Risk aversion ebbing as non-farm payroll approaches

Participants look set to continue adding back the risk jettisoned over the last few weeks.

It will be interesting to see how bonds respond today with non-farm payroll numbers typically bringing the volume that allows for big moves.  I would expect with momentum weakening in the recent rally and some talking of up to 700k jobs added in May that bonds end the day lower.

In commodities, it looks like oil is set to regain some of the ground it lost to gold recently.

Related articles

• Technical Analysis 101: Adam and Eve (globaltrader.blogspot.com)
• Employment Report Prediction: Bad Reporting! (calculatedriskblog.com)
• Thursday payrolla (ftalphaville.ft.com)

Memorial Day Links: No Bubble in Australian Housing and Greek Problems Continue

"The short story is that the escalation in housing costs has been mainly motivated by underlying demand- and supply-side fundamentals, not leverage as some doomsayers would have us believe. "


“Could this be the last weekend of the single currency? Quite possibly, yes.” (Hat tip Calculated Risk)

Long-term perspective on currencies and central bank policies

I was doing some house cleaning, tagging old entries and came across something I wrote in 2005 on central bank policies:

On a related note, foreign CBs will not turn net sellers of dollar assets. They will stop adding to USD reserves which still creates a substantial problem for U.S. interest rates. The markets will continue testing the CBs' appetite for dollars until we see real policy changes and a market determined equilibrium.

This referred to the US dollar but the underlying logic still applies to this week's scare regarding China turning seller of Euro assets.  China has deep pockets and very little interest in adding to currency instability.  The status quo (Yuan pegged at sub-market rates to stimulate Chinese exports) has done well by them and while it can't go on forever now would be a shockingly poor time for a drastic change.  Why would they do this in the midst of speculative fervor to short the Euro and a general panic regarding European assets?

My 2005 self went on to make the following predictions:

There will be some sort of market event with the most likely candidates being housing and interest rates.

This market event will ultimately require international cooperation (G7, G10). It may take a series of trials (maybe a series of crises) by various CBs and governments but eventually they will need to coordinate policy. The world will need to decide how to handle the issue of the weakening dollar as its main reserve currency.

On a related note, foreign CBs will not turn net sellers of dollar assets. They will stop adding to USD reserves which still creates a substantial problem for U.S. interest rates. The markets will continue testing the CBs' appetite for dollars until we see real policy changes and a market determined equilibrium.

Unemployment seems like the best indicator of how hard or soft the landing is in the real economy. Below the June '03 high of 6.3% seems like a good definition of a soft landing for the U.S.[The main question being discussed was whether the US was whether the Fed hiking cycle was leading up to a soft landing.]

The U.S. current account deficit will get worked off through the growth of emerging market consumption rather than U.S. economic contraction. These emerging economies are the logical target for the world's investment dollars so once the market regains control of capital distribution they should see some benefits.

While this was a useful high level map, in the end it mostly helped me to avoid risks.  The policy coordination I expected has yet to materialise and instead it is a dog eat dog world of competitive currency devaluations.  This makes a fertile (read volatility swings) ground for trading, especially in currencies.  I expect this will continue until central bank coordination occurs enabling debt-heavy importing countries to start paying off their creditors.

Technical Analysis 101: Adam and Eve

I got bullish a bit early on equities last week as the Euro bounced and it felt like panic was in the air on the day of the German trading bans.  Still the pattern in stocks looks constructive for the short-term with a target above S&P 1150 (SPY 115).

The chart for SPY bears a striking resemblance to a double bottom pattern with momentum ebbing as the panic low from two weeks back gets retested.   Also, as Bill Luby points out options traders seem to be getting ahead of themselves pricing implied volatility trading above what is being observed.

I am only playing through upstrike call options (where implied vol is less dear), so my downside is limited.  Momentum players may still have stocks to dump so I have positioned for a bounce but kept the risk low.

If we do manage a rally here it is easy to imagine the news coverage shifting to discussing the liquidity enema eminating from central banks as equity positive.

Are German naked short and CDS bans really that awful?

In response to the German bans on some naked short-selling and naked credit default swap (CDS) purchases Zero hedge declares:

If this pans out as expected, look for Bunds to collapse tomorrow, and wipe out a few billion from Pimco's NAV. We warned in February that the flight to safety in Bunds was both shortsighted, and too good to last.

I disagree.  Banning naked short selling and unmatched CDS purchases are fairly mundane regulatory changes.  Shorting is still allowed as long as the bonds or shares can be borrowed and default swaps are still available but only for hedging purposes.  Coming so soon after the bailout announcement, this is being linked to the "wolf pack" behavior mentioned by officials last week but these policies are in line with reform recommendations from before the Greek crisis made it to the front burner.

This may be the sort of news that can set off a panic given the view by many that the Europeans are flailing about but I expect the real money will take note of the limited scope and difficult enforcement of today's bans.  While I agree that Europe has not yet come to terms with Greece as a solvency problem rather than a liquidity problem, the current approach is still printing Euros to pay bond holders, so the downward pressure should stay focused firmly on the Euro.

With the lopsided view and large short positions in the Euro currently, I am not even sure the one way trip down there can continue through tomorrow.

Stock market stunned by its own fragility

The price action this week in equities was a change of pace.

I included the chart above to show just how low the short term volatility of SPY had fallen before the recent pull back.  As much as much as the Greek debacle may be the proximate cause of the stock drop, the steady grind higher over the last two months had left the market ripe for a pull back. The price drop is severe enough that momentum traders will be throwing out positions while value investors will still be on the sidelines for a few hundred more S&P points.  

US stocks continued lower on Friday, but the long bond and the Euro changed direction.  The long bond has been on a strong two week run up that was goosed higher by yesterday's late afternoon panic, while the Euro had been weakening in response to Europe's sovereign debt woes. Both trends are stretched but seem well supported by the current fundamentals.  The reversals in these markets, though mild, makes me think equities will not start next week in free fall.

The Greek saga (which began in early December 2009) dominated the headlines with European policy as of last weekend looking to keep the monetary union intact at the cost of a steadily weakening Euro.   There is still a lot of skepticism whether the current bailout for Greece is enough and whether the same thing can be done for the other PIIGS but it seems to me that where there's a will there's a way.   This is the train of thought that is driving the weakening Euro.  It may still happen that Greece abandons the Euro (likely leading to a sharp recovery in the currency) but I think the policy response of last weekend postpones it by a year while the powers that be wait to see if the austerity package works its magic.

A Greek debt restructuring will also relieve some pressure on the Euro and provide a far better template for the other PIIGS (should their situations worsen) to follow.  For all the weekly on again off again bailout announcements regarding Greece it is still not clear the authorities have done their homework and come up with a plan for the Euro and European debt markets that won't need to be reevaluated in the near future.  This lack of credible long term goals is the key uncertainty spooking the markets.  This thought from 2004 still reflects my view on why attempts to use the bailout package to discipline the Greek government is misguided.  

Most of the economic news out of the US has been positive, though ignored.  It was capped off today by  the best jobs report in years.  The positive recent news is being ignored due to fears of slowing growth in the second half of the year. As the US fiscal package winds down there is no obvious candidate to replace it.

Financial reform moves closer to passing

From the WSJ:

Democrats won the support of a senior Republican who voted in a Senate committee Wednesday for a sweeping overhaul of the market for derivatives, the complex financial instruments at the heart of the financial crisis.

With 41 Republican's in the Senate this is a critical achievement for the bill.  It will be interesting to see how bank shares react.  Tim Duy highlights positive developments making the economic recovery looks sustainable but stock prices and risk assets still appear to be on the high side.

This is particularly true of bank stocks given the public outrage over the pay structure and conflicts of interest.  Reducing systemic leverage is another likely regulatory theme.  Regulatory uncertainty along with lingering insolvency fears make it difficult to understand how owning bank shares makes sense to anyone here.  My personal view is that bank shares are in for a lost decade as deleveraging and capacity reduction work through the sector.  We shall see.

Link summary from my other blog

I had begun a new blog a few weeks ago while Globaltrader.blogspot.com was still unavailable for posting.  I plan to continue posting only on this blog now that it is restored but if it is removed by Google again I will return to that one.

Posts over the last few weeks had been:

• A look at some of the causes of the financial crisis and some thoughts on where the new regulations should focus.  This speech noted recently by Mark Thoma is also a good summary.  It is a bit odd that the US regulators still do not seem to acknowledge their role in the crisis.  
• China's position on the yuan.  The story is changing a bit with China's economy apparently shifting to domestic consumption without any currency adjustment but my conclusion is still the same.
• A news summary for the last full week in March. 
• Another summary focusing on mortgage delinquencies.  The note on yields possibly reaching a peak still holds with bonds trading strong last week and likely to benefit from continued Goldman / financial regulation fall out in equities.
• I celebrated the reappearance of Global Trader's Diary by looking up an old discussion on Fed policy and whether it was leading to distortions in the markets and underlying economy.  While not exactly predicting the crisis, it was fair to say many people saw the highly leveraged environment as ripe for catastrophe.  Naming GM, AIG, and FNM in 2005 as trouble spots, was a reflection of consensus among financial professionals and not due to any personal insight.  How were these problems allowed to fester until 2008?  I would give myself poor marks in estimating the timing of debt problems but I think the Fed failed in its dual mandate to maintain maximum employment.   A less leveraged economy in 2005 would almost certainly have led to an earlier adjustment of US saving rates and consumption patterns leading to a smaller shock to employment.
• Another update on mortgage delinquencies as Equifax data contradicted the city by city delinquency rates from CoreLogic. 

Are there scale economies in banking?

Mark Thoma concludes his summary on whether scale economies in banking justify the existence and benefit of large banks with the following:

I'd like to know the source of the scale economies. The paper linked above estimates returns to scale, but not their source. As noted in the introduction (and also noted by David):

Our results indicate that as recently as 2006 banks faced increasing returns to scale, suggesting that scale economies are a plausible (though not necessarily only) reason for the growth in bank size...

Without knowing the source of the changes in costs as banks increase in size, the (non-parametric) results -- results that differ from most previous work -- are hard to evaluate. I've been hoping for good estimates of the size and nature of the economies of scale for banks, but I'm not fully convinced by this evidence.

Mark is correct to try to figure out the specifics that are driving the returns in the study.  From my own experience - sales and trading in loans, bonds, and commodities - scale is found mostly through network effects.  The market players that have the most trading flow and transactional experience in a particular market have the accurate prices and up to date information.  This advantage leads to a higher return by being more likely to earn the bid / offer spread when making markets and being able to price services at a premium with clients wanting information access as well.  While this can be a stable and profitable advantage it was a small part of the profit in the banking areas I have worked in.

I would expect other economies of scale on the deposit taking side of the business as servicing a large number of depositors in a centralised fashion seems like a classic scale business.  The number of clients and transactions adds little marginal cost while the licensing, reputation, and infrastructure represent substantial fixed costs.  This advantage is hived off from the risk taking and higher margin bank  businesses with the internal treasury and risk department charging LIBOR plus a spread for use of funds.  These risky parts of the business still tend to grow fairly large despite the absence of scale economies.  I attribute this to the money politics of the industry as empires grow and shrink based on raw profit.  Growth is revenue rather than cost driven.   This fits well with the ease that hedge funds have found competing against banks in sales and trading functions though funds usually start with few people and no scale.

Another thought that I had from reading David's post, was that even if there are economies of scale that does not justify "too big to fail".  It shows that big can be a public benefit but if that is the case then a system needs to be created so that the naturally big entities created can be wound down effectively if necessary.  I believe this is now widely accepted following the difficult ad hoc responses that became necessary for troubled large institutions in 2008.

Particular banking businesses may need to be large to get the maximum public benefit but for the reasons above I doubt this applies to the financial industry as a whole.  Careful thought should be given so that if a safety net for large institution needs to be maintained it only applies to functions that can justify scale benefits.  If scale can be justified it still does not justify the lack of a mechanism to wind down large institutions when necessary.

Dollar Remains Unimpressed by U.S. Payroll report

From Briefing.com:

09:25 ET 10-Yr: -01+/32..4.487%.. GNMAs: +01/32.. USD/JPY: 115.0500.. EUR/USD: 1.3339

The Rally That Wasn't: The buck was given a strong boost over & through recent resistance zones on the majors following the data but that boost fizzled quickly. The brief rally was aggresively sold into sending the dollar well lower. The euro went from 1.3276 to 1.3237 to 1.3344 in the span of about 20 minutes. The dollar index, for all its 47 point range post-data is now sitting around where it closed yesterday at 82.72 (-0.04). Negative sentiment on the dollar was clearly unaffected by the jobs report.

Nothing about that report looked bad for the dollar as the initial bond reaction showed. Not sure how else to interpret the action other than sellers using the liquidity around the news to get out of more dollars.

In other dollar watching news Brad Setser points out ICBC's interest to repatriate $16 bn generated by its IPO. Guess the PBoC will just step up and buy them but I wonder if their will be some political chatter about the request.

Update 3:50 PM:

From the FT:

“The market was looking for the next trigger to sell the dollar, rather than buy it,” said Tania Kotsos, strategist at RBC Capital Markets.