The T Report: Weekly Firewall Edition

Volatile or Not?

It is strange to start a weekly update and not be sure whether the week was volatile or not. North American stock indices ranged from -0.4% for Nasdaq to 0.6% for the S&P. Not much to look at there.

U.S. fixed income finished with small weekly gains. The 10 year treasury was 2 bps better. Fixed income ETF’s like TIP, TLT, LQD, HYG, JNK, and MUB all had small gains. Even the CDS indices, IG18, and the underperforming HY18 saw some small spread tightening over the course of the week.

Looking at Europe and we start to see some more volatility and divergence. The DAX was up 2.5% will the IBEX was down 2.9%. Spanish bond yields were mixed to better on the week, but Italian yields were worse. In a week of obvious attempts by governments and central banks and the IMF to calm markets, they had limited success with the smaller and more easily manipulated Spanish bond market, and failed in Italy. One scary undertone developing in the market is the concern about France and the potential impact of the French election. French 10 year yields moved 14 bps, and it wasn’t because the situation was improving, because German 10 year yields moved 3 tighter on the week. Germany continues to have a flight to quality bid, but France, not so much.

Maybe it is the activity in Europe that made the markets feel more volatile than the weekly changes show. Or maybe it was that the futures traded in an almost 3% range – from 1,359 to 1,390 with several 0.5% swings during the course of most days.
Market darling Apple isn’t helping calm the market either. That can reverse on a moment’s notice, or a great earnings release, but the momentum that was dragging more and more hedge funds into the trade, is now working in reverse as stop losses are being triggered.

So often lately, the bulls are able to point to a decent tape in face of weak data and no stimulus, and this week ended with the opposite. Bulls will be nervous that decent earnings and a mega-plan from the IMF failed to provide strength to the market.

So, it was a strange week that was more volatile than the weekly changes show, and where some real cracks are being exposed.

Politicians and the Markets

In a week where the Birkin wielding head of the IMF went from G-20 delegation to delegation asking for them to commit their taxpayer’s money to another illusory firewall, it is important to focus on what was accomplished and what wasn’t.

By all accounts, the IMF has received commitments to increase the “firewall” by some amount, possibly as much as $500 billion. The politicians expect the markets to be excited about this “heroic” effort and the guarantee that no debt problem is too big that it can’t be solved with more debt. In spite of the headlines, I’m being asked

• How will the countries honor their commitments?
• Where will the money come from? Especially the European portion?
• How would the money be used? For countries? For banks?
• If commitments made in 2010 haven’t been approved, what good are these commitments?
• What does this do to help the countries that are in trouble? Why does the IMF think it is safe to lend when real investors won’t lend?

The list is long, but is also accurate.

The entire IMF Firewall is being run as though it was an election. The leaders use the same slogans over and over. They say the money is needed to avoid calamity. They say the money will help. No evidence of either is provided, but who needs evidence when you are just running a campaign. So they campaigned, and in their view, they “won” the election, by getting these commitments.

That is the big disconnect. Politicians are sitting around Washington convinced that they have won. They fought a hard campaign to convince people that the Firewall was needed and would be good, and they got the job done. What they haven’t done, is seen how the market will react.

Unlike a real election, the market doesn’t give the winner a free pass for a certain amount of time. You haven’t won until the next election, you have merely won until the market tests your resolve.

That test will come quickly, quite likely this week. Markets will likely put pressure on Spanish and Italian yields, and possibly French yields depending on the election results. Nothing about the firewall changes a thing about the current situation these countries find themselves in. That is the key. If the firewall actually did something for these countries, we might be able to stage a strong rally, but the firewall doesn’t have an immediate impact. The firewall just ensures that these countries can borrow more money. That when the markets shut down on their ability to borrow, the IMF will lend to them. Your best hope as a current lender, is to hope you own short enough dated bonds that the IMF is still being generous and lending to the country to pay you back, rather than having gone into PSI mode.

Spain and Italy need to reduce the current interest burden, the total debt, make long term adjustments that while technically austerity, can have minimal near term impact, and they need to embark on some growth policies. A debt restructuring can accomplish the first two items. Policy and some IMF money can help on the all important growth issue. Without some form of PSI, the firewall at best will shift who countries owe money to, and at worst will discourage banks from lending to anyone other than sovereigns.

The markets will test the resolve of the EU, ECB, and IMF this week. They will see how readily “commitments” turn into “actions”. Once again, the smug victory speeches being made by the politicians are likely to look very wrong, and possibly before they have even finished their victory tour.

Last chance to QE?

I think we have one group within the Fed that is desperate to do QE and wants to do it now. There is another group that believes the economy should be left alone, unless the data deteriorates significantly. As we head towards the election in November, the hurdle of what constitutes “weak” economic data will increase. Right now, Benyellen might be able to argue “only” 120,000 NFP jobs is enough to launch QE. I don’t think they would have a chance of launching in August with NFP numbers like that.

So, Benyellen will push hard at this meeting. I think they will still face too much resistance. It is only one bad NFP number and 2 bad “initial claims” numbers. Not enough for the last defenders of anything resembling a free market at the Fed. Housing has been weak too, but again, permits were up, and although not bouncing, there does seem to be some stability returning to the housing market.

I don’t expect QE this week. I think the statement will be slightly more dovish than the last one, but that is priced in as the market does often seem to take the “bad news” as good news path. Realistically, the next meeting is the most likely one to see QE announced since it would only take a few more data items confirming recent ones to let Benyellen railroad the rest into one more round.

Earnings, just how good?

I was frustrated and disappointed with BAC and MS. They aren’t the only ones (GS and C did accounted for things similarly), but for whatever reason, they caught my eye, and convince me that this is what is wrong with the market.

Last year, when DVA and FVO were big positives, those numbers were not only included in the headline, but in the case of Gorman at MS, were trumpeted as he pounded his chest that MS beat GS in Q3 2011. The quality and wisdom of DVA accounting has been questionable at best and the FVO adjustments are staggering in the ratio of the magnitude of the amounts versus the amount of disclosure.

I would much rather have seen headline numbers consistent with 2011. Then we could focus on how they did that quarter. What the business outlook is. Instead, it looks like they are trying to trick the media and investors and make the story better than it is. Investors aren’t stupid. They will do the work. They will figure out the differences in how Q3 2011 and Q1 2012 were reported. Then, not only will they be disappointed with what the firms tried to trick them on, they will question what else is being done. If you are willing to “massage” (sounds better than manipulate) the way you report each quarter’s earnings to make it seem the best, what else are you willing to “massage”? Banks are opaque. On 100’s of billions of assets, what’s a bp or two here or there?

All companies should lay it on the line. Report what happened in the way they always do, then rely on themselves and their conference calls and good analysts to figure out the longer term picture. Companies have to trust in the intelligence of investors and then investors will be able to have trust in the companies.