Thoughts On The Current Market Situation

We have switched gears, moving from Leen’s Lodge in Maine and a baked pickerel for lunch to the shark-infested waters near Wall St. in NYC. We are scheduled to guest-host Bloomberg TV's Surveillance on Thursday morning, June 28, from 6 to 7 Eastern time. Pristine Maine waters give way to the Hudson River.

“Too much information” said Tom Keene, as he and his colleagues interviewed David Rosenberg and Barry Ritholtz on Surveillance yesterday morning. TMI is an understatement.

Bullets for discussion.

1. How big is the fiscal cliff and is it really a threat?  Will Congress postpone the yearend confrontation?  Is the American political system capable of “doing the right thing”?  What is the right thing?  Is there a difference between raising taxes and raising spending versus cutting taxes and cutting spending?  We think so. However, others intensely disagree.

2. Is “Op Twist” distorting the short end of the curve?  Joe Abate (Barclays) thinks it is and suggests that repo can trade at a higher yield than the overnight reserve deposit rate. Is Op Twist a back-door way for the Fed to restore the “corridor”?  The Fed seems silent on these technical questions. Do they understand them?  How many actual, experienced bankers are on the Fed board?  One (Duke), whose term is up. How many market-experienced Feddies (governors, not presidents) are there, since Kevin Warsh left?  You answer and see if you can count above zero. Remember: the Fed presidents see “the field.”  The governors see the academic literature. There are big issues facing the Fed. Is market experience needed now?

3. Europe. Demand-deposit flight ensues in nearly all peripheral countries, including Portugal, Ireland, Spain, and Italy. Greece is now relegated to insignificance. Cyprus and Malta are small. But the disease spreads. Will France be next?

4. Switzerland is the new eurozone safe haven. We will excerpt from our pickerel exposé, reprinting the key section below.

“We want to call your attention to an added chart that shows the yields on Swiss government debt. Notice the Swiss shorter-term, 2- to 5-year debt is now trading at a negative yield. That is correct; people are paying interest to loan their money to the government of Switzerland. In the front end of the yield curve, Switzerland is financing itself at a profit. The 10-year Swiss franc-denominated government bond has become the benchmark bond of the eurozone.

“Imagine a construction in which the benchmark bond of a currency zone of seventeen countries is denominated in a different currency. That is what is happening in Europe. Why?  The Swiss have pegged their franc to the euro at a ratio of 1.2 to 1. The Swiss Central Bank will buy unlimited amounts of euros that are presented to it in order to maintain that price. The balance sheet of the Swiss Central Bank is growing continuously, as the influx of euros swells into the Swiss monetary system.

“Thus, we now have a de facto eurozone benchmark bond denominated in Swiss francs, maintained by the Swiss government and the Swiss Central Bank, and at a yield of almost 100 basis points below the traditional German benchmark bond.

“Markets seek this safety because it has become an established ‘one-way’ trade. Markets are betting that the eurozone will be dismembered, losing or expelling one or two of its members. The various scenarios have widely different outcomes, but the events are being considered. Markets are also betting that diminution in the German ability to maintain and finance the rest of the eurozone’s debt structure will eventually cause German credit to weaken.”

4. Even if the IMF and the G20 can agree and let the emerging-market countries have a larger political say in return for contributing; even if they do it, is the 1-trillion-euro, combined IMF, ESFS, ESM pot sufficient?  Many say no. We are not sure.

5. A technical point for economists. Many point to the negative "output gap.”  They use this concept to justify their positions. However, the output gap is not an accurately measurable item. Neither is the NAIRU. Both are concepts. Only after the fact and after many years of revised data can we estimate what they were. To base policy on a concept that is not forward-looking is like sculpting fog. You may get lucky. However, you may blunder. Are there better ways?

6. Household deleveraging continues in the US. The small-business sector is uncertain and restrained. NFIB data confirm it. Small business is dependent on domestic US economics, while larger companies have foreign exposure. The larger corporate sector has ample cash. It does not need to borrow. Can these two positions be reconciled in favor of more US growth?  We are not sure.

Lots to discuss on Thursday morning. So little time to do it. Yes, Tom, there is too much information.

BY David R. Kotok