Monday, August 1, 2011

IRA - Black Friday and the end of risk free returns


The world players are so loaded-up on US Treasuries that they can't even sell it to reduce their risk. Incredible.
Many countries already trade through the US CDS curve in certain maturities.
I am pretty confident that their debt doesn't trade through US Treasuries just because the Fed Funds rate is nailed to 0%.

Black Friday and the end of risk free returns
The IRA Advisory Service
July 29, 2011

We all have watched the past week roll buy, with one more bizarre statement after another coming from Washington.  This is a democracy, we keep reminding one and all.  Markets have learned that default involves an assessment of both the ability and the willingness to pay.  See the conversation with Tom Keene and professor Carmen Reinhart on Bloomberg Radio yesterday.  She spoke about the "repression" of low interest rates imposed by central banks to subsidize private banks.
We spent much of the week teaching journalists who are too young to remember (or even know) that 100 years ago, the United States had no credit rating and was forced to operate through the great New York banks when it came to international payments.  In the crisis of 1907, a state chartered bank called JP Morgan was the de facto central bank of the United States.  President Theodore Roosevelt advanced the House of Morgan millions in cash to help stem the bank panic, but Morgan and the members of the New York clearinghouse dealt with the crisis.  Viewed from Europe, the US was a young, unstable federation of states with a bad habit of defaulting on their debts and fighting troublesome civil wars that interrupted the flow of commodities to European factories. 
After WWI the tables were turned between the City of London and New York, with the former colonials taking the lead in world economic affairs.  The UK became just another poor state in Western Europe.  By the end of WWII, the US had taken over strategic responsibility for the former British Empire.  Discarding the proposal of JM Keynes for a competitive, multilateral currency system, the US instead took a page from the Roman Empire and equated the dollar with gold.  This act symbolically and functionally associated the dollar with risk-free assets.  The dollar was the sole means of exchange in much of global commerce for decades thereafter. 
Keynes remember was no free trader.  He saw the danger of using international capital flows to finance trade imbalances, as the US has done for decades with the happy acquiescence of our trading partners.  So here we are today, with the dollar heading towards less than half of global commerce and the mathematical limits of growth in the public debt in sight, especially in any sort of positive interest rate environment.  The central banks have responded to the housing collapse with low rates, to the point made by Dr Reinhart and others.  This is a temporary solution that eventually kills the patient as assets reprice and cash flows fall.  Notice please the chart showing net operating revenue for all US banks (and especially the largest names) plunging toward the floor on the first page of the latest Quarterly Banking Profile from FDIC:
Bottom line is that the change in the political equation in Washington, with a growing tendency in Congress willing to use the creative destruction of default to restructure the American political economy, means new rules for Wall Street as well.  The benchmark treasury curve has been been loosed from the bounds of earth and is now a relative benchmark, where "superior" corporate credits can and will be priced through Treasury and agency yields on a regular basis.  If this sounds a little too much like the world of quantum physics and Steven Hawking, all we can do is borrow a line from Joan McCullough at East Short Partners: "Get used to it." 
As we learned working in Mexico in the 1980s and 1990s, the world of debt defaults and fiscal crises inevitably results in strong inflation, but a big part of the inflationary process is perception.  Think of this week as the point in the learning curve when Washington started getting the attention of the entire nation and world -- a year before the next election.
*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com

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