Liquidity is dead...long live liquidity

As the unwinding of leverage across asset classes continues and the volatility term structure is "re-priced", it is worth noting that in environments when the volatility of volatility is high, the term structure if interest rates and expected returns is profoundly skewed to short-term securities. This rational tendency of participants has its own term strucure (i.e. when is panic abated?).

One in the hand...

After a spectacularly wrong forecast for the dollar, my only solace at the moment is a fairly good "forecast" (or "educated guess") for volatility in July. It appears that the carry trade and some of the larger players who are currently mired in credit concerns and have limited access to additional margin will not be able to prop up the market...which finally looks like accepting the obvious.

The financial economy always and everywhere follows the real economy. Real estate is certainly part of the real economy and the current malaise flowing through that system is not going away.

Bernanke is probably prepping the Ben-Copter as we speak.

Gentlemen, take your positions...

This article describing the end of the star-crossed relationship between Bear Stearns and Barclays as a result of the recent Hedge Fund collapse is interesting. The "adjudicator" of public opinion is used more often (and I must quantify this) it seems in large securities cases. That this tactic would be used is somewhat obvious - reputational risk is a large component of any investment bank's cache and ability to attract and retain clients.

As I said before, this is the beginning of the story with regards to Bear's legal liability, and if the "people familiar with the situation" have it correct, that Bear did indeed step outside of accepted parameters and did not disclose this to its investors, then one can easily recommend that Bear write this entire episode off and settle very, very quickly.

http://tinyurl.com/2kyxx3

Increasing global violence...

...admittedly based on anecdote and vividness of recall. A chinese food safety minister is executed for taking bribes. The Red Mosque is taken down the Pakistani government. However, this is something entirely different, and far more dangerous. More assassination attempts in foreign jurisdictions by mother Russia.

Security services 'foil plot to kill Berezovsky at the London Hilton'
Richard Beeston, Diplomatic Editor
Boris Berezovsky fled Britain three weeks ago on the advice of
Scotland Yard, amid reports that he was the target of an assassination
attempt by a suspected Russian hitman.

The exiled tycoon and fierce critic of President Putin of Russia told
The Times last night that he had been warned that it was not safe for
him to remain in London, where he had been living since being granted
asylum in Britain.

"I was informed by Scotland Yard that my life was in danger and they
recommended that I leave the country," he said. "I left three weeks
ago but have now returned."

Glorious theorizing...

Brad DeLong, an wonderfully well-qualified economist waxes on in an ex-post narrative of how modern China got the way it did...largely through the efforts of one benevolent dictator. This is a great article for showcasing confirmation bias and the tendency for brilliant people with PhDs to make grand "hand-waiving" arguments when the real causes are much more likely to be parochial and formed by spontaneous order.

http://delong.typepad.com/sdj/2007/07/delong-smackdow.html

Worst than anticipated...

Bear Sterns making the news in the wrong way: both the highly leverage CDO funds were virtually wiped out. Not too many people anticipated this and it likely holds legal ramification for Bear as the funds must have been highly leveraged in the more "speculative" tranches that fell double-digits.

By Yalman Onaran
July 17 (Bloomberg) -- Bear Stearns Cos. told investors that
assets of two hedge funds that almost collapsed last month are
virtually worthless, the Wall Street Journal reported.
The assets of the High-Grade Structured Credit Strategies
Enhanced Leverage Fund are worth almost nothing, the Journal said
on its Web site, citing people familiar with the matter.
Assets in a second fund, the High-Grade Structured Credit
Strategies Fund, are worth about 9 percent of the value since the
end of April, the Journal said.
Bear Stearns was forced to provide $1.6 billion in emergency
financing to one of the funds last month after it made wrong-way
bets on collateralized debt obligations tied to subprime
mortgages.

Announcements...

...regarding the demise of the dollar have been greatly exaggerated. The following from Bloomberg describing the heavy foreign demand for U.S. securities. The last bit regarding the oil exporting conglomerate is especially enlightening.

China, the second-largest holder of U.S. Treasuries, reduced
its holdings by $6.6 billion, bringing its total to $407.4
billion. Over the two months of April and May, China's
investments in Treasuries have slumped by $12.4 billion, the most
in at least seven years. China is diversifying its foreign-
exchange reserves, the world's largest, to seek higher returns.
Japanese and U.K. investors increased their holdings of U.S.
government debt in May, while Caribbean countries' holdings
declined, the Treasury said.
Japan, the largest foreign owner of U.S. Treasury
securities, increased its holdings by $400 million to $615.2
billion.
The U.K., which, through London, acts as a transit point for
international investors, especially those in the Middle East,
added a net $33.1 billion, bringing holdings to $167.6 billion.
Caribbean banking centers, which analysts link to hedge
funds, sold a net $28.5 billion, bringing holdings to $48
billion.
Major oil exporters -- a group that includes the members of
the Organization of Petroleum Exporting Countries, Ecuador,
Bahrain, Oman and Gabon -- bought a net $9.1 billion of U.S.
securities.

Stupid analogy of the week

Ah yes, its time to go back to the Associated Press, which seems churn out consistently bad analogies and anthropomorphism involving the markets and biological organisms. I am, of course, sometimes guilty of the same trasgression, but I would like to think I don't submit gems like the following:

"Blue chips stocks jumped Monday as news of a potential big telecom deal involving Verizon gave a boost to the Dow and put the index closer to 14,000. Overall, stocks traded largely flat as investors digested the market's huge gains of last week."

Exactly...the market and its constituent investors are "digesting" the "huge" gains of last week. And so I ask, are they also metabolizing and secreting the same gains?

Yuan (the paper of the Paper Dragon)

In response to a friend asking about the implication of Yuan appreciation:

While standard Keynesian macro-economic analysis adequately address the various "hand waiving" or "this happens then that happens in perfect textbook lockstep like fashion", one must keep in mind the probabilities involved here. What is more likely (or more easy politically), the Chinese government (still communist) allowing state-owned businesses to fail, or continuing to prop them up for a time? For example, China injected about 50 billion into a certain domestic bank prior to its IPO simply to clean up its liabilities and zombie loans...I very much doubt they will stray from those habits should the Yuan start hurting large exporters.

We can take a lesson from the Japanese MOF on this one. Its a very similar policy model in the sense that "all" of the MOF members went to the same university and think the same way: Weak yen = good until we can actually generate domestic aggregate demand (although I really am reluctant to use Keynesian concepts in todays world of fiat currency)

Lastly, let us quantify who owns what. Notice the foreign ownership of U.S. debt securities purchased by China on a monthly basis...some simple relationships reveal themselves while comparing net purchases, the U.S. dollar, the S&P and, of course, bond yields.

http://www.treas.gov/tic/s1_41408.txt

"Slightly" off topic to investments...

...readers here will recall that I am highly interested in science, and more specifically with feedback systems. I wrote the below recently to some friends explaining one of my favorite examples of feedback phenomenae.

We all know the importance of time intervals and sample periods when
looking at the markets, and it is somewhat unfortunate we lack
millions of years of data to strengthen our inferences or provide
additional hypothesis generation.

The market is rife with feedback mechanisms, both on granular (individual stocks)
and global (indexes) scales.

Fortunately, the planet earth has a wonderful temperature regulation
feedback system that serves to illuminate why global warming is a
problem of scale – humans will have to actively engineer, on a massive
scale (like blowing up the Rocky Mountains) carbon introduction into
the atmosphere in the future if we wish to live here.

The system can be characterized thusly: Plate tectonics produces
carbon dioxide through volcanic emission, carbon dioxide warms the
planet. Warming increasing weathering (surface water is a function of
temperature, as temperature rises, water evaporates leading to clouds
and subsequent erosion). Carbon dioxide then attaches chemically to
silicate rocks experiencing weathering. This process removes the C02
from the atmosphere and cools the planet. Carbon Dioxide is
introduced again by volcanic emission (and water is needed here as
well for subduction), and on and on.

This process that has kept the Planet at a relatively constant
temperature (never below freezing and never above boiling) for around
4.5 Billion years. Planets need land, water, and plate tectonics to
achieve this system that is very good for carrying life. An oceanic
planet would not be a very nice place to live, and likely would not
remain that way for long as the lack of temperature regulation would
likely boil the planet. (in the spirit of good taste, I will withhold
jokes regarding a certain movie starring Kevin Costner, as said movie
has already experiences too much suffering)

This feedback loop is interesting to me because of its massive time
scale. In the long run (geologic scale), we should be more worried
about making more CO2. But on relatively short scales (hundreds of
years), we may have a problem with increased temperatures due to our
own actions.

Looking at the markets, it is very clear what the "geologic" drift is,
caused by an extremely complex feedback system of its own…but when you
zoom in closer, it becomes apparent that too much on one side of the
differential equation can kill 90% of "oxygen-dependent species".
Life does go on, but it takes a different scale of time for that to
happen.

Oil

I must profess a high degree of ignorance regarding the extremely nebulous world of oil. As if the movie "Syriana" was not warning enough to amateurs such as yours truly.

Still, when probed by colleagues, I hazard the following observation regarding the price of oil in the coming year:

Saudis are setting price (and letting quantity float) now, in effect "cross-subsidizing" (read: bribing) Iran. This is analogous to Chamberlain's rationale in '39.

I can see oil at 22 occurring in two legs. If the supply of oil (and others on this list know these dynamics better than I do) increases enough to compel the Saudis to drop the price target and grab Spot bids. Chavez, Putin, and the Nordics then cut production for a further fall.

Of course, other things can compel the Saudis to drop their target as well...least of all the removal of all threats to the Saudis in the area...

EuroYen

...Reaches new highs just as the following happens. This is why consulting an economics textbook can only give the observer a very partial view of the entire global macroeconomic picture. Deflation is "supposed" to cause Yen appreciation. Euro players are backing up the metaphorical truck to the carry trade.

The Japanese monetary base in June fell 4.1% from a year
earlier to Y87.63 trillion, down for the 16th straight month,
preliminary data from the Bank of Japan showed. It followed a 5.7% drop
in May. Month-on-month, the monetary base decreased a seasonally
adjusted 0.5% at an annualized rate in June after a 25.6% drop in May.

And the Nikkei obligingly rises.