“…If you tax a nation to death, destroy its capital markets, nourish its unemployment, condemn it to an expensive currency and give its corporations liquidity at stupidly low costs you can only expect one outcome: Defaults….”
Let’s now briefly follow up on each of the market themes I covered in 2012:
1.-There has been no decoupling: The Euro zone is coupled to the US dollar zone
At the end of 2011, when the collapse of the banking system in the Euro zone (courtesy of M. Trichet) was dragging the rest of the world, the Swiss National Bank established a peg on the Franc to the Euro and the Federal Reserve extended and cheapened its currency swaps with the European Central Bank. These two measures –indirectly- coupled the fate of the assets in the balance sheets of the Euro zone banks to the balance sheets of the central banks of Switzerland and the US.
As in any other Ponzi scheme, when the weakest link breaks, the chain breaks. The risk of such a break-up, applied to economics, is known as systemic risk or “correlation going to 1”. As the weakest link (i.e. the Euro zone) was coupled to the chain of the Fed, global systemic risk (or correlation) dropped. Apparently, those managing a correlation trade in IG9 (i.e. investment grade credit index series 9) for a well-known global bank did not understand this. But it would be misguided to conclude that the concept has now been understood, because there are too many analysts and fund managers who still interpret this coupling as a success at eliminating or decreasing tail risk. No such thing could be farther from the truth. What they call tail risk, namely the break-up of the Euro zone is not a “tail” risk. It is the logical consequence of the institutional structure of the European Monetary Union, which lacks fiscal union and a common balance sheet. I am not in favour of such, but in its absence, to think that the break-up is a tail risk is to hide one’s head in the sand. And to think that because corporations and banks in the Euro zone now have access to cheap US dollar funding, the recession will not bring defaults, will be a very costly mistake. Those potential defaults are not a tail risk either: If you tax a nation to death, destroy its capital markets, nourish its unemployment, condemn it to an expensive currency and give its corporations liquidity at stupidly low costs you can only expect one outcome: Defaults. The fact that they shall be addressed with even more US dollars coming from the Fed in no way justifies complacency.
In January of 2012, I laid out an analytic framework to visualize the dynamics between these two currency zones. I reproduce the figure below without comment, as it is self explanatory:
In February, I anticipated that the European Central Bank was eventually going to need to floor the value of sovereign debt. It took about seven more painful months to see this take place, with the announcement of the Open Monetary Transactions. With this in mind, I suggested not to chase the stock rally and warned that shorting the euro would be a painful trade.
2.- Manipulation in the gold market
From my years at the Universidad de Buenos Aires, I always remember professors J. M. Fanelli and Daniel Heymann, because they used to and still think that policy makers (in Argentina) had no choice but to “manage” the price of the US dollar (vs. the peso) to fight inflation. The value of the US dollar, in pesos, was a signal that shaped inflation expectations, according to them. In the same fashion, I am convinced that those at the helm of the G7 central banks believe that to shape inflation expectations and avoid the burst of the bond bubble, they need to manage the price of gold. And that is exactly what they have been doing (via swaps, leases from their deposits at below market rates), since Standard & Poor’s downgraded the sovereign risk rating of the US. They are wrong of course and in time, it will prove to have been an expensive decision. The proof? Movements like the $100/oz drop upon the announcement of the second Long-term Refinancing Operation at the end of February. Nobody who lives marked to market would ever dump so much gold in seconds in a market, let alone do so sustainably and predictably, as it often happens, between 10am and 11am ET. I am convinced that had it not been for this manipulation, gold would have had a stellar performance this year. But how serious can I sound debating a counter-factual statement?
3.-Liquidity will not fund capital expenditures but share buybacks, dividends
In March, we were perhaps the first to suggest that the US dollar liquidity enabled by the Fed via swaps was going to be used to buy back shares and distribute dividends, rather than finance capital expenditures (I say “perhaps” because a few days later David Rosenberg expressed the same view). This is a typical outcome of financial repression. Nations under financial repression generate bankrupt companies owned by wealthy owners. Time will tell but so far, numerous articles have been suggesting that this trend is taking place (Eric Beinstein, from JP Morgan, shows evidence to the contrary, in his latest Credit Markets Outlook report). Because of this, I proposed that as a trading theme, one should buy the product, rather than the producers, which is a winning trade in inflationary environments. Therefore, the suggestion was to buy gold, rather than gold miners.
4.-To defend their currency, the Euro zone destroyed its capital markets
(At this stage, I think no comments are needed on this point, which I made in March.)
5.- Sovereign debt owned by other sovereigns is a concern
In March too, I noticed that the situation in 2012 resembles that of 1931, as Greece and increasingly other peripheral EU countries owe to other governments, the IMF and the European Central Bank. Private investors have been wiped out and just like in 1931 (when France, for political reasons, allowed the KreditAnstalt to go bankrupt), when the next bailout is due, political conditions will be demanded that no private and rational investor would demand.
6.-Canada’s story will be different
In April, I proposed that the Canadian context was different and that rather than expect contagion from the banking system to the government, in Canada, we should expect contagion from the government to the banking system. I still expect this deterioration to be triggered by an exogenous development (i.e. outside Canada) and the reaction of the Canadian dollar to the revised unemployment rate on December 7th may be telling us that this view has merit.
7.- September marked a tectonic shift
I will not elaborate on the points below. I wrote extensively about them in September (see here, here and here), but I need to mention them because they are very relevant for the next year. These points, I must clarify, are my best case scenario, because the necessary condition for their validity is that Spain and any other peripheral country in need of a bailout asks for one and receives the support of the European Central Bank (ECB) in exchange :
-The market will arbitrage the rates of core Europe and its periphery, converging into a single Euro zone target yield (with higher German rates).
-We will no longer be able to talk about “the” risk-free rate of interest, when we refer to the US sovereign yield. Inflation expectations will pick up
-The Canadian dollar should not rise significantly above the US dollar (i.e. above $1.04 per 1 CAD).
-The ECB backstop (i.e. purchase of sovereign debt) generates capital gains for the banks of the Euro zone and transforms risky sovereign debt into a carry product (i.e. an asset whose price is mostly driven by the interest it pays, rather than its risk of default, because this risk has been removed by the central bank)
This implies that in the future, sterilization at low rates or the suggested negative deposit rates at the European Central Bank, under Open Monetary Transactions, will not be feasible. Banks will demand high rates in exchange, if they are to sell the debt to the central bank.
In my next letter, and likely the last one of the year, I will address the topic of why we have not yet seen high or hyper inflation and what is necessary, in general, to see this phenomenon take place. The letter will go dedicated to Peter Schiff. In it, I will seek to show that unlike Keynesian economists believe, not only are high nominal interest rates compatible with high inflation, but in fact they are a necessary condition for high inflation to exist and morph into hyperinflation. This is a paradox to mainstream economics…and, coming from Argentina, I love paradoxes.
A final observation, on method
As my approach is within the Austrian school, you may have noticed that I use praxeology. ( “a theorem of a praxeological science provides information that has been derived by sheer reasoning; it is the product of pure logic without the assistance of any empirical observation”, I. Kirzner). Hence, you find almost no statistics in my articles. My aversion to them is due to my view that the national accounting system used to date is simply a barbaric relic of mercantilist doctrine. But that’s a story for another time… I walk through problems using simple axioms and test their logic with identities (i.e. balance sheets). Mainstream economists, on the other hand, use equations. Hence, they need to “torture” their stats to prove their propositions, because they are inductive. I use deduction.
The market crashes driven by HFT, like that on the NYSE in May 2010 or the recent one affecting the Knight Capital Group should be a big wake-up call. This is a new technological change which the Austrian School of Economics should further analyse. We, at “A View from the Trenches”, just wanted to leave our two-cent contribution with our thoughts.
In our last letter, we made some comments on high-frequency trading. Today, we want to briefly analyse, from a macroeconomic perspective, the underlying ideas thrown in its favour, as well as the impact this activity has on the capital markets. Why is this important? Because more than half of the trading volume in equities in the main world exchanges is driven high-frequency trades today (More than 70% of volume in the US exchanges alone).
What is high-frequency trading? We will never exhaustively address this issue here. We recommend that you do your own research on the subject. There are numerous articles on this topic. High-frequency trading (HFT) consists in using sophisticated technology to trade securities. It is highly quantitative, employing algorithms to analyze incoming market data. HF investment positions are held only very briefly, with HF traders trading in and out of positions intraday tens of thousands of times. The important feature is that at the end of a trading day there is no net investment position. Processing speed and access to the exchanges are critical.
HFT strategies can be broadly thought in terms of three main groups: Those that provide liquidity, those that trade headlines and those that trade statistics. The statistical ones are the easiest to understand (at least for us): They are based on technical analysis, correlations. The headline strategies seek to profit from momentum trading, filtering information that describes intra-day action in the exchanges. The so-called liquidity strategies are either based on market making (to profit from bid/ask spreads) or from rebate trading. Operationally, HF traders collectively send millions of orders, the most part of which (we understand above 90%) are cancelled before they are even hit. This often causes delays in the exchanges that receive them, potentially creating arbitrage opportunities in those stocks that trade in multiple exchanges.
Two main factors have been put forward in support of HFT. We will quickly dismiss them:
a) HFT provides liquidity to markets
We think this point has been misunderstood, because at a macro level, one must not refer to the liquidity of a particular asset, but of liquidity in general or, more properly, liquidity preference, since liquidity is not a condition intrinsic to any asset, but the result of preference by market participants.
Indeed, HFT may and does provide liquidity to a particular asset, but it is a different thing to say that HFT provides liquidity to the market, at an aggregate level. At an aggregate level, the liquidity preference of market participants is what matters. If they want to be liquid, they have the means to do so either by holding money or by changing it for commercial paper or short-term obligations of borrowers with a solid and steady cash-flow stream. Collectively, for market participants to allocate some of its savings to liquid assets, there is no need to see millions of quotes a day, for instance, on a risky junior mining company with assets overseas, thereby creating the illusion that the junior mining equity space is liquid.
Market participants do not need to see the universe of liquid assets expanded to satisfy their respective liquidity preferences. And if they have to get their savings out of an asset which until a minute ago seemed liquid but now is not, they will be able to do that with or without HFT, because there is no reason to believe that under a shock, the HFT bid will not disappear in a nanosecond, making the situation even worse.
Having said this, it is clear that the impact of the quoting activity by HF traders generates a distortion in the capital markets and particularly, in the capital structure of an economic system. Companies that, given the nature of their businesses, would have been forced to raise secured long-term bank debt to fund their capital expenses before the influence of HFT, may now find it easier and cheaper to raise equity. And those with investable assets captive in the system (i.e. registered funds, 401ks) will now fall prey to very risky projects, under the belief that they are protected by electronic stop-loss orders. Banks that might have been willing to provide secured lending to these equity issuers, will now find that they can only bid for less profitable working capital lines, under the belief the loans are protected by stock pledges! And it gets even worse: Those who invest in this equity may decide to pledge it under, say a 3x coverage ratio, to borrow funds and invest in even riskier, “more profitable” assets!
The liquidity argument in favour of HFT is just one more Keynesian version of the notion that inventing purchasing power ex-nihilo can get us somewhere better, but this time, applied to the capital markets in particular.
How does HFT invent purchasing power? The liquidity premium embedded in assets that wouldn’t otherwise be liquid or would not even exist, is the purchasing power we refer to. For this same reason, those who defend HFT now fear that by prohibiting it (just like their fear to prohibit fractional reserve lending) we will see a collapse in valuations. Unfortunately, that collapse will eventually take place, only still bigger and affecting global capital markets.
b) HFT facilitates the process of price discovery
What media and those in favour of HFT commonly refer to price discovery is nothing else but algorithms sniffing stop losses, causing volatility in the process. There really isn’t anything particular about HFT with respect to pricing, which human beings cannot achieve on their own. Throwing orders to exchanges that are immediately cancelled to test floors or caps on the price of a certain asset cannot be credited with price discovering. Indeed, efficient markets are those which always challenge valuations and in the process, prevent the misallocation of resources from further growing. But the challenge of valuations always represents the challenge of their underlying assumptions: Sales, leverage, productivity, management, etc. Shaking the nest, the way HFT does (with the sudden introduction of millions of quotes) to “discover” key levels is hardly the feature of a healthy capital market.
Let us bring an analogy: Human lives are not traded. Yet, if a criminal kidnapped somebody’s daughter and asked for a ransom, he would certainly be “discovering” the price of her life: The parents of the girl, having offered all they had in immediate liquid assets, would have told the criminal what the price for their daughter is. Now, this is exactly what algorithms do when testing price levels in the absence of economic news, as we have painfully seen across a myriad of asset classes.
This is not a healthy way to price assets, because just like the parents had never thought of trading her daughter for money, market participants not challenged by economic developments but by millions of fake orders, were forced to do so. A trade actually took place in an otherwise illiquid market but…what will happen next time? Neither the daughter will be left alone by the parents nor our market participants will be there for the criminals to profit from them, which is why retail money will keep flowing out of the stock exchanges (the system) as long as the status-quo is not changed.
Perhaps too, our fictional criminal will regret not having given the father more time to liquidate more assets, but of course, that would have come at the cost of higher risk. There is no difference between the criminal’s short-term line of reasoning and that which keeps HF traders from keeping positions for longer than seconds or minutes. Therefore, if we were really thinking about price discovery, neither our criminal nor HF traders did discover the true price. In the end, all we ended up with was volatility that will exponentially increase, as the exchanges impacted by HFT see participants leave to over-the-counter markets (like real estate?)…Is this the actual reason behind the high percentage of HFT volume in exchanges? Is it because we are leaving the exchanges all to HF traders?
The market crashes driven by HFT, like that on the NYSE in May 2010 or the recent one affecting the Knight Capital Group should be a big wake-up call. This is a new technological change which the Austrian School of Economics should further analyse. We, at “A View from the Trenches”, just wanted to leave our two-cent contribution with our thoughts. We leave with an interview on the subject, to Scott Patterson, author of “Dark Pools”, dated August 8th:
Click here to read this article in pdf format: August 6 2012 Today is a holiday in Canada and our letter is published later than usual. We will make a few comments on what we believe were the most relevant events impacting capital markets (do these still exist, by the way?) last week: No news [...]
Today is a holiday in Canada and our letter is published later than usual. We will make a few comments on what we believe were the most relevant events impacting capital markets (do these still exist, by the way?) last week:
No news on monetary policy
During the past week, both the Fed and the European Central Bank had the opportunity to execute on new policies, be it price or volume driven. As we anticipated in our last letter, these banks decided to past on such an opportunity. There is really nothing else they can effectively do, except explicitly monetize sovereign debt. If they opt for unconventional policies, the medicine will have a worse effect than the sickness, although we want to make this clear: Monetizing sovereign debt is also not the solution. However, it buys time and is the less distorting of all available measures. Having said this, if we are right, the rally we saw in the Euro was only short-covering and soon, we will have to enter a new downward leg.
Relevering of corporate balance sheets: Rich shareholders, poor corporations
A few months ago, we warned that: “…in the past 10 years, you have seen the S&P500 index fluctuate, nominally, without making any “improvement”. This has huge ramifications and one of them is that businessmen who would want to monetize the fruit of their labour would not be able to do so, on average, because if they are lucky, they only break even when they sell their businesses. If you were one of them, what would you do in the face of the recent monetary expansion?
I for one would leverage my company with cheap credit lines and distribute (or increase the distribution of) dividends, to cash out. And this is precisely what we are seeing and will continue to see: Leverage seems to have bottomed and now is reverting in corporates. This is not positive for growth and hence, we don’t want to own shares. We don’t want to own mining companies. We understand that the recent rally was fully driven by the expansion of the Fed (via swaps) and the European Central Bank (via Long-Term Refinancing Operations). We are simple investors and are humble enough to know that we will not be able to call the exact day in which the reversal in stocks takes place…”
This trend is increasingly becoming more evident, as new multi-billion shares-buyback programs and dividend raises are announced every week. Who’s financing this? Banks mostly and they will be sorry for it by the time interest rates (i.e. real interest rates go up). In the meantime, let’s enjoy the party!
Reconsidering our last comments on the repo market: Why we may be proven wrong
At the end of our letter on June 25th, we brought up what we thought was a sharp comment from Murray Rothbard, in his book “America’s Great Depression”. In its Chapter 12, under the section titled: “The attack on property rights: The final currency failure”, Rothbard told us that: “…despite the gigantic efforts of the Fed, during early 1933, to inflate the money supply, the people took matters into their own hands, and insisted upon a rigorous deflation (gauged by the increase of money in circulation)— and a rigorous testing of the country’s banking system in which they had placed their trust…”
We concluded therefore that this crisis has to end with a rigorous deflation or liquidation of liabilities, which must be expressed in terms of a new standard. In the ‘30s, the US dollar was still backed by gold and gold was the Fed’s asset. Today, the US dollar is backed by US Treasuries. Therefore, we concluded, “to insist upon a rigorous deflation” is to repudiate the US Treasury notes. On July 2nd, we made the case that such a repudiation was going to take the form of lower volumes in the repo market. By that, we meant illiquidity in the repo market. The same was going to make harder to short commodities naked, brining eventually one net short position in the futures markets to bankruptcy. In the process, counterparty risk would rise exponentially endangering the respective clearinghouse and forcing the Fed to intervene. The key conclusion here was that from that point on, spot prices of commodities were no longer going to be manipulated, given the broken futures markets, opening the door to high inflation.
As the title of this paragraph suggests, we may be wrong in this analysis. What makes us think so? New information: Namely, the potential massive use of floating rate notes (FRNs) by the US Treasury, starting 2013. We want clarify this: The introduction of FRNs will not suppress the process described above. It will only delay it and make the fall even more catastrophic.
The new information came to us upon reflection, based on a series of anonymous articles published on Zerohedge.com, regarding the upcoming change in the funding policy of the US Treasury. Please, find the links to these articles below. Give yourselves some time to read them carefully. They are worth it. We present them in chronological order:
Floating Rate Notes are variable rate notes. If you hold them and rates increase, for instance, you don’t suffer a capital loss. Since the beginning of the crisis, the US Treasury has basically issued fixed rate debt. The long term portion of it, courtesy of Operation Twist, is being massively bought by the Fed. The short end, is accumulating in the balance sheets of the primary dealers. If interest rates were to rise, these dealers would suffer untold capital losses, and it would be politically difficult to bail them out. Therefore, the same dealers are pushing the US Treasury to slowly start refinancing this short-term fixed rate notes in their inventory with floating rate notes. That way, by the time interest rates rise, the problem will have already been transferred to the US taxpayer, who will be in a deeper hole.
What does all this have to do with our previous analysis of the repo market? Well, if floating rate notes are issued, they will have a strong bid from money market funds and liquidity will be enhanced in the repo market, which would continue funding the commodity futures markets.
However, with the US Treasury facing a higher fiscal cliff, the Fed would be forced to intervene buying not only the long-term, but the also short-term debt, to ensure that inflation transforms these higher nominal short-term rates into lower “real” rates. The Fed would not do this only to save the US Treasury, but also the private sector. Why? As short-term liquidity shifts from commercial paper to government-issued floating rate notes, levered companies (and we just said companies are pushing leverage) would have a hard time finding short-term working capital funding. Potentially, and only years ahead, this could well end in situations seen in Latin America, where banks offered weekly or weekend guaranteed investment certificates at high rates. Gold, again, would end up being “the” store of value. But this, this is years ahead and in the making.
The consequences of high frequency trading and the myth that it is needed to bring liquidity to markets
High frequency trading was brought back to light in the past week, after the tremendous losses suffered by the Knight Capital Group. We don’t have much time but want to simply say this: The whole idea that high frequency trading brings liquidity to markets is born out of a misconception of liquidity. And here, we go with the Austrian school: Liquidity is not and should never be intrinsic to an asset, but is the result of preference by acting men.
Secondly, High frequency trading does not even provide liquidity. It just plays the operational weaknesses of markets. In a casino, when the croupier says “rien ne va plus”, all the real bids are locked. In a stock exchange, it appears that this doesn’t happen, allowing high frequency traders to introduce false signals to trigger stop losses or profit taking. If that is liquidity, our markets are broken. It is another Ponzi scheme, with no real cash at the end, played within mili-seconds.
But the underlying point here is that we should not force liquidity into all stocks. If some are not liquid, it is for a reason and providing fake demand via high-frequency trading is an expensive mistake. If the world allows high frequency trading to continue, it will end, paradoxically, in illiquid markets. The real money will leave markets and flow to real assets, because if liquidity means being exposed to the manipulation of high frequency trading….why pay a premium to be liquid?
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