Yes, my dear reader. This is how quickly you move from away from the apocalyptic abyss . . . → Read More: First Act of Greek Default Proceedings Drawing to a Close]]> Global stock markets are up about 10% since the beginning of the year, volatility has collapsed, US economic data continue to defy even the mild slowdown proponents and the ECB seems to have backstopped the European banking system.

Yes, my dear reader. This is how quickly you move from away from the apocalyptic abyss and back to normal. My base case is that we are close to excess complacency in equity markets and a sell off is overdue, but it is exactly also under these circumstances (where smart money start to hedge) that the market may deliver one final run up to get everyone and the postman in before hosing everyone.

In the short term, one of the only remaining stumbling block in the form of the ongoing default proceedings in Greece seem to be no match for the ongoing positive animal spirit of the equity market. Only a week ago, we got news that talks in Greece had stalled, but most recently we have been reassured that talks are back on track.

The main niggle on the first occasion appeared to be what kind of interest rate that investors would get on their new bonds and thus, ultimately, the loss of face value currently said to be 50% but also, by some, claimed to be as high 62.5%. Another issue would be whether Greece would pass legislation that forces investors to participate in the debt swap if a majority of investors agree to the PSI terms. This was specifically being discussed in the context of a particular group of investors holding both CDS contracts and the underlying bond and who would maximize their payout on the former by forcing through a hard default.

None of the terms seems have changed massively in the past week, but time is running out with March the 20th set as the final deadline as this is when Greece would otherwise have to make a payment of 4.5 billion-euro ($18.7 billion) on maturing debt. The general consensus is that if no agreement is reached, this date would mark the hard default. The reason for the optimism is then that we are very close to full surrender in the form of a 90% participation rate of creditors and, we are told, it is only a matter of time before the final 10% agrees.

The details reported so far are as follows;

Quote Bloomberg (21 Jan 2012)

The parties are near an initial agreement under which old bonds would be swapped for new 30-year securities carrying a coupon that would begin at 3.1 percent, reach 3.9 percent and go as high as 4.75 percent, Athens-based newspaper Proto Thema reported on its website yesterday, without saying where it got the information.

The desired macroeconomic outcome of all this is obviously well advertised. In 2020, Greece is supposed to have a government debt to GDP ratio of 120% and presumingly some form of growth that would allow this level of debt to stay stationary or perhaps even decline over time.

Let me be clear absolutely clear here. Within any conceivably realistic macroeconomic model, there is no way that Greece can reach a stable debt level with moderate growth under these conditions. Under the interest rate scenario noted above (let us with a average interest rate of 3.8% on the new debt) the nominal interest rate would still be substantially higher than the growth rate of the economy. The only way, the nominal debt level could then be kept stationary is by forcing the fiscal balance into surplus. However, the problem is that this affects the denominator in the debt/GDP calculation by sucking out demand (growth) from an economy already structurally impaired (within a currency union and all that).

The implications are clear. The promises of stability that the PSI currently holds (even if it comes with considerable pledges of IMF money) are bound to disappoint.

First act of several to come

First of all, let us be clear. Despite, politicians’ mortal fright to use the D-word and the media’s acceptance of this fact on the basis that CDS contracts are not activated under the PSI, this is a stone wall default. Anyone, who bothered to take merely a scant look at the history of sovereign defaults will see that the current Greek situation fits well within all the models. Indeed, the proposition that this is not a default because CDS contracts are not activated is ludicrous since in the vast majority of sovereign defaults, the debtor country begins negotiations with creditors well before the actual default is forced upon it. The fact that insurance contracts bought to protect a creditor involved in such negotiations have now been rendered useless says more about the nature of the our modern financial system than it does about the definition of a sovereign default.

Hence, we come to the real nature of this game.

The deal which now seems to be close to completed by no means closes proceedings. It is very likely in my opinion that private creditors who are currently the only ones being forced to take a haircut to seniority of the IMF and the ECB will face a near 100% loss on their holdings. The argument here is simple. Given the amount of debt held by the ECB and the IMF and the fact that these two institutions are senior debt holders the debt held by private creditors become something else than actual bonds. It becomes equity, i.e. the tranche which takes the first (and often complete) loss in the event of a default.

Of course, once we reach this point the issue of CDS contracts will rear its head yet again since if a 50-60% haircut can be considered voluntary anything beyond this becomes very difficult to characterize as such. Any rating agency would find it difficult not to classify further losses as a default and thus begins the fun in earnest. And then comes the ECB and IMF’s share. It will be politically dynamite if the ECB had to print on the liability side to cover losses on the asset side on Greek sovereign debt [1].

Finally, Greece only represents the starter here. Any deal agreed on in Greece will be ardently watched in Ireland and Portugal who will feel they are entitled to the same deal with their private creditors.

Most tragedies have several acts, twists and turns. Investors should expect no less from the one currently being played out in the European sovereign debt markets.

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[1] – In practice the ECB could do nothing and see its balance sheet shrink with the amount lost on the asset side (i.e. reduce lending to the banking system (delevering) with the amount lost on the bonds). However, it is likely that it would “need” to credit reserves with the amount lost on Greek bonds (hence printing money). Mind you, only a central bank could do this as it is free to increase the assets of the banking system by creating its own liabilities.

Risky Assets to fly in . . . → Read More: Random Shots – 2011 Musings Edition]]> I did have some plans to do a series of post to give a brief overview of my main macro and trade themes for 2011, but time has, not surprisingly, caught up with me. As such, you will have to make due with a special version of random shots.

Risky Assets to fly in 2011? – This one is a bit too general to answer in full of course, but one interesting discourse that has emerged lately is that as bond vigilantes are feasting on the Eurozone (and even going for an altogether larger prey in the US), investors are being pushed into equities.

Following a well worn cliché in the world of finance, equities is the least ugly alternative.

Now, this may only be a working explanation on the surface since the underlying move into equities is also part of a more structural consequence of QE2 since the Fed is not only trying to move investors around on the yield curve, they are also trying to move them out of the curve altogether and into more risky alternatives. In this sense, what appears to be a melt up in equities might just be a slow but steady excess liquidity driven grind. Surely, Bernanke is in no rush to raise interest rates in 2011 and if the US economy continues to slowly heal, there will be only speed bumps ahead of a general trend upwards. One interesting thing here will be how the market reacts to event the slightest hawkish tone from the Fed or perhaps even a downtoning of the dovish stance. I think; not all too well but precisely because of this assumption (which I think many share with me), the Fed will remain uber dovish as far ahead as the eye can see.

Technically, I think the melt up towards the end year is in for a rude stop in the beginning of the year and I have the SP500 declining to about 1180-1190 in January. This would then provide a potentially tasty entry point for a 2011 rally. Other than a veritable cataclysm in the Eurozone (which appears the main source of systemic risk at the moment) and China suddenly slamming on the breaks in an unduly harsh manner, I see little resistance for risky assets in 2011. This is especially the case as the BOJ and the ECB will likely add their interpretation of “QE2″ to the table to respond to the ongoing sluggishness of their respective economies.

We have already gotten a barrage of 2011 predictions and outlooks from research houses, banks and other financial sages and quite frankly it is quite difficult to get a bearing on it all. I did find the Barclay Macro survey quite interesting though as it shows that about 70% of all investors see risky assets in the form of commodities and equities to outperform in 2011 while US treasuries will underperform. The underlying rationale is again quite simple I think. Given the severity of the crisis, monetary policy will tend to apply the brakes with a considerable lag and if 2010 saw the first signs of the effect of such a lag, 2011 could give us the full force. Again, this is especially important to note as the ECB and the BOJ might just be about to join the party.

On the other hand, “underperforming treasuries” will also present Bernanke with a dilemma in the sense that the extent to which the infamous bond vigilantes fancy more than a pot shot on US bonds he may be forced to apply even more pressure to keep yields low.

Low Growth in the OECD – This one is hardly news and hardly one exclusively for 2011 either. However, I still think there is a lack of recognition of just how low growth in the OECD is likely to come in for the coming years. In this way and just as investors have their focus set on outperformance in Asia and Latin America, I think that the ultimate growth outcome in the OECD will be worse than the market currently expects.

The point I am basically getting at is that we need to think about the fact that the Eurozone periphery essentially are going to be hampered by negative trend growth rates and that the rest of the OECD will be dependent on exports to grow (think mainly Germany, Japan and now also the US). Apart from any productivity miracle or some other exogenous source of growth, the growth engines in the OECD are simply tapped out. Indeed, this is probably the most important structural macro theme for me at the moment.

Now as for 2011, a lot of this will also depend on whether economies really intend to walk the walk in terms of fiscal tightening or whether they are simply talking. Clearly, countries under the spotlight in the form of the Eurozone periphery will see their growth rates severely dented by the need to consolidate public finances. In the US on the other hand, I think the latest estimate for the 2011 budget deficit is 10% of GDP which is hardly tight.

According to the IMF’s latest forecasts “Advanced Economies” will be running a deficit on the structural balance to the tune of 5% in 2011 and the G7 as a whole one of 5.88%.

But all this only goes to accentuate the issue since if there is one thing we have learned by now it is that one cannot borrow ad infinitum and especially not as you are essentially borrowing against a depreciating asset in the form of future growth held down by population ageing. So the big (as in biig!) question is; if you substract the 5% government spending induced deficit from the equation what kind of trend growth rate is left in the OECD as a whole?

Clearly, we know that some economies are now basically saddled with negative trend growth rates, but I think that even the aggregate number in advanced economies would be scary reading. We could call this decoupling in reverse and thus how vulnerable we now are to the continuing growth spurt of Asia and other so called emerging economies. But in the end, it is a basic question of not having any more components of the national identity to lever up as it is obviously clear that governments are only going to find it increasingly difficult to borrow (even in the case of very generous central banks).

Indeed, as we move forward I see this low growth environment for the OECD (and actual negative trend growth in some economies) as one of the main components in my call that we are going to see some spectacular and costly sovereign defaults in the OECD edifice going forward. On this, I think the current mess in the Eurozone is only the beginning.

The Euro and the Eurozone - Actually, I have not followed FX a lot lately so I am a bit of out form here, but I still use my Old Maid metaphor when thinking about big global currency movements and intra G3 movements especially. Interestingly, 2010 saw the JPY as a looser and thus holder of Old Maid in the sense that it appreciated significantly against the USD and Euro. In essence, the USD was being held down by the Fed’s policies and the Euro actually acted as a nice buffer against the crisis in the Eurozone as it fell strongly throughout the spurts of Eurozone tension in turn providing a much needed boost to external competitiveness when it was needed the most.

In principal, these trends do not stop at year end and will continue to dominate at least part of the intra G3 movements in 2011. The main question is what kind of bazooka, if any, the BOJ will pull out to revive the ailing Japanese economy. If it becomes the kind of shock and awe many are expecting we could be into a nasty long squeeze in the JPY. This also goes for the Euro in the context of the ECB being forced, kicking and screaming, into supporting Eurozone bond markets. I hold this to be almost given since the current setup simply does not work.

Today, Trichet called for more bold action on the fiscal front and in terms of capitalising the stability front (didn’t he just tell them to tighten their belts?). This is no doubt part of a futile attempt to preempt any defacto query, to the ECB, by part of the EU on taking an active and open role in the bailout. Trichet and his compadres are not going to like it, but the alternative asking Italy and Greece to pay for the bailout of Spain who in turn helped finance Greece and Ireland is simply hogwash.

As I have noted on several occasions; should the issue turn out to be contained with Greece, Ireland and Portugal the fiscal solution/stability fund would suffice, but evidently we are looking at a much more structurally problematic issue and Spain is surely next in line and even yields on German and Belgium bonds have begun to break loose. As such, it is becoming increasingly clear that the ECB will have to take a more active part beyond “simply” supplying liquidity to the banking system and buying bonds on the drip (or covertly).

I tend to have little opinion on the EUR/USD in general, but I will timidly forward the idea that we can expect the ECB to surprise with some of open support to the periphery, it should provide some pressure on the single currency. Yet, it is also fair to assume that the extent to which risky assets fly in a bath of excess liquidity the USD will depreciate and the Eurozone will gain on carry flows as interest rates are still higher in the Eurozone (especially, if things get so calm that the ECB starts turning hawkish again, but this may be selfdefeating in itself of course).

Emerging Markets – Well, the EM story is important enough to merit its own section even if it is intimately tied to the risky asset story. Yet, there is no need to re-invent the wheel and in this sense I think that Morgan Stanley’s Manoj Pradhan’s recent note on the 2011 EM outlook is pretty much accurate in all the important areas.

Especially his first point is important on structural outperformance by the EM relative to the developed world whereas 2011 should see EM growth cooling and, hopefully, growth in the developed world nudging up. As such, 2011 will see relative outperformance by developed markets. This is a bold, but also astute, call. It is bold because I think the link between the EM and DM is still too strong to see DM growth decouple entirely for a relative slowdown in emerging markets. In this sense, how far and how fast monetary policy in emerging markets are tightened in response to fears of overheating will be key. It is astute because, all things point in the direction of a slowdown in the emerging world after a breakneck 2009 and 2010 and in this sense, on the margin, perhaps the developed world is the place to be in 2011 on a tactical basis.

I also like that he spends some time on the inevitable, but important, process of rebalancing away from a reliance of an overlevered Anglo-Saxon consumer in the OECD (and of course, a now cracked Eurozone periphery). Reverse decoupling and rebalancing towards the emerging markets are two of the main global discourses and real economic drivers at the moment.

Finally, I think it is also important to re-emphazise the basic problems emerging markets face as they try to cool their economies through higher interest rates only to allow more hot money flowing in. The policy mixture is obviously being developed as we move along with some form of capital controls being implemented across the board. In a world of structural excess liquidity this policy dilemma becomes an additional issue on top of the more traditionally discussed trilemma.

As such, I am large cautious on the emerging markets going into 2011 as I think they are overloved, but the long term bull call stands uncontested. In addition, there appears to be general acceptance and expectation that key emerging economies (China most notably) will react strongly to any lingering signs of overheating and just as Bernanke might not care that his low interest rates will fuel asset bubbles far from the shores of the US, so may Chinese policy makers care very little if they have to slam on the brakes to the detriment of global growth and OECD’s recovery.

Now the Fed might be able to prop up the bond market in nominal terms, but what this will do is precipitate . . . → Read More: Does Dina Titus Support Wild Speculators?]]> As I articulated in a previous commentary, if the Fed stays loose to prop up the bond market, this will only undermine the bond market.  In real terms, the bond market tanks.

Now the Fed might be able to prop up the bond market in nominal terms, but what this will do is precipitate an exodus from all dollar-denominated securities (e.g. equities and bonds), compelling speculative activity in other asset classes in order to protect themselves against a depreciating currency.

As the Fed undermines Tituslandia’s bond market in the process of trying to prop up it up, yields remain artificially low.  This compels lenders/investors to seek higher rates of return in other asset classes.  I can only conclude, then, that Dina Titus supports wild speculators.

The Mystery Behind the Parabolic Yield Curve is a nice report by Gary Dorsch, an American chartist I follow. Rarely does Australia get a mention in his reports. It is good that he’s done so now. His charts . . . → Read More: The Australian Yield Curve and Mortgage Rates]]> Below is a short commentary on mortgage rates I received from Jackarine Ludwig of Aggregated Awareness:

The Mystery Behind the Parabolic Yield Curve is a nice report by Gary Dorsch, an American chartist I follow. Rarely does Australia get a mention in his reports. It is good that he’s done so now. His charts a good, because they tie in with political & economic events.

Although I don’t see the rise in the Australian yield curve as a mystery. And whether Wayne Swan wishes to call it the fault of the ‘bond vigilantes’ in the US Debt markets or not is irrelevant. Fact is, China is the biggest foreign holder of bonds, both from the US and elsewhere, including Australia. It is obvious that they are the ‘bond vigilantes’ which Swan refers to.

Regardless, it makes perfect sense from a fundamental supply/demand equation, that more supply would reduce prices, so I don’t know what Swan is complaining about? Under his, Ken Henry’s & Kevin Rudd’s command, the Treasury is going into record setting hock mode for the foreseeable future. By 2012, this government has projected a total deficit of A$300 billion. You read that right, that’s billion with a B. What did he reckon was going to happen? Bond Prices to rise & yields fall when he was getting involved in issuing more bonds? HaHaHaHa…What a fool. It is obvious to anyone with a brain, that more Australian bond supply would reduce bond prices & subsequently increase yields. Nothing conspiratorial there Mr. Swan.

If you wish to follow the short & long end bond yields of Australia, US & UK, may I suggest this site. It is updated daily.

Now if you didn’t think bond yields are important, then you have obviously never borrowed any money or paid any taxes. If you have borrowed money or paid taxes, then I can say that the yields on 3 year Aussie Treasury bonds, sets the mortgage rate for 3 year adjustable rate mortgages, and the 10 year Aussie Treasury bond sets the rate for longer term mortgages, the 7 year, 10 year or 15 year fixed rate mortgages. And these yields are the interest paid by your tax dollars toward those creditors who have purchased these bonds, both domestic & foreign.

For mortgages, the normal rule of thumb is that banks add 2.5% to the price of these bonds to come up with the mortgage rates. Although lately, because of the rising bond yield, and the fact that it’s politically unpalatable to raise home loan rates at the moment, the banks have been copping the bond rate increases and not passing it onto retail borrowers. Therefore, in the past month, banks have not been adding 2.5% to bond yields to calculate their mortgages, but more like 1.7% for the 15 & 10 year fixed mortgages. But I read a story yesterday that said that CBA were looking at raising rates again, but having just gone to their site we can see that they haven’t raise them yet.

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