Weekly Strategic Plan 09102012

Liquidity Cycle
This week was all about Draghi and his plan. Very little was done early in the week and then Thursday the ECB President spoke and markets had lift off. Once again the Liquidity Cycle Indicator had been reluctant to move up with the SP Index but rocketed higher when the hope of aggressive policy action arose. Action is reminiscent of the first LTRO announcement in December 2011, and again at the end of July 2012 when Draghi and others spoke of the irreversibility of the EuroCurrency. The big plan Draghi revealed will be discussed more in some of the articles toward the back end of this letter. But a couple of things are clear. First the market place wants to put piles of low yielding cash type assets at risk and will do so with little provocation. Second there is going to be more liquidity available if Draghi, Rajoy, Hollande, Samaras etc. have their way, and they will. Last week also China pitch in with a big infrastructure program producing a rally in the market there. Only thing putting a damper on the market was the disappointing Payrolls data Friday morning. Though the market managed to absorb that news and still maintain the advance.
The week ahead brings two more heavily anticipated events: the September FOMC meeting with a prospect of a QE type program reveal and the German Court decision on the constitutionality of ECB bailout efforts. The case for FOMC action at this meeting is bolstered a bit by the fact the European policy proposal is on the table and has had a positive reception so far. This frees Bernanke from the worry of European policy moves to which he might have to react. Bernanke is also known to be more concerned with deflation risks than inflation risk because of more proven tools for addressing an inflation problem. Mediocre job growth and this past months shrinking of hours worked offer cover for additional stimulus efforts. The German court decision is critically important of course as a negative decision would certainly throw a spanner in the works. I suspect the careful wording of the language of the Draghi plan as short term intervention for purpose of currency stability is designed specifically to slip between the cracks of German law. This is reminiscent of Clinton administration Treasury Secretary Robert Rubins justification for use of dollar stabilization funds as aid to Mexico during the Latin American banking crisis. There is a long history of using weasel words to evade the intention of existing law. Legal behavior is such an annoyance to the average politician. Those events will be the important drivers of action this week so I try to keep the letter a bit shorter this week, but, first a few other charts illustrating the plurality in the action.
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Equity Market Ranker:
Sector Grid: All sectors up on the week.
Volatility Environment
August left almost all of these markets in neutral or quiet mode.
Index Volatility:
Commodity Prices and Volatility Tables
Articles and Commentary

I am going to break off a bit earlier to bring impressions from others during this past week. The first is from David Kotok of Cumberland Advisors.
In Europe, we continue to witness this game of lights on and lights off. We watch moral hazard increase with each action. And we watch economies shrinking as countries avoid reforms, defer the reduction of expenditures, and impose higher taxes. The politicians are doing the reverse of what is needed to contain the crisis. Until they emphasize growth in the private sector, this downward spiral will continue. Europe is in recession, and it is getting worse. The newest ECB program is another can kick. It may buy some time. It uses monetary policy to address fiscal problems. It may delude markets, as it did in the short-covering rally. The OMT lacks headlights that could be turned on to achieve clarity. That is revealed on close examination of the nuances. Jens Weidmann is correct.
ECB, OMT: Nuances and Fireflies Outright Monetary Transactions (OMT) is the name of the newest program launched by the European Central Bank (ECB). If you havent read about it, if you dont care about it, dont waste any more time reading this commentary. Nuance 1. The ECB now views sovereign debt instruments with three years left to maturity as cash equivalents. There is a reason behind this strange definition; we discuss it in Nuance number 2. Under OMT, a promise to pay you in euro banknotes three years from now is viewed as the same as the banknote today. The adjusting process is the nominal interest rate on the seasoned and market-trading note. That interest rate will be manipulated by the ECB to something lower than market forces would set. That manipulation will be performed by the central bank issuer of the banknotes. Technically, it will be implemented by the 17 national central banks (NCB) that make up the euro system. The nuance is in the direct admission of this concept. By declaring this policy Mario Draghi has moved the policy needle to the extreme left. The ECB will disregard the creditworthiness of the sovereign issuer. The ECB standard is already down to a BBB-level rating. The ECB has bent its rules many times. Investors must ask how this latest move ratchets up moral hazard. They must guess when and where the presumed increase in moral hazard risk will evidence itself. Nuance 2. The ECB publicly commits to a parity claim with the private creditors. Here the ECB is admitting that the previous assertion of a senior claim in the case of the Greek default created unintended negative consequences which the ECB must now repair. In the case of Greece, the collective action clause retroactively changed the terms of a sovereign bond of Greece. The CAC was used to stiff the private-sector holders of Greek debt. Prior to that arrangement, the ECB had manipulated its creditor position to a senior status. The result was to widen the spreads on Spanish, Portuguese, and other weaker eurozone credits. Market agents concluded that the European powers would stiff them again if things deteriorated. With this OMT action of denying seniority, the ECB is trying to cure a Fool me once, fool me twice folly. An additional nuance here is that the forthcoming ESM rules state that, starting January 1, 2013, all eurozone sovereign debt issued with greater than one-year maturity will have identical collective action clauses. Thus the ECB is positioning in advance of that rule and trying to manipulate the specific market in advance of the ESM. That leads to nuance number 3. Nuance 3. Conditionality is the new buzzword. It has replaced the previous ECB construct used with Greece. Greece deteriorated ahead of changes in ECB policy actions. In each tragic step of Greek restatement, credit downgrade, spread widening, etc., the ECB acted after the fact. It kept amending the rules to permit Greece more time for misbehavior. The cost of this moral hazard increase has been severe. ECB policy-making was backward-looking. With conditionality, the ECB will require a country to request assistance and thereupon submit to review, supervision, and agreedupon austerity measures. The ECB says its purchases of weaker-credit, 3-year-maturity debt will occur only after the sovereign has requested help. This, too, is a new form of central banking. It changes the rules. Sovereigns now need to determine if they are going to submit to conditions that are externally imposed. They will try to pre-negotiate the outcome. Spain is the candidate under scrutiny now. Investors need to determine how they will position on this uncertainty. Does the promise of ECB intervention keep Spanish rates lower than they would otherwise be, thus enabling Spain to avoid conditionality? Or defer it? We shall see. Is there a future unintended consequence that is going to result in a market shock? An example is Spain waiting too long to make adjustments and reforms, then encountering an accelerating downward spiral in its economy. Note that Spanish banks have been bleeding from capital flight. The Spanish central bank is now using Emergency Liquidity Assistance (ELA) to prevent bank failures. That happened and continues to happen in Greece. We shall see. Nuance 4. The Bundesbank publicly dissented to the new ECB program. Its president, Jens Weidmann, declared the ECB move tantamount to financing governments by printing banknotes. Germany has only one vote in the ECB governing council decision, but note that Germany is the largest capital key in the eurozone. It is 27% of the weight and therefore incurs 27% of the cost of any failed ECB action. France is second at 20%, Italy third at 18%, and Spain fourth at 12%. Also note that as a country gets into trouble and requests help, its share of the capital exposure to EFSF and ESM guarantees is reduced to zero. That is consistent. How can a Greece, which cannot pay, guarantee anything? So far Greece, Ireland, and Portugal are on this zero list. That leaves the other 14 eurozone members more exposed. The recalculation to date has raised Germany to 29%, while Spain is up to 12.75%. If Spain requests aid and drops to zero, the recalculation among the remaining 13 eurozone states will be large. Weidmann is rightfully worried. Where does this lead? We have labeled the European sovereign debt saga a dance of the fireflies. Why? Fireflies dance in the dark. They create a mosaic, an appearance. Turn on the headlights and they stop. The image you then see is much clearer. Turn off the headlights and they resume their alluring but unpredictable dance. Headlights are the metaphor for unencumbered market forces. In a recent (August 15, 2012) Cato working paper entitled World Hyperinflations, co-authors Steve Hanke and Nicholas Krus document 56 episodes of monetary policy running amuck. The first was in France in 1795-6. Germany was 1922-3. Greece was 1941-5. About 40% of the episodes were in Europe. Jens Weidmann knows his history.
Super Mario Cocks the Bazooka
The strong reaction of risky assets in response to the ECB unveiling its new OMT programme (Outright Monetary Transactions) may seem odd at first. After all and despite the ECB outlining potentially unlimited bond purchases the bazooka was not fired, but merely cocked. Still, there is plenty to suggest that this will indeed be a game changer in so far as goes the fact that the ECB now seems to stand unconditionally behind backing the euro. Draghis comment that journalists would have to guess the identity of the lone dissenter on the governing board was almost comical. After Axel Weber left the ECB and despite Weidemanns ongoing quibbles in the press against the ECB, the anti-inflation crowd and the Bundesbank itself have been steadily pushed into the periphery of eurozone monetary policy making.
In that sense, the market response and follow up Friday morning is logical. A grave tail risk now seems to have been contained and the extent to which risk asset markets were pricing such tail risks, there is now room for re-rating prices. However, a more pertinent point is that the ECB is now, by far, the most aggressive central bank in the world in terms of providing stimulus and acting as a counterparty or actual buyer in private and sovereign securities markets. It is important to understand the basic dynamic here. Potentially unlimited purchases of government bonds means exactly what is says on the tin, namely the potential for an unlimited expansion of the ECBs balance sheet.
Initially of course, the ECB will do nothing. Deploying OMT requires conditionality and more specifically such conditionality needs to be attached to the official rescue programmes put in place through the EU structures (ESM/EFSF) and/or a EU/IMF Troika programme. However, it is noteworthy to consider that Portugal may be the first beneficiary of OMT not only because the country is so far complying nicely with its Troika programme but also because it is a market whose size is perfectly suited for a trial run of the OMT. Needless to say, the Portuguese yield curve had a strong reaction to the ECB meeting.
China bulls have spent the entire summer waiting for stimulus moves from the Chinese leadership. A few even occurred but, none have been the big blockbuster green light the bulls have wanted. Last week did get an announcement of a large new infrastructure program. This was not 2008 large but it is something. The US drought along with troubles in India, Russian and other crops this year has heightened fear of food inflation and that is a sensitive matter in China. Consequently Chinese leaders are being prudent. But here is a little encouraging news in this chart.
The next logical step to expect would then be for Spain and Italy to ask for the bailout which would make them eligible for OMT intervention, but the issue remains that neither Spain nor Italy feel that they need to abide to the same degree of conditionality as e.g. in Greece or Portugal. However, Draghi has the made process considerably easier by now making redemption strictly conditional on a Troika programme. Beyond the issue of conditionality, the following issues are important to emphasize and highlights that the ECB has moved a big step further down the road of outright monitisation of eurozone government liabilities. - Purchases are going to be unlimited and despite the ECB noting that such purchases may be terminated on non-compliance with EU/IMF macroeconomic stability conditionality we very much doubt that OMT purchases can be suspended once they begin. - Purchases are said to be fully sterilised which in ECB jargon means that the ECB will drain liquidity from its open market operations by taking in 7d, 14d or longer maturity deposits. Still, the popular notion that this does not expand the ECBs balance sheet is wrong. The ECBs balance sheet will be expanded one for one with OMT purchases, but the composition of the liability side will change so that high powered money (overnight reserves) is exchanged for longer term deposits. This, in theory, means that the effect on the money supply is neutral. We would add two points here. Firstly, it is unclear to us that 7d deposits represents a meaningful difference from overnight reserves in adding to the money supply and secondly, the ECB may very well fail to attract enough bids for deposits once wholesale purchases of Spanish and Italian bonds kick in. ECB sterilisation has failed before. - Collateral criteria further reduced. It is surprising to us that this issue is not getting more attention as the road is now clear for the ECB to take unprecedented market risk in all manners and kinds of debt securities issued in the eurozone. Investors should think back to the initial open market operations conducted by the ECB back in 2008 where the ECB had very strict rating requirements for the securities that would be accepted as collateral. That era is now over and the ECB is now effectively ready to accept anything (with the exception of Greek sovereign bonds). The ECB is consequently now willing to accept government guaranteed debt securities from countries under Troika programmes as well as non-EUR denominated securities. Our view is that this is specifically targeted to help Spanish and Italian financial institutions and to avoid the usage of ELAs in said countries. The implication for the real economy are difficult to gauge, but the implications for inflation are clear. The ECB has now fully committed itself not only to saving the euro at any cost, but also to provide unlimited to support for government bond markets. The sequence of events here is logical as ECB intervention requires that countries abide to the official EU conditions and thus what we are seeing is merely one more step towards full fiscal union unanimously backed its central bank.
The next chart shows more detail and overlaid with the Shanghai Index.
Australia: The Unlucky Country Australia has been described as the lucky country, but it is running out of luck and has a terrible combination of fundamental factors. In fact, Australia reminds us in many ways of the housing bubbles in the UK, Spain and Ireland. In each case, the country experienced a banking crisis. Australian growth has been dependent on two huge bubbles: a domestic housing market that is one of the most overvalued in the world and a reliance on the Chinese fixed asset investment craze. Despite extraordinary commodity exports, Australia has run current account deficits and has a terrible international investment position. A substantially weaker currency in Australia is inevitable given fundamental factors. Over sized banks dependent on external financing, a bursting housing bubble and a slowing Chinese economy are all fundamental factors which are likely to weigh on the currency. As we explain, a weaker currency can either come in the form of the Reserve Bank of Australia (RBA) reducing interest rates or a balance of payment-like crisis in which foreigners pull funding from the banking sector. In both cases, the RBA would likely have to expand domestic liquidity substantially to prop up the banking system. The burden of Target2 falls on Germany. When is enough enough? Please visit Variant Perceptions website for the full version of the report. > Australia is a classic case of the Dutch Disease. The Dutch Disease denotes the loss of competitiveness in the tradable manufacturing and industrial sector as a result of a resource/commodity boom which leads to an overvalued real exchange rate. In Australia, the mining sector has crowded out almost all other sectors of the economy and also funnelled credit and liquidity into a housing bubble in the real estate sector. > Australia net external debt levels resemble those seen in the European periphery; the currency is fundamentally vulnerable. Australia has been running a persistent current account deficit since 1980 and the countrys negative net international investment position is one of the largest in the world. On this background, the strong currency makes no sense and fundamentally the currency is very vulnerable to capital flight from the banking system. > Australian banks and corporates rely heavily on foreign funding; the RBA will have to provide liquidity through LTROs. Structural global deleveraging and stop-go flows add volatility for Australian banks. As the housing market continues to correct, it may be difficult for Australian banks to fund themselves. Lowering interest rates will hurt the margins of the banks, and the RBA will likely be forced into domestic liquidity operations to prop up its banks. > Two options to weaken the currency, lower rates or a balance of a payments crisis. The Australian currency will weaken in one or two ways. Either the RBA gradually reduces interest rates to accommodate a structurally slowing economy and a relative end to the mining boom or the economy will suffer from a balance of payment crisis as external financing dries up due to the decline in the terms of trade exposing the negative current account. > Australias commodity sector is tied to a structurally slowing Chinese economy. The commodity sector remains a force to be reckoned with in Australia and will remain cyclically tied to China. Still, the Chinese economy is structurally slowing down and this will impact the growth rate of mining and resource related activities in China. Australia is likely sitting on significant overcapacity in the mining sector which will be difficult to transfer to other sectors. > The Australian consumer is overlevered, but demographics are relatively positive going forward. The correction in the Australian housing market is far from over and the Australian households remain overlevered. Yet, the savings rate has already increased substantially and in the long run demographics look far more robust than in eg Europe. > Stay long government bonds in Australia on convergence towards low interest rates in the rest of the OECD. Whether it be as a result of the RBA gradually cutting rates to reflect slower growth or because foreigners start bidding up Australian bonds due to carry, yields are going down in Australia. We continue to like being long government bonds in Australia. > Our long-term technical buy signal on Australian equities is in effect, but avoid miners and banks. We currently have a long term technical buy signal in effect on Australian equities as a result of the recent sharp sell-off. This is usually followed by good returns over the next 6 months or so. Although the market cap on the ASX 200 strongly favours overweight in mining and financials (market weight), we would avoid these two sectors and buy into defensives (consumer staples and health care) as well as industrials. > Industrials and manufacturing will outperform on lower interest rates and a weaker currency. The gradual end to Dutch Disease will eventually lead to outperformance of the industrial sector. In the long run, our view is that the Australian equity market cap will re-weight away from mining and financials towards industrials and eventually consumer and retail. > Buy CDS on big four Australian banks. Australian banks remain the weakest link in Australias economy, and they are too big to fail. We like buying CDS on Australian large cap banks as an outright trade or as a hedge against the long-term technical buy signal on Australian equities mentioned above.
From Credit Suisse:
From a big report on Oil by Torbjorn Kjus of DNB Norway.
The excitement over the Draghi plan is the triumph of hope over reality. I understand the need and do expect the markets to use this as a further springboard higher if it sneaks by the German Court decision. Perhaps 2 or 3 months of upside is possible, especially if Uncle Ben and the Feds kick in a little more QE joy juice. But in truth this is merely a shuffling of the deckchairs on the Eurotanic. If this is the whole program, well, then the Euro will be circling the drain again soon. As long as the deal is being applauded stay long the strong equities. Oh and stay with Gold, the Chinese and other central banks (not run by Ivy League Economists) are going to keep accumulating, and so should you. Bruce Lawrence September 9, 2012

Weekly Strategic Plan 09102012

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Weekly Strategic Plan 09102012

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Liquidity Cycle

icmWEEKLY STRATEGIC PLAN

Equity Market Ranker:

Sector Grid: All sectors up on the week.

icmWEEKLY STRATEGIC PLAN

icmWEEKLY STRATEGIC PLAN

Commodity Prices and Volatility Tables

icmWEEKLY STRATEGIC PLAN

icmWEEKLY STRATEGIC PLAN

Articles and Commentary

Super Mario Cocks the Bazooka

icmWEEKLY STRATEGIC PLAN

icmWEEKLY STRATEGIC PLAN

icmWEEKLY STRATEGIC PLAN

From Credit Suisse:

From a big report on Oil by Torbjorn Kjus of DNB Norway.

icmWEEKLY STRATEGIC PLAN

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