Home > Uncategorized > 2011/06/08: Trading Tendencies: How About Perspectives from Financial Luminaries… Toxic or What?!

2011/06/08: Trading Tendencies: How About Perspectives from Financial Luminaries… Toxic or What?!

If there is one thing we can count on after the last couple of days, it is that communication from central bankers or finance ministers accepting as reality current weak economic tendencies or expressing the need for further control on the financial industry are not very helpful in an equity market that has already assumed a ‘risk-off’ mentality. That will continue to be important into the release of the Federal Reserve Beige Book this afternoon. And then there is another, far broader, general factor which is significantly reminiscent of the sort of 1970s style markets we have noted we have been back into for some time now: Official dislocation from the reality of the financial or regulatory situation.

In that regard, Mr. Geithner’s comments yesterday were nothing less than delusory. Criticize London for “light touch” regulation when the major source of the theory and practice of exotic over-the-counter derivatives was the United States? And while quite a few financial firms in London might have followed suit once the party was rocking, it is now well established and broadly admitted fact that the US regulatory failure on all fronts was most egregious: including the central bank, other regulators, the rating agencies, internal strategic and tactical controls within the financial services industry, and a general lack of willingness on the part of the financial fourth estate to sound the clarion call on all that abuse and neglect (with a few notable exceptions such as Gillian Tett of the Financial Times who was questioning reduced covenants and off-balance-sheet holdings of banks as early as 2005.)

But the real failure at present is not so much a lack of regulation as where the regulatory environment is headed. And while Mr. Bernanke was quick to point out the lack of ability to fully assess that involving environment because it is “…too complex…” (sound familiar?), there was one hero who consistently has risen to the occasion and was not afraid to ask the right questions yesterday.

While quite a few competitors might not like our lauding a particular bank’s chief executive, and there are undoubtedly others who don’t necessarily agree in general with our view on this… God bless Jamie Dimon.

Never one to mince words, and seemingly very capable at developing a balanced view, his initial praise for the ways in which things have improved was clearly a setup for further criticism of the Fed chairman during the question-and-answer session yesterday. And that came in the form of the telling question about whether all of the evolving regulations which are more extensive than anything seen in the history of the financial industry might be a bridge too far, with the potential to cripple the industry… especially in the US. We suppose the financial services industry here is suffering a bit from the ‘Boy Who Cried Wolf Syndrome‘ due to the previous evolution of industry regulatory structures. It was indeed the case that at every major turn the industry would scream, “You’re regulating us out of business.” And as the industry came through in subsequent periods to continue to find ways to make enormous profits, there is some basis for skepticism on the part of both regulators (who have proven to be not as smart as those who are in the industry) and the general public to feel that the industry is yet again complaining needlessly in an effort to enhance its profit potential.

We will have more to say on all of that soon, but suffice for now to say that when Mr. Geithner speaks of ensuring there are very strict regulatory restraints, there is no surprise that the financial services outlook dims and takes the sense of credit availability for the general economy right down the drain hole with it. Yet the coup de grace so far this week has been Mr. Bernanke’s assessment that the combined impact of the looming regulatory expansion cannot be properly assessed because, “We don’t really have a quantitative tools to do that.While this is a regulator speaking and not some operative in the financial services business who is attempting to foster some new exotic alternative investment vehicle, the fact that something is out there which is “too complex” to be properly assessed smacks of the same sort of mentality that created the intractable problems during the CDO and MBS phases of the Credit and Housing Bubble.

That was a case of industry excess that the regulators came in to correct, and the governments collectively wrote a check for the bailouts to prevent the next Great Depression. What happens if the regulators are wrong about the complexity being so great that no one can figure it out after they have strangled the financial services industry? And as it relates to the future prospects for the general economy and equity market, that goes far beyond anything having to do with just the banks. It revisits the issue of the sheer complexity that is leaving record amounts of uninvested funds on corporate balance sheets because of a lack of clarity on the future environment. It is fairly apparent that well beyond financial services regulation many mainstream businesses are having to consider what the pending regulation (passed into law and due to be implemented unless it is repealed) will mean from the likes of the EPA, NRLB (with a current effort to eliminate ‘right-to-work’ states’ latitude to remain non-union environments), OSHA, Obamacare’s huge additional costs (from which the politically connected are increasingly being awarded waivers), etc.

So when we get to a trading view that an equity market which already has significant downward momentum is not reversed for more than a very brief period (in fact only intra-day over the past couple of sessions), it shouldn’t really be any surprise. We have seen phases like that in the equity markets before during ‘risk-off’ phases and the same sort of tendencies have impacted the ostensibly more staid government bond markets at times as well. And it should be of no comfort to the current government bond bulls who are benefiting to some degree from the weakness of equities that the govvies are indeed withstanding all manner of negative predictions at present. Once the full weight of the fiscal and debt disconnect in the United States comes home to roost the same sort of intractable weakness is likely to infect the fixed income market; and possibly at the same time as equities in spite of the classical counterpoint tendencies which prevail under normal circumstances.

That was certainly the case during the almost laughably inept G. William Miller Federal Reserve of the Carter administration. Even though various members of the Fed team of the day or various levels of officials from the Treasury Department would come out on almost a daily basis to explain why US rates were too high already and had no business going up any further, the T-bonds would break after any modest rally and interest rates would push higher. That prevailed all through the late 1970s into the broad swinging, yet still troubled, market of the first half of the 1980s. The only thing that finally sent the long-dated government bonds back into a bull market was the late-1985 into early-1986 implosion of energy prices.Another case of ‘sound familiar?’

Even under the guidance of our more credible central bankers, there are times when conditions are just unmanageable in light of significantly changed circumstances. Such was the case in the wake of German reunification, when the West German government agreed to exchange all of the worthless East German marks for the far more valuable deutsche mark. The sheer degree of expansion of the money supply which was therefore necessary to provide this gift to their reunited compatriots in the East was enough to bring the previously very stable German Bund (10-year German government bond) under significant selling pressure. And due to the sort of (to quote Mr. Rumsfeld) known unknowns and unknown unknowns attendant to that situation, that aggressive downward trend in the German Bund at that time was accompanied by significant volatility.

As just one example, the estimable head of the Bundesbank at the time was Karl Otto Pöhl, a central bankers’ central banker to the core. Overtly every bit as hawkish as anything we have heard from Monsieur Trichet in the last couple of years, yet willing to wink and allow for a bit more money supply growth when necessary to offset weak cyclical phases. During the German reunification break in the German Bund there was a day when he was speaking in support of it after the market was already in an aggressive downtrend.

In fact the aggressive (technical) down channel resistance for this extremely active trend was near the higher trading limit of the day, which was 150 points higher (a full percent-and-a-half of the par value of the bond) at that time. Being extremely oversold in the short term at the bottom of what had been a couple of week debacle, the market was happy to rally into and during his speech. And it actually made it up to the exact aggressive down channel resistance at 140 points higher on the day. As we had counseled our clients in that event that anything short of the market locking limit up still maintained the aggressive downtrend, we were very happy (and the powers-that-be were not very happy) to see the German Bund future finish that session back down at a full percentage point (100 trading points) lower on the day. A 250 point trading swing from a very encouraging early session recovery into a demoralizing weak new low for the overall down trend by the Close.

Needless to say, that is the sort of volatility for the previously staid German long-dated government bond which was not even imaginable prior to unification, let alone anything anybody had ever seen. It is another good indication of just how aggressively government bond markets can move once they realize there is a significant disconnect in the fiscal or monetary picture. And that is also very consistent with how markets behave when there is a disconnect between the official perception and communication and the reality of the situation.

In that regard we don’t know what was worse: Mr. Geithner’s absurd comments about the rest of the world’s lack of previous regulatory credibility, or Mr. Bernanke’s sanguine discussion of how much everything still stinks. Thank you Professor Ben; it’s good to know that you can clearly explain to us all why things suck, yet will studiously avoid the clear indications that the overzealous regulatory regime of the current administration is going to constrain any chance for improvement. The minor bits of upbeat “moderate growth” folderol didn’t do much to offset his overall assessment of weak housing and employment that are the real crux of the matter, and won’t improve until small-to-medium sized businesses began hiring once again.

And the discussion of those previous perniciously weak volatile trading phases is not only an historic perspective. It is also a very meaningful cautionary word for what might happen in a worst-case scenario if the US chooses to be less than forthcoming in the address of its fiscal and debt dilemmas. Recent weak economic news has encouraged a bid in the govvies that the ‘bond vigilantes’ are certain should be worth much less than current values. However, the lack of further extensive strength in the government bond markets (elsewhere in the world as well as in the US) in the face of such pronounced weakness in equities is the first hint of the degree to which govvies and equities can sink together under the most highly stressed financial scenarios; even if that is significantly atypical under normal circumstances. We’ve seen it all before.

Thanks for your interest.

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  1. christopher maytum
    June 8, 2011 at 3:13 PM

    An excellent piece, as one would expect and thank you, from the U.K., whence, I fear, came derivitives through the gilt edged market, with callable and puttable stocks.

  2. June 9, 2011 at 7:43 PM

    Thanks Chris. Certainly the other ‘advanced’ financial system was happy to ‘get with the program’ once it was apparent such insanely large fees were available for promising something the firms made no provision for actually delivering (with AIG and Lehman default swaps as the most egregious example.)
    Yet, it was more so the way in which nobody at all on this side of the Pond bothered to stress test the academic assumptions that tuned into an entity unto itself… totally removed from classical financial reality.
    The best examples are the otherwise very smart folks who told me they didn’t need to retain Rohr’s or anybody else’s trend analysis, because they had the most clever model on the planet for valuing OTC derivatives of derivatives. And they seemed completely immune to my cautionary word that they were trading pure ‘air’. Of course, the ultimate culprit remains the current head of the Fed, who did not cool the bubble Mr. Greenspan had already let run on for awhile. That allowed all the ‘air’ traders to continue swapping allegedly profitable floating castles until their firms also started evaporating.
    And the theories behind it and regulatory lassitude which allowed it to continue ad nauseum were all based in the US in the first instance.

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