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.

FINANCIAL REVIEW

Say Cheese

Sinclair Noe — January 15, 2015

Podcast: Play in new window | Download (Duration: 13:17 — 6.1MB)

DOW – 106 = 17,320
SPX – 18 = 1992
NAS – 68 = 4570
10 YR YLD – .06 = 1.77%
OIL – 2.28 = 46.20
GOLD + 33.50 = 1263.60
SILV + .11 = 17.06

After going through all of 2014 without a losing streak of more than three days, the S&P 500 today completed its second slide of five straight days. The benchmark gauge is down 3.4 percent over the past five days.

For the past 3 years the Swiss have kept their currency, the Swiss franc, from getting too strong; they imposed a cap to keep the euro from trading below 1.20 francs. In early 2010 one franc was less than 0.7 euro. By the middle of 2011 the franc was nearly at parity against the euro, a massive move in a very short period. As the Eurozone experienced economic strife, Switzerland was calm and offered a safe haven. As money poured in, the franc became more and more expensive; which means that things made in Switzerland became more expensive when the Swiss exported. So, they capped the franc. That basically involved printing more francs and buying more euros.

Fast forward to 2015, and the Eurozone is once again experiencing economic strife; money is once again pouring into Switzerland as a safe haven, and after 3 years the Swiss just threw up their hands and said they had enough; it didn’t make sense for the Swiss National Bank to keep on an endless path of buying more and more euros just to keep the currency down, and there was probably some concern that they had too many euros, which might be a liability. So, they removed the cap, without warning. It was quite the surprise.

What does it mean? Well the Swiss franc spiked a whopping 30 percent against the euro. So, it you were planning a vacation to Zurich, it just got more expensive; for many people in Europe who have mortgages with Swiss banks, their mortgage payments just went up; if you were planning to buy a Swiss watch it just got more expensive; same for Swiss chocolates; and if you need a corkscrew that can also work as a screwdriver, pliers, wrench, and knife – that will cost you more. The Swiss stock market fell about 11%. And if you were invested in a company such as Swatch, Nestle, Novartis, or Roche – you just got hammered. Sorry. And if you were trading in the currency markets and you were short the franc and long the euro – please step away from the ledge.

Thursday’s decision to call time on its efforts to keep the euro from trading below 1.20 francs came amid mounting speculation that the European Central Bank will next week back a big government bond-buying program that will put more euros in circulation, diluting their value. That expectation has seen the euro face intense selling pressure in currency markets, particularly against the dollar. The euro has fallen to nine-year lows against the dollar and below its launch rate in 1999. As a result, the cost for the Swiss central bank of constantly defending the peg by buying euros or selling francs has been rising.

The SNB clearly expected to see a huge surge of inflows in the week ahead and saw little reason to provide these buyers of francs with an artificially cheap rate. Switzerland’s immediate neighbors are countries in the Eurozone. The franc’s contiguous boundaries are with the euro. Switzerland’s central bank worried about inflows of hot money from Russia, either directly or via the euro. Think of it this way: yesterday a Moscow-based oligarch could move money from ruble to euro. Then he could move it from euro to Swiss franc, and the Swiss government and Swiss National Bank would maintain a 1.2 currency peg. That is now over.

In addition to making Swiss exports more expensive, a stronger currency makes imports into Switzerland cheaper, further dampening prices already-subdued by big drops in oil prices and other commodities.

In an effort to contain the franc’s appreciation and limit any damage to the Swiss economy, the central bank on Thursday also lowered a key interest rate — what it charges commercial banks to deposit at the bank — to minus 0.75 percent from minus 0.25 percent. That’s right, banks have to pay the Swiss central bank to park reserves. The hope is that it dissuades banks from parking their cash at the national bank and instead possibly invest it. That might not work; the Swiss franc is still considered a safe haven for investors. The franc’s value will remain sensitive to developments around the world, including the crisis in Russia and the oil market slump.

Switzerland is a small country. For most people, the Swiss surprise really is not a huge event, but today’s move confirms that deflation is a clear and present threat to the global economy.

If you were planning a trip to Davos Switzerland for the World Economic Forum, we can save you some money. The WEF 2015 Global Risks Report was published today; geopolitical issues are considered to be the biggest threat to global stability over the coming decade. According to the WEF’s lead economist, “Twenty-five years after the fall of the Berlin Wall, the world again faces the risk of major conflict between states,” and the means to wage such conflict are broader than ever, whether through cyberattack, competition for resources or sanctions and other economic tools. “Addressing all these possible triggers and seeking to return the world to a path of partnership, rather than competition, should be a priority for leaders as we enter 2015.” When asked to assess risks in terms of their potential impact, the nearly 900 experts surveyed by WEF found water crises as the greatest threat to the world.

US producer prices in December recorded their biggest fall in more than three years on tumbling energy costs while underlying inflation pressures were muted. The Labor Department said its producer price index for final demand declined 0.3 percent, the biggest drop since October 2011, after falling 0.2 percent in November. A sustained plunge in energy prices is keeping a lid on inflation throughout the pipeline, from bills for businesses to the consumer’s cost of living.

The number of Americans filing claims for unemployment benefits increased to a four-month high last week.

Consumer confidence increased last week to the highest level since mid-2007 as steady declines in gasoline prices and more hiring boosted Americans’ attitudes about the economy. The Bloomberg Consumer Comfort Index rose to 45.4 in the period ended January 11, from 43.6 the week before.

Bank of America, the second-largest US bank by assets, reported a 14 percent fall in quarterly profit as a decline in sales and trading revenue more than offset a big drop in operating expenses. Revenue from bond trading, which is part of the bank’s sales and trading business, plunged 30 percent to $1.46 billion.

Citigroup reported its fourth-quarter profit plunged as the bank was hit by large legal charges. The bank reported a profit of $350 million–which includes $3.5 billion in previously disclosed legal and repositioning charges–compared with a year-earlier profit of $2.46 billion. On a per-share basis, Citigroup reported a profit of six cents. Analysts had expected earnings of nine cents a share including the charges. On Wednesday, a provision — drafted by Citigroup — to repeal part of the Dodd-Frank financial reforms (Section 716) was added by House Republicans to their spending bill. On Thursday, Citigroup led the charge to persuade enough Democrats to vote for that bill. The repeal of Section 716 stayed in the spending bill only because Wall Street brought so much pressure and influence to bear. Apparently buying politicians is cheaper than paying fines and settlements for violating the law. Of course, I still maintain that not breaking the law is the best solution, but clearly that is not under consideration.

Bank of America slipped 5.2 percent to the lowest since August and Citigroup dropped 3.7 percent.

After the close, Intel reported fourth quarter net income rose to $3.66 billion, or 74 cents per share, for the quarter ended Dec. 27, from $2.6 billion, or 51 cents per share, a year earlier. Revenue rose to $14.7 billion from $13.8 billion. Intel forecast first-quarter sales that may fall short of analysts’ estimates because PC sales are down.
We’re starting to see some oil companies respond to lower oil prices. Schlumberger, the oilfield services provider, announced it will cut 9,000 jobs, even as they reported a 6 percent rise in quarterly revenue. Revenue rose to $12.64 billion from $11.91 billion. Net income attributable to the Houston, Texas-based company fell to $302 million, or 23 cents per share, in the fourth quarter ended Dec. 31, from $1.66 billion, or $1.26 per share, a year earlier.

Apache says it will also lay off several hundred employees, cutting 5% of its workforce this week. The move signals one of the first major workforce cuts at an American oil producer after the recent drop in crude prices. Apache had been profitable until the third quarter of last year, when it reported a $1.2 billion loss.

BP is planning to cut 300 jobs from its 4,000-strong North Sea business following a review of its operations. The U.K.-based oil major, which has been downsizing since the Deepwater Horizon oil spill in 2010, said it had long planned the cuts, but was speeding up the process due to falling oil prices.

This afternoon, there was more news on BP. A US District judge has ruled that the company dumped 3.19 million barrels of oil into the Gulf of Mexico in 2010. Today’s ruling on the spill’s size sets the stage for a trial next week at which the judge will determine the amount of the fines, based on the law’s provision for as much as $4,300 per barrel released and factors such as what BP did to minimize or mitigate the effects of the disaster. The court rejected the government’s 4.2 million barrel estimate of the spill size, decreasing the potential maximum fine from $18 billion to a maximum fine of $13.7 billion.