Overview: Credit Markets and Volatility
Credit spreads in the credit derivatives and collateralized mortgage-backed securities indices (CDX and CMBX) have tightened significantly in most cases, indicating that some measure of confidence has returned to the market. BBB, BBB- and BB indices are still extremely distressed and trading near historical low NAV. The asset-backed securities index (ABX) remains highly distressed across the board. Even triple-A-rated ABSs are still down 8 percent from their “roll” value two months ago.
Throughout August, bonds were positively correlated, and equities negatively correlated, to three key factors: the volatility index (VIX); the yen-dollar currency pair, which formed the pillar of the carry trade; and credit spreads in the ABX/CDX/CMBX credit markets. In the first half of August, these three indicators spoke in bearish unison. As of Tuesday of last week, they finally began making some bullish noises; and over the weekend they turned bearish again as the yen surged against the dollar to just above 114 yen per dollar.
Bears Back for Seconds?
Last week, I noted that while my indicators showed that the market had calmed down quite a bit, the market had largely misread Bernanke; that the recent rally was heavily dependent upon that one piece of data; and that once the market discovered that it had misread Bernanke, it would surrender much of its recent rally.
Yesterday, that was exactly what happened. The minutes of the Federal Reserve's August 7 meeting were released to the public, and they showed that the Fed still took inflation more seriously than two years' famine in the land of Wall Street bonuses.
This was also somewhat predictable. Late last week, in the midst of equities' dead-cat bounce, Bernanke signaled that he would go back to minding inflation. Accordingly, Bloomberg, which was earlier running effusive quotations from off-the-record bankers that Helicopter Ben had <s>scrambled the choppers</s> passed his first big test with flying colors, suddenly changed its tone. Hedgies and bankers who had hailed Bernanke's genius the previous week were now whining to Bloomberg that Bernanke “was not prime time.”
Recall from last week's letter that Bernanke had calmed the markets by lowering the largely insignificant four-week discount rate. I noted that this window was almost never used, and the capitalization of loans from that window made it completely irrelevant, and betrayed a profound lack of understanding of Fed operations on the part of the larger market.
About five minutes after I sent out last week's newsletter, the Fed announced that it had gotten four flagship banks to borrow $2 billion using that specific discount window. No single bank that actually needed cash could have used that discount window, as that would only betray weakness on the part of that bank. So the Fed strong-armed four banks into using it. One of them might be seriously hurting underneath, or perhaps the Fed just wants to set a precedent so that other banks can come forward without betraying as much desperation. Either way, others haven't come forward, and the market is once again clamoring for a 50-basis point cut in rates.
The Crisis of Confidence
As also noted in last week's (long) newsletter, Bernanke does not have the freedom to cut rates even if he wanted to. The US dollar, and investment in the United States generally, has lost enormous luster for very significant economic and geopolitical reasons. Add to that the sad fact that Wall Street essentially screwed over foreign banks by stuffing CDOs and other mortgage-backed securities packages with absolute garbage, winked to the ratings agencies to rate them as investment grade, and sold them to credulous foreign investors who made the mistake of trusting Wall Street too much.
Outside investors who have always rolled one eye in exasperation at American policies feel they have been lied to on an institutional scale. And they would be right. Like auto executives and unions in the 1980's, Wall Street felt entitled to paying itself lavishly to export very “subprime” product. Even Bear Stearns's troubles pale in comparison to some European banks, particularly German and probably Spanish ones (Banco Santander?).
If Bernanke caves to Wall Street, the dollar will hemorrhage even more value. Foreigners will be especially screwed yet again. Political saber-rattling and financial hand-wringing aside, Bernanke's prime directive is monetary credibility. Judging from the Fed's own musings as well as self-interest, it would take another major drop (probably to the Dow 11,500 range) before the Fed would cut rates more than 25 basis points.
Thus, I am mildly bullish on the dollar relative to all global currencies except the yen, which I regard as largely unpredictable.
The Golden Conundrum
I don't know why gold has stayed dead in the water during the flight to quality. If the dollar loses value, the price of gold should go up, even after accounting for higher gold supply (which hasn't moved much as far as I know). Previously, I thought that hedge funds were unraveling long positions in gold to meet margin calls stemming from severe losses in other areas. Since commodities funds have encountered some of the worst turbulence of all, that was intuitively logical. However, gold has continued to perform significantly below my expectations. I suspect that some central banks are selling gold, but I cannot find a satisfactory explanation as to why gold has barely budged from 675.
Because the correlation between gold (in dollars) and the value of the dollar itself has apparently vanished, I can only return to my hunch that many funds are being forced to sell gold to meet unrelated margin calls.
Quant 'Misbehavior,' Revisited
Quant funds complained yesterday that equity correlations had begun 'misbehaving' again. In other words, correlations across supposedly uncorrelated asset classes had spiked again, forcing more margin calls, forcing more selling across previously unrelated asset classes. You can never trust financial media too much – clever fund managers always have incentives to submit phony rumors to stoke market activity – but if correlations start spiking again, another herd of quant funds will make a beeline for the market guillotine, and financials will get pummeled yet again.
Sarkozy's Squandered Mandate
American conservatives have a term for it: “the real Greenhouse Effect,” in which conservative Supreme Court justices betray their principles to please the (leftist) Washington, DC political historian establishment, epitomized by New York Times Supreme Court historian Linda Greenhouse.
Such is the sad story of Nicholas Sarkozy, the rhetorically audacious – if not downright reckless – Americaphile who won the presidency of France on the most pro-American platform ever attempted by any serious presidential candidate in that country. Investors figured that Sarkozy would follow through his promises of “rupturing” the statism of French politics. However, Sarkozy has apparently exchanged that opportunity for being the toast of the Paris politico-media elite.
In one of my first newsletters, I was jubilant at Sarkozy's electoral victory. Three newsletters later, I geared down to neutral on disappointment with Sarkozy's initial so-called “rupture.” Sarkozy has failed to impress, and I am once again bearish on France's CAC 40 equities index.
Additionally, Sarkozy could have inaugurated a round of fitful liberalization across continental Western Europe. If Sarkozy cannot meaningfully downsize the welfare state, other Western European politicians will fare no better. I am neutral on the euro.
KGB, Inc. Claims Another Scalp
According to Strategic Forecasting, Inc., the Russian government has sent out a warrant for the arrest of Mikhail Gutseriev, a key former investor in the Russian energy sector. Gutseriev was long thought to be a key confidant of Marc Rich, the multibillionaire Swiss financier and perennial refugee from the United States (even after being infamously pardoned by Bill Clinton the day before he left office). The fact that the Russian government does not even respect someone like Rich, a true “lone wolf” who simply does not have the leverage to threaten the Russian government in any way, signals that the Russian government is compulsively confiscatory when it comes to foreign investment.
Get out of Russia.
The Bottom Line
Bullish: Gold and precious metals; the Polish zloty; tentatively, the dollar
Neutral: Euro
Bearish: AUD; NZD; JPY; US equities; European equities, Spanish in particular; financial stocks worldwide.
--Alex Forshaw
Editor in Chief
http://www.bestwaytoinvest.com
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