Notes From Underground

The news over the weekend was chilling as the good citizens of Iceland, as expected, voted down the settlement agreement between the governments of Iceland, the U.K. and the Netherlands. The failed online bank, Icesave, which went belly up at the beginning of the global credit crisis, left many British and Dutch savers in the lurch. Iceland was a poster child of global investors’ rush to higher yields, as the Icelandic banks generated large profits through the massive use of leverage. When the asset market collapsed, all the leverage used turned into a debacle and the depositors were left holding the bag. After much acrimony, the Icelanders approved a resolution that would make the foreign depositors whole during the next 14 years.

The good citizens of Iceland balked and the resolution was forced to a referendum. The Icelanders rightly believe that the depositors should accept some of the responsibility as their avarice aided and abetted the banking bubble. The U.K. and Dutch regulators have been adamant to be paid in full but what countries citizens want to be on the hook for what their banks did (another case of privatizing the reward while socializing the risk)? Yes, we know that the Icelanders were giddy during the bubble but why should they pay the freight for the banks that failed? The market impact from this will be minimal but the political fallout that this may cause around the globe is the real story. This may be the vote heard round the world for the iced tea baggers. Just for the record, the NO vote recorded 93%.

Headlines are blaring that the Chinese are looking at severing the DOLLAR peg. This is nonsense of the first order as the talk is about a 2% revaluation during the next year. Chinese officials followed up by opining that the YUAN may find a place in the IMF-based Special Drawing Rights (SDR). This comes with no timetable, so from a trading perspective it is meaningless.

The other key story is the that the Chinese government is planning to nullify financing guarantees to local governments. In a move that would certainly curtail some of the robust credit growth, the central government would make the local administrations be on the hook to the banks. At this juncture we don’t have enough information to know its full effects, but this is worth watching as it could prevent Chinese banks from taking on unlimited municipal and regional debt without guarantees from Beijing. This story is one of many that leak from officialdom in China and it makes it difficult from a trading perspective. We are always cautious with Chinese financial news as it is hard to analyze what is official and what is speculation from anonymous sources, such as it is with a centrally controlled political economy.

There was a sizable rally in the EUR/YEN cross on Thursday and Friday, as the risk trade was back in full force. Global equity markets rallied and all asset classes performed in sync. Several pundits noted that the DOLLAR had not sold off as has been its wont as the carry trade has prevailed. While the DOLLAR has indeed not sold off dramatically, it has in fact stopped rallying even with the continued negative news from Europe. Even more interesting for the carry trade is the S&Ps versus the EUR/YEN, which had been the barometer of the carry trade crowd. In January, when the S&PS were trading at the levels we saw on Friday, the EUR/YEN crossrate was trading around the 131 to 132. We know that the EURO sold off against all the world’s currnecies as the debt problems of the peripheral countries called the question of the entire EU entity.

Now that some stability has been brought to the debt markets and an appetite for risk seems to be developing, will the EUR/YEN cross reassert its correlation to the global equity markets? We caution that this is March and it means year end for the Japanese balance sheets, which in the past has always meant great volatility until March 31. This year the Japanese corporations can repatriate capital at an almost tax free rate, thus adding to the combustible seasonality. The question is how much of this repatriation flow has already taken place? The answer is not known to us but the divergence that has taken place between the equity markets and the carry trade seems to imply that a great deal of the flow has occurred. This divergence has our attention and with the continuing war of words taking place between the BOJ and the Ministry of Finance regarding the recent  news of nascent deflation, the last thing the policy makers in Japan want is a strong YEN. Throw in Toyota’s recent woes and the EUR/YEN cross certainly has our attention. As we always caution, consult your technicals or your technician and find where price fails to support the analysis. As our bellweathers of the global equity trade are beginning to rally, we note that the risk on carry trade may find some new legs. Trying always to exist in a worls where 2+2=5 is a beautiful thing.