Whether It’s Euribor or Libor, It’s All IBOR All the Time

I wanted to expand on the issue going on in Europe with respect to funding.  I’ve been contending the situation is getting worse, not better.  And as a result, we’re seeing a blow-off coming in the Euro, which in spite of the recent “strength” we’ve seen, has some very fundamental issues and it’s questionable it will continue to exist in its current form.

But first, I wanted to present a more comprehensive view of the term structure of Dollar/Euro Libor spreads:

The telling thing here is the fact that the short end has risen much higher than the long end, so this is a bear flattening in action.

I should probably explain why I look at the spread between Dollar and Euro Libor rates in this manner.  Here’s why (emphasis, mine):

In response to the reemergence of strains in U.S. dollar short-term funding markets in Europe, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing the reestablishment of temporary U.S. dollar liquidity swap facilities. These facilities are designed to help improve liquidity conditions in U.S. dollar funding markets and to prevent the spread of strains to other markets and financial centers. The Bank of Japan will be considering similar measures soon. Central banks will continue to work together closely as needed to address pressures in funding markets.

via FRB: Press Release–FOMC statement: Federal Reserve, European Central Bank, Bank of Canada, Bank of England, and Swiss National Bank announce reestablishment of temporary U.S. dollar liquidity swap facilities–May 9, 2010.

That was all about this:

The purple circle goes back to the start of the sovereign debt crisis.  What nobody was talking about then was the sell-off in the Euro being driven by funding concerns with banks.  I wrote a post back in May where I came to the realization that these events are all about banks trying to fund themselves in the most relevant currency they can use.  To try and illustrate that, let’s take a look at the direction of those Libor spreads and the EURUSD exchange rate.

First, let’s take a look at a longer term daily EURUSD chart:

So you can see there was a bounce in early June and the Euro has been riding it ever since.  To get better visibility into what happened, here’s another EURUSD chart over a shorter timeframe:

Note the sharp break in the uptrend and change in trajectory of the rally.  But I want to focus on the beginning of the uptrend, June 8.  You can see what was happening to the spread between dollar and euro Libor:

Right around that time frame, spreads started widening.  So as funding was getting scarce,

Meanwhile, here is a look at Euribor curves going back to the beginning of the year:

One of these days I’m going to get something up and running and treat these properly by plotting them out as 3D surfaces to look at.  But that day is not today.  Regardless, you can see the curve is having some dramatic shifts out. Again, developing a 3D surface of Euribor, euro Libor and dollar Libor would probably help us in thinking this through to understand what’s going on.

But in the meantime, here’s are a couple of graphs of Euribor/Euro Libor spreads:

The humped nature of the spread curve indicates to me there are issues in the front-end of the curve out to 3mths and then they relax.

I’m curious as to why it happened, but I’m almost certain someone smarter than me is already working on it…

Libor and the Bataan Death March for European Banks

I’m a little late in getting this out, but the charts will speak for themselves:

That was just the actual Euro Libor curve.  Here are two ways to look at Euro Libor funding relative to Dollar Libor:

The pace of widening between Euro-denominated Libor and dollar-denominated Libor has dramatically increased over the past week or two.  And if you take a look at the EURUSD chart:

You can see the Euro low was set in June which coincides with the increase in Euro-denominated Libor.  What I am sensing here is a surge both in the Euro and rates being driven by the liquidity crunch in Europe that’s building to some sort of apex at which point the true nature of the deflationary, lackluster conditions present there will be visible to everyone.  So that means you can add Europe to the list of economies that will be dealing with a significant overhang of deflation/deleveraging.

Longer term, this is setting itself up to be the Deflationary Derby: Japan, the US, Europe and other participants to be named at a later date.

But before we get there, there are some banks in Europe that are bound to be casualties of the ongoing liquidity squeeze we’re seeing.  Something like the Bataan Death March in WWII: the soliders taken prisoner by the Japanese had no food and water.  The banks have no commercial paper and little to no short-term funding. 

But both have one thing in common: they happened under the hot, sweltering sun…

On Gold, Guns, Bread and Cadillacs…

Well, maybe not guns.  This isn’t that kind of post.  But I am going to talk about gold briefly.  One of the more interesting ways to think about the value of gold is its value in purchasing household items.  Because back in earlier times that was exactly how you paid for things.  Gold is money, after all.  Indeed, in the book “Hedgehogging” Barton Biggs refers to gold in such a manner:

The Old Testament recounts how, in 600 B.C., one ounce of gold bought 350 loaves of bread.  As of today, one ounce will still buy 350 loaves of bread in the United States.

Barton Biggs: Hedgehogging

In my area of the country in North Carolina, one ounce of gold will get you 446 loaves of bread.  So when measured in those terms, we’re overvalued even after the action we’ve seen over the past few months:

Today I heard it referred to in another way: gold vis-a-vis Cadillacs.  So first, I have to present to you the definitive video clip on Cadillacs…

And now back to the gold/Caddy ratio.  I stumbled across this post (hat tip: @hedgefundinvest and @FinanceTrends) that looked at the fact that in 1971 with gold pegged at $35 an ounce you needed about 11 pounds of gold to buy a ’71 Eldorado.  Take away the peg and it would’ve been much less gold (at $103 an ounce you need about 5 pounds).

Now?  You can get 2 Cadillac XLR-Vs for the same 11 pounds if you’re taking the $35 per ounce as your starting point.  If you used 5 pounds, well you’re out of luck because you won’t have enough based on Friday’s close at $1193.50.  So the starting point you choose is important.

But as for the overvaluation or lack thereof currently?  At these levels it may still be overbought even though we’ve seen a pretty sharp pullback from $1,250.  But I’d be wary about how much more of a decline we see here because volume has been higher even on up days and the revolt against central banks isn’t over by any stretch.

So in my mind, we’re in for more volatility not less.

Minding the Gap: Potential Real GDP vs. Real GDP

I was listening to Tom Keene Friday morning on Bloomberg Surveillance (a great show to listen to, by the way) and Tony Cresczenci was discussing the “output gap” or as I always thought of it, the difference between potential and actual real GDP.  So I made this chart to illustrate how I view it:

The blue line is forecasted potential real GDP while the red line is the actual real GDP.  The black circle represents the output gap and you can see it’s significant.  In fact, you can’t find a much bigger one (at least when you see it visually) since, well, you know when.  So just from a visual standpoint that tells me something.

But what about the sideways purple parabola?  That represents a range of projected paths real GDP can take.  I don’t know what the true shape of that parabola is, it can look the one above or it can look the one below, or anything in between:

Now if we assume potential GDP in the blue line is accurate, or said differently, we have no reason to believe it is inaccurate, recovery is all about seeing the gap between the red and blue lines close.  Hence the v-shaped recovery paradigm.  But what about other scenarios?  Other outcomes?

To answer those questions I went back to some of the earliest posts I wrote and found a few I wrote on Thailand and Japan which took a look at how things have turned out in both of those countries, because they’re the closest experiences we can draw on to compare with our current situation.  So thinking about the purple parabolas, we have four basic scenarios: the red line flattens out, it rises parallel to potential real GDP, the aforementioned v-shape or it falls again (the double dip).  The last two are easy to see and recognize so I’m focusing on the other two.

If the red line flattens, congratulations: we’ve replicated Japan.

If the line continues on a parallel path, we would’ve replicated Thailand post-97:

But I can’t help but bring up unemployment, because discussions of Japan and Thailand that don’t factor in that dimension are incomplete.  Here are the charts I have on that:

On one hand, we see in Japan that fewer people are producing a constant level of output, while in Thailand, more people are producing output but the gaps between the path of GDP in the mid 90s and its current one are widening.

If either scenario happens here, neither one is going to be a positive development.

Paul McCulley does Modern Monetary Theory | Credit Writedowns – And My Thoughts

I’ve been trying to make sense of the macro landscape since, well, that’s just what I do.  One of the frameworks I’ve been trying to learn more about is Modern Monetary Theory, but I have to admit it has been a bit of a mind-bending experience and I’ve not always had the greatest success getting my head around it.

Having said that, when I read about Paul McCulley of PIMCO doing MMT, I wanted to see what I could find out.  So I wrote up a question for Edward Harrison at Credit Writedowns, who I have a great deal of respect for:

Interesting stuff. Edward, I have two questions for you:

1) I agree with you about this being a secular change in aggregate demand instead of a cyclical change. So in your mind, will the MMT approach work? Maybe you said it already, but perhaps you could re-state.

2) China taking on the consumer of last resort makes sense given their surpluses. Do you think the news regarding the Dagong’s rating of the US vis-a-vis China is about getting cheaper costs of funds to take this role on or is about capital inflows because credit and real estate are facing headwinds there now?

Thanks as always.

via Paul McCulley does Modern Monetary Theory | Credit Writedowns.

Here’s Edward’s response:

Yes, MMT works. But, remember MMT is just a framework -a lens – through which to view actual economic events. It is a very useful framework though because it forces one to look at all individual transactions or any aggregate shift as having two parties with balance sheet effects.

If I reduce my purchases from you that has implications not just for me but for you too. A lot of politicians try to talk about the budget deficit in a unitary way without working through the numbers.

This still doesn’t get away from the longer term problems regarding the (mis)allocation of real resources (monetary and physical). But it doesn’t allow people to cheat intellectually and act like austerity will be positive for the economy.

I was actually in bed when I saw this via my friend Scott and got up just to write a quick blurb on it. So I am headed back there now! More in the morning.

Looking forward to what he has to say on this…

A Trillion Here, A Trillion There, Pretty Soon You’re Talking About Real Money

What a way to start out the week:

The European Central Bank, the Bank of England and the International Monetary Fund have all recently warned of a looming crunch, especially in Europe, where banks have enough trouble raising money as it is.

Their concern is that banks hungry for refinancing will compete with governments — which also must roll over huge sums — for the bond market’s favor. As a result, credit for business and consumers could become more costly and scarce, with unpleasant consequences for economic growth.

via Crisis Awaits World’s Banks as Trillions Come Due – NYTimes.com.

Wow.  I didn’t know I could get a S**t Sandwich special first thing on a Monday…

And in case that wasn’t enough, they threw in a menacing chart for emphasis:

And just in case you still didn’t get the message, there’s this quote from the article:

“There is a cliff we are racing toward — it’s huge,” said Richard Barwell, an economist at Royal Bank of Scotland and formerly a senior economist at the Bank of England, Britain’s central bank. “No one seems to be talking about it that much.” But, he added, “it’s of first-order importance for lending and output.”

And so this is where I roll out one of those Minsky charts that illustrates this.  Oh, wait:

But why all the fuss over banks being able to roll the debt over?  Forget the amount for a second.  The key is to look at the average maturity:

A study in November by Moody’s Investors Service found that new bond issues by banks during the past five years matured in an average of 4.7 years — the shortest average in 30 years.

Now why does that matter?  It matters because there’s this issue called a maturity mismatch, where the assets and liabilities have different maturities.  Usually the assets are longer dated than the liabilities because when a yield curve is upward-sloping like this (from the FT)…

The incentive is to borrow short-dated funds and lend on long-dated assets.  I’ve covered this in similar ways before talking about duration hedging in the past where you measure sensitivities to interest rate moves, and this follows in a related vein.  When the yield curve inverts, or you have rate shocks at the front-end of the curve, you can find yourself in a precarious position if you have a lot of paper to roll.  Which is exactly where a lot of banks are finding themselves now.

But take a look at this section from the article (emphasis mine):

The financing crunch has its origins in a worldwide trend for banks to borrow money for shorter periods.

The practice of short-term borrowing and long-term lending contributed to the near-collapse of the world financial system in late 2008 when short-term financing dried up. Banks suddenly found themselves starved for cash, and some would have collapsed without central bank support.

Government bank guarantees extended in response to the crisis also inadvertently encouraged short-term lending. The guarantees were typically only for several years, and banks issued bonds to match.

So the maturity mismatch issue played a huge role in getting us into this mess, and the government’s response may very well end up in exacerbating the problem.

Brilliant… I might as well go build a house and then torch it myself…

And Tim Backshall has a very interesting chart that shows the spreads between senior bank debt and sovereign are highly correlated and compressing.  That means the lines between sovereign and bank debt in Europe are getting blurrier:

View this document on Scribd

One other facet about this problem: the link between external bank funding and Euro Libor:

Bond issuance by financial institutions in Europe plunged to $10.7 billion in May, compared with $106 billion in January and $95 billion in May 2009, according to Dealogic, a data provider. New issues have recovered somewhat since, to $42 billion in June and $19 billion so far in July.

My take: proof positive that the funding crisis for European banks is ongoing and getting worse.  How so?  Simple.  Longer dated bond issuance has fallen, which has led to a change in the maturity profiles of European bank liabilities.

Because the banks are rolling into shorter-dated Libor based funding…

Which has lead to the run-up in the Euro…

One way to mitigate this risk is matched maturity funds transfer pricing – where the asset side of the balance sheet has the same maturity profile your liabilities has.  I’m going to leave you with this paper which I also posted on Scribd:

View this document on Scribd

And a link to this post by Don van Deventer at Kamakura, that has some really good ideas on how to implement funds transfer pricing effectively.

While Euro Libor Gently Weeps

In my mind there’s not much else to say about Libor in the Eurozone.  The charts do all the talking for me:

The curve is shifting out at a rapid pace, in a bear steepening fashion.  Looks like liquidity situation in Europe is getting worse, which keeps the Libor rates moving upward rapidly. And the Euro has followed suit:

This brings up an interesting point about the risk-on/risk-off trade: it depends on who you’re talking about.  For most people in the world, the risk-on trade is to hold anything except dollars.  Risk-off is to convert those holdings into dollars. For European banks, however, they have to convert everything back into Euros.  So with the removal of Euro-denominated liquidity facilities, “risk-off” takes on a different meaning.

Regardless, the funding squeeze continues…

I’ve Got Some Theories About The Real Estate Tax Credit

I read this post from Jacob Roche about what has happened in housing since the tax credit expiry.  There are a couple of surprising aspects to what we’re seeing so far.  First, a look at prices (emphasis, mine)

What I found was that on both a raw and population-weighted basis, prices increased after the tax credit expired, by about 5% in both measures. Most interestingly, on a dollar basis, prices increased by a raw $9,766.77 and a population-weighted $5,280.89 — very close to the $8,000 credit. This is extremely counter intuitive. If the tax credit expiration effectively raises all home prices by $8,000, why would sellers raise their prices roughly another $8,000, and why would buyers agree to it? In some areas, like New York, DC, and San Francisco, prices increased by the tens of thousands. Also interesting is that some of the biggest price declines occurred in Texas, although removing Texas from the population-weighted data changes the average by only a small amount — the biggest percentage decliner in the list is in Texas, but it’s also the smallest city in the list.

via Real estate prices, post tax credit.

The post goes on to look at the sale data (again, emphasis is mine):

Number of sales gives the data another dimension however. Roughly three-fifths of the cities in the list saw fewer sales post tax credit, and the declines in sales were generally much steeper than any of the increases. It’s regrettable Trulia doesn’t give the exact numbers, making it difficult to estimate how much money is flowing in or out of the market, but one could at least make a rough guess that the price increases are being offset by fewer sales. Interestingly, a couple of the cities with declining prices saw increased sales.

Now I have some theories about this behavior, purely using intuition and my own read of buyer and seller psychology.  On prices, I think the sales price increase is a sign sellers know the market is not as liquid now as it was with the tax credit.  So as a result they’re looking to maximize the price paid.  I would’ve thought prices would’ve been higher under the tax credit because both buyers and sellers would treat the credit as “found money.”  What I mean by that is if you find money that you had no expectation of getting, you’re more likely to splurge – to spend on things you may not have thought of getting before, but since you have the cash you decide to get it anyway.  Apparently it didn’t quite work out that way.

As for sales volumes, that’s not a surprise.  We figured sales would be lower as the market becomes less liquid.  And Jacob’s point about money flow is a good one.  Because ultimately that’s what it’s all about.  So when pundits talk about Case-Shiller price increases, my first question is how many sales-pairs made up the estimation?  Fewer transactions at higher prices can still result in negative money flow.

Overall, I think the tax credit did more harm than good.  Prices offered and prices bid are moving further away from each other, thereby resulting in fewer housing transactions which are actually done.  The market is becoming more illiquid and the process will take that much longer to heal itself and for transactions to clear in a meaningful way.  Plus, how much money was spent on this and did it get us the outcome we wanted?

Don’t think so…

On Inflation and Bonds… in < 140 Characters

Today I saw an interesting tweet from Jennifer Ablan:

And based on a daily move like this…

you get the impression there’s a divergence.  Stocks have a gangbuster move to the upside while bond yields have been moving lower.  Is Goldilocks appearing again?  Hardly.

But I had a response for her:

Yes, I cited Japan as the example.  But I don’t think they’re going to be alone.  Indeed, there are a couple of ways to look at inflation.  One is just prices paid and you can use the Consumer Price Index or the Personal Consumption Expenditure index.  Well, by either measure, they’re headed lower:

PCE hasn’t fallen the way CPI has but they are both still going lower.  Why?  Because as Steve Keen demonstrated with his Minsky-based approach, aggregate demand is falling because private debt is collapsing and unemployment is rising:

And the 2/10 spread has responded in kind:

One point I’d make is that when you step back and see what’s going on in bonds, unemployment, inflation and debt is there could be a new feedback loop between these things that has taken root.  I don’t know the mechanics of it, but I’d say there’s a link between these phenomena going on.

And it isn’t pretty.  Just ask the Japanese how well things turned out for them the last 20 years…

Eurozone Banks Are in the Vise

Looking at the Libor rates day after day – and watching them rise without mercy – is starting to get well, painful.  This is a weekly view of euro Libor:

This is a classic bear steepening in the curve: short-dated rates have risen, but the long-dated rates have risen faster.  And it’s shifting out the whole curve by basis points at a time.  In fact, 3mth and 1yr euro Libor rates have been rising on the order of a basis point per day.  But you have to remember Libor rate calculations trim the data: the 4 highest and 4 lowest are thrown out, leaving the middle 8 to determine rates.  So you know there are 4 other banks that are doing much worse than the middle 8.  And since the panel is made up of sizable banks,

Meanwhile, EURUSD has also been on a tear:

I’m going to take a look at correlations between euro Libor and the euro later, because I think there’s something to that story.  In the meantime, we should probably just note that the currency is strengthening as the bear steepener in rates continues.

A strengthening currency and inter-bank interest rates that are rising by a basis point per day?  Sounds like a real-life stress test to me.  So forget about the stress tests the Europeans did.  And if they think the European banks will have the same rebound that the US banks had, maybe they’d better think twice:

“The question is whether governments can shoulder their sovereign debt if they had to bail out half their financial system on top of it,” said Lothar Mentel, chief investment officer at Octopus Investments Ltd. in London “That is the real worry.”

via European Banks’ Hidden Losses Threaten EU Stress Test – BusinessWeek.

Indeed.  A number of those countries are in worse fiscal shape than we are, with economies that are less dynamic and have poorer growth prospects.  I don’t see how their policies are supposed to inspire confidence.

I think it’s just a matter of time before we see “Bank Fail Friday – Euro edition” unless we get something more than just a bunch of concocted stress tests (again from the Bloomberg Businessweek article):

“You can’t just have stress tests, you’d better prescribe some medicine as well, which is going be more capital-raising,” said Hank Calenti, a credit analyst at Royal Bank of Canada in London. “If some institutions need access to government recapitalization or other improvements, the market needs to know how that’s going to happen.”

Meanwhile, the cost of capital is going up…