My Diary 385 --- The Decoupling of Central Banks; Who is the Nex

My Diary 385--- The Decoupling of Central Banks; Who is the Next; We Are in Bear Market; The Lost of Confidence

March 7, 2008

The day before US payrolls is very ugly across various markets…… As I wrote in my previous diaries, all the uncertainty surrounding the credit crunch will coming back again to US and we are in front of another wave of credit-led-cycling……Overnight news flows were also bad, including 1) Fortis’ 4Q07 profit fell 45% due to EUR1.5bn ($2.31bn) in write-downs; 2) Fed’s Yellen said US economy faces an unpleasant combination of high inflation & weak job risks from burst of housing bubble; 3) The new reading of RBC Cash Index pointed out US Consumer confidence sank to 33.1 in early March (48.5 in Feb), the worst since the index began in 2002.

Today, Asian stocks markets set for their biggest weekly drop since Aug2007, with MSCI AP slumped 2.8%. The benchmark has lost 5.2% in the past 5 days and declined 11% ytd.  Elsewhere, Nikkei retreated 3.3% and Hang seng closed 3.6% lower. In the rate markets, swap spreads continued to blow out, with 5yr standing at all-time high of 112.5bp. UST 2yr yield dropped substantially 21bp to 1.412 and 10yr down 18bp to 3.485. US Dollar continued its free-fall today, trading @ 1.5418EUR and 101.88YEN now. Oil followed suit, rising to a new high of $105.24/bbl.

Well, life is real but we need a valid logic to go through tough time…and here come the Fed’s Rosengren and his comments on the recent market chain-events: Ratings uncertainties reducing liquidity and a cause for bank write-offs è housing price declines increase risks to economy è lower Fed rates hopefully turn economy…… but will that work in a high inflation environment?

The Decoupling of Central Banks

The acceleration in food and energy prices not only has pushed global inflation to a new cyclical high of 3.9% yoy in January, but also prompted widespread comparisons to the 1970s, when global commodity prices and consumer price inflation were in flying. However, as times go, things get changed. Thus, there are some similarities, but also differences.

Apparently, the sustained, broad-based surge in commodity prices is the first common point. Back to early 1970s, a series of bad harvests spurred the skyrocketing of food prices, while the booming economy produced a run-up in base metal prices, too. In 4Q73, OPEC quadrupled global oil price which triggered recession in 1974-75. At the same time, headline inflation continued moving up, jumping almost 5% from the previous years. That is what so-called 1970s “stagflation”. Today, although the rise in commodity prices is more demand driven, a combination of sluggish global growth due to the worst (maybe) housing slumps in US history and a tightening of credit conditions across major DMs, plus a rising inflation, is reminding the times of 1970s…

However, it is also important to mark down two crucial differences –1) in early 1970s, the wage/price spiral has firmly entrenched before commodity prices’ surge, while nowadays, even the unemployment rate has fallen to a multi-decade low in DMs, it has not translated into a surge in compensation anywhere near the level in 1973. Moreover, while productivity growth has slowed, unit labor costs have only moved up 1.7% yoy since 2006. 2) In addition, the policy front has changed dramatically as inflation targeting is the norm today, whereas it was unheard of in those days where central bank independence was rare.

Having said so, in a world dominated by inflation targeting, the breadth of "Decoupling" in the central banks remains strikingly wide. It was only the US Fed (plus BoC lately) that out the easing policy on their agenda, while other central bankers remain very reluctant to ease as the drags on growth are less intense outside US. Thus, as President Trichet said that the ECB has only one needle in its compass…… Indeed, the ECB staff raised its inflation forecast of 2008 and 2009, both above the ECB’s 2% ceiling…

Who is the Next?

The renewed financial turmoil is moving to a new dimension --- banks are calling back their lending to hedge funds (+$1.9tn AUM). This is now producing a negative cycle of risk reduction and asset dumpings, which has policy makers deeply worried. The whole credit mechanism working here is broken down as credit spreads blew out to new wides after CMBX and subprime ABX markets sank to new lows. The AAA CMBX has widened 36bp to 270bp, the AJ (junior AAA) index 98bp to 602bp, and the AA index 74bp to 845 bp.  The subprime ABX AAA index plunged another 3.31ppts to yet another all-time low of 53.88.

As the value of mortgage-backed bonds and other investments dropped in recent weeks, the lenders are demanding that borrowers put up more cash or assets to meet margin calls. Hedge funds now find they must unload even assets perceived as high-quality, such as bonds backed by the GSEs. So far, the margin calls has put Carlyle ($21.7bn on GSEs securities) and Thornburg ($4bn Alt-A mortgage) on the table of fire-selling. If such situation does not change, banks and other financial firms could end up holding even more hard-to-sell securities….. and the whole picture will go like this --- the more the market widens, the more likely it is that another leveraged player has to sell ---so it does feed on itself……Thus, the single biggest question right now is --- Who is the next to blow up, and how big are they? A candidate list will be hedge funds facing the greatest pressure, in particular those highly leveraged one, like Carlyle which manages only $670mn real money, but used borrowing to boost its portfolio size to $21.7bn, meaning +32 X leverage…in fact, market talks already see banks may have to take billions of dollars in further write-downs……stay tone…

We Are in Bear Market

My old colleague today said that by watching the HSI’s trading range, we are definitely in a bear market, as so far each low is lower than previous low……so we are not only in a yo-yo market but also a lo-lo one…… Indeed, today Hong Kong's stocks fell heavily, dragging the benchmark index to its biggest weekly drop in more than 6 years, on concern record crude oil prices will erode earnings and credit losses will deepen. The Index now is sitting below 350 MAVG with shrinking volume.

Negative fundamentals also fit in here as we are seeing earnings revisions to the downside, especially in China (1M3M -0.66) and HK (1M3M -0.46). Regionally AP earnings revision ratio in February experienced the largest 1-month fall in the 18-year history with the Ratio falling from 1.02 to 0.57. Flow side, China has accounted for over half of GEM redemptions at $800mn in the week to 05Mar. As a result, my market view is not particularly constructive. As I explained over the past few diaries, the short-term outlook remains nervous and a further leg down is quite likely. In this environment, I would look for companies with good track-record of earnings growth and high good dividend yields, like Esprit 330HK and China Mobile 941HK.

The Lost of Confidence

Overnight, USD Dollar fell to a record low against EUR on speculation the US jobless rate rose to a 2-YR high and traders bet a 98% chance the Fed will lower its target rate 75bp to 2.25%on March 18. The fourth weekly decline in US Dollar also is a response to St. Louis  Fed President, William Poole’s speech by saying the pain of mortgage-market losses is “not over yet'' and he doesn't expect a recession, but such a scenario is “possible.''

That kind of talks has led me to a further thought of the "confidence" toward the US Dollar.  Certainly, it's true that even the Dollar is falling along with US yields; the rise in fixed income prices implies that there is still ample demand for USD-denominated papers.  However, if the USD falls while the prices of USTs fall, that could be an indication that global investor confidence in USD-denominated securities is waning. Thus, the global demand for US securities is one of the key barometers to watch for the confidence of US Dollar…… Remember 1994 and early 1995, it was repeated US government’s intervention of FX market that eventually led to the creation of the "Strong Dollar Policy"…… And I wish such policy is “not over yet'' and even it is going against that policy stance, it should come slowly.

Good night, my dear friends!