Blog Move

I have moved my blog to johnbutters.org.

Morning Note 23/12/11

Floyd Norris has an interesting piece in the NYT today about the ECB's lending operation. Norris argues that the ECB's three-year lending to banks is effectively a bailout for governments, since banks will use the funding to buy the debt of their own governments and make a risk-free return (except for the risk of government default, but the banks would probably be bust then in any case). He also points out that the ECB is taking as collateral MBS that were rated A at issue -- many of which will now be rated as junk. Both sets of measures, Norris argues, should bring in peripheral sovereign spreads and help with the recapitalisation of banks.

I am not sure that Norris's picture of things is completely right. Why should three-year funding for banks make such a difference, when the unlimited one-year funding that was previously planned for the same date did not? Norris's argument suggests that banks should now be prepared to buy up to three-year government bonds because their funding is assured for that period -- so why have the Italian and Spanish yield curves fallen and steepened in a smooth way since the yield peak reached on 25th November, rather than showing a dislocation at the three-year point? Why have yields actually increased this week, when banks have finally got their hands on the ECB's money (EUR 489bn of it)? These observations are not consistent with the idea that a strategy of buying domestic sovereign bonds for which funding is assured has suddenly been adopted by the banks and has been the driver of falling peripheral spreads.

What happened in the Spanish and Italian debt markets was that yields began to fall on 25th November on speculation about bond-buying by the ECB, and then continued to fall even after Draghi said that that ECB would not be buying bonds. That means that something the ECB actually did do must have been at least as good as ECB bond-buying in order to justify post-hoc the fall in yields that had already taken place before the ECB meeting and to cause yields to fall further in the following days.

Perhaps it is that the ECB has assuaged concerns about the health of Eurozone banks by signalling its determination to provide them with liquidity. But that idea is also not borne out in the data. Banks are still concerned about other banks' financial health, as shown by the fact that they continue to demand high-quality collateral for any lending -- German bond yields are hitting new lows and repo rates remain at a historically wide discount to EONIA, which shows that banks desperately need collateral for their borrowing, and the picture is confirmed by the EURIBOR-EONIA spread, which remains close to its widest recent level.

If the ECB's action has not worked either by inducing banks to adopt a yield-curve-riding strategy or by signalling its readiness to act as lender of last resort (something that should not have been in doubt anyway, given its actions during the financial crisis), perhaps it has had some other practical effect. I can think of three possibilities here, all of which take the position of banks, not the position of indebted sovereigns, as having been primary in the recent run-up in peripheral spreads (the primacy of the banking crisis over the sovereign crisis is something Andrew Hunt has talked about for some time). 

1. It is all about small banks. By accepting much poorer collateral than before, the ECB has given access to funding to a wider range of banks, thereby improving their credit quality in the eyes of the market. This would include small banks that do not contribute to the EURIBOR panel, so EURIBOR has not fallen. The reason for the recent widening of sovereign spreads may have been the ongoing slow-motion bank run in the periphery, which caused the market to fear that governments would have to bail out their banks, something they are in no position to do. By making funding available to small banks, the ECB has offset the run on deposits, stabilised the position of smaller banks and taken the pressure off peripheral sovereigns.
2. It is all about collateral. Banks have recently come to fear lending to one another. That has meant a rising demand for collateral. As collateral became scarce, the risk of a collateral crunch came onto the market's radar screen. Peripheral sovereigns stand behind peripheral banks while peripheral banks are the major market for their own governments' debt, which means that a collateral crunch in the periphery would both have impacted the credit quality of peripheral sovereigns and at the same time reduced demand for their bonds. By lowering its own collateral standards, the ECB eased the collateral crunch, allowing banks to use collateralised borrowing to offset their ongoing deposit losses. That allowed the banks to return to the peripheral debt markets and reduced the chance of peripheral governments having to recapitalise their banks.
3. It is all about the term. Perhaps three-year funding is qualitatively better for banks than one-year funding. I do not know why this should be so.

Perhaps recent market moves have resulted from a combination of all three possibilities. 

What does this mean for my trades? The fact is that, even if I am not sure of the mechanism, the ECB's action has reduced Spanish and Italian yields to sustainable levels. That means that the euro crisis may be on hold for now (although I expect further crisis waves as austerity measures cause a nasty recession). Add to this the fact that American economic data continue to surprise on the upside and that my US leading indicator ticked up in November after months of flatlining, and the possibility of a wave of euro-funded money flows into risk assets, and my short on the S&P 500 starts to look suspect. In addition, without further short-term deterioration in the European situation, with the ECB having reversed its silly rate hikes, and with EUR/USD around post-2007 lows (ex. the period of extreme pessimism in 2010), my short on EUR/USD also starts to look less attractive. In consequence, I have closed both positions today.

As a result, I now have no open positions. Since I started at GNA in late July, I have made a realised profit of 7-8% (an approximate figure because I have not been as careful as I should have been about recording my total capital). Since March, when I began to work on the latest iteration of my trading method, I am up around 3-4% (owing to some early mistakes -- which I hope not to repeat, since I understand why I made them). I have not had any serious losing trades since I started at GNA and none of my stops have been hit. My major mistake has been to have too great an inclination to hold onto positions. It is hard to get the right balance here: it is hopeless to wimp out of positions at the first sign of trouble. But equally, it is not good to hold positions for too long. Had I taken profits when I decided to hold through October's rally (which I predicted), I would have been up more like 10% since starting at GN; on a mark-to-market basis, I was up over 12-13% at one point; and had I not held onto the trades, I could have re-entered near the top (on days I identified at the time) and made further profits on the subsequent fall. For example, I have held my short EUR/USD position through thick and thin, and have exited at about the lowest level since I entered the trade; but the price of that approach has been 1) that I got no extra benefit from trading around the position and 2) that I have failed to take good mark-to-market profits on several mediocre trades and then exited at a small profit or small loss. I think that I will change this aspect of my trading method in the New Year -- to become more inclined to take profits when they are on offer. I started trading being wrong as much as I was right, and losing money; then I went through a period of being wrong and losing money, which was the most frustrating part of my career so far. Now I hope I am getting the hang of being right and making money. But this is not a game one ever finally wins and I have no doubt that I will have the opportunity to learn from many more mistakes.

Turning to the US, John Boehner has given his agreement to the Senate plan to extend various fiscal measures for two months, putting off a decision about how they are to be paid for. This is good news for the US economy. It also promises more ludicrous theatrics from the US Congress next year. There was some disappointing news on the US economy, with Q3 GDP revised down from 2% to 1.8% in Q3. The change was a result of a downward revision to PCE and an upward revision to inventory investment (reducing the likely impact of any Q4 inventory bounce). An upward revision in the GDP price index from 2.5% to 2.6% presumably also had an impact.

Data:

Revised Michigan sentiment rises, b.e. Sentiment is now back to its pre-August levels. This bears out an observation made by various commentators when sentiment first fell, that events with a high media impact can damage consumer sentiment without having a commensurately large impact on consumer behaviour, and that it takes a few months for sentiment to recover.

Next 24 Hours:

Durable goods orders

Personal income and outlays report

New home sales.

Morning Note 22/12/11

The uptake of the ECB's first three-year long-term refinancing operation was much larger than expected, at EUR 489bn. This may be, as the ECB hopes, an indication that banks see plenty of opportunities for lending and were not making new loans because their funding was previously constrained. However, it is more likely that banks a) took the opportunity to borrow against as much of their dodgy collateral as possible and b) wanted to have three-year funding in place because they fear another credit crunch. I expect the depressed state of the European economy and the requirement to raise capital ratios to continue to drive deleveraging by European banks. 

Paul Krugman has been saying that the US is in a "lesser depression," and I am inclined to agree. A good indicator of the depressed state of the economy is real GDP per capita, which remains far below its pre-crisis peak and looks set to take years to regain even that level, let alone to hit current estimates of potential output. That is why things still feel bad, despite positive economic growth. What does this mean for equities? It is probably consistent with a market that behaves like the Japanese market since 1989 -- i.e. one that has rallies on waves of optimism, followed by declines on waves of realism. Eventually, of course, the optimism will be right, which means it is important not to become cynical about the prospects for economic growth. Several other developed countries look as bad as, or worse than, the US, including the UK, Japan, France and the PIIGS. Germany looks better, but I am inclined to qualify that statement with "for now." What is striking is that the BRICS (including South Africa) have already surpassed the pre-crisis peaks in their real GDP per capita. This tells us that there has been a kind of decoupling -- an idea of which I have long been very sceptical -- and suggests that the recent market declines that have been caused by developed-world problems present a buying opportunity for EM stocks.

The situation in North Korea briefly interested the market. Nightwatch (http://j.mp/uCDSYy) has a good piece today on the subject. Apparently there were several assassination attempts on Kim Jong-Il after he took power, and it is reasonable to assume that Kim Jong-Un fears the same thing. Army units have been told to return to their barracks, despite having recently started their annual training cycle -- something that would be consistent either with a move towards a war footing (either offensive or defensive) or with a lack of trust in junior officers and a desire to keep them under control. It is worth reading the whole piece.

Data:

Existing home sales fell, d.e., Nov. Recent data suggest that more new homes are being built (mainly multi-family structures) but that there is still a large shadow inventory of new homes to work through. I expect the housing market to remain subdued for the time being.

UK current account widened sharply in Q3, d.e. Further evidence of a collapse in import demand in Europe?

UK final GDP Q3 revised up from 0.5% to 0.6% b.e.

UK business investment revised up from -1.4% to +0.3% Q3.

Next 24 Hours:

Initial claims

Final GDP

Revised Michigan sentiment

Morning Note 21/12/11

The news that has caught the market's attention today is the ECB's first offer of 3-year money to Eurozone banks. The most interesting thing that has happened is that Spain has borrowed short-term for a much lower rate than in its last auction. Spanish 10-year yields are down to 5%. Is this an indicator of things to come for the other PIIGS, or something special to Spain? Certainly it suggests that credible austerity may stave off any crisis for the time being. Yields in the other PIIGS remain high for the time being (Italy 6.5%, Ireland 8.4%, Portugal 12.6%, Greece off the scale), but a general decline in yields would be an argument against my assessment that the latest European deal did nothing to address either the Eurozone's immediate or its long-term problems.

I find investing in equities a frustratingly wooly business. First, the relationship between earnings and the share price is generally not stable. Second, future earnings are very hard to predict. I have gone some way towards addressing the first point by using a two-factor model for the share price, the factors being earnings and a credit spread. But I have so far not come up with any great insight on the second point. In general, equity analysts attempt to forecast earnings by immersing themselves in a world of stories about the companies they cover, and using those stories to establish a broad direction for earnings (they then construct models with spurious precision). But stories can be misleading, and companies are so complicated that one may construct a story out of facts that do not turn out to be the most salient to the future path of earnings, or out of known facts when unknown or unknowable facts turn out to be most salient. Some analysts have over time successfully forecasted future earnings growth using an objective methodology (for example, Gary West and James Inglis-Jones at Liontrust), and I am now turning my attention towards doing the same.

Bloomberg reports that the US is now working with European countries on the idea of some kind of restriction on Iranian oil exports. Oil revenues supply 50% of Iran's budget, so a reduction in oil revenues to the regime would be significant, but restrictions on the physical export of oil would likely raise the price and could therefore benefit rather than hurt Iran (the nasty, selfish countries like Russia and China will likely continue to buy its oil). Bloomberg reports that the US has suggested to Japan that it impose a surcharge on Iranian oil imports, and quotes officials as saying that the objective of any action would be to reduce Iran's oil revenues, not to achieve a complete embargo of its oil exports. This hints at an idea that might work: to the extent that Iran is a price-taker in the global oil market, any surcharge should fall on Iran and not on the purchasers of its oil. If the US and Europe are considering basing their wider policy on this idea, that would cohere with reports that Gulf diplomats have said that they would make good any shortfall caused by an interruption of Iranian exports to Europe (i.e. they would keep the oil supply to Europe the same and thus keep global prices steady, ensuring that Iran remained a price-taker). However, an obvious weakness in the scheme is that rising political tension could add a significant risk premium to the price of oil. If the Iranians understand this, then they will create as much tension as possible, in order to maximise the risk premium and thus offset the effect of any surcharges.

Bloomberg also has a story with the headline: "Bankers join billionaires to debunk 'imbecile' attack on top 1%." A few thoughts on this subject:

1. The rich people quoted in the story appear to believe that all their success is down to their own effort. That will be wrong in the great majority of cases. Luck is a significant factor in getting rich.
2. People are not necessarily suggesting that the top 1% are wicked -- I certainly would not -- but merely that they should pay more tax. I have some sympathy with this view. It is a second-best answer to the extreme inequality of the income distribution in the US. I think a first-best answer would be to have an economic system in which more profit flowed to the providers of labour rather than to the owners of capital (hence I am less hostile to labour unions and labour regulation than I used to be), but that does not appear to be a realistic possibility at present.
3. The behaviour of bankers since the financial crisis is quite a good argument not just for utility-style banking, but also for the nationalisation of retail banks. The major theoretical objection to this idea is that governments would interfere in banking, forcing banks into irresponsible lending; but the fact is that banks are already run by people who are hell-bent on irresponsible lending and other strategies with the potential for good short-term payoffs combined with large risks that are long-term in nature. Nationalised banks could be overseen by an independent committee of experts similar to the MPC and FPC, with the objectives of the committee set by Parliament. Sadly I think that there is a serious practical objection to this idea for the UK, which is that it would cause havoc in the City and thus cause job losses and a fall in tax revenue in the short term. Perhaps during a future banking crisis this objection will be less relevant and an enlightened government will be able to nationalise the lot of them.

What is happening in the UK government accounts? I thought I would have a quick look into this today. On a 12-month trailling basis, social security spending continues to rise but government consumption excluding social security and interest payments has actually begun to full. Total government expenditure looks like it has just begun flatlining. According to the OECD, government employment has fallen sharply in 2011, continuing a decline that began at the start of 2010.

Data:

Eurozone current account returned to deficit, d.e., in October.

Italian trade deficit narrowed in October. Is the adjustment of internal imbalances under way through the mechanism of recession? If so it is sooner than I expected. Perhaps the problem is not that Europe's BoP imbalances will persist for a long time, but that they will only be eliminated under recession conditions and will re-emerge as soon as there is any growth, kicking off the whole cycle again.

UK Nationwide consumer confidence rose, b.e., but remains low.

German Ifo rose to 107.2, b.e.

Housing starts and building permits both rose to the top of their post-crisis ranges, b.e., Nov.

New Zealand current account deficit widened more than expected in Q3. Japanese trade balance moved further into deficit in Nov, disappointing expectations for a narrowing. Is this evidence of a slowdown in European or Chinese imports?

UK GfK consumer confidence declined, d.e.

Italian GDP 0.2% QOQ Q3 d.e.

Morning Note 19/12/11

I am back after a very good week in Abu Dhabi at the International Festival of Falconry (http://www.falconryfestival.com/). It does not feel like very much has changed. In the US, politicians are still wrangling over the extension of various fiscal measures, with the latest plan to extend them for two months likely to meet resistance from Republicans in the House. In Europe, politicians are still nowhere close to doing enough to end the crisis. One thing that has changed is that the EUR has dropped, putting my short EUR/USD trade further into profit, and a risk-off week has put my short S&P 500 deeper into the black.

Events in Europe have unfolded roughly as I expected. With respect to ECB action, on 8th December I said that I did not expect the ECB to start buying PIIGS bonds in a big way: "I think the ECB is going to continue to try to force a fiscal solution and that the market has misinterpreted the comments of a new central bank chairman -- as so often happens." This was consistent with my long-held views. On 13th September I said ECB bond purchases were, "something that the ECB is likely to resist strongly, and given its recent form I expect that it would dig in its heels as soon as politicians began to move away from fiscal solutions to Europe's problems. That means that it is likely to be part of the solution, but only as long as [EFSF expansion] is pursued." 

With respect to fiscal action, on 6th December I said: "To be effective, any fiscal transfer plan needs to be large enough to create a credible firewall... the market may be setting itself up for disappointment on this score." The market was duly disappointed, and the EUR and risk assets fell. Looking at the bigger picture, on 13th August I wrote: "The pattern I expect to see in the future is the same as the playbook for the current episode: poor economic performance raises PIIGS spreads again; politicians agree to expand the powers or capital of the EFSF to deal with the problem; and once agreement is reached, the ECB buys sovereign bonds to prevent a self-fulfilling crisis in the short term." This is a pretty close approximation to the latest round of action, with the ESM being brought forward and further loans to the IMF (I wrongly focused on the EFSF and neglected the other vehicles that were available, but the basic idea is the same). Europe's latest agreement represents a shuffle towards fiscal union, but not much more. This lack of movement was also not a surprise. I said of fiscal union on 13th September that it was, "only a plausible outcome on a multi-year time horizon."

So what is likely to happen next? 

1. The ECB will not buy peripheral bonds in large enough quantities to end the crisis single-handedly. It will buy enough to prevent collapse as long as governments continue to pursue fiscal solutions.
2. Austerity will continue to depress the European economy, leading to further misses of deficit/GDP targets and further episodes of spread widening.
3. In response, governments will continue to buy time with inadequate increases in fiscal transfers through the available mechanisms (presently EFSF, ESM and IMF).
4. There will be further movement towards fiscal union but it will be slow and volatile. This will confuse the markets.
5. If the government response is inadequate at any point, the ECB will act as necessary to prevent a financial collapse, including by buying bonds in unlimited quantity -- whatever Mario Draghi says at the moment.

Turning to today's news, the Europeans are debating how to deal with the EUR 200bn that they have pledged to the IMF in order to allow it to lend more to the Eurozone. EUR 150bn will apparently come from "national central banks", but since national central banks, taken together, form the Eurosystem, for which the term "ECB" is the generally-used shorthand, I am not sure how this can be right. The ECB does not have a balance-sheet of its own; the "ECB balance sheet" is the consolidated balance sheet of the Eurosystem. Since the ECB has pledged not to lend to the periphery, even through the IMF, I am not sure what is going on here.

Bloomberg had a headline this morning that contained the words: "Goldman sees commodity rally." Goldman Sachs is always long commodities (except, in fairness, when it calls a short-term profit-taking opportunity) so this is not really news. I am constantly amazed at the number of stopped-clock opinions that are reported as news.

The latest Chinese house-price data have been released. Taking a crude average of the 70 cities surveyed, existing house prices had their largest fall this year. Median change was -0.3%. But the decline from the peak is still less than 1%. Existing house prices are still up on a YOY basis. New house prices had their first significant fall, but are also up on a YOY basis. Transaction volumes remain high. This picture is hard to reconcile with the tone of some of the reporting on China, which suggests a property bust is in progress. Neither anecdote nor data can be trusted in China, but it is helpful when they at least present a coherent picture. The state of China is one of the most important variables at present but I am finding it very hard to get any clarity.

Data Last Week:

UK core CPI declined to 3.2%, d.e., Nov. I do not expect UK inflation to remain high.

US retail sales 0.2% d.e. Nov.

UK unemployment fell to 8.3%, b.e. Nov.

China HSBC flash PMI rose to 49.

Eurozone flash PMI rose to 46.9, b.e.

Eurozone flash services PMI rose to 48.3, b.e.

UK retail sales -0.4% d.e. Nov.

Eurozone CPI held steady at 3%, a.e.

Initial claims fell to 366k, the lowest since the crisis. The US labour market continues to improve.

Capacity utilisation 77.8% ~a.e.

IP -0.2% d.e.

CPI fell to 3.4% YOY d.e. 0% MOM d.e.

Morning Note 09/12/11

This will be my last morning note for a few days -- I will be on holiday in Abu Dhabi next week.  

All the exciting news of the past 24 hours has been about the monetary and fiscal developments in Europe. I will start with the monetary side. The ECB cut interest rates by 25bps in a majority decision (yes, there are people on the ECB board who think that the present situation does not call for a rate cut). At his press conference, Mario Draghi announced four further measures to help the Eurozone banking system:

1. Two 36-month LTRO's with the option of early repayment after one year. These will replace scheduled 12-month LTRO's.
2. The rating threshold for certain ABS will be lowered, in an attempt to reduce the collateral crunch. A second-best rating of A will be required (AAA previously). ABS that have residential mortgages or business loans as their underlying will be eligible.
3. Reserve requirement ratio will be reduced from 2% to 1% to free up collateral. 
4. Certain technical month-end fine-tuning operations will be discontinued.

Draghi also made it pretty clear that markets had misinterpreted his comments about "other elements" following from a fiscal agreement in the Eurozone -- as I said in my note yesterday. Markets took them to mean that the ECB might step into the sovereign bond markets in a bigger way. Draghi poured cold water on that idea, saying that the spirit of the EU treaties had to be respected regardless of whether any legal tricks could be found to circumvent the ban on ECB financing of national governments. He was very clear on this subject. Of course, a U-turn is always possible (and, in extremis, likely) but it would entail a significant loss of credibility for Draghi after yesterday's performance. This means that one solution to Europe's problems is probably off the table for now.

What was Draghi talking about when he use the "other elements" language? It seems that he has in mind a "fiscal compact" with three components:

1. National economic policy: fiscal sustainability, pro-growth policies and, consequently, job creation.
2. EU-level rules on fiscal policy.
3. A stabilisation mechanism -- Draghi's preference being the EFSF and ESM.

It seems that he meant that once 2. was in place, 1. and 3. could follow -- so he was doing political analysis.

Will the measures announced help the banking system? I tend to think that the answer is "yes, at the margin". Unlimited 36-month lending is more stimulative than unlimited 12-month lending plus a demonstrated willingness to take such a step if necessary -- but I cannot see that it is that much more stimulative. I have not seen any analysis on how much more collateral will become available as a result of the further relaxation of collateral standards (the ECB already has the loosest standards in the developed world). Draghi said that the move was mainly a measure to help smaller banks (which account for the bulk of SME lending). I have not done or seen any analysis of the effect of the reserve requirement loosening. I need to look further into all these questions in the coming days.

Let us move on to the fiscal side. After the first day of the latest European summit, it appears that the following measures have been agreed:

1. The ESM will be brought forward from July 2013 to July 2012. Its EUR 500m lending cap will be reassessed by March. With the monetary solution off the table, Europe requires a fiscal solution -- transfers from the periphery to the core -- and with this change, European leaders have said that they will think about creating a vehicle that is big enough to deal with whatever transfers prove necessary. That is hardly a breakthrough, although it is better than not thinking about it or messing around with leverage schemes in an attempt to shirk their responsibilities.
2. Countries, on an individual basis, will make an extra EUR 200m available to the IMF. This is accompanied by the usual chatter about some white knight from the developing world riding to the rescue. 
3. The 17 Eurozone countries will move further towards fiscal union with a new intergovernmental treaty that commits its signatories to fiscal rectitude. Most other EU members will intend to join this treaty at some point; Britain will not. The phrase "shutting the stable door after the horse has bolted" springs to mind, but an indefinite commitment to Germanic fiscal prudence is probably a precondition for the fiscal transfers through the IMF/EFSF/ESM. It seems almost churlish to point out that Germany was one of the worst miscreants when it came to breaching the old Stability and Growth Pact, Spain had low debt/GDP before the crisis and Ireland's budget was in surplus. Still, the Europeans have decided that fiscal malfeasance was the cause of the crisis. I try to avoid cynical conclusions, but it does seem to me that they are being awfully stupid in this regard.

Overall, the outcome of all the noise of the past few days is: no decisive ECB action; no increase in fiscal transfers to the periphery; and a treaty that commits Eurozone governments to the kind of austerity programmes they were doing anyway. I cannot see that any of this makes any real difference, although the IMF lending and hints of an expansion of the ESM show that Europe is groping towards a solution based on fiscal transfers. I expect its painfully slow progress to continue -- though painful it will be, with the ratification process for a new treaty now added to the mix -- and the ECB to buy peripheral bonds as necessary to prevent a meltdown in the meantime (but not so much as to take the pressure off national governments). As I said on 13th August: "The pattern I expect to see in the future is the same as the playbook for the current episode: poor economic performance raises PIIGS spreads again; politicians agree to expand the powers or capital of the EFSF [now read EFSF/ESM/EU-funded IMF] to deal with the problem; and once agreement is reached, the ECB buys sovereign bonds to prevent a self-fulfilling crisis in the short term."

Britain is apparently "isolated" in Europe after refusing to sign up for full-blown treaty change that would have seen us hamstrung by various daft EU measures like a Tobin tax. This is the British media's usual schoolyard-level analysis of the European situation. It is as if a bunch of cool kids have decided to do something silly and dangerous. If Britain refuses to join in, it is portrayed as the awkward child whom nobody likes; if it goes along, it is portrayed as the weak child who foolishly follows the crowd. The solution to this national neurosis is to grow up. Britain is a member of the EU and therefore part of the crowd. Our interests are as legitimate as those of any other member, and it is quite reasonable for us to protect them. They way to do that is to refuse to accept action on a European level when our vital interests are threatened. This is what other EU countries do, and have done at least since the French "empty chair" crisis of 1965. Countries that fall for the "community" rhetoric and fail to fight for their national interests tend to find them compromised.

Further, it is not just Britain that is wary of the latest round of EU measures. The FT reports that the Finnish parliament prevented the government from agreeing changes to the treaty that sets up the ESM; that pro-European parties in the Netherlands have threatened to force a referendum if there is treaty change; that the EU has become a major issue in the Slovakian election; that Ireland may have to have a referendum on any treaty change; and that even in Germany, the FDP is considering blocking the ESM. None of this bodes well for the smooth negotiation and ratification of a new treaty. Expect the market to be thoroughly confused.

Data:

Bank of England held rates and asset purchase facility size.

ECB cut 25 bps.

Inital claims 381k b.e. This is the lowest level since Q1 2011, and before that since 2008.

Wholesale inventories jumped 1.6%, a bad sign, in October.

Japan final GDP 1.4% QOQ. Revised down on negative corporate investment. Q3.

China CPI 4.2% Nov., lower than expected and down from 5.5%p. PPI 2.7%, also lower than expected. Chatter about monetary loosening abounds.

China fixed asset investment 24.5% YTD/Y, d.e. Nov.

China IP 12.4% YOY d.e. Nov.

China retail sales 17.3% YOY b.e. Nov.

German trade surplus fell, disappointing expectations, but remains wide.

French IP 0% b.e. Oct.

UK PPI 0.1% d.e. Nov.

UK trade deficit was narrower than expected, but remains quite wide.

Next 24 Hours:

US trade balance

Preliminary Michigan sentiment

Data 08/12/08

UK NIESR GDP estimate 0.3%.

New Zealand held rates at 2.5%.

US consumer credit 7.6bn b.e. Oct. Another fairly strong month.

Japan core machinery orders -6.9% vs. ~0%e. Oct.

Japan current account surplus fell, returning to quite low levels. 

Australia employment -6.3k d.e.

Australia unemployment rate rose 0.1% to 5.3%, d.e.

French final non-farm payrolls revised down from 0.2% to 0% QOQ Q3.

Next 24 Hours:

BoE rate

ECB rate

Initial claims

Rash of monthly Chinese data

French IP

EU summit

What is the ECB Going to Do?

Today the talk is all about the ECB stepping in to help the banks, rather than buying more sovereign debt. This is in line with my expectations, although I should say I don't have any expectations about the detail. I wrote to a correspondent a couple of days ago: "Why has the market suddenly decided that the ECB is ready and willing to provide a monetary solution to the problem, when only a month ago it was paranoid that the ECB was completely inflexible and would prefer to allow the euro to break up than to do anything about it? And all because European countries are going to write into law the kind of austerity programmes they were already pursuing! This just doesn't make any sense to me... What is it that people expect the ECB to do? I suppose it is a massive bond-buying programme. But that would require a major change in its philosophy -- from a horror of inflation to a cheery willingness to inflate away the whole debt problem... I think the ECB is going to continue to try to force a fiscal solution and that the market has misinterpreted the comments of a new central bank chairman -- as so often happens." Nonetheless, it did seem that the ECB was revving up for some kind of action -- but what? Yesterday I watched Perry Mehrling's explanation (http://j.mp/sSovPR) which suggested that the ECB will take on the loans that national central banks have so far been making to each other (which have allowed peripheral central banks to lend to their domestic commercial banks). This would be a welcome embrace of its lender-of-last-resort function, but I wonder how much practical difference it will make -- it does not imply any extra lending to the banking system. The ECB is already conducting unlimited one-year lending operations to the European banking system. There is talk of 2-year and 3-year operations, which I suppose would make banks' funding somewhat more stable. But that seems a marginal change.

Will commercial banks suddenly become enthusiastic buyers of peripheral debt because of any of the measures that are presently under discussion? I am not sure of the answer to this. On one hand, the present crisis began to kick off when the ECB withdrew from its emergency funding programmes in 2010. If similar programmes are not put in place, perhaps banks will start buying peripheral bonds again. On the other hand, peripheral banks are deleveraging in response to an ongoing flight of deposits, and it has become increasingly clear to the banks over the past two years that imbalances within Europe are the real problem and that there is no easy solution. I really do not know which hand is going to win out. Experience suggests it will be the second one -- i.e. that a vicious cycle is now in operation in the peripheral bond markets and consequently private-sector lenders will not return to them. In either case, further ECB funding of Eurozone banks will not remove the vulnerability of peripheral bonds to self-fulfilling runs.

A problem with the above account of the situation is that it does not make sense for the ECB to hold off from lending to the banking system just in order to force politicians to get set on the path to fiscal integration. The ECB ought to act as lender of last resort to the banking system and did so in 2008-09. Is it really prepared to hold back from the kind of lending it things is necessary in order to hold national politicians hostage? In order to promote European integration? If this really is what is happening, then it is worrying.

Data 07/12/11

Australia GDP 1% QOQ.

French trade deficit narrowed a little, but d.e. and still very wide.

Italian IP -0.9% d.e. Oct. -4.2% YOY.

UK manufacturing production -0.7% d.e. Oct.

UK IP -0.7% d.e. Oct. -1.7% YOY.

German IP 0.8% b.e. Oct. 4.1% YOY.

The industrial production series are volatile and not much can be read into the monthly changes. I have included the YOY changes to give a better feel. All three YOY growth rates are presently falling.

Next 24 Hours:

Nothing big. Slow week for data.

Brazilian and Australian Growth Figures

Brazil's growth slowed to 0% QOQ in Q3 (a.e.). The government appears committed to its inflation target (max. 6.5%) and inflation is currently above that level, so it seems unlikely that there will be any fiscal easing to help the economy in the short term. The Brazilian slowdown is likely to have an impact on Argentina, to which we are exposed through the GDP warrants. However, China, which is Argentina's other main trading partner, remains strong, and that is evidenced in Australia's latest GDP release, which showed faster growth in Q3 and upgraded the Q2 number. Growth was driven by the ongoing mining boom (i.e. China) and strong household consumption. It was notable that some domestic sectors showed quite large declines -- Australia appears to be on Chinese life-support, which perhaps makes the AUD and the Australian stock market good proxies for Chinese growth.

Secular fall in the employment/population ratio

I have read a couple of pieces in the past 24 hours about the effect of demographic changes in the US on the employment-to-population ratio. As more retirees leave the labour force, this ratio will have a tendency to decline, although at present it is lower than the demographic change would seem to suggest. I like population aging as a macro theme, because it is based on analysis rather than starry-eyed storytelling; but I am not aware of a clean way to play it. Does anyone have any ideas?

Angela Catches Up

Angela Merkel's spokesman has apparently clarified the German position on private-sector involvement in future bailouts. He said the normal IMF procedures would be followed -- i.e. restructuring is a possibility. What the Germans want to rule out appears to be the kind of forced-voluntary restructuring that happened in Greece. For the third day running, I am pleased to find other people coming round to my view. On 31st October, I said: "By inventing new kinds of default rather than sticking with the normal kind, European politicians have put all of the normal rules of the game in play, which means that an investor in PIIGS debt cannot feel safe until there is a sound, fundamental economic argument that the PIIGS will be able to pay." I made a related point in correspondence with a friend over a year ago, in a discussion of the Irish bailout: "The [Irish] government has swapped debt for which there is a well-established bankruptcy procedure -- i.e. bonds, and default -- for cobbled-together Euro-chimaera loans on which it is effectively impossible to default." If Ms. Merkel would like to make me a job offer I will consider it.

Exited Brent Crude

I have exited my short position in Brent crude. The market was down from my entry point but I had lost some money on two rolls, so I got out roughly flat (a very small loss, but I don't try to finesse these things). There are two aspects to my decision. First, the short-term economic outlook is very uncertain, with Europe heading for recession, EM potentially slowing and the US looking relatively strong (although growth is far from being absolutely strong). Political action in Europe could lead to short-term rallies and my stops being taken out. I remain short EUR/USD and S&P 500, but I thought that the Brent position gave me too much short exposure. Second, there were factors specific to the Brent position that made it unattractive: the negative roll yield, and the idea of EU sanctions on Iran. On the latter point, I mentioned the day when the market rallied on fears of an Israeli bombing campaign as a good day to go short, and so it proved; but unlike a bombing campaign, EU sanctions are a genuine threat that made my stop (120) look less of a sure bet as a price that would be the wrong place for the oil market in the coming months. In other words, the downside risk on this trade no longer appeared acceptable.

Morning Note 06/12/11

The market continues eagerly to anticipate the European summit. According to Reuters, Merkel and Sarkozy yesterday agreed the following:

• Treaty change, ideally for all 27 EU members but could be just for the Eurozone 17.
• 3% deficit target with automatic sanctions to be written into national laws.
• European Stability Mechanism to be brought forward to 2012.
• European bonds are not a solution.
• The European Court of Justice will check that debt brakes have been implemented in national law but will not have oversight of fiscal policy.
• The private sector will not be involved in future bailouts (The Economist reports that Merkel feels the private sector first said that losses on Greek debt were inevitable, and then said that a Pandora's Box had been opened with regard to the fiscal position of other countries). 

This all represents a continuation towards the fiscal-transfer solution. The treaty changes are all about convincing the German public and global investors that Europe is on a path to debt-sustainability. The EFSF/ESM provides a vehicle for fiscal transfers within Europe; politicians are apparently also exploring the idea of using the IMF for this purpose. Naturally the process of treaty change will rumble on and on, but that may not be a huge problem -- its purpose is to convince Germany to accept fiscal transfers and the ECB that politicians are moving in the right direction on the same subject.

The market has finally caught up with my view that the crisis can only get as bad as the ECB allows, and is now watching for any hint of ECB action. Since the ECB will want to maintain the pressure for a fiscal solution, it seems reasonable to expect that it will not announce a massive programme in response to the latest moves, but will instead continue its existing programme, which is justified in terms of keeping the monetary-policy transmission mechanism operating properly. It may signal a willingness to keep the programme in operation and step up its purchases somewhat. In the view of the ECB, there is a distinction between monetary policy, which is conducted through the interest rate, and liquidity policy, which is the realm of the ECB's other tools. It would be consistent with this view for the ECB to cut rates in response to the worsening economic situation but not to engage in large-scale asset purchases unless sovereign spreads remain, in its judgement, excessively high. In other words, the latest moves hardly change anything with regard to the ECB's likely actions. They have, however, brought the market closer to an understanding of the situation, and may thus allow a risk rally. I do not intend to attempt to trade this change, because a rally is far from certain and because timing will be extremely difficult. My protection against this kind of short-term vacillation is a good entry price.

An issue facing the ECB is the collateral crunch faced by European banks. Banks are still buying peripheral bonds in auctions because, although they will not accept them as collateral, the ECB will. If the ECB buys up more peripheral bonds, it reduces the pool of available collateral and thus the ability of Eurozone banks to borrow from the ECB. I am not sure whether this effect will be large enough to limit the ECB's freedom of action when it comes to peripheral bond purchases; but it may do so.

What about the effects of further fiscal transfers? We are yet to see any detail, but a combination of a strong fiscal transfer plan and commitment in the European periphery to further austerity may mean that peripheral spreads continue to fall (as they have done for the past couple of days). That would reduce the need for ECB action and might alleviate the collateral crunch that is presently going on in Europe by improving the perceived credit quality of peripheral bonds. However, to be effective, any fiscal transfer plan needs to be large enough to create a credible firewall. The last few have not been and I see no reason for optimism about the latest one. The market may be setting itself up for disappointment on this score. If the plan is big enough, peripheral spreads should fall.

But does any of this present a solution to the fundamental problem, which is the internal balance-of-payments situation in the Eurozone? No. Europe will still have a bad recession as the periphery attempts deflation via the mechanism of austerity. The ECB will have to cut rates further, and the EUR should fall. This is the story that has kept me short the EUR for some months, and nothing is presently happening to change it.

Talking of the European recession, the economist Tim Duy has produced some charts that show US and Eurozone industrial new orders. They are highly correlated, and the Eurozone series had a big fall in the latest month. Correlation is not causation, I know, but this point serves as a reminder that developed-world economies are highly interconnected and that the US is unlikely to be immune to the situation in Europe.

The FT has a piece on the expiry of the US's payroll tax cut. It reports that the Republicans want to extend the measure, and finance it by cutting the pay, and number, of federal government employees. The Democrats first countered by suggesting it should be funded by a tax on income above $1m (the Republicans love millionaires), and have now suggested a combination of such a tax and some spending cuts. The crucial point here is that both parties appear committed to funding the measure. The important question is: out of which year's budget? If it is 2012, then government net spending will fall as if the tax cut had expired (although the effect will be offset somewhat by unemployment benefits paid to any federal employees who are fired), and the net effect on the economy will be the result only of differing multiplier effects. If it is after 2012, then the measure will prevent a contraction of fiscal policy as a result of the expiry of the measure. I await more detail on this point.

The RBA has cut interest rates again in response to funding stresses, especially in Europe. AUD remains high -- I wonder whether there is an opportunity for a trade. AUD is high because interest rates remain relatively high, and they are likely to remain high relative to other developed-world economies. And AUD has been highly correlated with risk assets in general. Nevertheless, I should remain alive to the potential for a trade here.

Data:

ISM Non-manufacturing PMI fell to 52, d.e. Finally a disappointing US data point!

Factory orders -0.4% d.e. Oct.

UK BRC retail sales -1.6% Nov.

UK Halifax HPI -0.9% Nov.

Swiss CPI -0.2% d.e. Nov.

Eurozone revised GDP 0.2% a.e. Q3.

German factory orders 5.2% b.e. Oct. A very strong, and perplexing, number. 

Next 24 Hours:

None.

Morning Note 05/12/11

Expectations are high this week for the latest European summit. This strikes me as a triumph of hope over experience. At the end of the latest round of talks, fiscal integration and ECB action will be a bit closer, but the basic picture, that Europe is being forced into a recession by the logic of internal adjustment, and the ECB will do the minimum required to avoid a major crisis in order to force governments towards a fiscal solution, will remain unchanged. One thing that is changing as the ECB hints at a willingness to take further action is the probability of euro breakup -- but I have never thought that was remotely possible in the short term in any case (in the long term, anything is possible).

A correspondent asked what I thought would happen in Europe, in the context of piece by Ambrose Evans-Pritchard (http://j.mp/t2gqy5), in which the latter writes: "The crisis can undoubtedly be halted immediately by the ECB. The bank can reflate Club Med off the reefs. It chooses not to act for political reasons because this mean higher inflation for Germany. That is the dirty secret. Everybody must be crucified to keep German internal inflation under 2pc." Welcome to the club, Mr. Evans-Pritchard -- that is just what I have been saying. I think the most plausible story of what is going to happen next is that Europe will try to have PIIGS deflation for a while; then it will not work, so there will be another crisis, probably political; then we will have one of the solutions that will work, i.e. fiscal union or enough ECB action to create inflation in Germany. Because I think the crisis will rumble on, I remain short EUR and risk assets.

Last week I speculated about the reason for the market's strong rally after the central banks announced the institution of swap lines. I said that a fall in the probability of an extreme outcome could be the reason, and presented a simple model in which an 8% fall in the probability of such an outcome could lead to a 4% rise in the equity market. Reading Daniel Kahneman's book over the weekend, I found a better explanation: people sometimes exaggerate the likelihood of unlikely outcomes AND apply weightings to them that are higher than their probabilities. An 8% change in weighting in the calculation, which my model required, can be consistent with a much smaller change in the actual probability of an unlikely event. As I read Kahneman's book, hich presents a two-system model of the mind, I keep finding support for an idea I was already toying with, that much market behaviour is simply system 1 writ large. If one assumes (not unreasonably) that people's rational appraisals of the market -- a system 2 operation -- are evenly balanced between bullish and bearish at any time, it makes sense to think that the aggregate effect of system 1 processes is what moves the market in the short term. How useful this idea will be I am not sure, and I am yet to grasp the limitations of the theory (essential to become an expert user of any theoretical tool), but I am sure that there is at least something in it. If you do not know what I am talking about, I cannot recommend strongly enough that you read Kahneman's excellent introduction (http://j.mp/uOrb8h).

On 22nd November, I said that, "the fact that [the payroll tax cut and extended unemployment benefits] have been extended before suggests that it is possible they might be again." I was much less worried than the market appeared to be that these measures would expire. Now Senator Harry Reid is reportedly working in a compromise plan that would see the extension funded by current or future spending cuts, in order to assuage the concerns of the Tea Party (as ever more Mad-Hatter than Boston). No mention is made in the Bloomberg report of the other expiring measures -- discretionary spending caps from the debt-ceiling agreement, troop drawdowns and small expiring tax provisions, together totalling 0.5% of GDP -- and that suggests to me that US fiscal policy is on course to be at least mildly contractionary in 2012.

Data:

Initial Claims 402k d.e.

ISM rose from 50.8 to 52.7, b.e. and roughly in line with the 52.3 I estimated last week.

Vehicle sales 13.6m b.e. Nov. Another increase. This suggest PCE durable goods will rise 1.29% in November, and may presage further relatively strong data flow from the US.

Japan capital spending -9.8% QoY. d.e.

Non-farm payrolls 120k ~a.e. Nov. Still relatively anaemic.

Unemployment fell to 8.6% b.e. Nov. Of those who left the unemployment roll, roughly half went into jobs and half left the labour force.

Average hourly earnings -0.1% d.e. Nov.

Australia services PMI fell to 47.7.

Eurozone services PMI was revised down a little from the flash estimate to 47.5, still a MOM increase.

UK services PMI 52.1 b.e. and rose. Is this just volatility?

Eurozone retail sales 0.4% b.e. Oct. Eurostat takes so long to publish useful data it should be classed as a historical rather than a statistical organisation.

This Week:

Mon: US ISM non-manufacturing PMI, factory orders.

Tue: German factory orders.

Wed: German IP.

Thu: ECB rate (may cut again); US initial claims.

Fri: Monthly rash of China data; EZ summit and French IP; US trade balance and prelim. Michigan sentiment.

Morning Note 01/12/11

At the top of yesterday's note I wrote: "Today's central bank action is the big news for the market. Did anyone think central banks would fail to provide swap lines to each other in the event of a credit crunch?" In other words, I did not think the action was that significant. Why, then, did the market rally? The best explanation is provided by Andrew Hunt: the authorities have successfully signalled that they will act to prevent another Lehman-type event. Given their actions after the Lehman collapse, it always seemed likely that that was the case; but market participants had started to worry about a credit crunch, and perhaps a small probability of such an event was being priced into risk assets. Now that small probability has got smaller, and markets have rallied. It is possible to make a simple model of how this can happen. Imagine an index at 100. Risks to the index are evenly balanced, with a 50% chance it will rise by 20% in the coming year and a 50% chance it will fall 20%. Now imagine that the downside risk is split between a 40% chance of a 10% decline, and a 10% chance of a 60% decline (which seems not inconsistent with the idea of Lehman II). If some action is taken that makes no difference to the upside, but changes the downside probabilities, the index level can rise. To get a 4% rally in the index, the probability of the extreme downside scenario has to fall from 10% to 2% -- i.e. from pretty unlikely to highly unlikely. This is what I think happened yesterday. If yesterday's action precipitates a sustained rally, I will have been wrong.

Whenever there is a reasonably big move in the markets, people get excited about just how big it was. I am completely uninterested in these discussions. I do not think that individual days tell you anything at all about what the market is going to do next. The S&P 500 yesterday moved 4.2%, or 2.04x its average true range of the previous 10 days -- the latter is fairly uncommon, in that over the past 20 years, it has happened on around 1% of all trading days -- so perhaps people think it is unusually predictive. This morning I have tested the predictive power of strong up days over the past 20 years in the S&P 500. My strategies buy the market on a given day and hold for two weeks. The metrics used to evaluate them are the percentage of profitable trades, and the profit factor (=profits/losses). Here are the strategies:

• Buy at random. Percent profitable: 59%; profit factor: 1.15.
• Buy on up days when market closes in the top 1/3 of the day's range and true range > average of the previous 10 days x 2. Percent profitable: 55%; profit factor: 0.94.
• Buy on up days when market closes in the top 1/3 of the day's range and the day's move is over 4%. Percent profitable: 55%; profit factor: 0.83.

Unsurprisingly, strong up days are not predictive of good performance in the next 10 trading days. On the contrary, buying on strong up days is a losing strategy even in a market that has generally gone up over 20 years. That makes sense: buying such days will systematically get you in at a higher price than buying at random, and, other things being equal, getting in at a higher price is a bad idea.

Is it time to bet on Egypt? The elections have happened and early indications are a win for the proxy of the Muslim Brotherhood, which stood on a pro-market platform. I think that prolonged civil war is unlikely in Egypt -- either there will be a peaceful transition to democracy and the country will be governed by the Brotherhood, or the generals will manage to keep control. Either way, the environment should not be unfriendly to business. I wonder whether there is a revolutionary risk premium in Egyptian stocks that might present a buying opportunity.

Bloomberg quotes a fund manager as saying the economy is in "A classic Irving Fisher debt deflation." I do not see how anyone could say that. Fisher's debt-deflation story involves a vicious cycle between debt liquidation and falling prices. The fall in prices is crucial. Fisher himself says that "When over-indebtedness stands alone... the resulting 'cycle' will be far milder." Happily today, unlike in the Great Depression, we have both fiat currencies and central banks that are ready and willing to use the freedom they provide to prevent deflation -- exactly as Fisher prescribed. There is a problem of a debt overhang, but the analysis that is useful here is not "classic debt deflation" but classic circular flow. This model breaks the economy into households, firms, government and the external sector, and envisages a simple flow of funds between them. It suggests that for one sector to run a financial surplus -- such as households that want to pay down debt -- at least one other sector must run a deficit. At present, the government is helpfully running one. (This model has short-term implications for austerity programmes -- if government deficits are cut, household surpluses will have to fall). 

Ever since I have started trading for myself, I have asked myself the question: how is it possible to understand the market? It occurs to me that human beings are capable of focusing on only one or two elements of a situation. This means that the most important discretionary input it is possible to have in an investment process is to pick out the salient elements, and that is the skill I have been trying to learn is not so much comprehension as discrimination. What can one do, then, when it is necessary to assimilate several different data points to reach a conclusion, something at which human beings are very poor? Daniel Kahneman suggests some kind of algorithm. For example, when evaluating a fund manager one might score him on a number of different areas and combine the scores using a set formula. Recently I have been using a different approach to understanding the economy: leading indicators. I have created a leading economic indicator and pretty-much replicated ECRI's leading index for inflation. I thought yesterday that it might be worthwhile to create composite indices for other variables that are affected by a range of different factors, and I am going to experiment with so doing for short-term moves in the equity market.

Data:

China cut reserve requirements 50bps (which means a fall from 21.5% to 20% for the largest banks).

ADP non-farm employment change 206k b.e. by a large margin.

Chicago PMI 62.6 b.e. All the regional surveys are in and suggest a small rise in the ISM PMI from 50.8 to around 52.3.

Pending home sales 10.4% b.e. in a big way.

Australia AIG manufacturing index 47.8 -- 9th month below 50 in 2011.

Australia building approvals had another big fall.

Australia RS 0.2% d.e.

China PMI 49, d.e. and fell below 50. HSBC China PMI was revised down from the flash estimate of 48 to 47.7.

Eurozone PMI was as the flash estimate, 46.4.

UK PMI 47.6 b.e. but fell from last month.

Next 24 Hours:

Initial claims

ISM PMI

UK construction PMI

Non-farm payrolls