Thursday, July 31, 2014 - Ugly Day, Ugly Logic

Ugly Day, Ugly Logic

by Sinclair Noe

DOW – 317 = 16,563
SPX – 39 = 1930
NAS – 93 = 4369
10 YR YLD un = 2.55%
OIL – 2.12 = 98.15
GOLD – 14.00 = 1281.50
SILV - .23 = 20.48

Well, this was just ugly. The worst day for the Dow Industrial Average in about 4 months. Back on April 10^th, the Dow dropped 267 points; that same day, the S&P 500 was down 30 points. Today wiped out the gains from July, with July marking the first negative month for the Dow and the S&P since January.

The S&P is still up about 5% for the year to date, but the Dow started the year at 16,576. All those record highs for 2014 have just been washed away. That’s how it goes; the markets scratch and claw, higher and higher, inch by inch it’s a cinch, until the cinch breaks. A couple of weeks ago, we talked about shorting, and the advantage of shorting is that the moves can be quick and severe. Sure enough. And while this might just be one bad day, long overdue, the Dow dropped below its 50 day moving average, which is one of the major measurements of a trend.

So, the question is why did the stock market nosedive today? One recurring theme I’ve been hearing is that traders are afraid the Fed will pull away the punchbowl. Yesterday’s GDP report showing better than expected 4% growth in the second quarter combined with today’s employment cost index, which rose 0.7% in the second quarter, made people nervous about the prospect of an improving economy and the possibility of wages pushing inflation higher.

Now wait just a minute; that doesn’t sound so bad; the economy is expanding at a 4% pace which is certainly better than a contracting economy which we saw in the first quarter; and workers are being paid a little more – not much just a little - and that’s certainly better than watching the middle class shrink into oblivion. If you look at this explanation for the market decline, it is an example of perverse logic, where the stock market traders are in opposition to economic prosperity and are only happy in the face of hardship; other people’s hardship, not their own.

There might be something to that interpretation. Beginning in 2008, the Fed cranked up a series of programs to stimulate the economy. Of course, the Fed didn’t really stimulate the economy but they did stimulate certain financial sectors, such as housing, and very clearly the stock and bond markets. During that time, the Fed added over $3.5 trillion to their balance sheet, which now holds nearly $4.5 trillion. The basic mechanics were that the US government borrowed money by selling Treasuries, and the Fed bought a large portion of those Treasuries with freshly printed money. Since 2013 the Fed’s balance sheet has grown even faster than government debt, which has leveled off, almost. Overlay a chart of the S&P 500 with a chart of the Fed’s balance sheet; the similarities are more than coincidental. A big chunk of the money the Fed was printing sloshed over into the stock market. When the Fed stops printing all that money, who is left to buy stocks?

The accumulated “surplus” of printed money will only last a couple of months. Sooner or later (probably sooner), the stock market will start to feel the pain of this monetary tightening. Of course the Fed isn’t really exiting the money printing business. They won’t sell off the assets held on their balance sheet; they will let those treasuries and mortgage backed securities mature and expire, maybe even roll over a few. And government debt hasn’t disappeared, so the Fed will continue printing money. We don’t know how the Fed taper and eventual increases in interest rates will turn out; neither does the Fed know. It’s a big experiment; the Fed might throw a curveball or two along the way; the stock market traders might throw a tantrum, knocking down your IRA in the process. The recurring theme today was that the Fed might pull away the punchbowl; the Fed hasn’t actually done that; they said this week they would not do that anytime soon. There has been considerable consideration given to a Fed exiting. Imagine when they actually do it.

The big institutional traders may already be headed for the doors. Last week, investors added $379 million into equity mutual funds, the kind that’s popular with retail investors. At the same time, exchange-traded funds focusing on equities; the kind of securities traded by institutional investors because of their liquidity and lower cost, saw a whopping $7.97 billion in outflows. That’s the biggest outflow seen since February.

Anyway, the Wall Street traders’ logic is flawed; the 4% growth in second quarter GDP really isn’t as good as it seems. The 4% growth implies the economy is on a very slow growth path when averaged in with the -2.1 contraction in the first quarter. Taken together, the economy grew at less than a 1.0% annual rate in the first half of 2014. That is hardly cause for celebration on Main Street or trepidation on Wall Street. Also, the strong growth in the second quarter was in direct response to the weak growth in the first quarter. Inventory growth was very weak in the first quarter, subtracting 1.16% points from the quarter's growth, and so a reversion to the mean, or a return to a more normal pace of inventory accumulation in the second quarter was a strong boost to growth, adding 1.66 percentage points. Final sales grew at just a 2.3% annual rate in the second quarter. Even that rate was likely inflated to some extent by the weakness from the first quarter.

But that wasn’t the only demon plaguing the stock market today. If it’s not one thing, it’s another. And there have been a lot of other things.

The bond market has its own demons. Fitch warns a jump in US high-yield default rates looms. There have been 10 LBO related bond defaults thus far in 2014, compared with nine for all of 2013. While most sectors remain relatively calm, the utilities and chemicals sectors are seeing huge spikes in defaults. Since the Fed pushed rates down near zero people have been chasing yield and that means the high yield market has become crowded, and that means the yield on risky debt has dipped to a little less than 6% on average, compared to a more typical yield of a little less than 9% for junk  debt. If or when the Fed starts targeting higher rates, who will be looking for the junk with the not so high yield? A reversion to the mean would result in big capital losses, and it could turn ugly if people start running for the exits and can’t find a bid.

And then we can’t forget the geopolitical problems of the world. A negative July in stocks was matched by a negative July in Ukraine, and Israel, and Gaza, and Iraq, and Syria, and Libya. Toss in sanctions on Russia, which will also hurt the European Union.  And then late yesterday, Argentina put a cherry on top.

Argentina has defaulted, or as S&P described it, a “selective default”. A quick recap: In 2001 Argentina defaulted on its debt and it forced most of its creditors to take a haircut, that is a lot less money than the face value of the bonds. After the default, Paul Singer, a hedge fund manager of NML Capital, bought a lot of the bonds at a big discount, pennies on the dollar, and then demanded the bonds be paid in full. Argentina refused to pay the vulture hedge funds. So Singer took his case to the courts – not in Argentina, but in the US. The case was heard by a judge who didn’t really understand all the fancy talk about bonds, and so he ruled against Argentina. About a month ago, the US Supreme Court said they would not interfere. So now, Argentina can’t pay off the bondholders who accepted the discount, unless they also pay off the hedge fund vultures who demand full payment; which basically negates the whole idea of the default in the first place. So, the US courts have essentially told the sovereign country of Argentina that it is more important to pay off the hedge funds, than it is to default and reboot the Argentine economy on a fresh start.

While Singer’s firm has yet to collect any money from Argentina, some debt market experts say that the battle may already have shifted the balance of power toward creditors in the enormous debt markets that countries regularly tap to fund their deficits. Countries in crisis may now find it harder to gain relief from creditors after defaulting on their debt.

The big question, however, is whether Argentina will ever pay Singer and his vulture fund fellows what it wants. If the firm fails to collect, that would underscore the limits of its legal strategy. There is no international bankruptcy court for sovereign debt that can help resolve the matter. Argentina may use the next few months to try to devise ways to evade the US courts. In dire economic crises countries need to be able to slash their debt loads. The idea is similar to bankruptcy for individuals, a chance to restructure debts and start fresh because we long ago learned that throwing people in prison for the debts didn’t help anybody. The legal victories of the holdouts may embolden creditors to drive harder bargains after future defaults, which in turn could prolong or postpone debt restructurings and extend the economic misery of over-indebted countries. So, the problem in Argentina is not unique to Argentina, it affects the global economic system, we just don’t know to what extent.

Tuesday, October 15, 2013 - Downgraded and Defaulted

Downgraded and Defaulted
by Sinclair Noe

DOW – 133 = 15,168
SPX – 12 = 1698
NAS – 21 = 3794
10 YR YLD + .03 = 2.72%
OIL – 1.49 = 100.92
GOLD + 7.70 = 1282.00
SILV + .03 = 21.40

For most of the day the Dow Industrials were drifting just a little lower but as the afternoon dragged on it became more and more obvious that the politicians in Washington are still dysfunctional and signs of progress towards a resolution on the debt ceiling remain illusory. The House of Representatives started the morning with yet another plan that had no chance of success, and they were essentially sent back to the drawing board. Selling accelerated during the afternoon after Senator Richard Durbin said Senate negotiations had been suspended until House Speaker John Boehner can work out a fiscal plan that can proceed in the House of Representatives.

Losses were broad, with all 10 S&P 500 sectors falling on the day. Three-fourths of stocks traded on the New York Stock Exchange ended lower while 68 percent of Nasdaq-listed shares fell. The situation in Washington has driven trading lately, overshadowing the beginning of a busy week of earnings. Citigroup Inc reported weaker-than-expected results as the bank was hit by a double-digit drop in bond trading revenue for the quarter. Johnson & Johnson reported stronger-than-expected quarterly results on strong growth for its prescription drugs, while Coca-Cola Co reported revenue slightly under expectations. Intel reported revenue that topped expectations. CSX Corp and Yahoo Inc both also rose after posting results after the close. Since the government shutdown 2 weeks ago, the markets have dropped, then we had a few days of recovery, and the net change pretty much a wash. But now we're running out of time.

Fitch Ratings has placed the United States of America's 'AAA' Long-term foreign and local currency Issuer Default Ratings on Rating Watch Negative. The Rating Watch Negative would be a step toward cutting the credit rating. Fitch says it believes that the debt ceiling will be raised soon, but the political brinkmanship and reduced financing flexibility could increase the risk of a default.

The current 'AAA' rating also reflects the halving of the federal budget deficit since 2010, which is now approaching a level consistent with debt stabilisation.  The prolonged negotiations over raising the debt ceiling (following the episode in August 2011) risks undermining confidence in the role of the US dollar as the preeminent global reserve currency, by casting doubt over the full faith and credit of the US. This "faith" is a key reason why the US 'AAA' rating can tolerate a substantially higher level of public debt than other 'AAA' sovereigns. The repeated brinkmanship over raising the debt ceiling also dents confidence in the effectiveness of the government and political institutions, and in the coherence and credibility of economic policy. It will also have some detrimental effect on the US economy.

So, that's the latest blast from Fitch. If we hit Thursday without a deal, the best estimate is that most people wouldn't immediately notice the government has hit the debt ceiling, not right away. The government by law will no longer be able to add to the national debt, and will have to rely on incoming revenue and about $30 billion in cash to pay the nation's many obligations. Unless Congress raised the nation's debt ceiling, the money would be gone within days.

Some people claim the government is out of money, which is kind of silly. The government creates money; all the government has to due is issue bonds and the Federal Reserve will create the money. So the only way we can really be out of money is if we artificially say we will stop creating money; and right now, that seems to be the deal. You've heard the analogies of how the US budget is like a family budget, and the family ran up debt on the credit card. That's not true. The government is not like your family; the government can create money out of thin air; the government has a printing press. And on Thursday, the government faces the prospect of turning off the printing press.

That means the government will have to rely on incoming revenue and about $30 billion in cash to pay the nation's many obligations. Unless Congress raised the nation's debt ceiling, the money would be gone within days. The Congressional Budget Office estimates Washington would start missing payments between October 22 and the end of the month. America could miss a $12 billion payment due to its Social Security pension program on October 23. And with a few missed payments the economy will freeze up and lock up and grind to a halt.

It might happen before then. The political dysfunction would likely lead to a sharply diminished appetite for risk, which in turn would undermine equities; expect stocks to take a big hit. Sentiment for safe haven assets have already started to sour. In recent days, major money market mutual funds, including Fidelity, JPMorgan and Pimco; have started shunning US debt that comes due between October 17 and the middle of November.

Also, US Treasuries are used as collateral for trillions of dollars of financial deal; any default changes the understanding of that collateral and would likely result in massive defaults. Remember that a big chuck of those deals are also backed by derivatives, such as credit default swaps. If default triggers those swaps then the problems intensify exponentially. The problem with Credit Default Swaps are that they are used like a form of insurance, but unlike insurance the sellers don't have reserves in place to pay for claims in the actual event of a default. So, if there is a default, then everything freezes because nobody will know what anything is worth.

So the big question is whether the politicians will screw this up and default, or as the New York Times described: “a legislative failure and an economic catastrophe that could ripple through financial markets, foreign capitals, corporate boardrooms, state budget offices and the bank accounts of everyday investors”.

There is a reasonable argument that we've already started defaulting. Right now, with the shutdown, we’ve already reached the point at which the government is breaking very important promises indeed: we promised to pay hundreds of thousands of government employees a certain amount on certain dates, in return for their honest work. We have broken that promise. And the fact that many firms have stopped buying and sold short-term Treasuries also means the global faith in US institutions has already been undermined. The pieces of the catastrophic puzzle are in place.

And that means that economic growth will be slower than it should be, unemployment will be higher, unrest will grow. This government-by-crisis approach has cost the economy about 900,000 jobs and raised the unemployment rate by about 0.6 percent, according to a study by private forecasting firm Macroeconomic Advisers, commissioned by the Peter Peterson Foundation. Macroeconomic Advisers said in a press release: "Partisan divided government has failed to address our long-term fiscal challenges sensibly, instead encouraging policy that is short-sighted, arbitrary, and driven by calendar-based crises.”

Macro Advisers estimates that the government shutdown has already shaved about 0.3 percent from economic growth in the fourth quarter. A short debt default, starting Thursday and wrapping up within a few days, before any actual non-payment occurs, could cause unemployment to spike to 8.5 percent from 7.3 percent and cost 2.5 million jobs, Macro Advisers estimates. A longer default, lasting a couple of months, would cause an even deeper recession, pushing unemployment to 8.9 percent and costing 3.1 million jobs. All of this has weighed on economic growth -- which in turn has made government finances worse than they needed to be. Macro Advisers estimates that the austerity of recent years has cut GDP growth by 0.7 percent and cost 1.2 million jobs already.

While debt default is undoubtedly the worst of all possible worlds, then, the bonkers level of Washington dysfunction on display right now is nearly as bad. Every day that goes past is a day where trust and faith in the US government is evaporating — and once it has evaporated, it will never return. The Republicans in the House have already managed to inflict significant, lasting damage to the US and the global economy — even if they were to pass a completely clean bill tomorrow morning, which they won’t. The default has already started, and is already causing real harm. The only question is how much worse it’s going to get.

So, here's where we stand. On a day of political drama and confusion, House Republicans first proposed their own version of a Senate plan to temporarily end the political stalemate paralyzing Congress, then haggled among themselves over the details before finally agreeing to vote on it Tuesday night.

But shortly after announcing the planned vote, the House committee that sets the rules for such procedures postponed its hearing. There are some indications that the GOP leaders are struggling to round up the votes. Another factor is that apparently the conservative groups Heritage Action and Freedom Works came out against the plan. So, for now it looks like there will be no House vote today.

The conservative groups both said they will "key vote" a bill that was expected to hit the House floor Tuesday night.  Heritage Action said in a statement: "Unfortunately, the proposed deal will do nothing to stop ObamaCare’s massive new entitlements from taking root — radically changing the nature of American healthcare."