Basil goes to Brussels.

Cormac McCarthy, the American novelist, is an oft-quoted presence on these pages and indeed the following McCarthy quote (taken from his book "No Country For Old Men") has been utilised previously - but it is surely as apt now as it could ever be:

Deputy: "It's a mess, ain't it sheriff?"
Sheriff:  "If it ain't, it'll do 'til the mess gets here."

We refer, of course, to the current situation within the borders of Euroland and the increasing sense that the EU political leadership attended The Basil Fawlty School of Crisis Management. But without the humour. Every hour of this crisis presents fresh rumours, fresh fallouts, fresh plans — but no progress. Is the Greek crisis solvable? Of course. Will they solve it? Hopefully. But in the world of finance, where other people's hard earned money is under your advisory, "hope" is not a strategy. Trading the Euro now is a difficult enterprise but holding concentrated amounts of the currency is, undoubtedly, a risky venture. The support beneath the single currency has persistently eroded in recent months, aside from mere "sentiment" and political bungling, there have been fundamental shifts against sustained Euro strength - particularly a decrease in the superior interest carry it offers versus the US Dollar - a move exacerbated by both the Federal Reserve's recent Operation Twist program and fresh expectations that the ECB will reverse their recent, mistaken, base-rate hike. In its excitement the market recently decided that a 0.5% cut was in the offing for Europe's struggling mortgage holders but the exuberance has since waned and a 0.25% cut (or no cut) are now the considered outcomes. The idea of selling the Euro at current levels (1.36 to the USD) is tempered by the fact that speculators are very heavily exposed to the same position, meaning a move in the other direction could result in a squeeze as large numbers of people rush to buy back increasingly expensive Euros. Ideally, of course, one would wait for just such a rally to begin building a short Euro position: entering at a better price, and into a less crowded trade. Certainly it is our view that a secular shift may now be in progress for the EUR/USD with the 1.30 level likely to be tested in the weeks to come; below is a long term chart of the pair, with our own proprietary indicator showing its own switch to a negative bias (red):

Contributing to the "stronger Dollar" meme is further evidence of slowing global growth. Even ignoring the PIIGS completely, weakening data is prevalent throughout the investment empire; surprise rate cuts in Brazil; land prices collapsing in China; expectations of rate cuts in Australia; a sovereign downgrade of New Zealand; currency stresses throughout Asia; few seem to be escaping the rather loud sucking sound. Confirming such a scenario is Copper, the metal attributed a Ph.D. by the trading community for its accuracy in predicting global trends; Dr. Copper has performed with borderline scary bearishness in recent weeks, collapsing 30% from its price at the beginning of August to today's levels; the S&P being down a relatively splendid 10% in the same period, as the chart below shows:

In point of fact, if one were of the belief that the current negativity in markets is over done, and that a global easing will kick start growth, then Copper is likely a reasonable train to board for that journey. At the least it looks like a relatively cheap ticket for a Bull to buy; although such a journey would likely resemble the old train from Dublin to Limerick i.e. bumpy and uncomfortable, with an underlying air of danger.

How likely is a bounce from current stock-market levels? Hard to tell, but the Bulls certainly lost some ammo when disappointed by the Federal Reserve a couple of weeks ago, with Bernanke suddenly coming over all measured and coy, refusing to deliver the monetary bomb the Bulls were hoping for. Undoubtedly, the lame-duck Obama, hamstrung by a conniving Congress, is looking at Bernanke with desperate eyes but Bernanke now appears to be similarly trapped, with his own Board afraid to act. The apparent failure of QE2 hangs heavy above the Fed's neck, its theoretical impact failed dismally in the real world and has now lent support to the more extreme of the Republican views on monetary policy. In fact we were looking through some old posts here and stumbled upon one post, from about a year ago just as QE2 was being initiated, which included the following quote:

QE2 can't end right. Worthless paper after endless paper. What's good for the equity markets is not necessarily good for the economy. The equity markets are not going to create jobs. If you have a paper bag full of money are you going to go out and hire workers and take risk with healthcare and all these other regulatory restrictions? No, you are going to go ahead and buy high yield, you will buy equities, you will buy risk assets. The fallacy in the whole thing is that you are not going to go ahead and create jobs just by pushing up the market by 20%, 15%. In fact, to some degree, by pushing up commodity prices to levels that are going to be obscene, which is what is going to happen, you are hurting everybody in mainstream America.

There is no more accurate summation of what QE2 achieved, or rather didn't achieve. But, perhaps, therein lies hope for the Bulls: no massive QE3 should now help to subdue commodity price inflation and therefore assist the struggling American consumer: falling oil; falling gas prices; falling food prices might, ironically, be just what the Doctor ordered......

Marble Floor.

Stock markets continued their sell off right into the end of last week, as panic spread with regard to the Greeks and their ongoing membership of the Euro. The potential for further falls certainly exists, especially while the ECB and European Governments persist in communicating with all the clarity and unity of a bunch of sugar-filled kindergartens. Certainly there is no refuge seen for stocks from the window of the credit markets where, as the following chart clearly shows, a veritable collapse in high-quality corporate debt yields has been seen:

We're not spending time on the stock markets in today's post though, the madness of the last year's stock rally is a subject we've even bored ourselves of! Rather we have a perspective on the Great Swiss Euro Peg to offer. Firstly we acknowledge that this isn't, of course, a "peg" but rather a "floor" versus the Euro to which the Swiss central bank have committed themselves to defending at any cost. Analysing the thinking behind "the floor" is an interesting exercise; for reasons of illustration let us imagine that the members of the Eurozone are gathered inside a boat, the hull of this boat has impacted an Iceberg of debt and been breached; the Swiss, in their luxury yacht, have come upon the hapless Eurtanic now listing in the open sea. At this point the Swiss could, perhaps, have assisted a few of the members of the sinking Eurtanic to safety -women & children as it were- then set sail for the calmer vista of Lake Geneva... instead the Swiss appear to have holed their envied yacht and leapt, with  surprising gusto, aboard the sinking vessel. Is this a mission in solidarity or suicide? Who knows. One must suspect that, to take such drastic action, the Swiss have extremely solid information that the Euro will not sink beneath the waves. Or, perhaps, as we previously theorised, the two giant Swiss banks would have been so completely battered by a Euro collapse that the Swiss were effectively tied to the Euro already.

Whatever the thinking behind it, the move has shaken the currency markets and, as we see it, presented some superb trading opportunities. Reaction to the imposition of the floor has been revealing; many firms appear to have been caught on the wrong side of the trade - long the Swiss Franc (CHF) and short the Euro - and experienced instant 10% percent losses the morning the floor was announced. Many of these traders appear convinced that the Swiss Central Bank will eventually lose the battle to defend the 1.20 level.  An article over the weekend in the Wall Street Journal confirmed this thinking:

Hedge funds are considering ways to mount a counterattack against the Swiss National Bank, whose attempt to wrest control of the surging franc caught investors off-guard.

But we think they're wrong. Badly wrong. Allusions have been drawn, repeatedly, to the Bank Of England failing to defend predetermined trading levels for the Pound in the early nineties; famously the BoE were broken by speculators who sold vast amounts of Sterling until the Bank gave up defending it. However, in that case the Bank of England were attempting to hold up the value of the Pound or, to think of it in another way, hold down the relative value of the Deutsch Mark. This was proven to be an exercise in folly. But the Swiss situation is not just different it is entirely opposite. The Swiss are merely promising to devalue their currency as and when required and, considering they can print as much of it as they fancy, how can speculators sustain the fight? To draw another stretched metaphor (not quite as dramatic as the sinking ship): if the Swiss Franc were a stock like, say, Microsoft - this is equivalent to Microsoft saying we will issue new shares as required to keep the price below $20 a share. Trying to buy enough shares to "beat" them is just not a smart way to spend one's money. Similarly, we expect that traders who believe the Swiss Franc should be bought in preparation for the breaking of the Euro floor will be proven wrong. Not only will they be proven wrong but they are, in fact running a much larger risk than might initially be thought. How so? Well this, as we see it, is critical to the Swiss strategy and it is not an idea we have yet seen mooted elsewhere: the Swiss will simply move the floor higher. Yes the 1.20 level versus the Euro has now been named, but what is to stop the Swiss announcing next month that 1.25 is the new level, or 1.30? They can, and might, do exactly that, instantly wiping fortunes off the books of anybody who bought Francs in an attempt to crack the 1.20 floor and, in the process, cementing belief in their resolve. If we're correct in this stance, and we're confident that we are, then the trades to profit are really rather simple:

• As long as the Euro remains under pressure, sell the Swiss Franc against anything, particularly the last remaining safe-haven: the US Dollar.
• If the 1.20 level is approached, sell the Swiss Franc heavily against the Euro.

The chart above shows the moves in various currencies versus the Swiss Franc following the announcement of the Floor. All have clearly strengthened in value, with the only straggler being the Euro, we fully expect this trend to continue.

The laws of thermodynamics demand that the Swiss action must have a consequence, and so it does: inflation. The printing of Francs to defend their floor ultimately devalues each Franc, so the prices of "things" will rise to fill the void. Currently the Swiss are experiencing inflation of below zero (falling prices), so any fears of crippling inflationary pressures are some distance off. However, to complement the two trades above, we would also consider the selling of Swiss ten-year debt; currently such debt yields a meagre 1% and we expect that, as "the floor" gains respect in the financial arena, the realisation that Swiss interest rates must climb will also dawn, pushing yields closer to recent norms which are, as the chart below illustrates, around the 2% mark. Downside on such a trade is also limited as a sustained fall below 0.75% for ten year debt is an extremely unlikely scenario.

Finally, on the day that is in it, a nod westward: to the towers that defined a time, a city and a nation.
In our memories they stand proud; glittering in the night.

... Cuckoo Clock.

"For strange effects and extraordinary combinations we must go to life itself, which is always far more daring than any effort of the imagination."                                                                                                                                                                                  — Sherlock Holmes

Early Tuesday morning the Swiss Central Bank intervened in the currency market and nailed the Swiss Franc at 1.20 to the Euro. Nailing many traders with it. Our Monday recommendation, buying the USD/CHF, had its largest single-day gain in history:

This is a momentous development. It is either a huge gamble on the part of the Swiss or they are "in the know" with regard to the future stability of the Eurozone and the ECB's plans to support it. We will mull the implications and impacts and return to these pages with our thoughts and calls. But there is no doubt: the game is afoot...

Swiss Watch.

Recent weeks have seen the financial landscape continue its sad-eyed slide into the lowlands with most economic data supporting the drop. Friday saw the most recent rain cloud appearing, the monthly jobs number -with expectations north of 100,000- printed at, a surprisingly exact, zero. Certainly a great number for headline writers, and the first time in over fifty years that the monthly roulette wheel landed on the green, but neither will be much consolation to Messrs Bernanke or Obama on whose shoulders this latest shower descends. In our view the number is bad enough to warrant an instigation of QE3 and it is likely to be announced during the September month, the 21st being the next Fed meeting; it will take the shape of "extending the duration of the Fed's balance sheet" which is not a treatment for insomnia, as it may first appear, but rather the "dragging" down of interest rates further out in time with the theory (read: hope) that being able to borrow at low rates but also for a significantly longer period will entice the masses to dive again into the vaunted blue waters of  the Credit pool... Of course most participants are all too aware that their most recent swim in said pool almost resulted in their drowning and/or devouring by shark and it is questionable whether such memories can be dulled by, essentially, increasing the temperature. Nevertheless Bernanke will try, he is but an academic at heart and "theories" are all he has to offer. Obama on the other hand appears to not even be that, The Great Performer languishing in the polls... and theories don't cast votes. There is widespread anticipation of his "jobs speech" this Thursday evening, with the market expecting some serious initiatives beyond the "green jobs" blather; the trump card (not that Trump) would be a nod towards a massive refinancing scheme for US mortgage-holders. Speculation behind such a scheme has gained traction through late August and appears to be a serious possibility; it would, basically, allow some/all/a few households to refinance their mortgage at a significantly reduced (Bernankified) interest rate; currently many mortgage-holders cannot avail of today's lower interest rates because they cannot refinance a property that is in negative equity; a fresh government initiative would waive that requirement in an attempt to stimulate such households with lower monthly mortgage outgoings and stabilise (still dropping) house prices by slowing the relentless tide of foreclosures. Frankly, we see most government housing initiatives as pointless and wrong-headed but this, it must be said, has the rare smell of sense; in the grand scheme of things it may make only a small difference, but it targets a useful area of the economy... and anything is better than "green jobs". Make no mistake though, if the Teleprompter In Chief doesn't deliver the markets something tasty, then it is very difficult to see the Bulls wresting control from the Bears, very difficult indeed.

On the other side of the Atlantic things remain confused, confusing, contradictory and contrary. The ground beneath the Euro is shifting day to day with fault lines appearing weekly, the latest being the apparent acceptance of an IMF official that Greece will "hard default" within six months. Such comments are given weight by the fact that an ECB/IMF party left Greece in a major huff last week accusing the Mediterranean's of failing, again, to effectively invoke the required budgetary measures and also the fact that Greek one year debt is now trading at about a 70% yield. Makes the old savings-account rate look a bit stingy. The chart below shows last Friday's dramatic move in Greek debt, betraying a pretty clear, fresh, breakdown in the situation: 

We have long argued that a collapse of the Euro is a less likely event than many suggest simply because the reality of such a collapse would be bordering on the horrific. When one works through the knock-on effects of losing the € key on your keyboard it is not a pretty situation for anybody, and for some countries it would, genuinely, be a war-like scenario; despite what academic economists seem determined to suggest it is a situation which should be avoided at all costs. Amidst panic though is often opportunity and we suspect that it presents itself in the guise of an apparent safe-haven: the in vogue Swiss Franc. Hot and scared Euros have fled into Switzerland at a pace rarely seen in history bidding the price of the Franc up to exorbitant levels. But what if the scared money is wrong? If the Euro truly crumbles, if a sovereign (Greek or Irish...or Italian!) default is seriously on the cards then how will the large Swiss banks fare? Well they'll be about as screwed as everybody else's - which is to say "very". They are on the hook for over $50bln to the Greeks and Irish and a similarly large amount to the Italians. Perhaps revealingly, such exposure can be seen in the most recent Libor costs for the world's largest banks, seen in the following chart:

In first and third place, when being first is bad, are Credit Suisse and UBS. Last week Credit Suisse were paying 50% more for their funding than HSBC. Now call us cynical, but that does not spell "safe haven" in our world; Switzerland simply could not handle the detonation of either of her banking powerhouses without suffering extreme strain and, in such a scenario, owning a pallet-load of Swiss Francs could be quite an unpleasant experience. Of course selling the Swiss Franc against the Euro is a fools errand if a Greek/Irish/etc default were indeed to emerge, rather the angle is to sell the Franc against a real safe haven. We have a bias towards the  Norwegian Krone, which looks relatively cheap, reasonably immune from Euro-trash and offers a yield to boot. However the stand out trade is presented by the acceptance that there are but two true safe havens in this blue planet: one is shiny, yellow and expensive; the other is cheap, green and much-derided but, if a world were to emerge where the Euro was truly crumbling, it is the venerable US Dollar which would once again rule supreme, and passing parity with the Swiss Franc toward that standing would not only be assured, it would be easy. It is our view that USD/CHF is wildly weak and that, in today's volatile market, where buying insurance is a very expensive option (literally), out-of-the-money Calls on the USD/CHF pair are particularly mispriced and are just about the cheapest "disaster insurance" you can get.

....now don't get us started on toblerones...

Derailed.

Considering we rather cheer-led the Chinese launch of their high speed super-train just a few weeks ago, it is only right and honest that we highlight the fact that said trains managed to get about two days under their wheels before suffering a multiple-fatality collision.... and a couple of weeks after that all the Chinese high speed trains were recalled due to safety concerns. So it appears that China's metamorphosis into a massive Japan is rather further off than the optimistic might have suspected. (Incidentally, fatalities from Japanese high speed train collisions: zero.)  Nevertheless, the Chinese can take solace in the fact that it could be worse: they could be Russia... Enjoy the following short clip of President for life Putin test driving Russia's latest attack on the dominant German auto makers:

Maybe give it some more choke Vlad..?

Obviously the dominant financial news is the keeling over of the markets. The mainstream media seem utterly confused and baffled by the sell off, searching high and low for justifications and explanations. In our view there is a disappointingly simple answer: 1) stocks were too expensive; 2) people panic. Stocks were pricing in a utopia of growth and low interest rates with controlled inflation and Bernanke ready at the pumps whenever called on. This was clearly delusional. It was an attitude reminiscent of discussing the upcoming Premier League season with a Liverpool fan: at worst -at worst- they expect to finish the season second! The fundamentals do not apply: in the markets the Bulls ignored the unemployment issue, they ignored the fifty million Americans on food stamps, they ignored the battered balance sheets of Main Street; in Anfield they ignore the players and their lack of depth and talent. Needless to say both subjects must reset their expectations and, for the markets at least, that process is now under way. Recessions are normal occurrences, they are important and unavoidable parts of the economic cycle, and we expect America to enter recession by early next year; but that is not to say that the world will implode around us. It is important for market participants to realise that this is not 2008. In 2008 there was no question that complete collapse of normal society was a possible outcome, it might have been a 10/1 shot, maybe longer, but it was certainly an event that the world skirted around and avoided. This is not the same scenario and the panic of the media, and some traders, suggests to us the psychological phenomenon of "recency bias" - that is the tendency to place heavier weight on more recent events and lighter weight on less recent events; so, in effect, people scared out of their wits in 2008 (us included by the way) tend to expect a similar brouhaha from a 2011 recession when, in fact, there were 11 recessions in the last fifty years that did not cause complete carnage (just one that did). Companies are entering the next recession with healthier balance sheets with significantly lower levels of debt; the opposite is true of Countries entering the next recession, most are in a bit of a mess, but most can print currency so should, eventually, muddle through intact.

As we mentioned in our last post, the stock strategies which usually perform well in recessionary periods are likely to repeat that feat - i.e. being long solid dividend payers with good pricing power and good balance sheets while being short more speculative small caps. We touted Eli Lilly last week and it's interesting to note that Lilly remains just around positive since then despite the fresh sell off. Statoil is a similar proposition, a company paying about a 5% dividend, trading at six times earnings with about $15bln in cash; Statoil is now back around the levels it traded at at the worst of 2008; they announced one of their largest ever finds just last week (a size not found off Norway since the eighties); and, finally, being a Norwegian company, purchasing stock in Krone keeps one's precious readies out of Dollars or Euros if one is so inclined. Similarly we expect the agriculture arena to outperform equities, and movement since the July stock sell off would support that view; the following chart shows the S&P500 in orange and the DBA Agriculture Fund (which tracks a composite of commodities including corn, wheat, soy-beans and sugar) in blue, evidently the Ags still have buyers:

Nevertheless, it's critical to remember that the Bears are in charge of this market now, so guile and pace will ultimately be required to flourish. . .  coincidentally, exactly what Liverpool have none of.


Stay lucky,

Red or Fed

... don't worry Henderson - Bernanke will catch you anyway.

Apologies for the delay, some technical gremlins caused us a touch of trouble. A most interesting few trading days was bookended by Tuesday's massive relief rally, a move ignited by The US Fed's promise to keep interest rates pinned at essentially zero for another two years. As we've said repeatedly on these pages this should come as no surprise: too much of America's debt is short-term in nature so any increase in interest rates would swiftly skewer them (if people think the US has a debt problem now then imagine the mess if rates were twice as high). Ergo rates simply can't go higher, and so it has proved: the Five Year Treasury is today returning less than 1% per annum; the Ten Year close to 2%! This is an unprecedented situation - unless, of course, you are Japanese in which case it is boringly familiar. One should also note that Japan disproves the idea that America's recent debt downgrade will hike interest costs, Japan hasn't been a AAA credit since back in 1998 (at one point being rated below Botswana!) but rates have remained entirely subdued over the intervening years, her current Ten-Year debt yields just 1%! It's simply undeniable that there is increasingly little lost in translation when one compares the Japanese experience to America's current predicament.

There were perhaps two particularly interesting aspects of the Fed announcement (apart from the above rate commitment): firstly they essentially confirmed that they see the onset of a fresh recession and that it will be accompanied by its usual deflationary playmate; secondly the statement contained little indication of a distinct "Quantitative Easing 3" project, i.e. fresh asset purchases by the Fed or targeting a specific rate much further out the curve. Perhaps one reason we won't endure another round of the recent quantitative easing programs can be seen in the following chart, it built nothing but a big bubble:
(The Jackson Hole reference is the speech at which Bernanke fist announced his QE program)

Despite the lack of an explicit commitment to QE, stocks rallied strongly higher with many participants suggesting that investors, faced with another two years of earning zero interest, will be forced into the stock market to earn a return. There's undoubtedly some truth behind this and the likely beneficiaries of such a move would be the safer dividend paying plays (Eli Lilly, for example, pays about a 5.5% dividend and trades at 9 times earnings; a saver who puts $35k in Eli Lilly stock gets paid $500 by the pharmaceutical giant every three months, if they put the $35k in a bank then in real terms they'd likely be down in two years time, they certainly won't be up). The chase for yield can be a powerful force and it will be interesting to see if it presses higher yielding currencies back up after their recent declines. It is certainly difficult to see the medium term outlook as being positive for the Dollar (unless the Euro crisis drastically worsens) and global tensions will be piqued by Bernanke's latest statement: another two years of zero rates will irritate the emerging markets who are already struggling with inflation; it will certainly irritate the Swiss who have an absurdly strong currency  to deal with (one analyst pointed out on Bloomberg this evening that a Big Mac in Zurich now costs $17!) now there's less reason to move out of Francs into Dollars; and it will irritate the Russians because, well, they're irritable at the best of times.

More commentary as we dissect the market reaction...