RBS: Get Ready For The “Cliff Edge”

I’ve read some alarming research in recent weeks and months, but this one takes the cake.  RBS is sounding the alarm on risk assets with a call that markets are at risk of falling off the edge of the cliff.  They refer to equity investors as the “worst cult in history….which has no basis in fact, or history, but yet seems universally accepted.”  (There’s actually a strange truth in that comment).  They believe the current downturn could very well “destroy” this “cult”:

“Get ready for the cliff-edge. Be maximum long duration of nominal government bonds in safe haven markets. This means US, UK, Germany, in that order, and perhaps others. Be long gold. Think the unthinkable – we always do, and you should ask yourself why the consensus refuses to do so, and seems perpetually on the ‘everything is ok’ side of events. If I was any more bond bullish we would explode, this is identical to 2008, including the incredible complacent (and we believe wrong) consensus.

They’re not just bullish on treasuries – they are super bulls with a 2% target on 10 year yields:

“Get ready for sub 2% on 10-yr USTs; sub 2% on 10-yr bunds; and the UK not far behind, 2.5% 10-yr Gilts. Our long held US$2000 gold view as a trade for the breakdown of the financial system looks increasingly ok. We cannot stress enough how strongly we believe that a cliff-edge may be around the corner, for the global banking system (particularly in Europe), and for the global economy (particularly in the US/Europe). We have been wrong before, but we think the risks associated with us being wrong are low (ie, rates just stay where they are, yields back up a little bit, after all we are not about to enter a new global economic upswing!). The risks associated with us being right are >10% returns in 10-yr USTs at the same time that equities/commodities will collapse far beyond what even some equity bears anticipate.”

In terms of valuations they don’t see today’s levels as being particularly attractive:

“For a counter consensus look at just how rich equities actually are if we are right about the economy, and how far they can fall, look at Robert Shiller’s 10-yr real adjusted P/E ratio on the S&P500, which uses ten year smoothed earnings. We have used this as our marker for proper (unbiased) long-term valuations for many years – and is freely available to all investors to look for themselves on his Yale website – and it sits at 20.0. One pillar of our framework is that sometimes it is right to buy equity; sometimes it is right to sell equity. And call us old fashioned, but we will buy at low PEs, and sell at high PEs. So a PE now of 20, sits very uncomfortably right at the TOP of its range if we take out the pre-first great depression spike in 1929 and Nasdaq 2000 spike. We argued in 2007/08 pre crunch that we would buy equities again when they looked cheap, which would be at 6-8 PE on this metric. That is an equity fall of 60-70% from here. Fine, call us mad with such big numbers if you desire, and say we will miss the big equity rally on a structural view (what rally, having been short for 10 years, S&P500 total return since 1Jan2000 is actually -8.1%!). Meanwhile an investment in 30yr USTs has returned you +126%. You do not have to see -60-70% off risk assets to be cautious here, we are just suggesting this is what the numbers say are attainable if certain circumstances prevail, using a 120 year snapshot. The big turnover in the US economy will lead to dramatic turns down in valuations we suspect – and may finally destroy the world’s worst cult: the cult of the equity, which has no basis in fact, or history, but yet seems universally accepted.”

What’s this all add up to?  They believe the endgame approaches:

“This all sounds somewhat doomsdayish, so we should update how the real economy/banking is panning out for us. It is saying: the end-game approaches.”

RBS says housing is in the lynch pin in the whole economy and that the next leg down will trigger the collapse:

“First, we have been waiting for the last of the US fiscal easings, the first time homebuyer tax credit, to pass, and have been arguing strongly for some weeks to investors to get ready for the violent turn down which is about to occur. And the trigger (not the only reason, but the trigger) is the US housing market. This is all falling into place lovely. Last week saw the NAHB housing index dip; housing starts at -10%mom (6.3% under consensus), and building permits -5.9%mom (8.4% under consensus). This week has seen existing home sales -2.2% (8.2% under consensus); and new home sales -32.7%mom (14% under consensus). Our theme is building. The BoE financial stability report today shows there is a surplus of 1.75m housing units built since 2006 and even with normal household creation, this will take two years to remove. So the weak housing theme should now pollute its way into consumers, and kickstart the rebuilding of the savings rate (just 3.6% and delayed from rebuilding by the fiscal/monetary shock and awe).”

The problems don’t stop there though.  The banking system is still a mess:

“Second, the European banking system faces problems. We have seen downgrades continue in Europe this week. We discussed in last week’s weekly overview about the US$450bn shortage of dollar asset funding for non-US banks, and why the Fed had to reopen swap lines. We are amazed there is not now immense market & media focus on the new letters that will bring forward the end-game and worsen it: 2a-7.”

It gets even worse (amazingly).  They believe the implementation of SEC rule 2a-7 could be what pushes us off the edge of the cliff:

“What is this? The new (well ‘new’, it comes in on 30 June but has been known for a year despite no-one discussing it at all) SEC rule. This forces US money market funds – up to now the provider of USD liquidity to those who need it – to become ‘safer’. The SEC puts it thus: ‘The amendments tighten the risk-limiting conditions imposed on tax exempt money market funds by rule 2a-7…the amendments are designed to reduce the likelihood that a tax exempt fund will not be able to maintain a stable net asset value.’ (source: SEC). Our short-term strategists plan a piece next week. The key for us in FI is that these US$2.8trn of 2a-7 funds now have to a) own 30%, not 5%, of assets in sub 7 day liquid paper; b) weighted average maturity of fund has to fall to 60 from 90 days. We can all see the logic – the sovereign defaults from EMU have the power to hit EMU banks badly, and the USA does not want to repeat the calamitous ‘breaking the buck’ problem when in 2008 Reserve Primary Fund wrote down its Lehman assets, took its net asset value sub $1, caused a run
on money funds which then forced them to sell their assets, cutting NAV for other funds, etc. Contagion.

From what we can see, the USA is basically pulling up the drawbridge and retreating into its fortress, trying to protect its financial system from coming European banking problems. But the consequence is clear. Banking is about confidence. If you are reliant on markets to fund yourself and that confidence wanes, a total stop can occur immediately/within days. Northern Rock (75% reliant on wholesale markets) was the first example of this in the UK, though not the last. Once we apply 2a-7 (and the ability of US money funds to ‘put’ their EMU bank assets back to the issuer EMU banks within 7 days on signs of trouble, since the US money funds will from now on increasingly own 1yr securities with a 7 day put) to our economic slowdown/deflation themes, this means one thing. If there is a slowdown and sovereign trouble, the problems facing EMU banking have through this rule potentially become a whole lot worse. This worsens – and brings forward – the ‘cliff edge’ potential.”

And what will be the result of the collapse?  “Monster” quantitative easing:

“Monster QME coming. With fiscal policy off the agenda, we have always expected more QME (quantitative monetary easing). And this time will be different. We have always argued that buying of bonds is less efficient than guaranteeing yield levels, and that yields are the key, not raising money supply, given demand for credit is dead (so all QME did was raise bank reserves and show money velocity collapse). There has been a subtle shift from central banks toward our view, most evident from the UK MPC, whose £200bn programme started by focusing almost purely on underlying M4, but ended differently with MPC speeches about how successful it was in keeping Gilt yields low.

The next shock and awe will be in the form of large scale QME, but with one massive difference – it will be focused on lowering yields, not expanding money supply (I think). So do not be surprised if the next QME is about guaranteeing yields at, say, 2% 10-yr US, or lower. Even if it is a vanilla buying programme as before, expect it to focus along the curve and bring all yields down in a monster bull flattener (you cannot bring down 5s and not 30s because that just changes savings’ maturity preference, it does not deter saving). Note today’s Telegraph article alleging that the Fed are already mulling more QME of another US$2.6trn (to take their balance sheet to US$5trn), which is totally unsurprising (we think CBs are far more dovish worldwide than investors/investment banks are). Others will follow. We are getting more bond bullish, not less.”

Wow.  I don’t really know what to say about that….

Source: RBS

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via pragcap.com

Very bearish report from RBS.

Posted via email from Global Macro Blog

FT.com | Eric Posner - Echoes of subprime ring out across Greek crisis

In June 1992, Greece issued five-year bonds with a face value of $250m at a rate of 8.25 per cent. The spread between the five year Greek bond and the equivalent German Bund was roughly 228 basis points. Greece had a deficit of 11.5 per cent of GDP and a debt to GDP ratio of 110 per cent. Its S&P credit rating was a miserable BBB-.

In June 2008, Greece issued five-year bonds with a face value of $1.5bn, at an interest rate of 4.625 per cent. This time the spread with the equivalent German Bund was only 113bps, half of what it had been in 1992. Greece’s S&P rating was now a respectable A. Yet the underlying numbers had not improved that much. The deficit was 5 per cent of GDP and the ratio of debt to GDP was 98 per cent. And Greece was known to have fudged its financial health in official data.

EDITOR’S CHOICE

In depth: Greek debt crisis - Jun-28

Why Greece changes everything - Feb-28

OECD calls for urgent action on debt - May-26

Greece set for return to finance markets - Jun-28

Moody’s shadow over Greek ratings - Mar-29

Banks eye £90bn in mortgage asset swaps - May-16

There’s more. In the early 1990s, Greek debt contracts had numerous provisions that protected creditors from default. The debt contracts gave bondholders the right to accelerate upon an event of default. They committed Greece to membership in the International Monetary Fund and access to IMF funding — which meant monitoring by the IMF. And it appears (although it is hard to verify) that a major portion of Greece’s external debt was governed by some combination of English and US law. In the early 1990s, the credit market treated Greece as a third world country — like Ecuador or Venezuela.

By 2006, the contractual protections for external creditors had been narrowed. In its English law bonds, the right of acceleration could now be exercised only with the consent of bondholders holding 25 per cent of the outstanding debt. Greece also no longer had to retain membership in the IMF with access to its lines of credit. Most important, a large fraction of the bonds held by external creditors was now governed by Greek law. This meant that Greece could unilaterally restructure the debt simply by changing its law. Investors had promoted Greece from third-world debtor to first-world debtor while its finances remained third-world.

What could account for this change? Greece joined the eurozone in 2001. But why should the market have cared that Greece entered the eurozone when its finances did not improve?

The answer is probably that the market believed that either eurozone countries would discipline Greece’s financial excesses or bail out Greece if they failed. If so, the irony is palpable. Greece (like most other eurozone countries) did not comply with a treaty provision requiring financial discipline but was allowed into the eurozone anyway. Investors must have reasoned that if the treaty provision governing financial discipline could be ignored, then the treaty provision banning bail-outs could be ignored as well. And they were right. But if the treaty could be ignored, then why would entering a treaty make a difference to Greece’s creditworthiness in the first place?

We suspect that the story is about politics, not economics. In their effort to press forward with European integration, political elites sought monetary union in the hope that it would forge bonds between still mutually suspicious nationalities. But monetary (and political) union cannot succeed when vast disparities of wealth exist across regions, and the people of northern European countries had no interest in correcting these disparities by transferring wealth to the south.

Political elites squared this circle by (we suspect) encouraging national banks to buy up Greek debt despite reservations about its quality — so that transfers would take place but disguised as credit made cheap by implicit government guarantees. Apparently, the European Central Bank accepted Greek debt as collateral for loans on the same terms that it accepted the debt of more financially stable countries. European commercial banks would then devour Greek debt because it was liquid and secure, and paid a premium over the debt of safer countries — plus they received certain regulatory advantages because it was EU sovereign paper.

The rest is history. The parallel between the Greek debt crisis and the subprime crisis is striking. Trashy debt is alchemised to gold through manipulations driven by a political agenda. In the case of subprime debt, this took the form of collateralised debt obligations consisting of government-supported mortgage-backed securities. In the case of Greek bonds, it was European Monetary Union. Subprime debt, long believed to be risky, magically becomes almost as safe as Treasury bonds. Greece, which has spent half its existence as an independent nation in default, magically becomes almost as creditworthy as Germany. In both cases, investors expected to be bailed out, and were. In both cases, politically motivated wealth transfers were disguised as cheap credit. In both cases, taxpayers who resisted cash transfers to low-income groups found out later that they had to pay for what they did not want because the alternative was financial Armageddon.

Eric Posner is Kirkland and Ellis Professor of Law, University of Chicago. This piece was co-authored by Mitu Gulati, professor at Duke Law School

via ft.com

This essay from Eric Posner draws eerie and unsettling parallels between the Greek debt crisis and the collapse of US subprime mortgages. Definitely puts the scope of the ineptness that pervades the political class in nations around the world. How did modern society weave such a wickedly counter-intuitive financial system?

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Federal Tax Rates by Income Quintile

via gregmankiw.blogspot.com

Charting 30 years of income tax rates.

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