Notes From Underground

I make a distinct reference to the CASH HIGH S&Ps versus the S&P FUTURES has made an all-time high. According to the CQG charts, the all-time high in the S&P futures front month is 1586.75 and the high daily close is 1576.25. The CASH high is 1576.09 and the previous high CASH daily close was 1565.15, which was surpassed on Friday’s close. Here is a significant chart that shows the important difference between Friday’s close and the last record high close of October 9, 2007.

In February 2007 the 2/10 yield curve inverted, a sign that even though financial assets were still rallying, and Chairman Bernanke was maintaining the subprime crisis CONTAINED, the debt markets were telling a different story. The curve was still historically flat even though the FED had CUT the FED FUNDS rate by 0.5% at its September 18-19 meeting, which was larger than the market had anticipated. The CURVE WAS FLAT AND SIGNALED DANGER. Presently, the 2/10 curve is around 160 basis points positive and while that is historically healthy it is not overly robust. It is this difference that makes this S&P HIGH significantly different. The global macro events of Europe are certainly a catalyst for a correction but it seems that central bank easiness is trumping all other fundamentals AT THIS TIME.

As I  have noted many times, the European and U.S. levels of the 2/10 curve made the week of July 25, 2012 will be critical barometers of market sentiment. The low that week on the U.S. 2/10 curve was 117 basis points. The FOMC‘s rate cut of September 19, 2007 was a sign of how far behind the curve the FED was and how little it understood of the impact of the looming credit crisis. Through the summer of 2007 the Fed Chairman was voicing his opinion that the subprime crisis was CONTAINED. This week we will hear from the ECB president about the European situation and we will listen for Mr. Draghi to call the Cyprus situation CONTAINED.

The IMF and EcoFin head, Mr. Dijsselbloem, have placed President Draghi in a very difficult situation. By forcing the deposit issue before there is any type of European wide banking system and without out fiscal harmony throughout the EU, the ECB will be the lone player with EU-wide capability. And the instrument of choice is the OMT, which is predicated on severe measures of CONDITIONALITY. The last thing that is needed in the EU is more austerity for the ADVERSE FEEDBACK LOOP created by increased taxes and budget cuts is already tightening around the necks of the periphery nations, choking off economic growth. The only positive is that the ECB is not being led by J.C. Trichet and his bias toward raising rates.

In Thursday’s Financial Times there was an article by Robin Harding: “Tough IMF Stance Adds to Growing Tension With European Commission.” The article cites the renewed resolve of the IMF in standing against Cyprus and forcing a much firmer and tighter course of action. In a quote from the Peterson Institute’s Douglas Rediker, a former director of the IMF Board, he says, “The IMF is supposed to be the world’s leading and in some cases only credible international financial institution. If the fund is perceived as not having credibility, then the market is going to hesitate about getting back into the game.” He further states that Christine Lagarde is a much better director and less subject to political suasion than was Dominique Strauss-Kahn.

This article is pure rubbish in my opinion. The IMF got tough on Cyprus because it had the backing of the Germans and the Northern core and Cyprus’s small economy made it a supposed easy target for the IMF to punish in order to restore its tarnished credibility after the Greek debacle. The fact that Ms. Lagarde was Sarkozy’s finance minister reveals the political nature in which she was appointed. To think otherwise is to believe that the fallout from Cyprus is contained.

***In a hat tip to KM, Paul Krugman had a New York Times piece on March 24, “Hot Money Blues.” Professor Krugman raises the positive aspects of the need for capital controls post-Cypriot crisis. As the professor well knows, a NYT column is a very limited place to cover the arguments of this topic. It summarizes the world’s crises as a result of overwhelming hot money flows to various economies all over the globe, which creates booms upon inflow and busts upon rapid outflows. This is too simplistic and fails to question bad economic policies that get put in place by countries inundated with money. While I am not philosophically opposed to some time restrictions on money flows–let’s say a minimum of three years on certain deposits or an exit tax on early withdrawal–the end of the free flow of capital will be disastrous for global capitalism. Brazil has recently begun placing restrictions on the inflow of currency and it has slowed its economy but the restrictions are more speed bumps than the harsh measures in Cyprus.

Krugman says: “But the truth, hard as it may be for ideologues to accept, is that unrestricted movement of capital is looking more like a failed experiment.” Further on he says: “But the best predictor of crisis is large inflows of foreign money; in all but a couple of the cases I just mentioned, the foundation for the crisis was laid by a rush of foreign investors into a country, followed by a sudden rush out.” Again, yes I know it is written for the NYT and its audience but it’s limited space and simplistic arguments can lead to serious policy flaws. There is no mention of fixed exchange rates distorting policy, such as Mexico. Since Mexico has allowed the PESO to float and react in real-time, the Mexican economy has not suffered as much as many other countries with non-floating currencies. The discussion that Professor Krugman provokes is much bigger than the space provided in the Times.

***An article in the Atlantic by Matthew O’Brien is a primer for those struggling to understand the impact of Cyprus on the entire European Union. It is a summary of many things we have discussed in this blog and should clear up some complicated issues. Thanks to Eric N. for forwarding the piece and allowing us to link to it.

Tags: 2/10 yield curve, Christine Lagarde, Cyprus, Dijsselbloem, ECB, EU, FOMC, IMF, OMT, S&P

This entry was posted on March 31, 2013 at 3:03 pm and is filed under Cyprus, ECB, Equity, Europe, Fed, United States. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.