How The Fed Is Creating An ‘Incredible Mispricing Of Risk’ Reply

How The Fed Is Creating An ‘Incredible Mispricing Of Risk’

Earlier this week I published a piece on the CFA Institute’s Inside Investing section titled: Mortgage REITs: Does Doubling the Leverage Make Them a Good Investment?  The post was my response to UBS launching an ETN that provides 2x leverage on a basket of already heavily levered mortgage REITs “mREITs”.

In short, I believe it’s a dangerous product as many investors in the underlying REITs have little idea how 10%+ yields are being generated.  Moreover, they don’t understand the scenarios that could lead to a significant decline in share prices.  To paraphrase the great Howard Marks, “…do not confuse adding leverage to an existing investment with increasing return…if you take a 10% return in a security and lever it up 4x and after financing costs generate 15-20% returns, you haven’t increased your returns, you’ve just increased your leverage and significantly increased your risk, but you’ve also got a 20-25% downside threat”.  I think this thinking certainly applies to mortgage REITs today.

A bigger threat is upon us

Last week Annaly Capital’s CEO Wellington Denahan-Norris (who this week replaced the late Michael Farrell who tragically passed away), said some very interesting comments to Bloomberg on the state of the risk markets.  After discussing the impact of the Fed buying Agency MBS she said:

“It’s not just at the mortgage REITs where the returns in this market are being put under assault, It’s the general global landscape where you have an incredible mispricing of risk that’s being delivered at the hands of academics at the central banks of the world.

I could not have said it better myself.  I am firmly in the camp that both credit and duration is being dramatically mispriced due to the actions of the Fed.  They’ve created a reckless chase for yield that is being driven not so much by greed, but rather by needs based investing.  The yield piñata has burst and participants far and wide are scurrying to accumulate what they can across all sectors of the fixed income markets: IG corporates, CMBS, Non-Agency MBS, High Yield, Levered Loans, Munis, and others.

While equity focused investors don’t see the direct impacts of the Fed’s purchases, the spillover is pronounced in fixed income and is causing imbalances far and wide.  When I read the article about UBS’ new 2x leverage mREIT product, I couldn’t help but think that we are starting to see signs of these policies backfiring as the chase for yield has reached a more than unhealthy level.

By: David SchawelEconomic Musings source:


Poor US earning season so far and not expected to get any better. Reply

Roughly one third of the S&P has reported earnings so far, with another third reporting in the next five days and almighty AAPL on deck Thursday evening, and if there is one word to describe what has happened so far, that word would be “ugly.” The same word would be used to describe how Q4 is shaping up to be. And that word will be very a optimistic prediction of what 2013 will bring unless a major catalyst develops that pushes Congress to resolve the fiscal cliff situation. So far that catalyst is missing. But going back to Q3 earnings, here is how Goldman’s David Kostin summarizes events to date: “3Q reporting season is roughly one third finished. Two early conclusions: (1) Information Technology results have been startlingly weak with high-profile revenue disappointments by the four horsemen: MSFT, GOOG, IBM, and ORCL. (2) EPS guidance for 4Q has been overwhelmingly negative across all S&P 500 sectors with 18 of 20 firms lowering 4Q earnings guidance by a median of 5%. Analysts have lowered 4Q EPS estimates for stocks already reported by 0.4%. We expect further EPS cuts of 6% loom ahead. Firms reporting next week: AAPL, T, PG, MRK, CMCSA, AMZN, COP, AMGN, OXY, MO, UTX, MMM, CAT, DD, and FCX


Source: ZeroHedge

Bond Wars: Chinese Advisor Calls For Japanese Bond Dump Reply

Earlier today we casually wondered whether the US stands to lose more by supporting China or Japan in their escalating diplomatic spat, considering the threat of a US Treasury sell off is certainly not negligible, a dilemma complicated by the fact that as today’s TIC data indicated both nations own almost the same amount of US paper, just over $1.1 trillion. In a stunning turn of events, it appears that China has taken our thought experiment a step further and as the Telegraph’s Ambrose Evans-Pritchard reports, based on a recommendation by Jin Baisong from the Chinese Academy of International Trade (a branch of the commerce ministry) China is actively considering “using its power as Japan’s biggest creditor with $230bn (£141bn) of bonds to “impose sanctions on Japan in the most effective manner” and bring Tokyo’s festering fiscal crisis to a head.” I.e., dump Japan’s bonds en masse.

Should this stunning recommendation be enacted, not only would it be the first time in world history that insurmountable credit is used as a weapon of retaliation, it would mark a clear phase transition in the evolution of modern warfare: from outright military incursions, to FX wars, to trade wars, culminating with “bond wars” which could in the span of minutes cripple the entire Japanese fiscal house of cards still standing solely due to the myth that unserviceable debt can be pushed off into perpetuity (as previously discussed here).

Not needing further explanation is the reality that should China commence a wholesale Japanese bond dump, it may well lead to that long anticipated Japanese bond market collapse, as creditor after creditor proceeds to sell into a market in which the BOJ is the buyer of only resort in the best case, and into a bidless market in the worst.

The immediate outcome would be soaring inflation as the BOJ is forced to monetize debt for dear life, buying up first hundreds of billions, then trillions in the secondary market to avoid a complete rout, matched by trillions of reserves created out of thin air which may or may not be halted by the Japanese deflationary gate, and which most certainly could waterfall into the economy especially if Japanese citizens take this as an all clear signal that the Japanese economy is about to be crippled in all out economic warfare with the most dangerous such opponent, and one which just defected from the “global insolvent creditor” game of Mutual Assured Destruction.

Further complicating things is that Japan has no clear means of retaliation: it owns no Chinese bonds of its own it can dump as a containment measure. Instead, Japan is at best left with the threat of damages incurred on the Chinese economy should Japan be lost as a trading parting. It appears, however, that to China such a gambit is no longer a major concern:

Mr Jin said China can afford to sacrifice its “low-value-added” exports to Japan at a small cost. By contrast, Japan relies on Chinese demand to keep its economy afloat and stave off “irreversible” decline.


“It’s clear that China can deal a heavy blow to the Japanese economy without hurting itself too much,” he said. It is unclear whether he was speaking with the full backing of the Politburo or whether sales of Japanese debt would do much damage. The Bank of Japan could counter the move with bond purchases. Any weakening of the yen would be welcome.

Yes, but any offsetting Japanese hyperinflation would not, which is precisely what would happen if after 30+ years of dormancy the Japanese bond vigilantes were woken up by none other than a cuddly Panda bear with very murderous intentions.

Ironically, this terminal bond war escalation would also mean that Japan’s last ditch alternative is to threaten the US with dumping America’s bonds in turn if the US i) does not step up on behalf of Japan and ii) if Japan is forced to promptly convert debt from one denomination into another. The fallout effect would be most dramatic.

It is unclear if China will proceed with this “scorched bond” step: should this happen there is likely no turning back as it would force a market test of the entire developed world. And as our readers know all too well, the entire developed world is insolvent, and the only reason why it has perpetuated the illustion that all is well, is because being a closed system, nobody has the incentive to defect. Until now that is, when suddenly over a piece of rock in the East China Sea, China may find itself pulling the pin on the global debt grenade.

And even if this is not the final denouement, the market appears to already be pricing in several not much more favorable outcomes:

Markets are already starting to price in an arms race in Asia. Shares of China’s North Navigation Control Technology, which makes missile systems, have jumped 30pc in recent days.


China is becoming self-sufficient in defence. It was the world’s biggest net importer of weapons six years ago. It fell to fourth place last year.


Japan is at the other extreme. An official report this year – “A Strategy for Survival” – said Japan’s spending on its “Self-Defence Force” had shrunk by 4pc in 10 years. It called for “urgent” action to rebuild the country’s military.

One thing here is certain: Japan picked on the wrong country when two weeks ago it “purchased” the disputed Senkaku Islands. If it thought that China would just forgive and forget with a wink, it was dead wrong.

It now has several two options: undo all that has happened in the past fortnight, in the process suffering tremendous diplomatic humiliation, leaving Senkaku in the “no man’s land” where they belong, or push on, and suffer the consequences. And the consequences for the country represented by the question market in the chart below, would be tragically severe, as would they for the entire “developed”, insolvent and daisy-chained world


Source: Zerohedge

It’s Just Getting Stupid! Reply

As Cantor’s Peter Cecchini notes today:

“when things are this senseless, a reversion to sensibility will occur again at some point.”

His view is to be long vol and as the disconnect between the economic cycle and stocks continues to grow, we present three mind-numbing charts of the exuberant hopefulness that is now priced in (oh yeah, aside from AAPL actually selling some iPhones in pre-order). Whether it is earnings hockey-sticks, global growth ramps, or fiscal cliff resolutions, it seems the market can only see the silver-lining. We temper that extreme bullish view with the fact that all the monetary policy good news has to be out now – for Ben hath made it so with QEternity.

These three factors – weak economic growth, powerful monetary policy and elevated public policy uncertainty – remain the critical drivers of performance and with weakening data, the market is all the more dependent on central bank life support – and following the rally through the Fed signalling period to 1460, much of the monetary policy related rally seems to be priced in, with the market already discounting considerable data improvement. With already high oil, gasoline and food prices, the Fed’s balance sheet expansion risks driving down the dollar, boosting commodities and dampening consumption and thus growth.  

As this chart comparing P/E multiples to the ISM New Orders index, we need to see some serious unicorn-conjuring for these valuations to be sustained…


One tool often utilized to assess the attractiveness of equities relative to other assets is the equity risk premium (ERP), also known as the Fed model or the difference between the forward earnings yield and the yield on the 10 year U.S. Treasury. We have argued, based in part on the prior period of extreme financial repression in the U.S. following WWII, that a sustained contraction in the ERP and expansion of the PE multiple was unlikely until the Fed began the policy normalization process. Integrating inflation and a ratio of stock to bond market volatility paints a far less compelling picture for equity market valuation. We are at least 3 years from any normalization of Fed policy (according to them) and thus…

the following chart (or real rates vs P/E multiples) suggests current valuations are unsustainable at best, or down-right crash-worthy as you simply can’t fight the cash-flow forever…



The reach for yield and safety has led investors to push into mega caps – defensive ingredients including lower betas, lower earnings volatility, and lower P/E multiples as well as higher dividend yields. This has pushed the relative median P/E of the mega caps notably above smaller (and higher beta) stocks – as the somewhat odd beta-defying rally of the last few weeks took hold

Our point here is that 1) the spread between LTM and NTM PE is gaping (something that we saw in the run-up to the peak in 2008), and 2) that the mega-caps which dominate the indices (which everyone watches including Ben) are ‘over-valued’ rightly or wrongly relative to less-defensive stocks… leaving plenty of room for rotational risk-off as well as reality disconnects



On balance, Barclays are less bullish than they were at this time in either of the last 2 years. Investors seem to mis-remember history; monetary policy was not the only driver of the rallies following QE2 and Operation Twist. In the signalling period prior to QE2’s launch, and in the immediate aftermath of its commencement, both the economic and public policy outlooks were improving.

[They] remain relatively cautious given a weaker economic outlook and no clear trend in the polls to provide confidence that the U.S. can avoid the potential massive tax hike scheduled for January 1, 2013


Source: Zerohedge


Spain is Greece… Only Bigger and Worse

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Submitted by Phoenix Capital Research on 09/16/2012 20:42 -0400

Swing by for more market commentary, investment strategies, and several FREE reports devoted to help you navigate the coming economic and capital market changes safely.


As I’ve outlined in earlier articles, Spain will be the straw that breaks the EU’s back. The country’s private Debt to GDP is above 300%. Spanish banks are loaded with toxic debts courtesy of a housing bubble that makes the US’s look like a small bump in comparison. And the Spanish government is bankrupt as well.


Indeed, in the last month alone we’ve seen:


  1. Spain’s banking system saw a bank run to the tune of €70 billion in August. The market cap for all of Spain’s banks is just €114 billion. So Spanish banks need to raise at least €20+ billion or so per month in the coming months to stay afloat. This is without depositors pulling additional funds in September onwards. That’s really bad news.


  1. Spain’s now nationalized Bankia just took another €5.4 billion from Spain’s in-country rescue fund. This indicates that once nationalized, problem banks DO NOT cease to be problems.


  1. The region of Andalusia is requesting a bailout from the Spanish Federal Government. This comes on the heels of bailout requests from the regions of Valencia, Murcia and Catalonia (none of which want any “conditions” on the funds).


  1. Spain has set aside €18 billion to bailout its regions. The current bailout requests already amount to €10.8 billion. That’s just from this year alone.


If you need more info on Spain, the bullet items from them that you need to know are that:


  1. A huge portion of Spain’s banking system (representing over 50% of mortgage loans AND deposits) was totally unregulated up until just a few years ago.
  2. Spanish banks were drawing €337 billion from the ECB on a monthly basis to fund their liquidity needs.
  3. Every political figure and bank in Spain is HIGHLY incentivized to lie about the true nature of the Spanish banking system (a private text message from the Prime Minister claimed the REAL capital needs were closer to €500 billion… which is assuming he knows what he’s talking about/ the banks were honest with him… which I HIGHLY doubt).


Indeed, the markets are beginning to figure out the Spain is DONE regardless of what the ECB does. The truth is that Spain is in as bad a shape as Greece if not worse. Expect things to get very, very ugly soon.


The reason is two fold:


  1. Spanish banks need to roll over (meaning renew terms on) more than 20% of their bonds this year.
  2. Spanish sovereign bonds are collateral for hundreds of billions of Euros’ worth of trades.


With Spanish banks already under severe funding stress (again, they drew €337 billion from the ECB before the new OMT program… and depositors took €70 billion out of the system last month), they’re in no position to start paying out higher interest payments to bondholders.


And with investors realizing that Spain’s banks are all lying about the state of their balance sheets (remember, Bankia was talking about paying a dividendjust one month before it collapsed and revised its €41 million 2011 profit to a €3.3 billion LOSS), we’re going to be seeing plenty of bank failures this year.


Remember, Spain’s initial request was for the EU to bail out its banks NOT the country itself. However, with some six Spanish regions (probably more) looking for bailouts Spain is now facing both a sovereign debt AND a banking crisis.


The timing of this issue will be difficult due to the ECB’s intervention, but at the end of the day, the math doesn’t add up. Spain has big problems and when the market figures out that the ECB cannot solve them… it’s going to be a very difficult time in Europe.


Source: Zerohedge

The One Chart To Explain The Real Effect Of QE3 Reply

Much has been written over the course of the last few days/weeks about what Bernanke could do, has done, and the efficacy of said actions. Inflation, unintended ‘energy’ consequences, debasement, financial repression, scarcity transmission mechanisms all come to mind but realistically they are all just symptoms of what is really going on. As the following chart from Barclays shows, the real effect of LSAPs is to suppress the signaling effect of macro data from the real economy. During periods of extreme monetary policy, the stock market’s beta to macro-economic data surprises is dampened massively – and hence the forced mal-investment and mis-allocation of funds occurs. However, given the now open-ended nature of QE3, this may change with the ‘good news/bad news’ logic leading to a stronger market (higher beta) response (since all bad news is automatically attenuated by QEternity and thus all the good news is out there).


Via Barclays:

An important driver of this attenuated market response to economic news was the sense that important elements of the monetary policy framework were ‘in play’, and that policy was likely to respond if the economy weakened sufficiently, but not otherwise. In this context, bad economic news may not seem so horrible, if it is perceived to raise the probability of a market-friendly monetary policy response. In the run-up to June 2011, the question facing investors was whether the Fed would allow QE2 to end in June, in accord with the Fed’s stated intention. More recently, the question has been whether the Fed would put a more aggressive policy in place. But the ‘good news/bad news’ logic was much the same.


It seems to us that this logic will not, however, remain operative in the months to come, since the policy frameworks recently announced by both the Fed and the ECB have no stated end date on which markets can focus (as did QE2), and are not likely to be materially adjusted in response to economic data for some months to come. Economic news may have been a ‘good news/bad news’ story in the recent past. But now that the monetary policy responses to economic weakness are in place, markets have had the good news.

In the future, bad economic data will be, well, just bad, and good news will be unambiguously positive. This should lead to a stronger market response to economic data in the weeks and months to come.


Source: Zerohedge

The Fed’s Drugs Won’t Work Anymore Reply

QE3. No QE3. The markets have been injected with this hopium for months and have been let down on every occasion except for this last one. The Fed’s issuance of this last round of quantitative easing has rendered future doses of this drug ineffective.

It was explicitly stated that the Fed would issue QE as needed in unlimited amounts until the market is able to create enough jobs to stimulate dramatic growth. This means that there will not likely be any future spikes in the market as a result of another QE announcement…the market no longer questions whether or not more drugs will come, now they expect them.

The Fed had been using “QE hype” to rally the markets. Every time we were on the verge of a collapse another QE announcement would be made bringing us a few feet back from the fiscal cliff. But that tactic wont work anymore…

The Fed’s actions are fiscally irresponsible and the U.S. will quickly suffer the consequences of this poor decision. If the economic change needed to return to growth is structural then a monetary fix, or QE, isn’t the remedy.

The U.S. Dollar is on the decline against other major currencies, and investors are losing confidence in the Fed’s ability to manage the ensuing risk of another recession. Question that remains, what happens when the QE drug gets taken away?

It’s time to hedge; if the value of the U.S. dollar collapses how will you respond? Diversification is key. Learn to manage your risk by looking a head; join the Forward Thinking waiting list now.

Your currency analyst,

Justin Burkhardt

source: Zerohedge

The Hottest Meme In The Global Economy: Everyone Is Slamming Australia Reply

Ever since investors started panicking about a Chinese hard landing, analysts started warning about troubles in Australia, which supplies so many natural resources to China.


In April, Societe Generale’s Dylan Grice summed up concerns about Australia’s economy when he wrote that Australia is “a credit bubble built on a commodity market built on an even bigger Chinese credit bubble.”

And added, “Australia looks like leveraged leverage, a CDO squared.”

Then in August, BHP Billiton the world’s largest miner reported a 35 percent drop in second half profit, kicking off a storm about the Australian mining bust. Here’s what’s gone wrong in Australia:

  • Australia has been riding a mining boom that has helped it avoid a recession for 21 straight years.
  • But commodity markets are known for their boom-bust patterns and with a slowdown in China, curbs on the Chinese property sector, and a slowdown in the global economy, demand for crucial Australian exports like coal and iron ore are waning.
  • The massive investment in mining for coal has overlooked the shale gas boom in the U.S., according to Grice. While, Bank of America’s Bin Gao and Ethan Mou write that the increase in U.S. exports of coal to China have eaten into Australia’s share of the Chinese coal market.
  • Australia has a property bubble with Sydney, Melbourne, Adelaide, Brisbane, and Perth being some of the world’s most expensive cities, according to SocGen’s Albert Edwards.
  • The Aussie dollar continues to be stronger than the U.S. dollar despite the softening in commodity prices.
  • Australian stock price moves are closely correlated with China. Given the dismal performance of Chinese equities the Australian stocks are overpriced according to SocGen’s proprietary model. SocGen’s analysts write, “The strength of Australia is particularly hard to explain, given the recent weakness in figures like the housing data.”
  • Australia’s resource minister Martin Ferguson recently said (via The Telegraph): “You’ve got to understand, the resources boom is over. We’ve done well – A$270 billion  in investment – the envy of the world. …It has got tougher in the last six to 12 months. Look at Europe, the state of the European and global economy. Think about the difficulties in China. The commodity price boom is over and anyone with half a brain knows that.”
  • Last week, Deutsche Bank’s Adam Boyton and Phil Odonaghoe warned of the end of the investment boom and a 2013 recession in Australia. “It does seem to us that there is some complacency surrounding the prospect of a sizeable decline in the terms of trade – and some over-confidence that the investment pipeline is ‘locked in’. While there may be reasons as to why this time is different …history would counsel some caution on the investment outlook. Indeed, an average response to a circa 15% decline in the terms of trade would see business investment falling in year over year terms by early 2013.”


4 Things Everyone Gets Wrong About The Australian Commodity Bust Reply

4 Things Everyone Gets Wrong About The Australian Commodity Bust

Much has been written about the commodity bust in Australia. But that debate has reiterated “important misconceptions” according to Morgan Stanley analysts Gerard Minack and Katie Hill. 

Minack and Hill write that most focus  on Australian GDP growth, commodity prices, and the Chinese economy, and miss the real issues at hand.

They identify four things about the Australian commodity boom-bust debate that really annoy them:

Watching levels instead of growth rate

Minack and Hill believe commenters shouldn’t watch levels i.e. commodity prices or terms of trade (the value of exports relative to imports). They should instead focus on changes in real national income growth. For instance, the drop in costs of Chinese iron ore imports commodity prices will impact real national income, but terms of trade will still be high.


australia chart

Morgan Stanley

Watching real GDP instead of real income 

Real GDP growth wasn’t crucial to Australia’s commodity boom because the GDP growth was driven by higher commodity prices, rather than an increase in production.

Moreover, real GDP isn’t a good measure of real income when the terms of trade (the ratio of export to import prices) change, because mere price changes don’t impact real GDP (what a country produces).

A rise in terms of trade does however increase real income. Currently, Minack tells Business Insider, the commodity boom has caused a gap between real income and GDP, by adding 17 percent to real income. Focusing on GDP alone ignores the fact that in the event of commodity bust this real income will decline.

“This boom is different”

Talk that this boom is different is nonsense. This is because commodity busts aren’t caused by a decline in demand, rather, they’re caused by expanding supply. Australia according to Minack and Hill is in a supply-expanding boom.

“There is no bubble”

Mining is a bubble that could pose a threat to the Australian economy in the next two – three years. “The increase in commodity prices has far outstripped house price increases over a similar period. The income effect of the commodity boom has been more direct and powerful than the wealth effects of rising house prices”


According to DB on the whole, neither real money or hot money have participated in the risk rally of late. Reply

The Investor Positioning and Flow report is worth reading.  It notes “With the S&P 500 up almost 10% since early June, investors are assessing the sustainability of the risk rally. Our measures show that equity positioning has been fairly flat since mid-June: mutual fund managers have remained neutral while macro hedge and long-short equity funds have stayed underweight. The equity rally has largely been driven by real money inflows: equity inflows of $16bn since early June, compared to $4bn during last year’s post-LTRO rally (Nov-Feb). As we have discussed (“After the Rally”, March 26, 2012), equities should continue to get inflows absent new negative shocks; when the VIX has been below 24, equities have almost always seen inflows…Macro hedge fund beta has moved up only modestly and is still very short; Long-short equity funds have remained 4-7pp underweight since June; Mutual funds have maintained positioning close to neutral; Hybrid funds have cut back exposure over the last 2 weeks toward neutral; Energy is the large, consensus underweight for MFs and HFs; Discretionary and Materials the consensus overweights; Positioning shifts in regional and global funds have been larger than those in US funds and may have been a bigger driver of price movements… Fund managers could chase returns and raise exposures to “catch up” as they have in the last 2 years; mutual funds trail the S&P 500 by 1pp on avg YTD while returns for macro funds (flat) and L-S equity funds (2%) are weak.