stimulate a faltering recovery, forecasters said on Monday.

The Ernst & Young ITEM Club, which bases its quarterly report on finance ministry models, downgraded its 2011 GDP forecasts to 0.9 percent from the 1.4 percent it predicted three months ago.

Growth forecasts for 2012 were cut to 1.5 percent from 2.2 percent and unemployment will keep rising until it peaks at 2.7 million people in Spring 2013, the report said.

The central bank's second round of asset purchases is unlikely to kick start the economy in the face of worries about the euro zone debt crisis and uncertain global demand, according to the ITEM Club's autumn report.

"It's worse than we thought," said Peter Spencer, chief economic advisor to the ITEM Club, sponsored by accounting firm Ernst & Young. "The bright spots in our forecast three months ago -- business investment and exports -- have dimmed to a flicker as uncertainty around Greece and the stability of the euro zone increases."

'CRITICAL JUNCTURE'

Britain's economy has barely grown over the last year and the coalition government and Bank are under mounting pressure to take urgent steps to try to restore growth.

Inflation of nearly 5 percent is squeezing people's living standards as wages rise slowly and unemployment has started to increase again.

In 1988, a young black girl from Cleveland (Ohio) graced our ears with the song "Talking About a Revolution".  That girl was no other than Tracy Chapman.  She warned:

However, Ms Chapman, was far from the first to suggest an uprising by the less privileged in society.  But until now, the world never really took any notice.  Whether in Feudal Britain, the Prairies or within the depths of a Chinese Blogosphere, nobody cared.  Those who did were labelled Socialist or disruptive and their activism would be crushed by the Bourgeoisie with military precision. 

Enter the Internet.  The light speed transfer of ideas and thought that has single handedly redefined a generation and provided every individual with a voice.  An effect that has been so overwhelming that Books, Degrees, Think Tanks and a plethora of other Academic resources have been devoted to it.  

Enter the Age of the Revolution.

On 17 December 2010, a street vendor named Mohamed Bouazizi made the ultimate sacrifice for his cause.  Bouazizi, a street vendor in Tunisia, proceeded to coat himself in Gasoline and set himself on fire after an officer of the state confiscated his produce following prolonged humiliation and harassment.  This act proved to be the ignition switch for what has now been termed, "The Middle Eastern Revolution" which has led to a wave of prominent Middle Eastern officials stepping down from power at the will of the people.    

Last month, we reported that Gordon Brown had made a Gold trade that was so bad, it had cost the UK economy $22.5bn.  

However, we believe that the CEO of Dexia, the failed Benelux bank, may have blown GB's trade out of the water.  The Belgian paper De Standard is reporting that Dexia was bought down by short bund position in Interest Rate Swaps that they "forgot" to hedge, resulting in a single margin call of 46 Billion Euros.  Single handedly bankrupting the bank.  Ouch!

Kyle Bass is one of the chosen few who managed to call the 2008 credit bubble and get in on the CDS trade before the cost exploded.  According to CNBC, Bass was the youngest Senior Managing Director even Bear Stearns' history and after listening to him talk we understand why. 

In this video, Bass talks about the Macro issues affecting todays economy and even drops in some comments about Tick By Tick's favourite topic of loan demand. 

 This video is from the 17th Aug 2010

This morning, the Financial Times published a guest comment by Tim Bond of Odey Asset Management that criticised the long term effects of Quantitive Easing.  To our knowledge, this one of the first mainstream articles in the recent months that has hit back at the long term effect of the failed central bank experiment.  

Although the explanation of long term deflation varies compared with that of Tick By Tick's, our conclusion is very much the same.  QE is a ticking time bomb.  

Bond does a great job of explaining how this cash ends up in the commodity and foreign markets leading to cost push inflation.  We have attached a small excerpt below followed by a link to the full article. 

For the Full Article Click Here

“The market is going to fly” 

 “Sentiment is shifting as uncertainty dissipates amongst investors. Policy makers have taken the right steps to scotch the fear trade, which will improve equity and credit markets. Get ready. This is going to be some rally.”

Chad Morganlander (Stifel Nicolaus & Co) - Opinion on European Economic Measures

Without sounding satirical, one must see the ironic nature to Steve Jobs passing away last week.  The word on the lips of every politician in Anglo America happens to be his surname.  That's right.  Were talking about Jobs.  Or more specifically, the lack of them.  

Unemployment is like a virus, it can strip growth and confidence from an economy faster than one of CERN's Neutrinos .  This age old dilemma has defeated the theories of Keynes, Hayek and a plethora of other economists leaving a trail of destruction in its wake.  One must question why we are able to make a phone that we can talk to, and yet we are unable to create sustainable levels of employment.  

Gordon Brown famously stated that gone are the days of the boom and bust economy - yes, he really did say that - only to later find out that his irresponsible fiscal behaviour bought the former world super power of the UK to its knees begging for more.  Unlike Dickens, the good old folks at the Bank of England obliged.  They're the good guys you see, their favourite activities include debasing sterling, boosting debt and not buying Gold.  

So, what exactly is the issue with jobs?  Well, depending on the sector you represent, the issues vary with magnitude.  Here in the UK, we have serious structural and cultural issues that are becoming increasingly engrained into society as the days role on past.  Before I move onto the real topic of this piece, the US, I believe it is only fair that I elaborate on the statement regarding the UK. 

Mr Durden and his compatriots over at Zerohedge are reporting that another housing disaster is quietly brewing in the US.  Zerohedge points out that, in the last week of September, the new Primex housing index has collapsed following a Fitch report titled, "US Prime RMBS Performance Declines Continue - Negative Equity Drives Weak Performance".   

To read the full article, click HERE

Following the May 6th Flash Crash, caused by a Barclays Capital participate algorithm, the market community has pondered on the costs and benefits of Electronic Execution and more specifically the use of algorithms to execute orders.  Electronic trading is supposed to of increased liquidity and provided a more customisable level of execution for end client, although this may be true, the associated risks with objective mathematical assumptions driving money circulation is only just starting to rear its ugly head. 

The algorithm that BarCap used on May 6th, Participate, is designed to participate in the traded volume throughout the day to achieve near VWAP (volume weighted average price).  In a passive days trading, this can be a very effective strategy and in some circumstances will achieve better results than VWAP specific algorithms built on the technical components of "skill" and "luck".  However, what happens when it all goes wrong?

Enstar - (Zerohedge)

Well, look at the graph for Enstar on the 13th May this year, the stock went from trading at a level of $39 to 1 cent, back up to $38 in just a matter of minutes.  Unless you were one of the lucky few who picked up the stock for 1 cent and subsequently made a 380 000% return in under a minute, you should be concerned.  

Enstar - (Zerohedge)

We fundamentally believe that some algorithmic trading is good for the market, however we have genuine concerns that all of the strategies are becoming to similar which will result in increased volatility and mini Armageddon like events. 

Earlier, this afternoon Zerohedge published a chart to show the true extent of the sell off in financials.  In particular, Morgan Stanley, Citigroup and BOFA were eaten alive.  To put this point in context, if we discount Citi's reverse stock split in Q1 of this year, Citi is now trading at $2.30 a share.  For a company that has almost a quarter of a million staff, this is a worrying stake of affairs.  

The big question…would the US bail out the banks again?  Pictures from yesterday's Wall Street riots and the memories of the last backlash would suggest that this time the banks are so unpopular that they are destined to fail.  Throw a presidential race into the mix and there are sure to be fireworks on Wall Street. 

Meanwhile, our recommended inverse financial ETF returned 6.5% in todays trade.

Jack Ma, founder and CEO of the Alibaba Group, has risen to fame in recent months as his company continues to offer a portal for trade between the East and West.  Ma's idea is simple, open up the world to Asian enterprise and they will come.  In many ways, he has become one of the worlds most successful middlemen as Western enterprises look to utilise the lower production costs in Asia to beef up their margins. 

Ma, up to now, may have been relatively unknown to those outside of his growing empire.  However, speculation is growing that Ma is looking to acquire Yahoo!  A move that will catapult him into the big leagues.  Yahoo! one of the remaining Internet sensations from the new Millennium has seen it's business struggle as users deviate to social media services like Facebook and concentrate their search with Google.  

Yahoo! bought a $1bn stake in Alibaba in 2005 in return for 40% equity of the growing internet sensation.  A stake that is now worth $12.8bn, if figures from Alibaba's latest round of fundraising are to be believed.  Bringing the company within $6bn of Ebay under its new $32bn price tag.  This makes Yahoo!, valued at $16.6bn after Fridays close, an absolute bargain and we are strongly recommending a purchase of the stock.  

Yahoo!, under expelled CEO Bartz, turned down an offer in 2008 from Microsoft that valued the company at $47.5bn.   An offer that we estimate included around $15bn of goodwill.  A bid from Ma, at a third of that value plus the value of the Alibaba stake would send the stock sky high and that is without accounting for the rest of the business that is still operating.