The real thing to fear is illiquidity

Outlook:

We should always be suspicious of a giant market price recovery after a longer-lasting drop. It may be a dead-cat bounce, i.e., big players tricking the crowd in a short squeeze. When everyone can see a market is oversold, it’s fairly easy to rattle them into closing out shorts by buying.

Analysts note that volatility in several markets is exceptionally high, and volatility may breed instability. The WSJ reports “A widely followed gauge of volatility in the $13 trillion U.S. government-bond market reached a one-year high last week. Volatility in currency markets is at its highest level since late 2011, according to the JP Morgan Global FX Volatility Index. Wall Street’s fear gauge for stocks, the CBOE Volatility Index of options-based price-swing expectations, rose last week though it remains well below its recent high last August.”

While we may agree that high volatility is a worrisome thing, the real thing to fear is illiquidity, and we don’t have that, at least not in a global way. One place liquidity improved was in European bank equities and bonds, including contingents. The FT reports “Most European banks now trade at or below tangible book value. But there is differentiation. A first group of well-capitalised banks trade at discounts to book value because, like utilities, ROE is capped. A second group deemed as undercapitalised or bereft of viable business models trades on discounts as large as we saw during the peak of the sovereign debt crisis. As a result, a negative feedback loop between bail-in instruments and equity has developed, leading to a loss of confidence. Recent developments in Italy and Portugal have awoken investors to these new risks.”

The key concept here is “bail-in,” meaning it’s bank owners and investors rather than the taxpayer who foots the bill in the event of failure or near-failure. We are just not accustomed to the idea. The Economist puts all its splendid sarcasm on display in the current issue. In addition to non-performing loans at some €1 trillion (and that’s end-2014 data), Italy alone has non-performings at 18% of total lending.
And retail investors own €200 billion of bank bonds or 12% of GDP. Various half-baked deals are still on the table.

Here is the latest report from Reuters: “The European Central Bank is in talks with the Italian government about buying bundles of bad loans as part of its asset-purchase program and accepting them as collateral from banks in return for cash, the Italian Treasury said.

“The move could give a big boost to a recently approved Italian scheme aimed at helping banks offload some of their 200 billion euros ($225 billion) of soured credit and free up resources for new loans. Nonetheless, it would likely fuel a debate in other countries about whether the ECB is taking on too much risk by buying asset-backed securities (ABS) based on loans that have not been repaid for roughly three months. Italian Treasury officials told reporters the ECB may buy these securities as part of its 1.5 trillion euros asset-purchase program or accept them as collateral from banks in return for cash, in so called repurchase agreements.

“The ECB declined to comment.”

Now there’s a slippery slope if ever we saw one. We expect a central bank to be a lender of last resort but to buy bad loans rather than let investors suffer a bail-in runs directly counter to “best practices.” This is not going to end well.

To switch back to the US, it’s actually a pretty good week for news. We get the Fed minutes on Wednesday plus a slew of Fed speakers—see the Econoday calendar. On Friday it’s CPI. So far the market is totally unwilling to buy into the Fed’s Phillips Curve scenario that improving labor market conditions must lead to wage rises and thus to inflation, eventually. In fact, the players in the Fed funds futures market are taking the stance that the Fed does no more rate hikes this year. See the table from the FT below.

We say turmoil is not behind us just because China manipulated the exchange rate higher and helped set off a relief rally in global equities. Downward momentum may be broken and that’s a good thing, but nerves are still jangling and minds are on high alert for the next crisis. It might be a European bank bailin or something else entirely—but we don’t buy that oil has bottomed or fear of global recession has been conquered. Stay tuned.