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Friday, May 8, 2009
Stressing the tests
I won't even go into the ludicrous nature of the tests themselves, I'll let Yves Smith, William Black, and Tyler Durden do that for me.
So banks are doing well? Then why are Wells Fargo (WFC), Bank of America (BAC), Morgan Stanley (MS), and Citi (C) raising more cash by issuing equity (and adding billions to a preferred/common equity conversion plan in Citi's case). This is after BAC and Citi said they have no plans to raise more capital. I have been repeatedly stating that I expect insolvent financials to be issuing massive equity into this rally, and that is exactly what is happening.
Simon Property Group (SPG) diluted shareholders for the second time this year, which combined with Goldman's SPG short squeeze last month has left the public bagholding worthless equity.
The ECB cut rates to a record-low 1%, a clear indication the ECB is playing catch-up and will be resorting to quantitative easing soon enough, as I have been expecting. Berlin has been slow, if not deaf, to react to the Eastern European crisis and the Euro is going to face massive devaluation in coming months, especially considering the weak bond auctions lately in Germany.
The FDIC's credit line has been extended to $500B by Congress in the first wave of FDIC bailouts, like I've been mentioning. As more banks fail and more money is pledged to the presently-insolvent FDIC, watch gold rise sharply.
General Motors (GM) issued 60 BILLION new shares to dilute shareholders ahead of its June 1 bankruptcy (deadline). Yet it still trades at $1.60? Clearly sustainable, you can thank the green shoots for that.
The chairman of Hong Kong Exchanges LLC is saying stocks are at "their most expensive valuations since January" and is refusing to buy stocks at these levels. I'd have to agree, as market-neutral strategies are getting whipsawed hard and distribution volume continues to outpace accumulative volume.
With rates rising again in the short-term, expect a lot of more QE in coming FOMC meetings, until the Treasury bubble is sufficiently inflated, which equals the subsidization of enough losses for the contentment of the Federal Reserve. Once the QE is finished and rates start rising naturally, inflation will bleed into the economy (and equities), and gold will skyrocket. The nominal bottom in stocks will be seen in 2009, it's just a matter of time until we know whether the bottom was March 2009 or late summer 2009.
With so much equity being issued into this rally, insider selling at October 2007 levels, liquidity providers being forced to deleverage, and volume nowhere to be found, the sustainability of this rally is clearly suspect and whenever it does reverse, it will be hard and into an illiquid market. I have been getting wrecked as I try shorting this tough market, and recently a beautiful falling wedge in ultrashort ETFs was BROKEN DOWN on heavy volume. This corresponded with a rising wedge BREAKOUT in market indices. This equals parabolic. The reversal is inching closer and closer. If anything, this rally has taught me to rely more on technicals for entry/exit points, as the "unnatural" manipulative forces at work driving this rally are NOT to be underestimated. The sustainability of this rally is not to be bought into, however. This is a "broken" market with zero liquidity left and the impending reversal will uncover the true nature of this bear bounce, a market illquidity event. With a market with such low liquidity, Dow 9000/200DMA is possible, though improbable. I still expect my ultrashort ETF positions to yield massive gains when everything is said and done, but unfortunately the entry points weren't ideal.
Watch US and Euro nation sovereign CDSs to explode soon and the massive short squeeze in credit markets to be met with a dramatic reversal. For all of you bulls out there, if the Treasury's and Fed's capital injections have truly forced a bottom in equities, why is gold stagnant? Without government backstops, these banks are all insolvent, so why hasn't inflation crept back into the picture? If economic second derivatives are driving equities higher, surely inflationary risk should be driving gold much higher? The Dow/gold ratio needs to hit 1 before we bottom in real terms. Simple as that.
I leave you with the words of terrific market prognisticator David Rosenberg:
So banks are doing well? Then why are Wells Fargo (WFC), Bank of America (BAC), Morgan Stanley (MS), and Citi (C) raising more cash by issuing equity (and adding billions to a preferred/common equity conversion plan in Citi's case). This is after BAC and Citi said they have no plans to raise more capital. I have been repeatedly stating that I expect insolvent financials to be issuing massive equity into this rally, and that is exactly what is happening.
Simon Property Group (SPG) diluted shareholders for the second time this year, which combined with Goldman's SPG short squeeze last month has left the public bagholding worthless equity.
The ECB cut rates to a record-low 1%, a clear indication the ECB is playing catch-up and will be resorting to quantitative easing soon enough, as I have been expecting. Berlin has been slow, if not deaf, to react to the Eastern European crisis and the Euro is going to face massive devaluation in coming months, especially considering the weak bond auctions lately in Germany.
The FDIC's credit line has been extended to $500B by Congress in the first wave of FDIC bailouts, like I've been mentioning. As more banks fail and more money is pledged to the presently-insolvent FDIC, watch gold rise sharply.
General Motors (GM) issued 60 BILLION new shares to dilute shareholders ahead of its June 1 bankruptcy (deadline). Yet it still trades at $1.60? Clearly sustainable, you can thank the green shoots for that.
The chairman of Hong Kong Exchanges LLC is saying stocks are at "their most expensive valuations since January" and is refusing to buy stocks at these levels. I'd have to agree, as market-neutral strategies are getting whipsawed hard and distribution volume continues to outpace accumulative volume.
With rates rising again in the short-term, expect a lot of more QE in coming FOMC meetings, until the Treasury bubble is sufficiently inflated, which equals the subsidization of enough losses for the contentment of the Federal Reserve. Once the QE is finished and rates start rising naturally, inflation will bleed into the economy (and equities), and gold will skyrocket. The nominal bottom in stocks will be seen in 2009, it's just a matter of time until we know whether the bottom was March 2009 or late summer 2009.
With so much equity being issued into this rally, insider selling at October 2007 levels, liquidity providers being forced to deleverage, and volume nowhere to be found, the sustainability of this rally is clearly suspect and whenever it does reverse, it will be hard and into an illiquid market. I have been getting wrecked as I try shorting this tough market, and recently a beautiful falling wedge in ultrashort ETFs was BROKEN DOWN on heavy volume. This corresponded with a rising wedge BREAKOUT in market indices. This equals parabolic. The reversal is inching closer and closer. If anything, this rally has taught me to rely more on technicals for entry/exit points, as the "unnatural" manipulative forces at work driving this rally are NOT to be underestimated. The sustainability of this rally is not to be bought into, however. This is a "broken" market with zero liquidity left and the impending reversal will uncover the true nature of this bear bounce, a market illquidity event. With a market with such low liquidity, Dow 9000/200DMA is possible, though improbable. I still expect my ultrashort ETF positions to yield massive gains when everything is said and done, but unfortunately the entry points weren't ideal.
Watch US and Euro nation sovereign CDSs to explode soon and the massive short squeeze in credit markets to be met with a dramatic reversal. For all of you bulls out there, if the Treasury's and Fed's capital injections have truly forced a bottom in equities, why is gold stagnant? Without government backstops, these banks are all insolvent, so why hasn't inflation crept back into the picture? If economic second derivatives are driving equities higher, surely inflationary risk should be driving gold much higher? The Dow/gold ratio needs to hit 1 before we bottom in real terms. Simple as that.
I leave you with the words of terrific market prognisticator David Rosenberg:
Of all the market forecasters, Mr. Bond gets it right most often.With 30yTs tanking and T-bills showing massive demand, clearly Mr. Bond is bearish.
Thursday, May 7, 2009
Parabolic charts...
...finally showing distirbution and topping patterns.
Ahead of stress tests, massive gap up in bank stocks (and indices). Met with massive distribution all day.
Expect a gap down tomorrow after test results are released at 5PM today and a sell off for the next 6-8 weeks.
If we consolidate the market's rally so far (I literally have no idea how this would happen but IF we do) with no reversal sell-off, then my thesis for the last couple months goes out the window.
Watch gold here and especially in a few months. Bond auction was met with poor results today, expect massive QE in FOMC meetings from here. Also, if equities decline from here or if rates keep rising (my TBT play is doing great), watch USA sovereign CDS to explode and American sovereign credit to tank, which is heavily bullish for gold. I am long IAG and GLD but that is the only material exposure I have to precious metals.
Let's see how liquid and sustainable this market and its rally really are. Here we go...
Ahead of stress tests, massive gap up in bank stocks (and indices). Met with massive distribution all day.
Expect a gap down tomorrow after test results are released at 5PM today and a sell off for the next 6-8 weeks.
If we consolidate the market's rally so far (I literally have no idea how this would happen but IF we do) with no reversal sell-off, then my thesis for the last couple months goes out the window.
Watch gold here and especially in a few months. Bond auction was met with poor results today, expect massive QE in FOMC meetings from here. Also, if equities decline from here or if rates keep rising (my TBT play is doing great), watch USA sovereign CDS to explode and American sovereign credit to tank, which is heavily bullish for gold. I am long IAG and GLD but that is the only material exposure I have to precious metals.
Let's see how liquid and sustainable this market and its rally really are. Here we go...
Friday, May 1, 2009
Chartology
10-Year Treasury Notes ($TNX) yields are on the rise again after the most recent FOMC announcement. In Mid-March, rates tanked on news of quantitative easing, but the bond market has since shrugged it off as insufficient and yields are at higher levels than pre-QE. In fact, they're at their highest since November of last year. Evidently the stimulus isn't enough and the bank earnings rally wasn't indicative of the economic state that still persists. Equity markets scream complacency while bond markets are calling shenanigans.
13 Week T-Bills ($IRX) are showing lower yields and more demand, even in the face of this rally (signified by the SPDR S&P 500 ETF in green on the chart). This suggests risk aversion in bond markets despite the stock ascent. The low volume in stocks and the outflow from longer-term Notes into short-term T-bills suggests an impending reversal in stocks and an end to the present irrationally exuberant consensus on economic conditions in the United States.
The Nasdaq Composite ($COMPQ) has finally reached its 200DMA and found some serious supply at that level. In markets where prices fall significantly below long-term moving averages, like in the case of a crash, large bear rallies to these long-term averages often occur, but they are nothing more than bull traps.
For some perspective, this is the Dow Jones Industrial Index ($DJI) in 1929-1930. After the fall 1929 crash, you can see a rising wedge bear rally of more than 50% into its 200DMA around mid-April 1930. This sounds identical to the current market, especially when compared to the Nasdaq index. From there, the Dow tanked and eventually broke its crash lows and went on to go much, much lower. The Fed's QE + Treasury's spending + FDIC's guarantees won't allow deflation for an extended period like the 30s, but it is important to note the nature of bear rallies and not get complacent.
The last chart is the Direxion 3x Inverse Financials (FAZ), the wild high-convexity ETF on which I'm so bullish. Chart shows a falling wedge coiling for breakout, corresponding with the apexes I'm seeing in index charts. It is important to note, however, that if this rally has one more "upswing" left, it could be a parabolic move of sorts because of the lack of liquidity in the market, very similar to January of this year. The subsequent reversal would be that much more volatile and strong but it is important to keep all options considered.
13 Week T-Bills ($IRX) are showing lower yields and more demand, even in the face of this rally (signified by the SPDR S&P 500 ETF in green on the chart). This suggests risk aversion in bond markets despite the stock ascent. The low volume in stocks and the outflow from longer-term Notes into short-term T-bills suggests an impending reversal in stocks and an end to the present irrationally exuberant consensus on economic conditions in the United States.
The Nasdaq Composite ($COMPQ) has finally reached its 200DMA and found some serious supply at that level. In markets where prices fall significantly below long-term moving averages, like in the case of a crash, large bear rallies to these long-term averages often occur, but they are nothing more than bull traps.
For some perspective, this is the Dow Jones Industrial Index ($DJI) in 1929-1930. After the fall 1929 crash, you can see a rising wedge bear rally of more than 50% into its 200DMA around mid-April 1930. This sounds identical to the current market, especially when compared to the Nasdaq index. From there, the Dow tanked and eventually broke its crash lows and went on to go much, much lower. The Fed's QE + Treasury's spending + FDIC's guarantees won't allow deflation for an extended period like the 30s, but it is important to note the nature of bear rallies and not get complacent.
The last chart is the Direxion 3x Inverse Financials (FAZ), the wild high-convexity ETF on which I'm so bullish. Chart shows a falling wedge coiling for breakout, corresponding with the apexes I'm seeing in index charts. It is important to note, however, that if this rally has one more "upswing" left, it could be a parabolic move of sorts because of the lack of liquidity in the market, very similar to January of this year. The subsequent reversal would be that much more volatile and strong but it is important to keep all options considered.
Wednesday, April 29, 2009
A delve into the March-April rally in equities
The S&P 500 is now up 31.0% since off of its March 6 lows around 666. Europe's Dow Jones Stoxx 600 Index has broken even YTD. But since the announcement of the Public-Private Investment Program (PPIP) on March 23, the equity market's rally has been defined by a rising channel on low volume. There have been no high-volume breakouts, the channel-defined uptrend's slope is very low, and the market has trended approximately sideways since April 9.
Readers may notice I mentioned the possibility of a rally to Dow 9000 back around the PPIP announcement. I mentioned this because if the Fed and Treasury were intent on printing our way out of this starting as soon as possible, their combined price-inflating powers would be unstoppable. There is no check or balance to the Federal Reserve and there has never been an audit of its balance sheet.
However, since the PPIP's announcement, the equity market has not shown traditional bullish technical movement. A slow ascending channel on low volume indicates a sloppy, bleeding market to the upside, nothing more than a setup for big downside action. Also, gold went down since the PPIP's announcement, which didn't add confluence to the price-inflating thesis behind the Dow 9000. This is why I turned bearish on the market, expecting a drastic sell-off, possibly to March lows and maybe below.
With such low volume, how is this market continuing its slow, yet upward ascent? Quant fund deleveraging has become the reason of choice to which this market movement has been attributed. Quants tend to short stocks with weak fundamentals and relative weakness versus indices, and quant deleveraging should manifest in weak stocks seeing dramatic share surges as quants scramble to cover shorts to lessen market exposure. And that's exactly what's happened. Stocks like XL Capital (XL), American Capital (ACAS), Vornado Realty (VNO), and Liz Claiborne (LIZ) showed massive rallies since March lows, leading the market and far outpacing stronger, more fundamentally-strong stocks, even ones with high beta. Even Crocs (CROX) enjoyed a 50DMA breakout. This is highly indicative of a "short squeeze" bear bounce, rather than a sustainable bottoming rally, which is characterized by new market leaders and sectors showing relative strength against previous leaders and breaking out of tight bases formed over several months.
Even if perennial short candidates are being squeezed, why? Why are quants deleveraging so quickly into this rally? It seems like the initial rally ingiters caught quants (and reality in fact) surprised. I am of course talking about the Citigroup (C), Bank of America (BAC), and JPMorganChase (JPM) memos/releases announcing returns to profitability for the banks. Then came the earnings reports to back them. As many of you know by now, these announcements were all a load of hot air, as illegal AIG (AIG) wholesale portfolio unwinds financed the one-time "fixed-income trading" revenues that boosted all of the earnings and FASB accounting gimmickry allowed writedowns to take a minimal cut from positive surprises.
On top of that, however, Zerohedge pointed out the significant role Goldman Sachs (GS)'s program trading arm is having during this rally. With 1 billion shares principal traded becoming a weekly regular for Goldman and its principal/customer facilitation+agency maintaining a ratio above 5x, Goldman has been massively increasing its participation (in its principal trading, at that) while other quants and prog trading arms are quickly deleveraging. The conspiracy theorist in me wants to say the Fed/PPT is throwing kool-aid capital at the market through administration girlfriend Goldman Sachs to drive up the market and force short covering. Of course, this is timed perfectly, as banks offer BS earnings reports financed by illegal AIG transactions aided and abetted by the Fed and Treasury. But of course, only the conspiracy theorist in me would ever dare make such an assertion.
As a recap, this rally starts primarily with the AIG unwinds. AIG was bailed out by the Federal Reserve in September 2008 as its bankruptcy was deemed a systemic risk because of AIG's massive counterparty obligations in the CDS arena. The liquidity extended by the Fed to AIG was meant to allow CDS settlements to counterparties at significant haircuts, but with enough payment to prevent a systemic crisis. But were haircuts taken or were these trades settled at 100% face value with massive profits to counterparty banks? Former New York Attorney General Elliot Spitzer clearly seems to think not, as he wrote in his terrific article The Real AIG Scandal. All of the hooplah has led TARP's inspector general Neil Barofsky to launch an investigation into the extent of contract settlement repayments. Bank of New York Mellon (BK) missed earnings estimates by $0.10 in the middle of amazing Q1 numbers from the other big banks. Such is the result when you aren't eligible for AIG counterparty money. Especially interesting is Goldman Sachs's counterparty relationship to AIG, an issue delved into as early as last September itself in the the NY Times.
But I digress. The AIG CDS unwind trades were allowed by new trade protocols given by the IDSA, the only regulator of the OTC CDS market. In turn, these massive unwinds (financed by the taxpayer, who paid for the initial AIG bailout and all credit lines extended since) yielded huge one-time profits for banks, who flaunted them like no tomorrow. After releasing memos (the first of which was from Citi on March 10, the rally's first day) asserting first-quarter profitability, banks saw huge rallies in their stocks. At this point off of the lows, the rally was merely an oversold bounce and its sustainability was very much in question. Looking back, any sideline capital that was infused into financials on the news of these memos was misallocated, as the memos presented one-time illegal gains as indicators of sustainable turnarounds in bank earnings.
The market rallied on the news and started selling off around S&P 800, at January cycle lows and index 50DMAs. This is where I expected the rally to end, as previous support (January lows) tends to offer resistane once broken and important moving averages like the 50DMA offer important buy/sell points, depending on the market.
Then came news of the PPIP and the market once again soared. Since then, the market has rallied just over 6% on very low volume. This is where the quant dislocation comes into play. Quants, who make market-neutral high-frequency scalp trades on leverage to produce returns, were caught short in a strong rally. Again, the rally itself was initially catalyzed by bank announcements that attempted to present unsustainable profits as sustainable, so the rally in effect of the news would also be just that-- unsustainable. But the quants were forced to deleverage into the rally as their models were getting whipsawed by the unusual market activity. As they deleveraged and covered short positions in weak stocks and were forced to hedge their delta by taking bullish positions, this added fuel to the rally, which caused more deleveraging, and so on. This is evidenced by Renaissance's recent underperformance against the S&P by 17%, as well as a possible reason for the possible unwinding of Morgan Stanley's PDT arm. A recent WSJ article even claims quants are "brewing trouble" over at Morgan Stanley.
So where is the breaking point? A look into the why instead of how of this rally can offer some insight. This whole rally is essentially a scam to pass off asset depreciation in struggling financials to the taxpayer. The AIG counterparty profits were all taxpayer-financed. The PPIP's leverage is taxpayer-financed. But the real issue is the equity raises in this rally. Goldman announced an equity sale with its earnings a day after pre-announcing earnings. This is $5 billion of Goldman equity being traded for $5 billion of the public's cash on misconceived presuppositions of sustainable profitability. REITs have been offering shares all over the place, and conspiracies of their own have developed between the connection of JPMorganChase and Merril Lynch/Bank of American analysts and the REIT secondaries these banks have been underwriting.
Also, the recent surge in Goldman principal program trading starts to take some context here. If Goldman's program trading arm has been feeding into the rally and forcing quant deleveraging, then this explains why-- so it can raise cash by selling stock. Which I predicted and which indeed occurred. It'd be interesting to know how much of Goldman's $5B have been raised at these scam-inflated prices ($123/share I believe was the going price for the secondary). As soon as it's "finished," I fully expect GS's 5x principal/customer facilitation+agency ratio to fall off a cliff. On top of the equity sale, Goldman also just sold $2B in bonds, just days ahead of stress test results. Again, the timing is very strange. In a terrific article entitled Goldman's Offering and Recent Rally: Coincidence?, Ben El-Baz states "although there is no hard evidence that Goldman intentionally hyped up the market rally and the financial sector to get a better price on its offering, it would be very naïve to assume that they passively let the market determine the price of this massive dilution." This principal trading participation is the circumstancial evidence I'm sure he would love to see to back up his thesis.
Technically, the rally should end when quant deleveraging catches up with the rest of the market. That is, when the slow-money directional trend-setters deleverage their long buy-and-hold positions into the rally at a higher pace than the fast-money liquidity-providing quants do. This should occur at important inflection points where lots of supply is offered, otherwise known as resistance levels. I have been pointing out S&P 875 as a significant resistance level that might mark the rally's top and so far it hasn't been able to breach that level past a few points on no volume.
The selling/deleveraging into the rally has already started and should start picking up on volume soon. According to Washington Service, NYSE listed company insiders have been selling into this rally at the fastest rate since October 2007. Insiders sold over $8 for each dollar they purchased of stock in the first three weeks of April. To give that some context, the S&P topped out on October 11, 2007 and declined 57% before hitting March 2009 lows. If everything is so peachy and keen in the market and economy, why aren't insiders buying or at least holding stakes in their own companies? Possibly because they recognize that the "green shoots" are just weeds.
When it does end, slower money participants will be selling into a highly illiquid market, due to the deleveraging quants (liquidity providers) have had to face in the last several weeks. This will cause a spike in volatility and failed trade executions and whipsaws galore. Reality will quickly return to the market and the AIG CDS unwind story may gain more exposure, especially through the work of Barofsky and Spitzer. This would damage the investment thesis of all those who bought banks on their memos or earnings announcements, which would erase a big part of their recent huge gains.
So who loses in this rally? The taxpayer of course. As bank equity is sold to the public into a rally financed by illegal and unethical uses of taxpayer funding. This is clearly all done with the full aiding and abetting of the Treasury and Federal Reserve, which has come under recent attack because of its alleged involvement in forcing BofA CEO Ken Lewis to buy Merrill Lynch and hide the distressed bank's true dismal state of affairs from BAC shareholders. If Goldman's principal trading increase is indicative of PPT activity, that also is taxpayer money being funnelled into an unsustainable rally, this time through the intermediary of Goldman's program trading arm.
The memos, the earnings, the statements all say the same thing-- banks made money Q1 2009. They don't mention why-- because of AIG portfolio unwinds and accounting gimmicks. Clearly causing an unsustainable hype in the soundness of American banks will lead to an unsustainable rally in equities. And that's what is happening.
The United States GDP contracted over 6% in Q1 2009, well worse than estimates. A flu outbreak characterized as an imminent pandemic by the WHO is spreading across the world, with early targets at total losses estimated around $2-3 trillion. General Motors (GM) announced its debt restructuring plan this week, met with sharp criticism and a drastically different counteroffer from bondholers, suggesting Chapter 11 is in order for the struggling automaker. Chrysler is expected to announce its own bankruptcy tomorrow. Even government stress tests, whose worst-case scenarios are tangentially worse than current economic conditions, suggest at least six of the 19 banks tested need to raise more capital. The selling catalysts are all over the place, while the buying catalysts were one-time unsustainable profits.
After announcing $1.2 trillion of arranged agency and Treasury purchases in mid March, The Federal Reserve didn't announce anymore quantitative easing today, while keeping rates at all-time lows. Once markets sell-off and liquidity once again contracts, the Fed will have much more political capital left to be able to monetize much more of this ludicrous spending. Expect rates to rise from here (TBT is a good play for that) until the next wave of deflationary deleveraging and equity selling allows the Fed justification for another big round of QE, again capping rates and inflating the Treasury bubble. Mortgage rates are at Greenspan levels. Clearly the powers that be are reflating a reflated bubble. From dot-coms to houses and now to Treasuries. What is all of this? Passing off asset depreciation to the taxpayer in the form of currency depreciation. Wait for the black swan in Treasuries to implode the bubble (which is currently inflating), rates to rise, and rampant inflation.
But I yet again digress. Looking at the market right now, it is approaching the apex between important resistance at S&P 875 and the support trendline of its ascending channel. After breaking its shorter term rising wedge, it has formed a bear flag, and is approaching a break of its channel trendline, which should send the market falling. Other indices show similar bearish patterns, with the Nasdaq approaching massive supply at its 200DMA. Several oscillators have indicated divergences lately, suggesting the market is ready for its next wave down.
A breakout of 875 on big volume would change things, possibly indicating the BS rally found a way to incite slow money to buy into the rally, perhaps bringing enough buying power in to confirm a sustained bull market (assuming the Treasury continues to spend and the Fed continues to print). Irrational exuberance has been evident in the markets before but the deciding factor that allows it to drive sustainable (at least for the 1-2 year time horizon) bull markets is the inclusion of slow-liquidity sidelined instutional directtional trend-setting capital in the rally. There is volume to direct the equity prices' ascent. That simply doesn't exist right now and premarket gaps up are responsible for a big part of the rally. For the rally to continue, even in the face of complete irrationality, it needs sidelined cash to come pummelling into equities. It needs large volume accumulation to drive directional trends. A low volume rally floating higher is not indicative of any of that.
I want to say here that I understand there is no arguing with the market. It is never "wrong" as only price pays. I share the opinion that the only "fair" price of a stock (or anything in the world) is its current price in the open market-- the intersection of supply and demand. However, that does not mean price trends that appear sustainable are sustainable. That does not mean market participants are always right in their trades or that their investment theses are "right." My point is that this current rally is unsustainable and the higher we go, the harder and more volatile the fall will be. The catalysts behind the rally were all BS and there is clear government-bank collusion to pass off losses to the taxpayer.
I leave you with charts of securities I see possible big trades in.
Readers may notice I mentioned the possibility of a rally to Dow 9000 back around the PPIP announcement. I mentioned this because if the Fed and Treasury were intent on printing our way out of this starting as soon as possible, their combined price-inflating powers would be unstoppable. There is no check or balance to the Federal Reserve and there has never been an audit of its balance sheet.
However, since the PPIP's announcement, the equity market has not shown traditional bullish technical movement. A slow ascending channel on low volume indicates a sloppy, bleeding market to the upside, nothing more than a setup for big downside action. Also, gold went down since the PPIP's announcement, which didn't add confluence to the price-inflating thesis behind the Dow 9000. This is why I turned bearish on the market, expecting a drastic sell-off, possibly to March lows and maybe below.
With such low volume, how is this market continuing its slow, yet upward ascent? Quant fund deleveraging has become the reason of choice to which this market movement has been attributed. Quants tend to short stocks with weak fundamentals and relative weakness versus indices, and quant deleveraging should manifest in weak stocks seeing dramatic share surges as quants scramble to cover shorts to lessen market exposure. And that's exactly what's happened. Stocks like XL Capital (XL), American Capital (ACAS), Vornado Realty (VNO), and Liz Claiborne (LIZ) showed massive rallies since March lows, leading the market and far outpacing stronger, more fundamentally-strong stocks, even ones with high beta. Even Crocs (CROX) enjoyed a 50DMA breakout. This is highly indicative of a "short squeeze" bear bounce, rather than a sustainable bottoming rally, which is characterized by new market leaders and sectors showing relative strength against previous leaders and breaking out of tight bases formed over several months.
Even if perennial short candidates are being squeezed, why? Why are quants deleveraging so quickly into this rally? It seems like the initial rally ingiters caught quants (and reality in fact) surprised. I am of course talking about the Citigroup (C), Bank of America (BAC), and JPMorganChase (JPM) memos/releases announcing returns to profitability for the banks. Then came the earnings reports to back them. As many of you know by now, these announcements were all a load of hot air, as illegal AIG (AIG) wholesale portfolio unwinds financed the one-time "fixed-income trading" revenues that boosted all of the earnings and FASB accounting gimmickry allowed writedowns to take a minimal cut from positive surprises.
On top of that, however, Zerohedge pointed out the significant role Goldman Sachs (GS)'s program trading arm is having during this rally. With 1 billion shares principal traded becoming a weekly regular for Goldman and its principal/customer facilitation+agency maintaining a ratio above 5x, Goldman has been massively increasing its participation (in its principal trading, at that) while other quants and prog trading arms are quickly deleveraging. The conspiracy theorist in me wants to say the Fed/PPT is throwing kool-aid capital at the market through administration girlfriend Goldman Sachs to drive up the market and force short covering. Of course, this is timed perfectly, as banks offer BS earnings reports financed by illegal AIG transactions aided and abetted by the Fed and Treasury. But of course, only the conspiracy theorist in me would ever dare make such an assertion.
As a recap, this rally starts primarily with the AIG unwinds. AIG was bailed out by the Federal Reserve in September 2008 as its bankruptcy was deemed a systemic risk because of AIG's massive counterparty obligations in the CDS arena. The liquidity extended by the Fed to AIG was meant to allow CDS settlements to counterparties at significant haircuts, but with enough payment to prevent a systemic crisis. But were haircuts taken or were these trades settled at 100% face value with massive profits to counterparty banks? Former New York Attorney General Elliot Spitzer clearly seems to think not, as he wrote in his terrific article The Real AIG Scandal. All of the hooplah has led TARP's inspector general Neil Barofsky to launch an investigation into the extent of contract settlement repayments. Bank of New York Mellon (BK) missed earnings estimates by $0.10 in the middle of amazing Q1 numbers from the other big banks. Such is the result when you aren't eligible for AIG counterparty money. Especially interesting is Goldman Sachs's counterparty relationship to AIG, an issue delved into as early as last September itself in the the NY Times.
But I digress. The AIG CDS unwind trades were allowed by new trade protocols given by the IDSA, the only regulator of the OTC CDS market. In turn, these massive unwinds (financed by the taxpayer, who paid for the initial AIG bailout and all credit lines extended since) yielded huge one-time profits for banks, who flaunted them like no tomorrow. After releasing memos (the first of which was from Citi on March 10, the rally's first day) asserting first-quarter profitability, banks saw huge rallies in their stocks. At this point off of the lows, the rally was merely an oversold bounce and its sustainability was very much in question. Looking back, any sideline capital that was infused into financials on the news of these memos was misallocated, as the memos presented one-time illegal gains as indicators of sustainable turnarounds in bank earnings.
The market rallied on the news and started selling off around S&P 800, at January cycle lows and index 50DMAs. This is where I expected the rally to end, as previous support (January lows) tends to offer resistane once broken and important moving averages like the 50DMA offer important buy/sell points, depending on the market.
Then came news of the PPIP and the market once again soared. Since then, the market has rallied just over 6% on very low volume. This is where the quant dislocation comes into play. Quants, who make market-neutral high-frequency scalp trades on leverage to produce returns, were caught short in a strong rally. Again, the rally itself was initially catalyzed by bank announcements that attempted to present unsustainable profits as sustainable, so the rally in effect of the news would also be just that-- unsustainable. But the quants were forced to deleverage into the rally as their models were getting whipsawed by the unusual market activity. As they deleveraged and covered short positions in weak stocks and were forced to hedge their delta by taking bullish positions, this added fuel to the rally, which caused more deleveraging, and so on. This is evidenced by Renaissance's recent underperformance against the S&P by 17%, as well as a possible reason for the possible unwinding of Morgan Stanley's PDT arm. A recent WSJ article even claims quants are "brewing trouble" over at Morgan Stanley.
So where is the breaking point? A look into the why instead of how of this rally can offer some insight. This whole rally is essentially a scam to pass off asset depreciation in struggling financials to the taxpayer. The AIG counterparty profits were all taxpayer-financed. The PPIP's leverage is taxpayer-financed. But the real issue is the equity raises in this rally. Goldman announced an equity sale with its earnings a day after pre-announcing earnings. This is $5 billion of Goldman equity being traded for $5 billion of the public's cash on misconceived presuppositions of sustainable profitability. REITs have been offering shares all over the place, and conspiracies of their own have developed between the connection of JPMorganChase and Merril Lynch/Bank of American analysts and the REIT secondaries these banks have been underwriting.
Also, the recent surge in Goldman principal program trading starts to take some context here. If Goldman's program trading arm has been feeding into the rally and forcing quant deleveraging, then this explains why-- so it can raise cash by selling stock. Which I predicted and which indeed occurred. It'd be interesting to know how much of Goldman's $5B have been raised at these scam-inflated prices ($123/share I believe was the going price for the secondary). As soon as it's "finished," I fully expect GS's 5x principal/customer facilitation+agency ratio to fall off a cliff. On top of the equity sale, Goldman also just sold $2B in bonds, just days ahead of stress test results. Again, the timing is very strange. In a terrific article entitled Goldman's Offering and Recent Rally: Coincidence?, Ben El-Baz states "although there is no hard evidence that Goldman intentionally hyped up the market rally and the financial sector to get a better price on its offering, it would be very naïve to assume that they passively let the market determine the price of this massive dilution." This principal trading participation is the circumstancial evidence I'm sure he would love to see to back up his thesis.
Technically, the rally should end when quant deleveraging catches up with the rest of the market. That is, when the slow-money directional trend-setters deleverage their long buy-and-hold positions into the rally at a higher pace than the fast-money liquidity-providing quants do. This should occur at important inflection points where lots of supply is offered, otherwise known as resistance levels. I have been pointing out S&P 875 as a significant resistance level that might mark the rally's top and so far it hasn't been able to breach that level past a few points on no volume.
The selling/deleveraging into the rally has already started and should start picking up on volume soon. According to Washington Service, NYSE listed company insiders have been selling into this rally at the fastest rate since October 2007. Insiders sold over $8 for each dollar they purchased of stock in the first three weeks of April. To give that some context, the S&P topped out on October 11, 2007 and declined 57% before hitting March 2009 lows. If everything is so peachy and keen in the market and economy, why aren't insiders buying or at least holding stakes in their own companies? Possibly because they recognize that the "green shoots" are just weeds.
When it does end, slower money participants will be selling into a highly illiquid market, due to the deleveraging quants (liquidity providers) have had to face in the last several weeks. This will cause a spike in volatility and failed trade executions and whipsaws galore. Reality will quickly return to the market and the AIG CDS unwind story may gain more exposure, especially through the work of Barofsky and Spitzer. This would damage the investment thesis of all those who bought banks on their memos or earnings announcements, which would erase a big part of their recent huge gains.
So who loses in this rally? The taxpayer of course. As bank equity is sold to the public into a rally financed by illegal and unethical uses of taxpayer funding. This is clearly all done with the full aiding and abetting of the Treasury and Federal Reserve, which has come under recent attack because of its alleged involvement in forcing BofA CEO Ken Lewis to buy Merrill Lynch and hide the distressed bank's true dismal state of affairs from BAC shareholders. If Goldman's principal trading increase is indicative of PPT activity, that also is taxpayer money being funnelled into an unsustainable rally, this time through the intermediary of Goldman's program trading arm.
The memos, the earnings, the statements all say the same thing-- banks made money Q1 2009. They don't mention why-- because of AIG portfolio unwinds and accounting gimmicks. Clearly causing an unsustainable hype in the soundness of American banks will lead to an unsustainable rally in equities. And that's what is happening.
The United States GDP contracted over 6% in Q1 2009, well worse than estimates. A flu outbreak characterized as an imminent pandemic by the WHO is spreading across the world, with early targets at total losses estimated around $2-3 trillion. General Motors (GM) announced its debt restructuring plan this week, met with sharp criticism and a drastically different counteroffer from bondholers, suggesting Chapter 11 is in order for the struggling automaker. Chrysler is expected to announce its own bankruptcy tomorrow. Even government stress tests, whose worst-case scenarios are tangentially worse than current economic conditions, suggest at least six of the 19 banks tested need to raise more capital. The selling catalysts are all over the place, while the buying catalysts were one-time unsustainable profits.
After announcing $1.2 trillion of arranged agency and Treasury purchases in mid March, The Federal Reserve didn't announce anymore quantitative easing today, while keeping rates at all-time lows. Once markets sell-off and liquidity once again contracts, the Fed will have much more political capital left to be able to monetize much more of this ludicrous spending. Expect rates to rise from here (TBT is a good play for that) until the next wave of deflationary deleveraging and equity selling allows the Fed justification for another big round of QE, again capping rates and inflating the Treasury bubble. Mortgage rates are at Greenspan levels. Clearly the powers that be are reflating a reflated bubble. From dot-coms to houses and now to Treasuries. What is all of this? Passing off asset depreciation to the taxpayer in the form of currency depreciation. Wait for the black swan in Treasuries to implode the bubble (which is currently inflating), rates to rise, and rampant inflation.
But I yet again digress. Looking at the market right now, it is approaching the apex between important resistance at S&P 875 and the support trendline of its ascending channel. After breaking its shorter term rising wedge, it has formed a bear flag, and is approaching a break of its channel trendline, which should send the market falling. Other indices show similar bearish patterns, with the Nasdaq approaching massive supply at its 200DMA. Several oscillators have indicated divergences lately, suggesting the market is ready for its next wave down.
A breakout of 875 on big volume would change things, possibly indicating the BS rally found a way to incite slow money to buy into the rally, perhaps bringing enough buying power in to confirm a sustained bull market (assuming the Treasury continues to spend and the Fed continues to print). Irrational exuberance has been evident in the markets before but the deciding factor that allows it to drive sustainable (at least for the 1-2 year time horizon) bull markets is the inclusion of slow-liquidity sidelined instutional directtional trend-setting capital in the rally. There is volume to direct the equity prices' ascent. That simply doesn't exist right now and premarket gaps up are responsible for a big part of the rally. For the rally to continue, even in the face of complete irrationality, it needs sidelined cash to come pummelling into equities. It needs large volume accumulation to drive directional trends. A low volume rally floating higher is not indicative of any of that.
I want to say here that I understand there is no arguing with the market. It is never "wrong" as only price pays. I share the opinion that the only "fair" price of a stock (or anything in the world) is its current price in the open market-- the intersection of supply and demand. However, that does not mean price trends that appear sustainable are sustainable. That does not mean market participants are always right in their trades or that their investment theses are "right." My point is that this current rally is unsustainable and the higher we go, the harder and more volatile the fall will be. The catalysts behind the rally were all BS and there is clear government-bank collusion to pass off losses to the taxpayer.
I leave you with charts of securities I see possible big trades in.
Future spending, its monetization, and the final black swan
The Federal Open Market Committee announced today that it would keep target rates unchanged at 0-0.25bp yet made no mention of additional quantitative easing:
On March 18, the Fed announced it would be printing $1.15 trillion to buy agency debt/securities and Treasuries. The Congressional Budget Office announced a $953 billion deficit for the first half of FY2009 and estimates a $1.7 trillion deficit for FY2009 ($1.8 trillion if Obama's proposals for budget reform and accounting shenanigans banishment are enacted). The CBO also estimates that the total budget deficit for Obama's first term to be $3.8 trillion. These are all based off of CBO baseline budget statistics and don't take into account Congressional spending plans yet to pass, which surely we will see a lot of in coming months and years.
I mention these budget figures because they represent baseline figures that need to eventually be paid. These don't count any of the future spending programs, which will surely be massive, such as the commercial real estate, insurer, airliner, and newspaper bailouts that will be most likely be coming in the next 1-2 years.
The commercial real estate and insurer bailouts in specific are significant because they are both worthy of "systemic risk" characterization if AIG and Citi were deserving of the label and also because of their magnitude. Commercial real estate loan maturities by 2013 total $1.4 trillion, according to this insightful article and Bloomberg reports that the Fed is already considering expanding TALF to include CRE loans and CMBS.
As for insurers, they have over $200 billion in their own exposure to CRE maturities by 2018. Life insurers have billions in guaranteed variable annuities that are eating away at equity as the equity and debt markets pummel. They also have troubling exposure to Eastern Europe, the next region to face cataclysmic default. In essence, as AIG taught us, insurers have used policyholder capital as investment in overleveraged insurers-turned-hedge funds exposed to toxic assets. Principal (PFG), Hartford (HIG), Lincoln (LNC), and Prudential (PRU) all have tangible common equity/tangible asset leverage ratios of 35x or higher. These are absurdly high leverage ratios that will eat away at insurer equity as their assets depreciate and they write down losses. Using these numbers, a 1.04% depreciation written down in Hartford's assets would wipe out the entirety of its common shareholder equity. This is why Hartford, Genworth, and Lincoln have already bought commercial banks so they qualify for TARP bailout funds.
Sure enough, the Treasury extended the TARP lifeline to life insurers and many applied for the funds, including insurers without commercial bank acquisitions yet. The immediacy of bailing out insurers is especially important because of the credit rating downgrade risks they face. For example, Moody's recently cut Prudential's senior debt to two notches above junk. Two more notches lower and Prudential would no longer qualify for the Commercial Paper Funding Facility (CPFF), which is instrumental for these failing insurers to roll over debt. Also, as credit rating agencies cut the ratings on some of the debt held as assets by these insurers, that also eats away at equity because of capital requirements and increased risk. Moody's cut credit ratings on CMBS in February, causing tension in insurers with massive exposure to CRE and CMBS. Moody's also recently downgraded its outlook on property-casualty commercial insurers.
With commercial real estate and insurers representing tens (if not hundreds) of billions of bailout spending, one can start to imagine the type of deficits the United States government will be running in coming years. And if AIG (AIG) provides any precedent, the bailouts won't exactly be the most efficient or ethical use of funds. Bailouts are supposed to be necessary uses of taxpayer money to prevent systemic collapse. For example, in AIG's case, its bankruptcy would mean its counterparties would be screwed on their CDS transactions, overexposing their own risk to toxic assets and also losing them money on their CDS profits not being settled. The AIG bailout was meant to provide capital to AIG to give to its counterparties in the form of CDS trade settlements at haircut prices-- high enough to prevent systemic collapse, but no higher than that. On the contrary, banks received full face-value trade unwinds at past prices, as AIG took two more waves of bailout cash. This type of moral hazard is inherently present in bailouts with no conditional liquidity and will continue to be prevalent as more sectors receive bailouts.
The FDIC needs a bailout of its own, as four more banks and another credit union went under this past weekend. According to its Quarterly Banking Profile, its Depositor Insurance Fund (DIF) reserve ratio declined to 0.40% at the end of Q4 2008. This means for each dollar held on reserve by the FDIC, it insured $240. Since then, 29 more banks have failed, and most likely DIF reserves are all but gone. FDIC Chairman Sheila Bair in fact admitted the FDIC will go broke without a bailout: "Without additional revenue beyond the regular assessments, current projections indicate that the fund balance will approach zero." Clearly the government cannot allow the entity preventing the depositor confidence crises that lead to bank runs to go under. In September 2008 when Lehman's bankruptcy caused money market funds to break the buck and ignited a widespread liquidity crisis, money market funds witnessed an "electronic" bank run and the Treasury had to step in and guarantee money market funds' assets in the event NAV drops below $1.
General Electric (GE) is another bailout target and has the "AIG syndrome" of having a sturdy main business being crippled by a much smaller but highly-levered financial division. GE's finance arm GE Capital Corp (GECC) has massive exposure to domestic residential and commercial real estate loans and securities, as well as UK and Eastern European real estate loans. According to its most recent earnings release, parent company GE has a tangible common equity/tangible asset leverage ratio of over 200x, mostly due to GECC. GECC's exposure to Europe alone is estimated to yield losses over $35-40 billion, which would immediately wipe out GE's entire $4 billion of TCE and even GECC's $33 billion in total tangible equity. And according to a Fortune report, a credit rating downgrade to AA- would cost GE an immediate $4 billion in GIC payments, which would also wipe out GE's shareholder equity. And because of its massive exposure to Europe, whose distressed loans the Fed cannot merely force the ECB and BOE to purchase with printed Euros and Pounds, the Treasury and Fed are very likely to have to infuse cash directly into GE rather than letting their bailouts of the toxic asset industries themselves help GE indirectly.
This could amount to trillions of dollars of more spending on top of what is already committed. Thus far, $10.5 trillion has been committed by the United States government. And adding trillions to that figure is not at all beyond reason.
But how will this deficit spending be financed? The Federal Reserve has made it clear it will be monetized. On March 18, the FOMC released its scheduled statement with an unexpected addition to the status quo.
As if printing $1.15T to buy toxic debt wasn't enough, according to the Financial Times, the Fed put the ideal interest rate for the United States economy at -5%. The monetary stimulus required for this target would be titanic and statements like these this early on in the deflationary deleveraging wave are clear indications on the monetary goals of the Fed-- it is going to print its way out of the mess.
This comes as no surprise to anyone, as Fed Chairman Ben Bernanke has been widely quoted in his "helicopter" speech from 2001 entitled Deflation: Making Sure "It" Doesn't Happen Here. Below are some goodies from the speech:
With the QE already started, why then did the Fed not expand its balance sheet further this week? The massive spending and now printing has been using up a lot of the Federal Reserve's and Treasury's political capital with the public. Tax Day Tea Parties sprung up across the United States on the 15th of April as common-era allusions to the Founding Fathers' revolts in Boston on the British government's tea tax. Gold surged and the USD tanked on the QE news and inflationary risk started to creep back into public discourse.
With the necessity to start talking about the "green shoots" of economic recovery in order to lend credence to the recent bank record earnings (financed by illegal AIG trade settlements and blatant accounting shenanigans) so banks could offer equity at inflated prices. To print more money just as the stock market rallies over 30% and economic recovery shows its first signs would not be met with a very accepting public, nor would it allow the Fed to continue monetizing the deficit without a watchful public eye.
Why is Bernanke doing all of this? The most important step in understanding his policies is to understand the nature of inflation itself.
Inflation is essentially a regressive consumption tax, regressive because the income elasticity of the most inflation-sensitive goods is naturally less than 1. This is because inflation is a price rise not met by a corresponding expansion in goods. It is a monetary phenomenon caused by an increase in liquid money supply not met by an increase in goods represented by that money. This causes malinvestment as inefficient businesses "work" due to the artificially higher prices of inflation. The malinvestment often ignites more investment as prices keep rising to the point where speculators start entering the market, at which point the malinvestment is a bubble. Eventually, there isn't enough of the bubble asset to chase with more investment and the Ponzi scheme of sorts collapses. This is how the housing bubble happened-- through the easy credit policies of former Fed chairman Alan Greenspan incentivizing the misallocation of capital into houses and consequently mortgages and mortgage-backed securities.
In the context of Bernanke, however, he aims for inflation because it allows the financial sector to share its burden of depreciating asset values with the taxpayer. When the Fed prints $100, it is taking $100 worth of wealth away from the aggreagate and spends it where it wants to. That is why inflation is a tax. Printing $1.15 trillion amounts to about an $8200 tax increase on average on each taxpayer, and this ignores inflation's regressive taxation nature. The assets purchased with the "inflation tax" are depreciating agency securities and debt and long-term Treasuries, which the Fed itself said is aiming for negative real rates in. This is theft but is to be expected with the conflict of interests prevalent in the unchecked, unaudiated Federal Reserve.
The Public-Private Investment Program (PPIP) is a prime example of passing off toxic asset depreciation onto the taxpayer. The FDIC provides PPIFs 7x leverage through non-recourse loans and the Treasury provides 2x leverage to purchase toxic securities and play hot potato with them until default. The PPIFs would of course buy massive CMBX exposure for their leveraged toxic asset exposure, so when the CMBS starts depreciating, the default swap derivatives rake in tons of cash for the PPIF while the CMBS depreciation is mostly passed off to the FDIC because of the loan's non-recourse nature. As we have already concluded, the FDIC-- the government entity created to protect the solvency of the American banking structure-- is insolvent and will need essentially a government bailout. The Treasury is financed by bond purchasers, which include the public and now the Federal Reserve (with printed money, so really just taxpayers). Which means the taxpayer pays for all of this (well, almost all-- don't forget the poor foreign holders of US government debt that will face partial default through QE debt inflation).
Why is taxpayer wealth being used by the government as 14x leverage financing for hedge funds to purchase toxic assets? Because the government wants to pass off the bank's problems to you, the taxpayer. What's even more ridiculous is TARP-capitalized banks are even considering applying to the PPIP. The logic of being bailed out for legacy security exposure and then using the bailout money to take leveraged positions into those toxic assets seems to be shaky at best. But the banks win, they free up equity in their balance sheet. The PPIFs win, they collect profits from their default insurance exposure while facing only 7% of asset depreciation losses because of non-recourse financing. The government wins, it makes everything look great. So who loses? Anyone who holds Dollars or Treasuries. That's right-- you.
The AIG counterparty fiasco and the ludicrous Q1 bank earnings were othre blatant examples of passing off toxic asset depreciation onto the taxpayer. Quantitative easing is an extension of all of this, as it essentially forces the public into buying these toxic securities and bearing the burden of their depreciation. Printing money amounts to a tax on holders of dollars and a partial default on holders of Treasuries.
With rates right back to where they were pre-QE and rising, I expect the Fed to resume its QE in its next announcement on June 24. This should cap rates once again and direct more of America's wealth into Treasuries. As equities again start to decline and the economy's green shoots dull to a yellowish hue, risk-aversion will be the name of the game and anyone who didn't already deleverage their worth out of their 401k's and home equity will do so, into the safety of the United States Treasury. Unfortunately, it is these types of crowded trades caused by incentive crises due to too much government influence that causes black swan events.
I expect a Treasury bubble to inflate in the next several months as the Fed prints money to buy American government debt and when it finally collapses, rates will rise and the Dollar will begin its drastic decline as gold begins its surge up. Unfortunately for foreign creditor nations, the threat of economic mutually assured destruction will force them to have to face the effects of the inflation-default on their Treasury holdings. Not to mention trying to liquidate Treasury holdings would be tantamount to asking for a nuclear war with the United States. The USD won't see hyperinflation, like the GBP and EUR possibly could (and MXN almost certainly will), but it will face sharp devaluation once the Treasury bubble-- the final episode of the Greenspan-Bernanke trifecta of asset bubbles-- comes crashing down.
Release Date: April 29, 2009This is a very interesting policy direction, especially when taken in context of recent Fed monetary policy statements.
For immediate release
Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower. Household spending has shown signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit. Weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment, and staffing. Although the economic outlook has improved modestly since the March meeting, partly reflecting some easing of financial market conditions, economic activity is likely to remain weak for a time. Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.
In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.
In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of financial and economic developments.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.
On March 18, the Fed announced it would be printing $1.15 trillion to buy agency debt/securities and Treasuries. The Congressional Budget Office announced a $953 billion deficit for the first half of FY2009 and estimates a $1.7 trillion deficit for FY2009 ($1.8 trillion if Obama's proposals for budget reform and accounting shenanigans banishment are enacted). The CBO also estimates that the total budget deficit for Obama's first term to be $3.8 trillion. These are all based off of CBO baseline budget statistics and don't take into account Congressional spending plans yet to pass, which surely we will see a lot of in coming months and years.
I mention these budget figures because they represent baseline figures that need to eventually be paid. These don't count any of the future spending programs, which will surely be massive, such as the commercial real estate, insurer, airliner, and newspaper bailouts that will be most likely be coming in the next 1-2 years.
The commercial real estate and insurer bailouts in specific are significant because they are both worthy of "systemic risk" characterization if AIG and Citi were deserving of the label and also because of their magnitude. Commercial real estate loan maturities by 2013 total $1.4 trillion, according to this insightful article and Bloomberg reports that the Fed is already considering expanding TALF to include CRE loans and CMBS.
As for insurers, they have over $200 billion in their own exposure to CRE maturities by 2018. Life insurers have billions in guaranteed variable annuities that are eating away at equity as the equity and debt markets pummel. They also have troubling exposure to Eastern Europe, the next region to face cataclysmic default. In essence, as AIG taught us, insurers have used policyholder capital as investment in overleveraged insurers-turned-hedge funds exposed to toxic assets. Principal (PFG), Hartford (HIG), Lincoln (LNC), and Prudential (PRU) all have tangible common equity/tangible asset leverage ratios of 35x or higher. These are absurdly high leverage ratios that will eat away at insurer equity as their assets depreciate and they write down losses. Using these numbers, a 1.04% depreciation written down in Hartford's assets would wipe out the entirety of its common shareholder equity. This is why Hartford, Genworth, and Lincoln have already bought commercial banks so they qualify for TARP bailout funds.
Sure enough, the Treasury extended the TARP lifeline to life insurers and many applied for the funds, including insurers without commercial bank acquisitions yet. The immediacy of bailing out insurers is especially important because of the credit rating downgrade risks they face. For example, Moody's recently cut Prudential's senior debt to two notches above junk. Two more notches lower and Prudential would no longer qualify for the Commercial Paper Funding Facility (CPFF), which is instrumental for these failing insurers to roll over debt. Also, as credit rating agencies cut the ratings on some of the debt held as assets by these insurers, that also eats away at equity because of capital requirements and increased risk. Moody's cut credit ratings on CMBS in February, causing tension in insurers with massive exposure to CRE and CMBS. Moody's also recently downgraded its outlook on property-casualty commercial insurers.
With commercial real estate and insurers representing tens (if not hundreds) of billions of bailout spending, one can start to imagine the type of deficits the United States government will be running in coming years. And if AIG (AIG) provides any precedent, the bailouts won't exactly be the most efficient or ethical use of funds. Bailouts are supposed to be necessary uses of taxpayer money to prevent systemic collapse. For example, in AIG's case, its bankruptcy would mean its counterparties would be screwed on their CDS transactions, overexposing their own risk to toxic assets and also losing them money on their CDS profits not being settled. The AIG bailout was meant to provide capital to AIG to give to its counterparties in the form of CDS trade settlements at haircut prices-- high enough to prevent systemic collapse, but no higher than that. On the contrary, banks received full face-value trade unwinds at past prices, as AIG took two more waves of bailout cash. This type of moral hazard is inherently present in bailouts with no conditional liquidity and will continue to be prevalent as more sectors receive bailouts.
The FDIC needs a bailout of its own, as four more banks and another credit union went under this past weekend. According to its Quarterly Banking Profile, its Depositor Insurance Fund (DIF) reserve ratio declined to 0.40% at the end of Q4 2008. This means for each dollar held on reserve by the FDIC, it insured $240. Since then, 29 more banks have failed, and most likely DIF reserves are all but gone. FDIC Chairman Sheila Bair in fact admitted the FDIC will go broke without a bailout: "Without additional revenue beyond the regular assessments, current projections indicate that the fund balance will approach zero." Clearly the government cannot allow the entity preventing the depositor confidence crises that lead to bank runs to go under. In September 2008 when Lehman's bankruptcy caused money market funds to break the buck and ignited a widespread liquidity crisis, money market funds witnessed an "electronic" bank run and the Treasury had to step in and guarantee money market funds' assets in the event NAV drops below $1.
General Electric (GE) is another bailout target and has the "AIG syndrome" of having a sturdy main business being crippled by a much smaller but highly-levered financial division. GE's finance arm GE Capital Corp (GECC) has massive exposure to domestic residential and commercial real estate loans and securities, as well as UK and Eastern European real estate loans. According to its most recent earnings release, parent company GE has a tangible common equity/tangible asset leverage ratio of over 200x, mostly due to GECC. GECC's exposure to Europe alone is estimated to yield losses over $35-40 billion, which would immediately wipe out GE's entire $4 billion of TCE and even GECC's $33 billion in total tangible equity. And according to a Fortune report, a credit rating downgrade to AA- would cost GE an immediate $4 billion in GIC payments, which would also wipe out GE's shareholder equity. And because of its massive exposure to Europe, whose distressed loans the Fed cannot merely force the ECB and BOE to purchase with printed Euros and Pounds, the Treasury and Fed are very likely to have to infuse cash directly into GE rather than letting their bailouts of the toxic asset industries themselves help GE indirectly.
This could amount to trillions of dollars of more spending on top of what is already committed. Thus far, $10.5 trillion has been committed by the United States government. And adding trillions to that figure is not at all beyond reason.
But how will this deficit spending be financed? The Federal Reserve has made it clear it will be monetized. On March 18, the FOMC released its scheduled statement with an unexpected addition to the status quo.
To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.The additional $750B of agency securities, $100B of agency debt, and $300B of Treasuries scheduled for purchase amounted to a $1.15 trillion quantitative ease.
As if printing $1.15T to buy toxic debt wasn't enough, according to the Financial Times, the Fed put the ideal interest rate for the United States economy at -5%. The monetary stimulus required for this target would be titanic and statements like these this early on in the deflationary deleveraging wave are clear indications on the monetary goals of the Fed-- it is going to print its way out of the mess.
This comes as no surprise to anyone, as Fed Chairman Ben Bernanke has been widely quoted in his "helicopter" speech from 2001 entitled Deflation: Making Sure "It" Doesn't Happen Here. Below are some goodies from the speech:
By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
People know that inflation erodes the real value of the government's debt and, therefore, that it is in the interest of the government to create some inflation.
With the QE already started, why then did the Fed not expand its balance sheet further this week? The massive spending and now printing has been using up a lot of the Federal Reserve's and Treasury's political capital with the public. Tax Day Tea Parties sprung up across the United States on the 15th of April as common-era allusions to the Founding Fathers' revolts in Boston on the British government's tea tax. Gold surged and the USD tanked on the QE news and inflationary risk started to creep back into public discourse.
With the necessity to start talking about the "green shoots" of economic recovery in order to lend credence to the recent bank record earnings (financed by illegal AIG trade settlements and blatant accounting shenanigans) so banks could offer equity at inflated prices. To print more money just as the stock market rallies over 30% and economic recovery shows its first signs would not be met with a very accepting public, nor would it allow the Fed to continue monetizing the deficit without a watchful public eye.
Why is Bernanke doing all of this? The most important step in understanding his policies is to understand the nature of inflation itself.
Inflation is essentially a regressive consumption tax, regressive because the income elasticity of the most inflation-sensitive goods is naturally less than 1. This is because inflation is a price rise not met by a corresponding expansion in goods. It is a monetary phenomenon caused by an increase in liquid money supply not met by an increase in goods represented by that money. This causes malinvestment as inefficient businesses "work" due to the artificially higher prices of inflation. The malinvestment often ignites more investment as prices keep rising to the point where speculators start entering the market, at which point the malinvestment is a bubble. Eventually, there isn't enough of the bubble asset to chase with more investment and the Ponzi scheme of sorts collapses. This is how the housing bubble happened-- through the easy credit policies of former Fed chairman Alan Greenspan incentivizing the misallocation of capital into houses and consequently mortgages and mortgage-backed securities.
In the context of Bernanke, however, he aims for inflation because it allows the financial sector to share its burden of depreciating asset values with the taxpayer. When the Fed prints $100, it is taking $100 worth of wealth away from the aggreagate and spends it where it wants to. That is why inflation is a tax. Printing $1.15 trillion amounts to about an $8200 tax increase on average on each taxpayer, and this ignores inflation's regressive taxation nature. The assets purchased with the "inflation tax" are depreciating agency securities and debt and long-term Treasuries, which the Fed itself said is aiming for negative real rates in. This is theft but is to be expected with the conflict of interests prevalent in the unchecked, unaudiated Federal Reserve.
The Public-Private Investment Program (PPIP) is a prime example of passing off toxic asset depreciation onto the taxpayer. The FDIC provides PPIFs 7x leverage through non-recourse loans and the Treasury provides 2x leverage to purchase toxic securities and play hot potato with them until default. The PPIFs would of course buy massive CMBX exposure for their leveraged toxic asset exposure, so when the CMBS starts depreciating, the default swap derivatives rake in tons of cash for the PPIF while the CMBS depreciation is mostly passed off to the FDIC because of the loan's non-recourse nature. As we have already concluded, the FDIC-- the government entity created to protect the solvency of the American banking structure-- is insolvent and will need essentially a government bailout. The Treasury is financed by bond purchasers, which include the public and now the Federal Reserve (with printed money, so really just taxpayers). Which means the taxpayer pays for all of this (well, almost all-- don't forget the poor foreign holders of US government debt that will face partial default through QE debt inflation).
Why is taxpayer wealth being used by the government as 14x leverage financing for hedge funds to purchase toxic assets? Because the government wants to pass off the bank's problems to you, the taxpayer. What's even more ridiculous is TARP-capitalized banks are even considering applying to the PPIP. The logic of being bailed out for legacy security exposure and then using the bailout money to take leveraged positions into those toxic assets seems to be shaky at best. But the banks win, they free up equity in their balance sheet. The PPIFs win, they collect profits from their default insurance exposure while facing only 7% of asset depreciation losses because of non-recourse financing. The government wins, it makes everything look great. So who loses? Anyone who holds Dollars or Treasuries. That's right-- you.
The AIG counterparty fiasco and the ludicrous Q1 bank earnings were othre blatant examples of passing off toxic asset depreciation onto the taxpayer. Quantitative easing is an extension of all of this, as it essentially forces the public into buying these toxic securities and bearing the burden of their depreciation. Printing money amounts to a tax on holders of dollars and a partial default on holders of Treasuries.
With rates right back to where they were pre-QE and rising, I expect the Fed to resume its QE in its next announcement on June 24. This should cap rates once again and direct more of America's wealth into Treasuries. As equities again start to decline and the economy's green shoots dull to a yellowish hue, risk-aversion will be the name of the game and anyone who didn't already deleverage their worth out of their 401k's and home equity will do so, into the safety of the United States Treasury. Unfortunately, it is these types of crowded trades caused by incentive crises due to too much government influence that causes black swan events.
I expect a Treasury bubble to inflate in the next several months as the Fed prints money to buy American government debt and when it finally collapses, rates will rise and the Dollar will begin its drastic decline as gold begins its surge up. Unfortunately for foreign creditor nations, the threat of economic mutually assured destruction will force them to have to face the effects of the inflation-default on their Treasury holdings. Not to mention trying to liquidate Treasury holdings would be tantamount to asking for a nuclear war with the United States. The USD won't see hyperinflation, like the GBP and EUR possibly could (and MXN almost certainly will), but it will face sharp devaluation once the Treasury bubble-- the final episode of the Greenspan-Bernanke trifecta of asset bubbles-- comes crashing down.
FOMC at 2:15
...and some bullish action (on no volume of course) around S&P 875.
I'm scaling back some bearish positions and remaining cautious until after the announcement, when I'll most likely jump back in.
Update: No new bond purchases. Scaling back on gold positions, jumping back in equity bearish, starting position in TBT.
I'm scaling back some bearish positions and remaining cautious until after the announcement, when I'll most likely jump back in.
Update: No new bond purchases. Scaling back on gold positions, jumping back in equity bearish, starting position in TBT.
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