Shadow Capitalism

Posted with minimal commentary…

All we have to say is…

Two hours.

The Swiss are taking a page out of recently-released Gucci Mane’s lyrics book:

Thumb print me, finger print me,
But can we agree to disagree?
I’m from east Atlanta 6, where the boys dump bricks
But we don’t bump the Blueprint 3.

If only the SNB would stop dumping bricks (CHF) and would give the Blueprint 3 (Alchemy of Finance) a virgin listen or two.

Co-written by Qasim Khan

Since the recent boardings of the Turkish flotilla last week and the MV Rachel Corrie on Saturday have grabbed headlines, much has been made of the economic significance of these events. However, many notable pundits continue to claim that this situation presents much less of a concern than other tensions in the region and throughout the world. Normally we would be inclined to agree with their reasoning, but a recent Economist piece on the conditions in Gaza has forced us to question this position. It appears that contrary to its intended purpose, the shunning of Gaza has resulted in increased control and legitimacy of the Hamas government. The article is a must read, but here are a couple especially important highlights:

Initially Hamas and other militant groups, drunk on their self-claimed success in forcing Israel’s departure, sought to fight their way out with projectiles. The number of mostly home-made rockets hitting Israel rose from 281 in 2004 to 1,750 in 2008; and their range rose from a few kilometres to reach Tel Aviv’s outskirts. But stung by the ferocity of Israel’s reprisals, most lethally in the January 2009 war, Hamas reined in its fire and forced others to do likewise. So far this year 34 rockets have landed in Israel, none launched by Hamas. “Hamas is defending Israel,” chuckles an Israeli foreign ministry official.

…

Instead Hamas has turned its energies inward. With Gazans locked inside the 40km by 10km (154 square-mile) strip, the siege has given Hamas a free hand to mould the place… At first the resistance economy failed to meet people’s needs. But today, thanks to the tunnels, Gaza’s shop shelves are brimming with goods that often arrive cheaper and faster than when Israel opened the gates.

…

Humanitarian agencies, with an eye on external financing, bewail the lack of development. But their indices miss the point. Gaza is redeveloping, and Hamas is making society in its own image. Huge amounts now pass through the tunnel shafts each year, creating a new economy from which Hamas creams a handsome share of the profits to finance its rule. “The siege is a gift,” says a Hamas minister.

…

This has created stability but at the price of a reign of fear. When rival Islamists decried Hamas’s rule in Rafah, the militants stormed the mosque and killed its worshippers. When leftists protested that the tax rises hit a people already burdened by siege, they were hauled to jail. The death penalty has been reinstituted. And insensitive to comparisons with Israel, Hamas’s forces have bulldozed the homes of Gazans who had moved onto former settlement land without authorisation. A thriving political culture has been culled to a one-faction state.

Israel was put in a no-win situation regarding the recent humanitarian missions. Let the boats make it to Gaza and lose all credibility; stop the boats and become the villain. With increased Israeli backlash, (not to mention more tempered, albeit still undeniable support from the US) and increased resistance and protest efforts, this story will only continue to dominate headlines. We would suspect that we haven’t seen the last of boats, protests and resistance on an international scale either. The problem is because of its aggressive policies, Israel will continue to find itself in no-win situations, like denying entry to Noam Chomsky this week for a lecture to be given at the West Bank’s Birzeit University; it is clear that the current path is unsustainable.

Are we saying that there will be trouble in the near future? No. Very clearly this is just part of a conflict that stretches upon a much longer time horizon. But there is a very real possibility that this conflict reaches a breaking point within the next two or three years and Gaza could very well be the impetus for the ultimate breakout of the Israeli-Palestinian-Iranian-US-Oil-Restoftheworld clusterfuck of political tension, with severe global economic ramifications.

And the catalysts keep on coming. Just before the flotilla raid, Israel deployed the first of three nuclear missile submarines off the coast of Iran for a permanent nuclear presence in the area:

The submarines could be used if Iran continues its programme to produce a nuclear bomb. “The 1,500km range of the submarines’ cruise missiles can reach any target in Iran,” said a navy officer.

Apparently responding to the Israeli activity, an Iranian admiral said: “Anyone who wishes to do an evil act in the Persian Gulf will receive a forceful response from us.”

Israel’s urgent need to deter the Iran-Syria-Hezbollah alliance was demonstrated last month. Ehud Barak, the defence minister, was said to have shown President Barack Obama classified satellite images of a convoy of ballistic missiles leaving Syria on the way to Hezbollah in Lebanon.

Binyamin Netanyahu, the prime minister, will emphasise the danger to Obama in Washington this week.

Of course, Netanyahu never met with Obama as the flotilla raid happened a day later. The increasingly vocal alliance between Iran and Hamas, in enmity against Israel, has extensive implications on US foreign policy. Its positioning with Israel is finding increasing fragility, due to international pressure against Israel’s recent actions; meanwhile, its anti-Iran policy is at odds with further neutralization of its relations with Israel. With its own enormous problems domestically, the United States is at a critical turning point in its foreign relations regarding Israel, and the recent global anti-Israeli sentiment (which may increase as Israel rejects demands for an international probe on the Gaza flotilla raid) is putting pressure on Obama to not end up going the route of Bush 2.0 regarding Middle Eastern politics.

Political momentum is vital to furthering causes, as the anti-offshore drilling backlash to the recent BP turmoil attests to. And with anti-Israeli sentiment seeing a resurgence on the eve of recent events, further aggression from Israel will lead to a positive-feedback cycle of political death. Meanwhile, Israeli patrol killed four Palestinian militants diving off the Gaza coast today. The political ramifications of this, particularly in the global community (and thus affecting US policy), are enormous. Yet a more tempered stance from Israel would provide even more momentum for a homegrown revolution in Gaza.

And with Hamas gaining political and economic control in Gaza, time is of the essence for the United States to position itself properly. If it decides to use the Iranian support of Hamas as justification for a resurgence of American-Israeli relations, a political dichotomy will unfold in foreign relations, and Obama may be forced to go way of GWB. As Bush once said, “Fool me once, shame on — shame on you. Fool me — you can’t get fooled again.” And the international community will not let itself be fooled again by an aggressively militant United States presence in the Middle East. If the declining, yet still very existent, American support of Israel continues, Israel could find itself struggling for alliances and forced to increase its already aggressive policies. Either way, time is becoming a factor, and as the Economist puts it, “the Obama administration’s failure to cast a blanket veto on any deprecation of Israel is depicted in Israel almost as a betrayal,” rendering neutrality/indifference not an option for the USA.

Been busy, and still am– quick post…

S&P retesting and selling off 200DMA. Breakdown through 1040 should usher in major selling. Bear market is back.

AUD/USD continues to be best metric for risk appetite. Chart remains bearish and after the large selloff from 200DMA breakdown, the consolidation appears ready to break and resume selling. Recent WSJ article about copper price worries on back of Chinese economy cooling hurts Aussieland quite a bit (exporter of such metals), and its property bubble is preparing for burst any minute now.

USD, as expected, is being bid heavily. Congrats to readers who have used my commentary for actionable trade ideas reaping in profits.

Then:

Underweight Energy Pitch

Now:

Submitted by Qasim Khan

Perhaps one of the most overlooked phenomena in this world is the relationship between cause and effect. Financial markets and economics in general are often noteworthy exhibitions of a lack of recognition of this principle. In just a few minutes watching CNBC, you are bombarded with statistics that PROVE our miraculous economic recovery. The macro data has become better; anyone who denies that is disconnected from reality. However, as the markets have vehemently demonstrated recently, the fact is that these numbers have become increasingly irrelevant. Why you ask? Because we don’t live in a society where these numbers represent organic, secular conditions anymore; instead, they reflect the increasingly contradictory and escalating political tension of the world.

Importance of Geo-Politics

While CNBC talks about things like CPI, PMI, and Cramer’s PMS instead of bigger picture geo-political developments, their importance cannot be understated. And while many traders and investors do not heavily account for such macro elements (evidenced by the fact that the global economy could be brought to its knees by a largely unforeseen housing bubble), David Einhorn, whom I have had the fortune of meeting, perfectly explains the importance of this in a speech to the Value Investing Conference in October 2009. Einhorn, known for his bottom up investment style, found a greater appreciation for the importance of macro developments after the recent financial crisis. In the speech he offers several extremely poignant predictions based upon this macro-political perspective, almost completely vindicated by the events in 2010. He said:

At the May 2005 Ira Sohn Investment Research Conference in New York, I recommended MDC Holdings, a homebuilder, at $67 per share. Two months later MDC reached $89 a share, a nice quick return if you timed your sale perfectly. Then the stock collapsed with the rest of the sector. Some of my MDC analysis was correct: it was less risky than its peers and would hold-up better in a down cycle because it had less leverage and held less land. But this just meant that almost half a decade later, anyone who listened to me would have lost about forty percent of his investment, instead of the seventy percent that the homebuilding sector lost.

I want to revisit this because the loss was not bad luck; it was bad analysis. I down played the importance of what was then an ongoing housing bubble. On the very same day, at the very same conference, a more experienced and wiser investor, Stanley Druckenmiller, explained in gory detail the big picture problem the country faced from a growing housing bubble fueled by a growing debt bubble. At the time, I wondered whether even if he were correct, would it be possible to convert such big picture macro thinking into successful portfolio management? I thought this was particularly tricky since getting both the timing of big macro changes as well as the market’s recognition of them correct has proven at best a difficult proposition. Smart investors had been complaining about the housing bubble since at least 2001. I ignored Stan, rationalizing that even if he were right, there was no way to know when he would be right. This was an expensive error.

The lesson that I have learned is that it isn’t reasonable to be agnostic about the big picture. For years I had believed that I didn’t need to take a view on the market or the economy because I considered myself to be a “bottom up” investor. Having my eyes open to the big picture doesn’t mean abandoning stock picking, but it does mean managing the long- short exposure ratio more actively, worrying about what may be brewing in certain industries, and when appropriate, buying some just-in-case insurance for foreseeable macro risks even if they are hard to time.

Stimulus

This ideological change has become apparent in the market more generally as well. CNBC can toot all the numbers and expectations they want, the truth is economic data has taken a back seat to political circumstances in the new market.

To understand the causal dynamics of the current recovery it is necessary to ask “how” and “why” instead of asking the much trumpeted CNBC question of “what”. From this perspective it becomes clear that the “recovery” that we have experienced draws heavily on exceptionally generous intervention. The government response was in all likelihood necessary and has resulted in improved economic data; however, it seems that the stimulus improved the (certain) numbers simply for the sake of improving (certain) numbers. As this has become increasingly apparent, there has been a paradigm shift where political conditions and events increasingly overwhelm economic data and appear to continue to do so for the foreseeable future.

Perhaps the most pressing question is: “How much longer can sovereign governments afford to provide extremely loose conditions and subsidize private sector debt?” So how early is too early to remove stimulus? Einhorn wisely prophesied that government response to the financial crisis would make previously economic issues become subject to politics:

Imagine, in our modern market, where we now get economic data on practically a daily basis, living through three years of favorable economic reports and deciding that it would be “premature” to withdraw the stimulus.

An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fall out. Our choice may be either to maintain large annual deficits until our creditors refuse to finance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline.

This brings me to our present fiscal situation and the current investment puzzle.

Over the next decade the welfare states will come to face severe demographic problems. Baby Boomers have driven the U.S. economy since they were born. It is no coincidence that we experienced an economic boom between 1980 and 2000, as the Boomers reached their peak productive years. The Boomers are now reaching retirement. The Social

Security and Medicare commitments to them are astronomical.

When the government calculates its debt and deficit it does so on a cash basis. This means that deficit accounting does not take into account the cost of future promises until the money goes out the door. According to shadowstats.com, if the federal government counted the cost of its future promises, the 2008 deficit was over $5 trillion and total obligations are over $60 trillion. And that was before the crisis.

Over the last couple of years we have adopted a policy of private profits and socialized risks. We are transferring many private obligations onto the national ledger. Although our leaders ought to make some serious choices, they appear too trapped in short-termism and special interests to make them. Taking no action is an action.

In the nearer-term the deficit on a cash basis is about $1.6 trillion or 11% of GDP.

President Obama forecasts $1.4 trillion next year, and with an optimistic economic outlook, $9 trillion over the next decade. The American Enterprise Institute for Public Policy Research recently published a study that indicated that “by all relevant debt indicators, the U.S. fiscal scenario will soon approximate the economic scenario for countries on the verge of a sovereign debt default.”

As we sit here today, the Federal Reserve is propping up the bond market, buying long-dated assets with printed money. It cannot turn around and sell what it has just bought.

There is a basic rule of liquidity. It isn’t the same for everyone. If you own 10,000 shares of Greenlight Re, you have a liquid investment. However, if I own 5 million shares it is not liquid to me, because of both the size of the position and the signal my selling would send to the market. For this reason, the Fed cannot sell its Treasuries or Agencies without destroying the market. This means that it will be challenged to shrink the monetary base if inflation actually turns up.

Further, the Federal Open Market Committee members may not recognize inflation when they see it, as looking at inflation solely through the prices of goods and services, while ignoring asset inflation, can lead to a repeat of the last policy error of holding rates too low for too long.

At the same time, the Treasury has dramatically shortened the duration of the government debt. As a result, higher rates become a fiscal issue, not just a monetary one. The Fed could reach the point where it perceives doing whatever it takes requires it to become the buyer of Treasuries of first and last resort.

Austerity

The unsustainable nature of the interventionist mandate is becoming increasingly apparent, evidenced by the explosion of sovereign debt concerns this year. This crisis has resulted in a reexamination of the importance of fiscal discipline and introduction of austerity plans in Europe. While the US states do not face the same difficulties as their European counterparts, their problems may be just as difficult to overcome.

This past week, the great city of Central Falls, Rhode Island was placed in receivership, which comes as a tremendous surprise because the city website’s slogan led me to believe that Central Falls was “A City with a Bright Future.” It’s funny that their website failed to mention that its public school system was universally accepted to be well below satisfactory standards; so poor in fact that in February the Board of Trustees voted to fire the ENTIRE teaching and administrative staff of the school system. As misplaced or harsh as this measure may have been (clearly such systemic problems have more than one causal source), being labeled as “persistently lowest-performing” and having a 48% graduation rate is simply unacceptable. It is not surprising to find this result was an product of monetary union conflict. The articles points out:

Duncan is requiring states, for the first time, to identify their lowest 5 percent of schools — those that have chronically poor performance and low graduation rates — and fix them using one of four methods: school closure; takeover by a charter or school-management organization; transformation which requires a longer school day, among other changes; and “turnaround” which requires the entire teaching staff be fired and no more than 50 percent rehired in the fall.

…

Gallo and the teachers initially agreed they wanted the transformation model, which would protect the teachers’ jobs.

But talks broke down when the two sides could not agree on what transformation entailed.

Gallo wanted teachers to agree to a set of six conditions she said were crucial to improving the school. Teachers would have to spend more time with students in and out of the classroom and commit to training sessions after school with other teachers.

But Gallo said she could pay teachers for only some of the extra duties. Union leaders said they wanted teachers to be paid for more of the additional work and at a higher pay rate — $90 per hour rather than the $30 per hour offered by Gallo.

After negotiations broke down, Gallo said she no longer had confidence the high school could be transformed and instead recommended the turnaround model. Gist approved Gallo’s proposal Tuesday morning and gave the district 120 days to develop a detailed plan.

So let’s get this straight: the students were performing so poorly that in order demand more commitment from teachers, they should be paid an even greater amount? It’s no wonder why the school system would be so fundamentally unproductive. While I don’t believe a teacher would purposely sabotage their students, the breakdown of talks demonstrates that the teachers were not committed to the job they should already be doing. Talk about moral hazard. But it turns out that the problem of paying its current teachers was minor in comparison to the true problem of paying retired teachers, as this article points out:

“The pension plan is nearly broke,’’ said Joseph Larisa, a lawyer who argued in court yesterday for the receivership. “It’s really reached a breaking point where the budget cannot be balanced, whoever is in charge.’’

And if you believe that Central Falls is the only municipality struggling with its pension commitments, you might find this NYT piece quite enlightening. While Central Falls may be insignificant in the larger scheme of things, make no mistake, austerity measures will take place within the US and they will result serious consequences.

Geo-political Tension

And while the fiscal difficulties of the public sector are the flavor of the day, potentially much more dangerous geo-political tensions are developing throughout the world.

While posting a trade deficit in March has calmed the domestic calls for the appreciation of the Yuan, I doubt anyone would characterize the US-Chinese dynamic as warm. The Google censorship conflict presents an altogether different political challenge and I’m sure Hilary Clinton’s remarks today calling for China to increase corporate freedom and transparency failed to improve relations. Slowly but surely, we are seeing China capitalize on its economic power to gain political power, something that the US has largely had a monopoly upon the previous century or so.

While Thailand has seen its share of troubles, the conflict between the Koreas dominates the Asian soft-power political landscape. North Korea just happened to torpedo and sink a South Korean naval ship, killing 46 sailors. SoKo, understandably, wanted to make a strong statement of retaliation, but then remembered North Korea is nuclear and it isn’t. So they’re taking their case to the almighty UN Security Council, where they are left at the whims of regional giant and their biggest trading partner, China, which has yet to state a formal policy on the sinking of the ship. Can’t piss off China, can’t piss of North Korea… something will have to give eventually.

Speaking of nuclear issues, Iran continues to pose the biggest threat to the global economy and it does not appear likely to improve any time soon. Not only did the US fail to secure the release of three jailed American journalists in Iran despite having released two Iranian citizens held by US forces in Iraq and their mothers visiting them in Iran, it appears that it is losing credibility in the nuclear development conflict as well, evidenced by a recent interview with President Ahmedinejad on Al Jazeera:

In an exclusive interview conducted by the Al Jazeera network on Friday, Ahmadinejad stated that no country has the power to confront Iran, and added that Tehran advocates diplomacy as the ideal way to deal with international issues, the Fars news agency reported.

Ahmadinejad said Iran does not even take Israel into account and noted that Tel Aviv is not able to wage a war against the Islamic Republic.

…

On the deteriorating relations between Tehran and the West, Ahmadinejad said Western countries don’t have problems only with Iran but actually have problems with every country.

While the last quote is surprisingly insightful, once again Ahmedinejad leaves observers miffed. Don’t have the power? Apparently he missed the massive naval buildup in the Persian Gulf that the US has begun

Our military sources have learned that the USS Truman is just the first element of the new buildup of US resources around Iran. It will take place over the next three months, reaching peak level in late July and early August. By then, the Pentagon plans to have at least 4 or 5 US aircraft carriers visible from Iranian shores.

This situation is quite literally a perfect storm combining a lunatic head of state, nuclear weapons, oil and of course Israel. Particularly with respect to crude, who knows how long Obama can stick to his pro-drilling position as the oil spill has gone on for so long now that everyone seems to have either forgotten about the issue or submitted their best idea to BP. Just today, Iran threatened to abandon shipping some of its nuclear stockpile abroad as was planned if the US pursued increased sanctions against it; it will be interesting to see just how far the Obama administration is willing to press Iran on its nuclear aims.

The Moral Bankruptcy of Hamid Karzai

Oh and did we forget to mention the US is still conducting military operations in Iraq and Afghanistan? The economic costs of which, pointed out here perhaps somewhat satirically by Congressman Alan Greyson, are completely ignored. The situation in Afghanistan is particularly perplexing, epitomized by the enigma that is Hamid Karzai.

Here is a situation where we have a president who is quite literally telling us he supports the American effort while speaking English and the Taliban when speaking Pushto. No that’s not an exaggeration. He literally threatened to join the Taliban.

This is the same president who needed to commit severe election fraud to prevent a runoff election with a man named Abdullah Abdullah (if you’re not supposed to trust a man with two first names, how in the hell do you even consider trusting a man with two first names that just happen to be the same?). The same president who had one-third of his votes thrown out by a UN-backed fraud commission. The same president who then tried to take over the investigation commission that was supposed to look into fraud in last August’s election and then accused the UN of rigging the election, despite the fact that it was the UN who backed the investigation that revealed the massive fraud. The same president whose brother just shut down the regional council in Kandahar while he is being investigated for illegally appropriating government land. Oh and by the way, our success in the operation absolutely depends entirely upon securing Kandahar, the Washington Post points out. While Will Smith doesn’t believe in backup plans, I don’t think this is exactly what he envisioned.

Of course, not all of these tensions will escalate to have significant economic ramifications, but they just serve to show there is no lack of exogenous catalysts posing a threat to an increasingly global economy.

Politics and Gold

Perhaps the most politically contentious investment currently is gold. Gold, the asset that has no yield and no obvious pragmatic purpose has breached all time highs; and with such success inevitably comes much abuse, confusion and controversy. As seen by the recent Goldline-Glenn Beck- Anthony Weiner situation, the value of gold is primarily driven by political expectations. With the rise of the Tea Party movement producing legitimate candidate threats (although Rand Paul may have shot himself in the foot) gold will only continue to become more contentious. Once again, Einhorn shrewdly foretold:

I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Gold did very well during the Great Depression when

FDR debased the currency. It did well again in the money printing 1970s, but collapsed in response to Paul Volcker’s austerity. It ultimately made a bottom around 2001 when the excitement about our future budget surpluses peaked.

Prospectively, gold should do fine unless our leaders implement much greater fiscal and monetary restraint than appears likely. Of course, gold should do very well if there is a sovereign debt default or currency crisis.

A few weeks ago, the Office of Inspector General called out the Treasury Department for misrepresenting the position of the banks last fall. The Treasury’s response was an unapologetic expression that amounted to saying that at that point “doing whatever it takes” meant pulling a Colonel Jessup: “YOU CAN’T HANDLE THE TRUTH!” At least we know what we are dealing with.

When I watch Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches written by the Fed Governors, observe the “stimulus” black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the dollar. But then I look at the other major currencies. The Euro, the Yen, and the British Pound might be worse. So, I conclude that picking one these currencies is like choosing my favorite dental procedure. And especially now, where both earn no yield.

…

I believe there is a real possibility that the collapse of any of the major currencies could have a similar domino effect on re-assessing the credit risk of the other fiat currencies run by countries with structural deficits and large, unfunded commitments to aging populations.

I believe that the conventional view that government bonds should be “risk free” and tied to nominal GDP is at risk of changing. Periodically, high quality corporate bonds have traded at lower yields than sovereign debt. That could happen again. [editor's note: a possibility mentioned on ShadowCap on multiple occasions]

Regulation

The final piece of the political-financial landscape is regulation, a topic that has seen dramatic developments recently in the US. Here, perhaps more so than anywhere else, the global economy is purely subject to the flighty whims of politics. As such, regulation, while theoretically desirable, may pose the greatest threat of all because it never seems to deliver on its intended aims. Einhorn:

Rather than deal with these simple problems with simple, obvious solutions, the official reform plans are complicated, convoluted and designed to only have the veneer of reform while mostly serving the special interests. The complications serve to reduce transparency, preventing the public at large from really seeing the overwhelming influence of the banks in shaping the new regulation.

In dealing with the continued weak economy, our leaders are so determined not to repeat the perceived mistakes of the 1930s that they are risking policies with possibly far worse consequences designed by the same people at the Fed who ran policy with the short- term view that asset bubbles don’t matter because the fallout can be managed after they pop.

That view created a disaster that required unprecedented intervention for which our leaders congratulated themselves for doing whatever it took to solve. With a sense of mission accomplished, the G-20 proclaimed “it worked.”

And that is the message that the Administration is trying to send with the new financial reform bill that passed the Senate: Mission Accomplished. And that is how you end up with a new “consumer protection” agency, when we already have a obfuscated system of overlapping and redundant institutions.

Anyone who objectively observes the incentives of the current political establishment objectively is forced to admit that what regulation produces more so than anything else is more regulation. So while the SEC is busy surfing the web desperate waiting for the new Kendra sex tape, we have a new institution to place the blame upon when the next crisis inevitably occurs.

Financial reform was clearly passed now so the administration can claim a win for upcoming mid-term elections, however it is beyond all hilarity that the “reform” completely leaves the issues with GSEs and rating agencies unaddressed. Bill Gross has recently been on a campaign against rating agencies. Once again, Einhorn points out:

And, of course, these structural risks are exacerbated by the continued presence of credit rating agencies that inspire false confidence with potentially catastrophic results by over-rating the sovereign debt of the largest countries. There is no reason to believe that the rating agencies will do a better job on sovereign risk than they have done on corporate or structured finance risks.

My firm recently met with a Moody’s sovereign risk team covering twenty countries in Asia and the Middle East. They have only four professionals covering the entire region. Moody’s does not have a long-term quantitative model that incorporates changes in the population, incomes, expected tax rates, and so forth. They use a short-term outlook – only 12-18 months – to analyze data to assess countries’ abilities to finance themselves. Moody’s makes five-year medium-term qualitative assessments for each country, but does not appear to do any long-term quantitative or critical work.

Their main role, again, appears to be to tell everyone that things are fine, until a real crisis emerges at which point they will pile-on credit downgrades at the least opportune moment, making a difficult situation even more difficult for the authorities to manage.

Hm… we haven’t seen this exact problem in the Eurzone now have we? Globally we are seeing the effects of increased regulation, as Chinese tightening has set off a wave of fear in the region and a recently proposed mining tax on the heavily commodity based economy in Australia helped send the AUD plunging this past week. In the US, financial reform has spilled into the electoral arena, complicating an already far too convoluted project.

Take for example the new derivative amendment proposed by Arkansas Senator Blanche Lincoln, which almost no one takes seriously. Hell, even Paul Volcker opposes the amendment. Yet surprise, surprise with an upcoming election it was created for political gain and has remained because of political risk. A recent Bloomberg piece points out:

Regulators “have come out in a really unusual way and said, and I’m paraphrasing here, that this is a really, really stupid idea,” Senator Judd Gregg, a New Hampshire Republican, said in a recent floor speech. “Where this idea came from is hard to fathom because on the face it makes absolutely no sense. Yet for some reason it has found its way into this bill.”

…

Regardless of the outcome, Lincoln has reaped political gain. In a fundraising letter sent April 16, she said she was “proposing sweeping legislation that would drastically change the way Wall Street does business.”

On May 4, her campaign began airing a radio advertisement featuring President Barack Obama. “Blanche is leading the fight to hold Wall Street accountable and make sure that Arkansas taxpayers are never again asked to bail out Wall Street bankers,” Obama said.

And this is why all I can do is laugh when I see politicians crucifying Goldman for having conflicts of interest. Because if anyone has a conflict of interests, it is politicians. The recent actions of Blanche Lincoln and Arlen Spector demonstrate just how repulsive politics is ethically. Arlen Spector quite literally admitted his only reason for changing parties was to save his job, so it’s not really a wonder that he couldn’t secure the primary bid.

But such actions are the rule, rather than the exception. Every time I turn on the news to see a headline that reads something like BREAKING NEWS: State Attorney General Cuomo Declares Gubernatorial Candidacy, I am reminded at how seriously flawed the political environment currently is and its dominating influence over financial markets. For example, any reasonably intelligent human being could surmise that Cuomo already did this when he started conducting criminal investigations into Wall St practices that will undoubtedly result in absolutely nothing of substance.

So while I agree the Fed opacity presents a concern, I would be far more concerned if it had to report to the GAO or any other Congressional body because while Bernanke is certainly guilty of hubris, many Congressman are guilty of the far worse crime of absolute idiocy. Checks and balances are extremely important in theory, however, they can be equally unproductive if involved parties are incompetent.

However, that’s exactly where we are today; financial markets are a game of politics right now. It’s nice to see the unemployment rate tick up one-tenth of one percent or manufacturers gaining confidence, however when you understand the causal sources of these changes, they truly become much less important. When the Fed has a balance sheet of over $2T, Fannie and Freddie are still backing every mortgage in sight, and ZIRP is fueling banking profits (while will continue for a significant amount of time), it is no wonder. This trend looks like it will continue as well.

Everyone knows that such a path is unsustainable (although the United States enjoys a clear advantage in maintaining such conditions because of disastrous game theory political implications). Make no mistake, the intervention has had tremendous effects; however, the effects are not done and there will be a day of reckoning.

Some Obvious and Less-Obvious Financially Significant Political Events to Follow (in no particular order)

• Blanche Lincoln Runoff
• Subsequent Support for Her Derivative Measure
• Chinese policy response to Korean Crisis
• Tea Party Longevity
• Global Austerity Measures
• Military Success in Kandahar
• US Chinese Relations
• Euro Political Coordination
• Result of Goldman Case
• Campaign of Cuomo
• CB Intervention in the FX market (esp. EUR and AUD)

After gapping up a few hundred pips on news of the gajillion euro bailout, the euro is back near its lows against the dollar with pervasive selling into strength. Europe is China’s biggest export partner, and with talks of rampant asset bubbles and consequent monetary tightening coming out of there, things look increasingly bad for China. The Shanghai Index is indeed down over 20% off its highs, putting it in technical bear market territory, by some definitions. This weakness is spreading to commodities, for which China has been showing record demand in recent quarters, with crude and copper both down 12% off their highs. And this, of course, has spread to the Aussie Dollar, with the AUD/USD down close to 400 pips off its high and approaching a definitive 200DMA breakdown, which has been what I’ve been calling for as a terrific short trigger for various risk assets, including equities.

During the flash crash last Thursday, JPY and gold got the safe haven bids as investors fleed risk assets. Gold is a rational safe haven, considering the central bank policies of today, and indeed gold just made a new closing high today in terms of USD, after making new highs in EUR, CHF, GBP, and various other currencies recently. The yen, on the other hand, is less obvious of a choice as far as safe havens, considering Japan’s ballooned debt-to-GDP, which finally will put pressure on JGBs as the next wave of the financial crisis hits. The JPY’s strength as equities declined on Thursday reveals the carry trade nature of this market, as the JPY is the lowest-yielding of currencies and most apt to be carried for risk assets. Indeed, the selloff in EUR/JPY on Thursday preceded (and in my opinion, catalyzed) the risk asset crash. With the EUR back to near lows and commodities selling off, the EUR/JPY is close to breaking back down to crash levels, and in the process, close to catalyzing another wave down in equities in my opinion.

The charts will tell but things are once again getting interesting, and the huge volatility in the euro, especially with the massive selling into the bailout gap-up, could be a harbinger of worse to come, especially considering the record bid-to-cover in the recent 3yr Tsy auction. Risk aversion is here and even if we get a short-term bounce on some sort of political event/reactionary policy, it will be short-lasted and by the end of the summer/beginning of the fall, it should be clear that the next wave of the financial crisis has arrived.

And sovereign debt crises are much more political and have worse economic and social consequences (trade wars, revolts, riots, civil wars, and even world wars) than financial/private debt crises.

Courtesy of Tim Backshall:

This is a little complex but…GS CDS curve inverted yesterday and remains inverted today. Spreads a re lot tighter than they were the last time the curve inverted (middle of the crisis) but what this chart shows is the PV of the 3Y risk as a percentage of the PV of the 5Y risk.

We are at 69.4% which is actually more front-loaded than in MAR09 and only beaten by the 72.5% levels of SEP/OCT08.
The bottom line to us is that counterparty risk hedgers have gone wild here and loaded up on front-end risk.
By way of example, GS 3 and 5Y PVs were almost triple what they are now during that period.

If there are any equity analysts that are using any kind of discounted cash-flow approach to valuation of GS stock, then maybe a consideration of what this means for forward rates combined with the massively higher interest expense they will incur when they have to roll all $21bn of that TLGP debt – ouch…

Courtesy of ShadowCap Logan Schuler:

After today’s big sell-off and subsequent reversal, I took a quick look at the Nasdaq bubble’s top in 2000 to see if I could find a similar day. Indeed, April 4 2000 showed a similarly illiquid market and trading day, as the Nazzy sold off more than 15% but reversed course and ended the day down much less.

Here is the S&P with today as the last data point:

And the Nazzy with April 4, 2000 as the last data point:

And here’s a look at where the Nasdq Composite was a year later:

I’m not necessarily calling for a crash– they key point to drive home is how illiquid and momo-driven/positive feedback this market environment is.

I’m hearing rumors of computer/exchange problems being blamed for intensifying today’s selling. Suggests to me the possibility of quant funds forced deleveraging, as momo unwinds + program trading = forced quant unwinds, and even further illiquidity, intensifying the positive feedback loop. More as it comes, if it comes…

EDIT (4:30 PM): Lots of talk about a Citi fat finger. Not sure how believable I find this. But more importantly, the carry trade/risk on-risk off nature of this market was exposed today, especially in regards to the USD vs JPY. With perpetual ZIRP, the JPY has been the carry currency of choice for years. But going forward, especially post-crisis (when JPY surged as carries unwound), JPY/JGBs are terrible safe havens considering Japan’s ballooned debt/GDP, and USD is a more favorable candidate at least in relative terms. Today’s absolute plunge in USD/JPY shows how much of the rally since March 2009 was due to traders carrying low yielding currencies to chase yield. Absolutely a function of excess liquidity. And as far as market liquidity, today also exposes how little exists in this market.

EDIT (8:08 PM): A little credence to the algo-driven JPY carry unwind thesis to explain the mechanics of today’s plunge, courtesy of Bruce Krasting:

As of this writing none of the big trading houses has fessed up to adding a zero on an e-mini electronic order. We shall see. I think it was connected to a move in the Dollar/Yen. When that break occurred it triggered some algo machine to sell. And that happened when the NYSE had a halt.

It was computers that are behind it. Mary Shapiro at the SEC has been very reluctant to tackle this issue. Not any more. Look for her to make a statement shortly. The axe is going to fall on an important part of how the markets function.

Either way some damage was done. This is a picture of one stock that traded 3450 shares at .01 cent or $34.50. It was worth more than$140,000 at the close. The trade above for 7,254 shares at 41 cents resulted in a paper gain to someone of $300,000. These will be reversed. What a system…..

And check out some anecdotal comparisons drawn to September 30, 2008 (right at the onset of the 08 market crash), as pointed out by multiple readers:

Sept. 30 2008

NEW YORK (CNNMoney.com) — An accidental trade drove shares of Google Inc. to unbelievable lows Tuesday, causing the Nasdaq to correct the stock’s closing price and adjust the index’s final value.

The Internet search engine’s stock appeared to have plummeted to a low of $25.80 at one point during the session. Shares opened at $396 and traded in a relatively tight range before dropping sharply near the close of trade.

“A market participant sent in a large number of orders and drove the price down at approximately [3:57 p.m. ET] which caused the bid-offer to be artificially low due to their mistake,” according to a Nasdaq spokesman.

Google’s (GOOG, Fortune 500) official closing price will be adjusted to $400.52 from the original, inaccurate settle price of $341.43. And the closing value of the Nasdaq 100 Index will be changed to 1594.63.

Nasdaq said that it will cancel trades made at or above $425.29 and at or below $400.52 that were executed on the Nasdaq between 3:57 pm ET and 4:02 pm ET.

The closing value of the Nasdaq Composite Index and several other related products will also be adjusted.