Next Trade of the Century—Short German Bunds?

The eurozone meltdown that we anticipated and followed up on recently continues. Sovereign yields and spreads over German government bonds (also referred to as Bunds) are still on a frighteningly steep upward trajectory. While interbank funding in euros has eased and appears stable for the time being, interbank demand for U.S. dollars continues to intensify (often a sign of looming financial risk, as we noted yesterday).  Against this backdrop, some smart market participants and pundits have referred to a short bet on the euro (selling euros today and buying them back in the future, which will be profitable if the value of the euro declines during that time) as the next ‘trade of the century’ after shorting mortgage and mortgage-related securities going into 2008-2009. In a similar vein, we believe that sophisticated investors and speculators might want to consider taking short positions in Bunds, based on the following rationale.

The eurozone (via the European Central Bank or ECB) has the means for adding to the stock of net financial assets, but as an institution it suffers from mainstream macroeconomists’ persistent ignorance of how critical this function is to a financial economy, and remains stubbornly committed to it, not just legally through its charter, but also culturally, as its two main national influences, France and Germany, have long been hard money advocates. In the late 1920s and early 1930s, the Bank of France (the country’s central bank) led the charge toward resetting gold’s nominal parity at its pre-WWI level, turning what might have been a multi-nation recession into the worldwide Great Depression (the U.S. Federal Reserve was not innocent either). In the 1960s, under the post-WWII Bretton Woods monetary system, French President Charles de Gaulle railed against U.S. budget deficits (subscription required), and France increasingly redeemed its U.S. dollars for the Treasury’s gold until President Nixon finally closed the ‘gold window’ in 1973, bringing the Bretton Woods system to an end. Germany’s bent for monetary restraint is firmly rooted in its experience with the staggering hyperinflation of its post-WWI Weimar Republic in the early 1920s, a point emphasized recently by Jens Weidmann, president of the Bundesbank (Germany’s central bank) and member of the ECB’s governing council (an influential member, according to the Financial Times), in a speech in Berlin on November 8:

One of the severest forms of monetary policy being roped in for fiscal purposes is monetary financing, in colloquial terms also known as the financing of public debt via the money printing press…[The prohibition of monetary financing in the euro area] is one of the most important achievements in central banking [and] specifically for Germany, it is also a key lesson from the experience of hyperinflation after World War I.

Some degree of ‘hardness’ in money is fine and good, and hyperinflation is certainly one of the most severe forms of government malfeasance. But economists and bankers like Weidmann, in spite their credentials, exhibit a glaring intellectual gap relating to the concept of net financial assets under a soft currency system. Simply put, if money is going to be an inconvertible creature of the state rather than being based on the existing stock of precious metals and future additions to it, then the only way that users of that currency can, in the aggregate, accumulate precautionary savings and successfully lend or borrow money is if the government sector, as the monopoly provider of the currency, runs sufficient and (under most conditions) ongoing deficits. Weidmann demonstrates this glaring intellectual gap, and articulates some of the astoundingly wrong inferences it leads to, in comments attributed to him in a recent Financial Times article:

Mr Weidmann highlighted the stance being taken by the Bundesbank by arguing governments, not central banks, were mainly responsible for ensuring financial stability. Mario Draghi, the ECB’s new president, has said it is not the ECB’s job to act as lender of last resort, but Mr Weidmann went further, saying such a step would breach Europe’s ban on “monetary financing” – central bank funding of governments.

“I cannot see how you can ensure the stability of a monetary union by violating its legal provisions,” Mr Weidmann argued. “I don’t see how you can build trust in a system that violates laws.”

Mr Weidmann said current Italian interest rates levels were “not such a big issue” in the short run. “What we are facing in Italy is an acute confidence crisis, and only the Italian government can resolve that crisis.”

Since May last year, the ECB has been buying eurozone government bonds – a move opposed by the Bundesbank – but sees its role as limited and aimed only at ensuring functioning markets.

Mr. Weidmann must realize that trust cannot be built in a system whose legal provisions are leading directly to its long-term destabilization. Until its legal framework and operational realities are better aligned, building trust among EMU (and by extension, European Union) nations will remain a total pipe dream.

As for Weidmann’s invocation of the confidence fairy, what markets are confident in, judging by their recent behavior, is that:

1. At some future date, Italy, as a country that surrendered monetary sovereignty and now struggles under a heavy burden of what is essentially external debt, similar to emerging markets nations that experienced severe fiscal and currency crises in recent decades, will not be able to roll over its government debt in the private marketplace;
2. At that point, Italy’s creditors will receive the same treatment that holders of Greek government debt now face, which is a 50% “voluntary” haircut without any benefit from hedging arrangements they’ve already purchased;
3. And given the current realization of (1) and (2), the European and global financial systems are now at much greater risk of a 2008-like meltdown, as sovereign debt exposures begin to severely erode the balance sheets and capital positions of financial institutions due to (a) the writing down of assets such as holdings of eurozone government debt and (b) the marking up of liabilities, such as protection extended to counter parties on such debt (although with the “voluntary” Greek haircuts, who knows how to place a value on the latter?).

To be fair, Weidmann clearly gets point (2) above, as the following comment shows. Potential government debt buyers have seen what’s happening to Greek bond holders and many of them have gone on strike, driving up yields on all EMU government debt except for Finland, Germany and the Netherlands whose external currency requirements are met by running trade surpluses:

[Private sector involvement] might appear an easy way out of self-inflicted problems. If this is the case, you achieve the opposite of what you wanted to achieve. You will have more contagion instead of containment of the crisis because it’s seen as a potential model for other countries.

Here’s the rub though—without steady expansion of net financial assets (as opposed to just private sector and government borrowing) in the eurozone,  those exports from Finland, Germany and the Netherlands will become unsustainable somewhere around the time that net credit expansion in the eurozone becomes unsustainable—which is where the EMU appears to stand today. Given that reality, there is simply no way that Germany can remain immune to the current fate of most eurozone governments, unless it is willing to forcefully break with the legal and cultural status quo or abandon the euro experiment altogether. 

There are some economists and policymakers in the EMU who appear to get this. For example, German economic advisor Peter Bofinger asserted at a recent conference that “the ECB has to act before the financial system falls. And if they act, they should act properly and set an upper limit for sovereign yields.” Setting a cap on EMU government debt yields offers a simple, credible and far more efficient way for the ECB to hold the eurozone together while it works out a framework for closer fiscal integration, and while troubled nations work on resolving their fiscal challenges, than its current modus operandi.  

If the ECB did that, then selling German Bunds wouldn’t be anywhere near a potential ‘next trade of the century.’ But as long as the views expressed by Weidmann hold sway, the potential does exist, and here’s why:

• In spite of the realities outlined here, investors have flocked to German government debt at the expense of most other eurozone issuers, driving up Bund prices and pushing down their yields (see the first chart below). Up to this point, that tactic has likely served active bond managers well, if not in absolute returns then at least in relative terms (i.e., enhancing their performance against benchmark indices by overweighting securities that have performed well and underweighting those that have performed poorly).
• It’s likely that speculators have put on plenty of ‘pair trades’ as the convergence of eurozone sovereign debt yields over the last decade started to unwind in recent years. For example, a hedge fund might sell the debt of a troubled eurozone government and use the proceeds to buy the debt of a perceived safe haven issuer such as Germany. Those certainly have been winning trades to this point.
• That both of those trades would have succeeded thus far implies—along with prevailing market yields—that they could be rather crowded at this point. In that type of situation, a good contrarian speculator will look for incipient signs of a turning point—especially when the rationale for a contrary trade is as solid as the operational realities articulated above.

While they’re not in crisis territory yet, the price of credit default swaps on German government debt, which provide Bund owners with protection against German default (and also allow speculators—in all likelihood, too many speculators—to make “naked” bets against German Bunds), have spiked noticeably of late, as shown in the second chart:

Yield on 10-Year German Bunds

Credit Default Swap Index on German Bunds

This is an indication of rising (albeit incipient) risk aversion toward German government finances. And if we take into account the uncertainty thrust upon CDS markets by the latest Greek rescue proposal, CDS on German Bunds might even be understating current risk perception around Germany.

PLEASE NOTE: Although this trade may be of interest to sophisticated speculators and some institutional investors, it is far too sophisticated, difficult, and dangerous a trade for most individual speculators to consider, and in my professional opinion, it has no place in the portfolio of the average investor. Our firm has decided that it would be too difficult to implement in our clients’ accounts for whom it would otherwise be suitable, and due to capital constraints, neither our firm nor its principals are currently planning to implement the trade (that may change without notice). We have decided to publish our view on German Bunds for informational and educational purposes only, as it’s our sincere hope that it might dispel some of the prevailing confusion among economists, politicians, and citizens that is needlessly pulling the eurozone into recession.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.

Eurozone Meltdown Confirmed

File under confirmation bias—incoming data answers our question from last week (“Eurozone Meltdown Brewing?“) in the affirmative. European imports, sovereign debt and interbank lending markets, and currency exchange rates are now flashing red, or at least bright orange.

Korea announced that exports to Europe declined a staggering 20% year-over-year in October, confirming the recent negative PMI numbers (hat tip to Warren Mosler, who also passed along a report of “mayhem” in European debt markets today).  

Sovereign debt and interbank funding markets are showing signs of worsening. If conditions allow, we’ll upload graphics of various markets after publishing, but for now, these observations from ZeroHedge and the second chart from FT Alphaville should suffice. The first chart shows the difference between the interest rates on euros and dollars in short-term exchanges of the currencies (the trend is closely related to the exchange rate dynamics mentioned below). The second chart shows the yield-to-maturity for a 30-year French government bond and a similar German government bond (favoring the German bund over other eurozone government debt is a fool’s errand, in our view; more on that later if time allows).

We discussed the sudden and scary drop in the EUR-USD cross-currency basis swap last week and how it is perhaps a cleaner view of the funding crisis in Europe than the delinquent Libor market. Since our first discussion, the 3 Month EUR-USD basis swap has widened even further – only worse in the heart of the crisis in Q4 2008. As if that was not enough, GDP-weighted European Sovereign risk is back up to its highest levels ever as the clear message from the markets is the ring-fencing and backstopping of sovereigns and financials respectively is simply non-existent.

Currency exchange rates are extremely volatile—large percentage moves in a day are highly unusual and often signal a regime change (as in a change of economic equilibria, but it’s safe to assume that more political regimes could fall too). When a regime change is marked by a flight to U.S. dollars (USD), as is occurring in the table below (the euro (EUR) and British pound (GBP) rates are the denominators in the first two rates, and the USD is the denominator in the rest of them; so a higher rate in the latter implies that one USD can purchase more units of the other currency) it can be a harbinger of financial crisis (e.g., if driven by struggling and/or healthy-but-panicking financial institutions and/or the panicked unwinding of levered carry trades).

The EMU is the epicenter of the current crisis because, as we’ve pointed out, they run macroeconomic policy in a way that’s analogous to a gold standard with no gold mining allowed. Under such a system, financial institutions and practices as we know them simply cannot survive long-term. And given their inherent leverage (and the still-limited ability of regulators and rating agencies to get a handle on the systemic picture) financial systems and institutions can only tolerate the kind of stresses outlined above for so long before something breaks.

Europe now faces its ”they know nothing” moment (start at about 1:40), but its financial institutions are championed by mild-mannered technocrats rather than boisterous characters like Jim Cramer.  That means we could be treated to all of the financial, economic, political, and human wreckage of the last crisis but without anywhere near the entertainment value.

The data seems to be coming around to our view that things will get worse in risk markets before they get better. We might be wrong, of course. For example, bulls really seem to want to take out 1,300 on the S&P 500 by year’s end and they still could. But without concerted easing efforts by policymakers in Europe, which is unlikely due to severe cultural and legal constraints, the eurozone is set to drag the global economy into a nasty recession which, while priced into many credit markets, is not fully reflected in equity or commodity markets.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice. 

Obama to China: Enough’s Enough

President Obama took off the gloves toward China in a press conference yesterday after a meeting with his Chinese counterpart President Hu, leveling some of his most bellicose rhetoric yet at the country’s trade and currency practices.

Assumedly that he’s been made aware that this kind of behavior is almost never effective in influencing the Chinese, so it may imply an intense level of frustration within the Administration. If so, this could mark the beginning of some serious political turbulence, which would be likely to augment current market volatility.

On the other hand, it might just be political campaigning. If so, it’s safe to assume that Hu was warned or at least tipped off ahead of time, and that nothing serious will come of this. Time will tell.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. The firm and some clients of the firm hold positions that are expected to benefit from a decline in Hong Kong’s Hang Seng Index. All views and positions are subject to change without notice.

Technocrats Are Fine And Good, But…

The media has embraced a new buzzword, technocrat, following the political house cleanings in Greece and Italy. According to etymonline, the term technocracy was coined in 1919 and means government by experts.

Former EU commissioner Mario Monti, nominated to replace outgoing Italian prime minister Berlusconi over the weekend, is the latest reigning example of a technocrat. 

Monti may be a very capable analyst or policymaker and a suitable choice to form and lead an interim government. However, assuming he is, there’s still one nagging question–what if the technocrats are following an error-ridden manual, or are politically prejudiced against effective policies?

Meanwhile, in Germany, Chancellor Merkel offered little more than hand-wringing anxiety in a speech to her party. According to Reuters, the key elements were:

• Europe is in its most challenging situation since WWII.
• If the euro fails, European integration fails.
• This outcome must be prevented because it is a historically huge project.

Here’s a crash course in effective leadership for Chancellor Merkel—effective leadership is not about:

• Instilling anxiety in your followers
• Offering vague justifications for a present course that is imposing serious costs
• Offering no clear and convincing path forward other than what has already been tried and failed

Merkel is right that Europe is an unmitigated disaster at the moment. But the prescriptions are straightforward.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. The firm and some clients of the firm hold positions that are expected to benefit from a decline in Hong Kong’s Hang Seng Index. All views and positions are subject to change without notice.

Markets Still In Happy-Go-Lucky Mode

Bulls are continuing to carry the day, thanks to the investing herd throwing the ‘risk on’ switch in a big way.  Factors behind the optimism include:

• Greece and Italy forming unity governments more effectively than many had hoped.
• Someone (most likely the ECB) backstopping Italian government debt.
• China seemingly headed for a soft landing.

 Here’s why we’re not jumping on the bandwagon:

• In the intermediate to long-run, the austerity measures that will be passed in Greece and Italy are going to worsen, not improve, their debt-to-GDP ratios.
• The European Central Bank (ECB) is legally and culturally limited in its ability to “monetize” government debt of European Monetary Union (EMU) countries, and is chronically under-supplying net financial assets to the eurozone.
• While losses on the most recently attacked European government credits have eased, France (along with some other northern EMU credits) still looks shaky.
• While China may be able to avoid a financial crash, real external demand is almost certain to decline in the years ahead.

Credit markets in Europe are continuing to signal a severe decline in eurozone GDP beginning in 2012. Unlike the U.S.where, for example, the Fed was believed to be riding to the rescue with QE2 in late 2010 and early 2011, which had a buoyant effect on risk markets—the ECB is very unlikely to pursue highly activist policies, and national governments are severely limited in their ability to pursue fiscal easing. As a result, we don’t expect the recession indications to turn around until the eurozone is in the throes of a painful contraction.

That will have negative effects on the rest of the world, including Asian countries that are major export partners with Europe (there’s a reason the Chinese and Japanese governments will consider throwing money at Europe’s sovereign problem, and it’s neither benevolence nor return on investment). Countries that rely on demand from Asia will also suffer in turn. Our bearish view on China continues to frustrate. It goes without saying, but the degree of suffering among its trade partners will be much lower if it can engineer a soft landing (no easy feat), and amplified if it can’t.

Of the world’s developed economies, the U.S. and Japan look relatively healthy. It’s no coincidence that their governments (central bank plus national fiscal authority) are also running the largest deficits among developed nations, as that allows their private sectors to run surpluses, which in turn allow households to save (or de-lever) and maintain consumption levels. Unfortunately, this is not occurring at levels sufficient to improve growth trajectories or meaningfully lower staggeringly high unemployment levels, which implies that current deficits are not large enough, i.e., they are more than offset by private sector demand for savings (and, perhaps, carry trade funding; more on that below).

Finally, along with France and other northern eurozone credits, there are still some worrisome signs from interbank funding markets. For example, the two-year U.S. dollar swap spread, which is the difference between a particular interest rate banks charge each other in a two-year agreement and the two-year U.S. Treasury yield, is continuing to climb, reflecting increasing strain and rising risk aversion among banks. While still shy of 2007-2008 levels, its current readings are a clear yellow light for investors and policymakers.  

Two-Year U.S. Dollar Swap Spread, Last Six Months

Two-Year U.S. Dollar Swap Spread, Last Five Years

The TED spread, which is the difference between the interest rate banks  charge each other on U.S. dollar loans outside the U.S. and the yield on similarly dated U.S. Treasuries, is behaving in similar fashion, indicating a rising demand for U.S. dollars within the global financial system (a trend likely to be exacerbated by shrinking budget deficits in the U.S.). And history, especially recent history, argues for extreme caution when the world’s primary funding currency for carry traders is in short supply (carry traders borrow in a low-interest rate currency and use the funds to invest in various assets that are expected to return more than their borrowing costs).

The bottom line: It’s not easy being bearish on risk assets when the herd is ebullient, and it’s not fun taking lumps on the short side of a portfolio when everything seems to be highly correlated based solely on whether it’s a risky or safe-haven asset. But economic and institutional realities, along with some key credit and money market indicators, almost assure more trouble ahead in our opinion, which leads us to infer that risky assets will be available at even lower prices at some point in the future. In the meantime, we continue to take risk on the long side in securities that look to us like they are already significantly underpriced.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. The firm and some clients of the firm hold positions that are expected to benefit from a decline in Hong Kong’s Hang Seng Index. All views and positions are subject to change without notice.

Europe’s a Mess, but Watch Asia, Middle East

All eyes are on Europe of late, but investors shouldn’t overlook that Hong Kong’s Hang Seng stock index has seemed a bit decoupled of late (Hong Kong’s markets and economy are closely connected to events in China). Commentators are continuing to pin blame on Italy and Europe when markets hiccup (as they should), but the news flow seems to indicate problems in Asia as well: http://www.bloomberg.com/news/2011-11-10/asian-stocks-decline-on-europe-concern-as-italian-bond-yields-surge.html

There’s also been a peculiar publicity push on Iran and its nuclear weapons program of late. This could definitely cause some market agita, depending on what the behind-the-scenes endgames are (registration required): http://www.stratfor.com/memberships/204388/geopolitical_diary/20111107-irans-nuclear-program-and-its-nuclear-option

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. The firm and some clients of the firm hold positions that are expected to benefit from a decline in Hong Kong’s Hang Seng Index. All views and positions are subject to change without notice.

Italy x Leverage x Stupidity = Trouble

A November 9th note to our clients:

U.S. stock markets were down fairly hard today, between 3 and 5%, due to growing fears around Europe. The punditry seem to be laying most of the blame on Italian prime minister Silvio Berlusconi, but while he has certainly not helped things, this is nonsense.

The problem in Europe is that almost no one has a grasp of gross-versus-net financial assets. In a financial economy (i.e., one with credit), under any type of monetary system, some sector of the economy has to supply new, unencumbered units of money (or interest-bearing government debt) on a perpetual basis (i.e., a financial economy requires some sector to run ongoing deficits of something that will allow it to keep stable account of its ongoing production of other things, including financial assets). Under the gold standard, it was gold mines running ‘deficits’ of gold in order to add to the money stock. Under modern monetary standards (pdf), it’s sovereign governments, either through a fiscal authority perpetually spending more than it takes in with taxes, or a central bank expanding its net liabilities (which typical central bank asset sales and purchases, even the permanent ones, don’t do), or some combination of the two.

In 1973, the U.S. and most of the world moved off of a gold standard and onto our modern fiat system of inconvertible paper money. However, mainstream macroeconomic textbooks never fully accounted for that move. In the wake of the Great Depression and World War II, and with the tailwind of the Baby Boomers in the last three decades of the twentieth century, there was so much room for private sector credit growth  that governments could run relatively small deficits and the global economy still grew at a healthy pace. So the old assumption (which is correct when money is something external like gold) that there was a difference between a government borrowing money via bond issuance and a government printing money was never properly re-examined (economist Abba Lerner was a notable exception, as was Wynne Godley more recently). Economists also mis-measure inflation and ignore factors like population age structure (for example, the Baby Boomers entering their household formation years in the 1970s were a huge factor in the so-called inflation of that era).

As a result, 90% or more of the economics profession believes (1) that it’s more prudent (indeed, virtuous, as some view it as a morality play) for governments to tax and borrow in order to finance their expenditures, and (2) that any time a central bank purchases a financial asset with newly created money, it is “printing money” and expanding the money supply, which will inevitably cause inflation or hyperinflation. But these beliefs are just plain wrong, and they’re destroying the European Monetary Union (EMU or eurozone) today and threatening the U.K., Japan, and now the U.S.

Greece’s government debt was problematic, but by itself it was not going to bring down the global financial system or world economy. But the most recent rescue package from the European Union (EU) was so badly designed that it has caused buyers of Italian government debt to go on strike (legitimately, at least until Italian debt is selling at 50 cents to the euro or less). And now interest rates demanded of Italy are too high for it to ever successfully service given its much lower expected rate of domestic economic growth.

The result is that the world’s fourth largest issuer of government debt now stands on the precipice of a debt default crisis, which is a very big deal. When you take the size of Italy’s outstanding debt, global systemic financial leverage, and prevailing economic and political stupidity into account, the potential outcomes look really bad—as bad as or worse than the 2008 financial crisis. According to one anonymous Federal Reserve official, when they carried out eurozone-related stress testing of U.S. banks, it all looked OK until they simulated Italy going under. The official, summing up their findings, said, “if Italy goes, God help us all.”

There are several key points:

• If Italy were still monetarily sovereign (i.e., had its own central bank like the U.S., U.K., Japan, Canada, et al), it could manage this crisis rather easily. But its government ceded sovereignty to the EMU and European Central Bank (ECB) when it decided to join the eurozone.
• The ECB has all the necessary firepower (as it and it alone can create an unlimited supply of new euros) but (1) EMU rules essentially put it in a straitjacket and (2) many of its members live in mortal fear (erroneously—see the macro textbook point above) of reliving the hyperinflation of 1920s Weimar Germany.
• The EU’s European Financial Stability Fund (EFSF) could potentially step into the breech and backstop (start buying) Italy’s debt, but it doesn’t have anywhere near the authorized capital required to do so. And what capital it has is collected from EMU taxpayers and outside investors and lenders, because the EMU as a whole doesn’t demonstrate any understanding of soft currency economics (the euros required can come from only one place—the ECB).

Worst of all, while sovereign nations and the EMU have all of the tools at their disposal to prevent this from happening, they aren’t likely to act until the damage to the financial system has brought the real global economy (i.e., the things that people outside of the financial industry casino do for a living) to its knees. And at current un- and underemployment levels in many parts of the world, that’s not just one more grotesque display of agency malfeasance by my industry and the political class—it’s unnecessary, unjust, and just plain immoral. I only wish that the 99’ers (99 weeks or more unemployed and the 99 percenters) as a whole had a firmer grasp of the problem (continued education disinvestment will ensure that this wish becomes a pipe dream).

It’s fair to ask whether a more activist ECB would cause inflation. There’s a risk of inflation in all monetary systems, but especially with soft currencies like today’s that can operationally be created out of thin air. But it’s first important to realize that inflation is the only constraint on the world’s ability to resolve the European debt crisis. (And as the Great Depression and other episodes show, resolving a debt crisis is likely to just lessen deflation rather than cause inflation). As noted above, inflation is an abused and widely misunderstood term (how many times have we been promised hyperinflation and exploding interest rates in the U.S. and Japan, and yet we only see it in countries like Greece and Italy that don’t have the ability to “print” money?). It’s also a chronically mis-measured and over-estimated variable according to current academic research (http://www.voxeu.org/index.php?q=node/867), viz (emphasis added): “[In] the United States, we found that most of the movements in conventional measures of inflation…are due to relative-price changes. Only around 15-20% of the movements in these measures of inflation correspond to pure inflation…” 

In a better world, governments would be focused first and foremost on putting people back to work and ring-fencing the global financial system from the real economy, and we would be able to legitimately concern ourselves with potential (and actual) inflation. Instead, we’re forced to endure chronic un- and underemployment, economic growth and investment well below potential, a series of policy errors worldwide that would be comical if not for the human suffering they cause, and policymakers throwing up their hands and saying that there’s little more that governments can do. Even the staunchest government debt Cassandras should be able to see which of these is the greater insult to future generations.

That’s the end of today’s rant. For less politically charged reading, you might enjoy our look at October’s astounding stock market performance.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.

A Closer Look at October Equity Returns

The broad rally in equities in October was massive, regardless of whether one views it as a dead cat bounce or a new leg up. Either way, it was enough to cause investor whiplash, and correlations across individual stocks remain historically high.

For the S&P 500, it was the eighth highest monthly return since 1950…

…clearly a “right tail” outcome:

Though sympathetic to the ‘wall of worry’ arguments out there (and in our active strategy, licking our wounds from October), we’re still skeptical and believe that equity markets will end lower before embarking on a bull market:

• Credit markets are still flashing recession warnings for most of the world, especially Europe.
• At current levels, following their rallies, equity markets look fairly priced at the very least and highly optimistic compared to other asset classes.
• Certain credit market indicators are also warning that corporate earnings forecasts may contract by double digits, rendering low price-to-earnings arguments moot.
• Demographic headwinds will remain in place in much of the world until at least the latter half of this decade.
• Policymakers worldwide are still favoring austerity over growth.

That said, it looks to us like the U.S. economy, although we expect it to enter recession sometime between early 2012 and early 2013, could still outperform expectations along the way. One of our recently-triggered recession indicators turned around after only a month, for example:

The last time this occurred was in 1989 (a positive recession signal) and at the end of 2002 (a negative signal), so the forecasting power would appear to be no better than a coin flip, especially considering the small sample size we’re working with. The only qualitative data we can bring to bear is that in  1989, policy measures were trending in the direction of austerity (higher taxes, strong dollar, rising interest rates), while in 2002-2003 policy was headed in a more stimulative direction (other than uncertainty over whether an invasion of Iraq was imminent).

Finally, it’s interesting to take a close look at the demographic aspects. As shown below, seven of the ten largest one-month moves in the S&P 500 from 1950 through October 2011 occurred from 1974 to 1984, a period in which age structure in the U.S. and many other developed nations fluctuated dramatically. In the 1970s, Baby Boomers began entering their household formation years in earnest, while in the 1980s, they began entering their peak earning, saving, and investment years:

The volatility of the 1970s was associated with a secular bear and eventually range-bound stock market, while the volatility of the early 1980s was associated with the beginning of an almost two-decades-long bull market.

Today, Baby Boomers in advanced western economies are entering their retirement years (in Japan, this occurred about ten years earlier), which could have persistently negative implications for stock markets, at least until their children, the Echo Boomers, begin saving and investing in earnest (an activity that events of recent years may influence them away from at the margin). Thus, it seems likely that we’ll continue to see 1970s-style volatility and sideways or downward trends in stock markets for at least a few more years.

However, investors with suitably long time horizons should keep in mind that, despite the popular characterization of a lousy investing climate in the 1970s, it was actually a great time to buy stocks in general. As long as the global economy can manage to hold it together and avoid a low-probability 1940s-style outcome, long-term equity investors who stick to a disciplined process (and where suitable, take advantage of the opportunities presented by periods of high volatility, i.e., buying low and selling high) should do OK over the coming decades.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.

SOL 99ers Now the Majority of the Unemployed

CNBC reports that there are now more unemployed persons who have exhausted benefits than the number still receiving them (hat tip to Warren Mosler):

The jobs crisis has left so many people out of work for so long that most of America’s unemployed are no longer receiving unemployment benefits.Early last year, 75 percent were receiving checks. The figure is now 48 percent — a shift that points to a growing crisis of long-term unemployment. Nearly one-third of America’s 14 million unemployed have had no job for a year or more.

Congress is expected to decide by year’s end whether to continue providing emergency unemployment benefits for up to 99 weeks in the hardest-hit states. If the emergency benefits expire, the proportion of the unemployed receiving aid would fall further.

That means an even higher poverty rate in what’s supposed to be the most advanced nation on Earth, which means an even greater long-term burden on public sector budgets. It means chronic loss of skills and further deterioration in the employability of millions.  Worst, it probably means that the disturbing trend of rising suicide rates will continue.

This is the United States of America, folks. We can do better. In times past (in fact, the last time a deep financial crisis collided with negative demographic internals), this country offered dignified employment to everyone who desired a job. It was effective, and an employer-of-last-resort policy has support today from diverse points along the political spectrum. But first, we’ll have to forget everything we think we know about the federal government’s budget.

Eurozone Meltdown Brewing?

Though most eyes are focused on the latest political turmoil in Greece, economies in the rest of the European Monetary Union (EMU or eurozone) are showing signs of increasingly severe weakness. 

As we’ve previously argued, the government debt crises in the EMU can be contained as long as the European Central Bank (ECB) stands in to backstop the whole mess by buying government debt (as it alone has the power to create net new euros). However, it will take far more concerted and difficult-to-coordinate efforts to prevent the eurozone from sliding into recession (which in turn makes preventing a financial crisis more challenging). Barring a sharp recovery in credit markets, the EMU economy now looks set to contract by at least 4% in 2012.  

Recent data are confirming this view, as eurozone purchasing manufacturer indices (PMIs)—including for Germany, the prevailing economic paradigm’s darling—looked absolutely abhorrent last week. German construction figures were awful today, and productivity figures for the European Union (the EU, which includes both EMU nations and countries that do not use the euro as their official currency) are now in territory last seen during the 2008 recession. A chart of German PMI looks like a tired swimmer chained to a bunch of cinder blocks. Yet amazingly, the swimmer continues to complain that the blocks aren’t yet heavy enough. 

Eurozone Composite PMI (Source: Markit)

If a full-blown EMU debt crisis erupts, which is still a very real possibility, that figure could be five times worse; if accompanied by a currency crisis as well, it could be ten times as bad.  

Because the EU and eurozone’s institutional arrangements (1) lack a central fiscal body with the authority to implement stimulative measures, and (2) restrict activist policies by the ECB, the entire framework has a pro-cyclical bent, which means more pain ahead even if a financial crisis is avoided (which becomes increasingly difficult as fears of a slowdown intensify). This is likely to go on until a critical mass of people have finally had enough, and politicians and bureaucrats are frightened enough to take them seriously. 

But the looming problems in Europe have little to do with Greece, and everything to so with Italy, Spain, Belgium, France, and eventually Germany. 

Despite the hooplah over a new framework for Greece, bond investors are continuing to drive yields up (i.e., prices down) on Italian government debt. Italy is now uncomfortably close to an interest rate level capable of triggering a debt-default spiral. The fact that the world’s fourth largest issuer of government debt is now a non-sovereign with 100% external liabilities (because it cannot create new euros) should put serious fear into the hearts of investors (it has already done so for central bankers, apparently). 

10-Year Italian Govt Bond Yield (Source: Bloomberg)

Spanish government bond yields are also higher (and prices lower) since summer. 

10-Year Spanish Govt Bond Yield (Source: Bloomberg)

Risk aversion has also spread rather dramatically to the core EMU nations of Belgium and France. 

10Y French Less 10Y German Govt Yield (Source: Bloomberg)

And the cost to insure against a default by the German government has spiked dramatically since summer.  

German Govt 10Y Credit Default Swap in $ (Source: Bloomberg)

The distinction between “core” and “peripheral” Europe is becoming increasingly irrelevant, an outcome virtually guaranteed by the EMU’s institutional framework. And thus far, it’s required an unbroken string of better-than-bi-monthly EU summits and untold time and effort from the private sector and its regulators just to prevent Greece from taking down the eurozone (and possibly global) payments system. Will Europe have the necessary stamina and flexibility to effectively deal with a much larger crisis? It’s unlikely to receive much help from abroad either; consider that the G-20 proved itself worse-than- useless at its just-adjourned summit, with vague offers of help and still-pronounced infatuation with fiscal tightening, despite an apparent worldwide shortage of aggregate demand. 

It could well be that we’re witnessing the beginning of the end for the prevailing macroeconomic paradigm. Unfortunately, before it can be drastically improved, we’ll have to endure yet more tinkering, such as nominal GDP targeting by central banks. But eventually, we will hopefully be able to lay at least some of our era’s innocent frauds to rest and replace them with principles that better reflect reality. The most important one is that a sovereign currency-issuing government does not fund itself through tax revenues or borrowing; taxation simply enforces the widespread acceptance and use of its currency. From that one fact, several important observations follow: 

• Such governments are never fiscally constrained; the only economically relevant constraint on deficits (via spending increases, tax cuts, or central bank operations that add to the net stock of financial assets) is inflation.
• Current government deficits and debt (whether interest-bearing, such as Treasury securities, or not, such as money) do not impose any burden on future generations, unless they lead to inflation at a high enough level to severely undermine investment and future productivity.
• For productive saving and investment to occur, a sovereign government, via its treasury and/or central bank, must run deficits, as that is the only sector of the economy (the restricted ability of export activities aside) capable of adding net financial assets.

Compare those to the faulty inverse propositions guiding policymakers worldwide: 

• Governments must finance their expenditures via taxation and borrowing (which assumes that net additions to the stock of financial assets ’just happen’).
• Current deficits lead to an expansion of government debt which must be paid off by future generations in the form of higher taxes and/or fewer public goods and services.
• Government must add to savings by saving, i.e., by running balanced or surplus budgets over the long-term (which fails to recognize that this is a de facto argument for contracting the supply of net financial assets, i.e., deflation).

And it’s staggering how many academic and political reputations are chained to these errors. As Warren Mosler has pointed out, there are legacies being trashed—The Emperor Wears No Clothes, writ large. 

In the meantime, the U.S. Congressional super-committee has yet to release anything promising, the Chinese government is continuing its attempts to tame inflation and crush its overheated residential property sector, and credit markets are flashing serious economic and market warnings. Blissfully unaware, most major stock markets have exuberantly extended their historic October rallies into November.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Past performance is not indicative of future results. This material does not take into account your personal investment objectives, your personal financial situation and needs, or your personal tolerance for risk. Thus, any investment strategies or securities discussed may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment strategy or security. It is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any particular strategy or investment.  We do not guarantee any specific outcome or profit from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. All views and positions are subject to change without notice.