FED regulators in hot seat

The timing of JPMorgan's $2 billion-plus trading loss made public last week by Jamie Dimon over an emergency call with analysts was an awkward timing for the Fed. It raised serious questions about whether the New York Federal Reserve and other regulators were asleep at the wheel or whether it is asking too much of them to keep up with the financial engineering conducted by complex institutions with diverse, global operations. Despite the Fed ramping up the number of staff embedded at JPMorgan Chase & Co since the financial crisis, it is unclear whether any of these regulators detected something high-risk and untoward going on in JPMorgan's Chief Investment Office in New York or in London. This will raise issues again on the appropriateness of using Value at Risk (VaR) models by banks given its inherent limitations as a way of measuring risk. VaR represents the potential losses in a trading portfolio over a given period of time at a given level of market confidence. That covers almost all eventualities. The trouble is that problems almost always arise in the ones that are not covered… Eric Tan, London

UK banks : international in life but national in death?

The discussions in Brussels by European Union finance ministers this week follow an agreement among major economies, known as Basel III, to raise the requirement for the minimum amount of highest-quality capital held by banks so they can absorb sudden losses, like those associated with the collapse of Lehman Brothers in September 2008. Britain is amongst the countries likely to press for the right to require its banks to hold more capital than the E.U. minimum to try to reduce the risk that its taxpayers will be called on to finance future bailouts. But other countries argue that allowing governments the latitude to raise capital requirements could undermine parts of the European banking sector and might push banks to tighten their belts when they are already wary of lending because of the shaky economy. That, in turn, could further dent sluggish growth prospects in Europe. Given Spanish banking sector’s heavy exposure to real estate and risks further state bailout or nationalisation, and concern that capital for shoring up bank reserves across Europe is limited, the EU has to decide if to agree on the single rule or not... Eric Tan, London

US Housing Market - Are the early signs of recovery emerging?

Early indicators are hinting that the battered US housing market is showing signs of recovery. The NAHB index continues to rise and is close to a 5-year high.

We feel that the US housing market cheap on the below measures:
1) low house price-to-wage ratio,
2) low house price-to-rent ratios,
3) attractive rental yield versus mortgage rate and
4) low house prices versus their 100-year trend
5) further central bank policy on QE and Fed buying of mortgage backed securities

Further evidenced last week is the sharp jump in US 10 year bond yields by 33 basis points to 2.30% which signals that investors are now less fearful and is prepared to take on risk and switch from lower risk assets to higher risk. This is a positive signal for home owners.

This week's the latest report on US housing starts and sales figures for new and existing homes may just provide the confirmation to the recent trends.

Eric Tan,
London

So, what next?

This week, Bank of England has decided that the economy needs another round of QE and agreed to inject a further £50bn of monetary easing via Gilts purchasing.

On surface, it looks logical that more money in the financial systems, leads to more money in circulation but economists have argued about the effectiveness of the QE1 and QE2 since central banks in developed economies went full throttle into it 3 years ago as a means to fix the financial systems.

However, one thing for sure, by driving up the price of gilts, the Treasury is depressing the yield of these bonds and the income received by pension funds and annuity payouts. Pension funds and insurance companies who are already heavily under-weight equities, will have more reason to buy into the current equity rally when they next meet in their monthly asset allocation committees in February.

Note these committees didn't meet in Dec and when back in Jan, the market was already 7-10% ahead, so a pull-back in the equity markets would probably see the long funds and insurers scrambling back in...

Eric Tan
London

Two-speed Europe

After this weekend's EU summit, we are further away from a EU single market than ever and Britain looks to be on its own. This brings back to mind how Henry VIII separated England from Rome in 1534.

Theological history aside, what Cameron has disagreed with the other EU states means that Britain will be outside a new intergovernmental treaty that has the backing of EU's other 26 states.

Below is a summary of the treaty details:
- The EU commits to a new “fiscal rule” that will be legally enforceable and will seek limits on structural deficits
- States running large deficits will face automatic consequences including sanctions
- The EFSF leveraging will be deployed more quickly, using the ECB as an agent in transactions
- EFSF financing will remain active until mid-2013
- The ESM will enter into force with a target date of July 2012
- The overall ceiling of the EFSF/ESM remains at €500bn, but will be reviewed in Mar 2012
- The EU will ensure that ESM paid in capital is at least 15% of ESM issuances
- Member States have 10 days to confirm provision of additional €200bn in bilateral loans to the IMF
- The EU “look forward” to parallel bilateral loan contributions from the “international community”

Looks like the Prime Minister will win some plaudits from his backbenchers tomorrow, but in the long term, Britain's influence in Europe has started diminishing...

Eric Tan,
London

23 October 2011

The Market is fixated with 23 October. People think that the European leaders are going to come up with a bazooka solution to the European crisis...
The Guardian this morning announced the prospects of a 2trillion euros EFSF bailout fund which no doubt will spur the market to continue it's wishful thinking, but why would investors want to plough their money in when European banks are trying to reduce their assets to raise capital. Think 1 trillion euros...or more... What they will end up selling will be the liquid assets and end up being stuck with a bigger proportion of the same assets that got them into trouble in the first place...

At what rate could you borrow? A question of LIBOR.

At the moment the spread between the high and the low fixing banks still stand at around 11bps. This shows how banks continue to just pay lip service to the definition if LIBOR. Result is that the rate remains lower than it ought to be expected if banks use this as a PR exercise to artificially manage expectations instead to reflecting their true cost of borrowing in this market condition. If you believe the numbers published, we should all go long the French banks...

Eric Tan,
London

Complacency?

This week, we received a stark reminder that regardless of how a) Europe-Sovereign agreements have been agreed, b) Corporate profits are beating expectations, c) US debt ceiling extension approved….

We cannot ignore the US economy. If US economy slumps, the world's economy slumps.
The US is by far the world's largest economy and it's most important.

This message have been hammered home with last Friday's GDP numbers and yesterday's ISM numbers.
Given trading desks are short-staffed due to summer holidays and trading volumes are thin, we should not forget that the last major corrections all happened in the summer of 2007, 2008, 2009 and 2010.

Now, that's for thoughts…

Eric Tan,
London

A dismal Non-Farm Payroll. Markets for the week ending 6-Aug-10

The Friday that the market has been waiting for has churned out dissappointing NFP numbers for July. Total non-farm payrolls fell 131,000 against expectations of a 65,000 decline. Private jobs rose less than expected and the acceleration in the improvement of the job markets turned to a pessimistic picture where a risk of the Fed moving to ease policies became closer to reality.

Markets are expecting a policy of further quantitative easing from the Fed via purchase of US Treasuries or mortgaged backed securities to be announced during next week's meeting. This led to a sharp weakening of the dollar against a basket of curencies. Dollar versus Yen declined to 85.03 which triggered market scares of a Japanese central bank tightening, however, against other currencies, the Yen has not strengthened significantly, hence I believe these scares are over-rated (besides in purchasing power terms,the Yen is not considered massively over valued - an entire topic to be discussed in coming weeks)

Financial sector weakened on Friday, but I believe this is the excuse the market has been looking for to catch a breather, and also the chance for funds who missed the last couple of weeks run to put some money into the market next week. Over the rest of August, the risk is to the upside as equities drift up, abeit on low volumes (an interesting article in the FT on Thursday 5-Aug was dedicated to how the move up in Jul and Aug was on low volumes i.e. based on the opinion of a small group of investors).

The next checkpoint will be the September PMIs, the indicator which could be the turning point for the markets as most of Europe return from it's holidays.

Eric Tan,
London

Sell in May and go away. Markets for the week ending 27-May-10.

Investors seemed to have heeded the old adage "Sell in May and go away".

US stocks on Dow Jones Industrial Average fell below 10,000 for the first time since Feb-2010 as sovereign debt woes continue to unsettle global stock markets compounded by last Friday's announcement by Fitch to downgrade Spain's sovereign debt rating by one notch to AA+ becuase of the country's sluggish outlook for economic growth.

May's slump in risk assets were also excerbated by geopolitical risks in the north Korean peninsula and China tightening of monetary policies.

This month, we have also seen the consensus over a Chinese reminbi revaluation crumble apart as analysts and traders changed their forecasts for a modest Chinese revaluation to none at all for the next 12 months. This is largely prompted by the sharp fall in the euro against the dollar driven by the euro crisis. In euro terms, the renminbi has risen 13% against the euro so far this year, threatening profit margins of many chinese companies who export to Europe.

So, any further speculation of revaluation on the renminbi is going to be closely tied to outlook of the European debt crisis and whether euro/dollar will plunge further.

Eric Tan,
London

The week European policy makers unveiled a $1 trillion loan package

Market took a beating on Friday with DJ Eurostoxx 50 down -4.7% and Spanish IBEX taking one of the largest Eurozone hit of -6.64%.

Fears that the eurozone economy is heading for a death spiral of falling prices and plunging output threw global markets into a tailspin. This was the unlikely story the same week Eurozone policy makers unveiled its $1 trillion loan package to help struggling countries with their debt. But the doubts about ECB's independance and strains amongst partners are becoming clear as the market digests news of the rescue package one and a half times the size of the US TARP.

Analysts have been working through the week to assess if Spain's problems could be too big to bailed out and market rumours that Spain could need a 280 billion euro loan raised alarm bells on Friday.

Essentially, what the European policy makers are trying to do is to treat a solvency problem as if it was a liquidity problem, however such an expansionary policy will simply just buy Eurozone more time but real improvements still needs to be made to reduce government deficits and promote growth in the "more-abled" Eurozone countries.

As the Euro trades for the fourth week lower against the USD, we are likely to continue to see downside pressure and test the key level of $1.165 before the year end.

Eric Tan,
London

Understanding the Japanese Debt-ridden Economy

- OECD estimates that Japan's debt to GDP ratio is expected to rise to twice it's economy this year, significantly higher than Greece's 123 percent
- The Finance ministry estimates that Japan's public debt is expected to swell to 973.2 trillion yen by next year
- On 26 Jan 2010, S&P lowered it's outlook on Japan's debt to negative from stable and issued a warning that it was concerned with the large deficit and sluggish growth outlook of the Japanese economy, which currently ranks 2nd in the world economies.

Qn: Is Tokyo's fiscal foundations really shakier than those of Athens?

Optimists have insisted that it is wrong to focus on Japan's gross debt, since in net terms, the state only owes the equivalent of slightly over 100 percent of its GDP. This is because Japan is the holder of more than 100 trillion yen in foreign exchange reserves and also holds a large portion of it's own debt.

So in net debt terms, it puts Japan's debt burden in the same category as Italy, but its ability to attract local buyers (domestic savings and institutional investors)for its debt have been the key to the low JGB yields. Investors this week have snapped up an offering of 10-year Japanese government bonds carrying a coupon yield of 1.4 per cent.

However, institutional purchases by Japan Post Bank and Japan Post Insurance peaked at 29 per cent of market share in 2008 and have since been declining as they suffer from a structural decline in deposits and seek to diverisfy from holding JGBs.

Currently, the main buyers of JGBs are private Japanese banks and insurance companies. Banks are buying to meet new liquidity rules, because they lack alternatives in deflationary Japan and as they have excess deposits due to a lack of demand for corporate loans. Meanwhile insurers are buying JGBs to better match liabilities that they will have to mark to market from 2013.

In recent months, the government's ability to raise revenues have been called into question. Nanto Kan, the finance minister, and his colleagues are trying to draw up plans for fiscal sustainability to be implemented once economic growth strengthens, but their ability to reassure markets in the meantime will only mean more volatilty for the Yen till then.

Eric Tan, London

Greek options. Markets for the week ending 7-Feb-10

As the markets brace itself an escalating EU crisis, I wonder what options are available realistically to Greece..

1) Go-it-alone fiscal adjustment
This is the most probable approach that the Greek government will take to convince the markets and other European nations that it will be able to handle it's own domestic affairs, at least for the time being. It's a polite way of handling its problems but the feasibility is low. This will take a lot of support from the nation as it prepares to slash government budgets and halt pay increases for the government sector.
FEASIBILITY RATING: LOW

2) EU Bail-out
The main issue of an EU-led bail-out is the moral hazard attached. A modern Trojan Horse tale of how the Greek army invaded the city of Troy (in this case Germany and France) and opened the gates for Spanish, Irish and Italian armies could be written in the books of modern finance history. However, if the EU can agree on how the bail-out can be structured it could be feasible. I'm in favour of loan guarantees or short-term bridging loans, with strict conditions attached of course.
FEASIBILITY RATING: MEDIUM

3) Default or Debt restructuring
This could give temporary relief to Greece as it writes down its debt but will have a large cascading effect on other eurozone economies. We have already witnessed how Portugese CDS spreads have widened since the Greek crisis began and a default would make it costly for it's neighbours to raise debt.
FEASIBILITY RATING: LOW

4) Go NUCLEAR!
A full blown default and devaluation in Argentinean-style is what the markets fear most. Greece will have to leave the EU and this will have significant domino effect on the world economy as the Euro collaspes. The Greek GDP may fall as much as 10% and having most of it's debt denominated in Euros, it will be a long time until Greece recovers from its post-crisis trauma. However, markets have short memory and it may not be long before they start buying Greek debt again
FEASIBILITY RATING: VERY LOW

Eric Tan,
London

A Chinese Bubble? Markets for the week ending 23-Jan-09

As the Chinese government made moves to suppress escalating lending growth driven by excess liquidity, it's worth comparing the similarities with the Japanese experience during it's boom years.

1) At its 2007 peak, the Shanghai A shares traded at more than 7 times book value. Japan's Nikkei index in 1989 peaked at 5 times. Chinese stocks has since halved in value
2) Price to earnings ratio of Chinese stocks using past 10 year average earnings (Graham and Dodds PE ratio) is 50X compared to about 15x in US
3) Residential real estate of Chinese cities is at a multiple of 15-20 times household income versus 12-15 times during Japan's real estate boom
4) Fixed asset investment as a proportion of GDP in China is currently 50% and Japan had similar growth rates then with 30-35% GDP
Finally a thought to hold:
A decrease to 10 year ago investment-to-GDP rates for China would have a disasterous effect on all emerging economies and countries exporting to China.

Eric Tan,
London

Factors affecting soverign default risks. Markets for the week ending 15-Jan-09

Given recent statements made by senior central bankers in Europe with regards to a further deterioration in the Greek bond markets, what are some of the factors that markets should be concerned about in terms of soverign default risks:

1) Debt servicing costs are set to soar as a proportion of GDP in Europe and US as the government debt issuance over the last 18 months to rescue the economy was one of the largest in recorded history
2) Structural deficits from a drop in tax revenue (from certain sectors) over the recessionary period experienced in the last 18 months may become a permanent feature that countries will have to come to face with
3) Weak and unstable economic outlook makes it difficult for governments to time and put in place their plans for fiscal tightening
4) Age related and social services spending are starting to rise and may alter the status quo and result in significant under-budgeting
5) High levels of capital mobility can complicate debt management and credit agencies are becoming very quick to issue concerns and downgrades

The only way out for governments is to come up with creditble details for financial stabilisation and plans for structural reforms to convince the investors that they will be able to address these demographic issues, such as raising pensionable age and look for new growth sectors to replace the sectors affected by the crisis. Strong political leadership is necessary to push through the changes necessary.

Eric Tan,
London

Hold on tight. Markets for the week ending 8-Jan-10

The financial world was almost at a standstill this week as market observers waited for the December US non-farm payroll numbers to be announced on Friday.

And to the nasty surprise of the markets, the 85,000 drop in non-farm payrolls served as a timely reminder that the US economy is not completely out of the trough yet. As we begin 2010, it is not a bad idea to remind ourselves that despite the stock market recovery experienced in the last 3 quarters of 2009, the new year is likely to bring more volatility. On many metrics, the S&P500 valuation is probably close to +/- 20% fair value, which means, unless there are more positive market data or economic indicators, the market has already priced in the restocking cycle and increase in demand from US consumers as property values stop falling.

On closer inspection of payroll numbers, we should also note that as much as 660k people chose to leave the labour force and stop looking for work, hence the adjusted headline rate of unemployment would should really be 10.4% instead of 10%.

Eric Tan,
London

A sigh of relieve. Markets for the week ending 4-Dec-09

This week, the world's financial markets started the week beset with concerns about the impact of Dubai World's debt, but took a twist for the better on Friday as U.S. job figures provided the optimism for recovery.

U.S unemployment rate fell from 10.2% to 10% and risk assets enjoyed strong gains on the last day of the week as investors were encouraged by the first drop in since jobless rate since April 2008.

The U.S. dollar rallied as interest rate expectations underwent a dramatic shift. Relative to the Japanese yen, the U.S. dollar rose more than 3.5% as investors focused on the impetus for the Federal Reserve to exit from its ultra loose monetary policy stance sooner than forecasted.

Eric Tan,
London

Dubai Inc - Markets for the week ending 27-Nov-09

Question: What is(are) the key lesson(s) from the Dubai World event?

a) A timely reminder that this is a too-quick-to-be-true recovery for the global economy
b) The decoupling story that emerging markets carries higher growth opportunities deserve to be charged higher risk premiums
c) Risky investments NPV-ed against implied state guarantees carries default risk that are typically underweighted by investors

Answer: All of the above.

Eric Tan,
Singapore

How far will the USD carry trade go?

The combined efect of zero Fed funds rate, quantitative easing, credit easing and massive purchases of long term debt instruments by the US government is resulting in a boon for the USD carry trade and boosting highly leveraged global asset bubbles.

However, if the dollar reverse and start to appreciate, this popular leverage trade will result in a stampede of investors to close their risky asset positions across all global asset classes to cover the short USD position.

This can happen as a) the USD will have to stabilise at some point; b) Fed's asset purchase plan will have to end and volatility will rise; c) US GDP growth may start to accelerate leading to raising of interest rates; d) Global economic worsening resulting in flight to safety of the USD; and e) coordinated intervening of the USD depreciation by emerging economies.

Eric Tan,
London

Domino effects. Markets for the week 30-Oct-09

In the last 3 days, global stock markets corrected with the announcement of ING's breakup. As Brussels set the stage for regulating banks which received massive government help during the crisis, other banking groups are reeling from investor's fright of a domino effect on the sector.

The lessons learnt from giant financial groups to the likes of AIG, Citigroup - too big to succeed, impossible to run and too big to fail are becoming the nightmares of regulators who are entrusted with the responsibility of maintaining market stability and preventing systemic risks.

At the height of the crisis, governments had to approve mega consolidations of banks such as Lloyds and HBOS or JPM and BearStearns. This is probably sowing the seeds of new crises unless regulation is revamped.

With poor economic data released this week, optimism for the future is low. So, investors will have to sit tight as it seems like the next few weeks will be a rough ride.

Eric Tan,
London