My Diary 322 ---I Save the Market, Wait For a Relief, This Is Vo

 

My Diary 322 --- I Save the Market, Wait For a Relief, This Is Volatility, You can't hedge Liquidity!

September 4, 2007

A quiet start today across every market after Labor Day …… I have a lot of thoughts hanging over in my mind. One of the ”can’t -wait” answers  is that with the US and Canada back in today, market will tell if last Friday's stock market gains on the back of the Two Bs assault was a one off or whether we see another round of risk reduction……So keep your eyes open tonight.

ISM = I Save the Market?

With US ISM comes in later, I think this is the first indicator of how businesses have been affected by the credit issues prevailing in recent weeks. A print below 50 could mean another round of dollar sell-off and worse case is another bout of risk aversion cannot be ruled out. The rational behind my argument is that if business spending tanks, US will highly likely be heading for a recession.  Hey, I am not trying to punch the market as I know how big my fist is…

I actually have other negative news today regarding the boarder US economy. Early the morning; Merrill’s analysts said the probability for a US recession is now more than 60% and later they cut their earnings estimates for a dozen U.S. banks, including BOA, Wachovia and Wells Fargo, on concern about the economic outlook.

To be honest, It is not surprised to have Merrill’ warning because as the pain of higher borrowing costs could spread wider as consumers and businesses follow investors in shying away from risk, increasing the odds of a recession. This grey chart is not too hard to imagine if you put together the softness in the housing sector, contractions in credit, increased uncertainty and volatility, and losses in household wealth. I am not joking here as the first-time applications for jobless benefits have risen for five straight weeks, the longest streak since May last year. This implies that the pressure on consumers may increase if jobs become harder to get.

Now I believe you have all the reasons as I have to wish for a good ISM data (“I Save Market”) and please do forget the July’s above-expectation retail sales, durable-goods orders and new-home sales number. Those figures only showed the US was strong before credit markets got caught-up in August.

To Wait For a Relief!

We had a relief in the market over the past few days, but I wish you have not felt bored to hear several “grandfather-like” words --- We definitely are not out of the woods yet.  OK…let us firstly look at what could bring us a real relief (Definitely no Thai Massage here :-) ……There are couple things I can think about.

1) Robust economic data shows that the tightening credit conditions has no dramatic impact on US consumption and corporate spending  --- “Low probability” and we more like to see a soft landing and risks are skewed to the downside; 

2) The world’s largest central banks will continue to support the markets --- “ Almost for sure” and the central banks will do whatever they can to support the market;

3) A slowdown of negative news flow regarding the sub-prime related losses --- “Big doubt” as the crisis have moved from the US subprime, to the broader US mortgage and global credit markets. No doubt, there will have more bad news ahead of us.

Now, This Is Volatility!

More bad news will cause more volatility and I clearly remember my current boss said in mid-August – “Now, This is Volatility!” According to Bloomberg, Volatility rose last month to the highest since May 2004, measured by Merrill Lynch's MOVE Index, an options-based gauge of expectations for price swings in Treasuries, touched a three-year high of 118.5.

The global flight to the safety of government debt has caused the widest price swings in Treasuries in 3 years. Such a price swings showed up most in the Treasury bills market, the safest securities with the shortest maturities. There were 15 days last month when yields on three-month bills swung by 10 or more basis points, according to Bloomberg. The difference between bid& ask was widened to 20 bp last month from the typical 1 bp. That means commissions on a $1 million order swelled to $185, from about $20. Sounds a good news to brokers, definitely… that is why brokerage stocks keep rising in HK!

The real case is not for more commissions. In fact, the price swing triggered many so-called black-box traders to drop orders as much as 80%. As a result, securities firms have to increase commissions as much as 9X to avoid losses should offers to buy or sell bonds suddenly disappear. Now this sounds not funny anymore…. And I heard my US colleague say that “this phenomena typically happened in a financial crisis environment.''

You can't hedge Liquidity!

I hate repeating words, but I have to because liquidity is still an issue. In Hong Kong market today, 1-3M HIBOR keeps on going higher, 3M HIBOR was 33bp higher than last week. The reason behind was still the poor liquidity in the USD and HKD cash market, the 3M LIBOR rate is around 10bp higher than yesterday and that’s why it led the HIBOR funding to higher level.

Therefore, it is too early to conclude whether we have seen the worst of market volatility in this crisis. I believe that we will be reminded of the concept of liquidity once again. In fact, the definition of liquidity has undergone a sea change in recent years, from cash and cash equivalents to any borrowing power (leverage). We all know now that credit securitization/structuring was used to turn illiquid financial instruments into newly tradable and liquid ones, and had convinced too many investors and lenders jump into this game.

But leverage and liquidity require two participants -- A borrower needs a lender, and a buyer needs a seller. Otherwise each is just a piece of fire wood in the forest. As pointed out by Bill Gross recently, "nothing within the current marketplace allows for the hedging of liquidity risk and that is the problem at the moment." This point is so obvious that it can be overlooked. Rocket scientists and financial engineers have spent so much of their intellectual and financial resources trying to figure out how to hedge every kind of risk it can imagine. But the one kind of risk that repeatedly brings down markets is liquidity risk.

I have to use my close friend’s, Mr. Xiong Peng, comments – the market is a game of human nature. Yes, one can't hedge human nature and maybe the only possible hedge against liquidity risk is cutting-off human being's greedy.

Good night, my dear friends