FINANCIAL REVIEW

Theories on Apples and Applesauce

Sinclair Noe — January 16, 2015

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW + 190 = 17,511
SPX + 26 = 2019
NAS + 63 = 4634
10 YR YLD + .04 = 1.81%
OIL + 2.32 = 48.57
GOLD + 17.70 = 1281.30
SILV + .83 = 17.88

Stocks bounced back after five sessions of losses. All 10 of the S&P 500 sectors were higher, though energy led the charge, rising 2.8%. U.S. crude oil futures settled up 5% after the International Energy Agency said there were signs that lower prices had begun to curb production in some areas. On the week, oil rose 0.7%, snapping a seven-week losing streak. The IEA report said that the market’s floor was still anybody’s guess, but “the sell-off is having an impact,” and “A price recovery – barring any major disruption – may not be imminent, but signs are mounting that the tide will turn.

We love lower gas prices. A gauge of consumer sentiment jumped up to an 11 year high this month. The preliminary January reading on the University of Michigan’s consumer-sentiment index increased to 98.2, the highest level since January 2004, from a final December reading of 93.6. Also, more households were reporting increases in household incomes.

Consumer inflation in December saw the biggest monthly drop in six years. Consumer prices, the CPI, fell 0.4% in December. You know the big driver for lower prices; energy prices plunged 4.7% in December, the biggest drop since the end of 2008, as gasoline prices fell 9.4%. Overall consumer prices grew 0.8% in 2014, the second smallest calendar-year increase in the last five decades. Core inflation was 1.6% during 2014. Also, the government reported that inflation-adjusted average hourly earnings rose 0.1% in December. For the year, real average hourly earnings rose 1%.

Good news, everything is on sale. Well, not everything; beef, tomatoes, and eggs went up in price; and rents jumped last year. Most things are cheaper but it may not be cause for celebration. We’ve just seen the weakest stretch for prices since 2009, which was not a good year for the economy. The euro zone is in outright “deflation,” which is the opposite of inflation, prices fall instead of rise. Japan, went through a couple of lost decades when prices just went flat or even dropped. Japan has already started on a quantitative easing program. The Eurozone is expected to announce next week that they will start buying sovereign bonds to stimulate their economy.

Of course the problem is that when prices are falling we tend to put off buying stuff because we expect we can get a better deal tomorrow or next week. When everybody is waiting for a better price, nobody is actually buying; when people stop buying things, it is bad for the economy; really bad. The Federal Reserve tends to think this won’t be a problem; they are planning on raising rates at some point in the not so distant future. Unless something upsets the apple cart.

By the third quarter of this year, the Federal Reserve’s 0.25 percent interest rate is expected to at least double, according to economists surveyed by Bloomberg News. The Fed already has an idea of what the market impact will be: The so-called taper tantrum in May 2013, when then Fed Chairman Ben Bernanke first suggested the U.S. bond-purchase program would be scaled back, saw the yield on the 10-year Treasury jump half a percentage point in four weeks to end the month at 2.13%.

There’s a risk, though, that this time, having flagged the prospect of a change so far in advance, policy makers will be complacent about the probable market reaction. That’s what happened in 2008 when Lehman Brothers went bust. Treasury officials convinced themselves that the financial crisis had been rumbling on long enough for participants to have shielded themselves against the collapse of a big firm; turned out, not so much.

Right now there is a sort of similar situation with regard to Greece, where the problems have been going on so long, that people forget that Greece is on the edge of collapse. Today, two Greek banks applied for emergency funding from the national central bank. This could be a signal that depositors are pulling their money out at an alarming rate. Or it might just be another scheme to scare Greek voters ahead of next week’s election. After the election, the Greeks might repudiate their sovereign debt; the Euro Union might kick them out. Maybe it won’t be a problem.

The big problem seems to be when something happens without warning; like the Swiss abandoning a cap on their currency. Boom, markets move fast, somebody loses a boatload of money. Soon after the Swiss National Bank unexpectedly ended its three-year policy of keeping the franc weaker than 1.20 per euro, bearish bets on Europe’s common currency soared. While setting a record low versus the franc yesterday, the euro also plunged 3.5 percent against a basket of 10 developed-nation peers, the most since its 1999 debut, and reached an 11-year low against the dollar today. When the news was first announced, the franc exploded, up 41% versus the euro before things calmed down.

Generally, currency trades don’t have big moves. And so brokerages and exchanges allow leverage to entice traders. The U.S. Commodity Futures Trading Commission allows investors to put down as little as 2 percent of the value of their foreign-exchange bets. Brokers may get stuck with the balance of losses suffered by clients who used leverage, borrowed on credit cards, or did both to bet against the franc. FXCM handled $1.4 trillion in currency trades last quarter; today they say clients owe $225 million on their accounts. This afternoon, Leucadia National announced it would provide $300 million in financing to FXCM, which would allow FXCM to maintain its regulatory capital requirements. FXCM isn’t the only casualty from the franc’s sudden move. Global Brokers Ltd., based in New Zealand, said losses from the surge are forcing it to shut down.

Meanwhile the Chicago Mercantile Exchange announced that it will double, then triple, margin on Swiss franc futures contracts. That means they will extend a bit more credit and hope their customers just wait it out and everything will return to something like normal. That will reduce the margin calls but it won’t eliminate them, and I suspect we’ll see some more tales of woe in coming days. And that includes some of the big banks; both Deutsche Bank and Citigroup each reported lost $150 million on Swiss franc trades. The losses are mounting, but so far nothing the markets can’t absorb.

Now let’s look at another market that has seen some fast moves – oil. We’ve been tracking the decline since last summer, but still, that is considered a fast move. The day traders have certainly had their chance to get in or out of a trade, but there are many other investors who can’t jump in and out of positions quite so fast. For example, there is quite a bit of debt associated with oil exploration and drilling and refining. And that energy debt is then bundled together in pools, known as CLOs or collateralized loan obligations, and then those CLOs are traded. But the market for CLOs is not as liquid as you might think, and it becomes less liquid when it looks like some off the loans that were bundled might not perform.

Under provisions of the Dodd-Frank Act, banks are required to sell their stakes in certain complex securities, such as CDOs and CLOs. But there has been a push to repeal parts of the Act. The Volcker reprieve would have given banks until 2019 to sell their stakes in CLOs. Much of the recent energy boom has been financed with junk debt and a good portion of that junk debt ended up in collateralized loan obligations. CLOs are also big users of credit default swaps, which are an important target of the Dodd Frank push-out. In addition, over the past 6 months banks were unable to unload a substantial portion of the junk debt originated and so it remained on bank balance sheets. That debt is now substantially underwater and, potentially, facing default. To hedge or hide the losses, banks are using credit default swaps. Hedge funds are actively shorting these junk debt financed energy companies using credit default swaps.

The Dodd-Frank Act was supposed to get the banks out of that derivatives business in 2015, but if the banks had to mark to market on those CLOs today, it would likely lead to big losses. And so they are asking the politicians to delay implementation of the Volker Rule, so they have more time to sell off their bad CLOs, or maybe for the market to rebound. The reason to expect such heavy concentration of energy debt in CLOs is that energy debt has made a big increase in its total share of the junk bond market, up from 4% ten years ago to 16% now. 16% might not seem like a big deal until you realize that the real increase in energy credit issuance happened in the last few years, so the proportion of energy borrowing to total risky borrowing was vastly higher of late so as to move the averages so much in a short time.

We don’t know exactly how much bad energy debt is bundled into CLOs. Some estimates peg it around $200 billion, but that doesn’t mean everything will go into default. But here is where CLOs are dangerous; they take good energy debt and bad energy debt and other types of debt and they smash it all together. It’s kind of like taking a bunch of apples, and making apple sauce. And once you smash the good apples with the bad apples, you can’t unmake the apple sauce.

The opacity of the banks’ situation is creating a mindset on Wall Street to sell first and ask questions later. On days when oil is plunging in price, big bank stocks are getting hit across the board. Institutional investors with large bank positions who can’t readily dump shares are trying to hedge their exposure by buying puts on Exchange Traded Funds (ETFs) which track the financial services sector. Wholesale dumping of shares could come later if more negative news emerges.