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US Banks Go Ba-DONK!
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You will not see this on the front page of the Wall Street Journal, but last evening, Moody’s warned that the Dodd-Frank Bill (a.k.a. DONK) could have significant negative impact on US bank ratings. The primary goal of DONK is to eliminate”too-big-too-fail” by explicitly stating that the government will not bail out systematically important financial institutions. To our mind, we did not need legislation to end “too-big-to fail”, all the Fed/Treasury has to do is refuse to bail-out troubled institutions…as far as we can tell there was no legislation requiring bail-outs. Perhaps this line of thinking is why our playground is the financial markets and not Washington D.C. We digress, back to the matter at hand.
The thrust of Moody’s report was that US bank ratings (both commercial and regional) had been boosted by several notches due to implicit government support. Now that DONK aims to explicitly end support of systematically important financial institutions, banks ratings are too high. While Moody’s did not cut ratings, it reserved that pleasure for the next few months as DONK is fully implemented.
In essence this change will likely lead to higher borrowing costs for banks as lower rated credits pay more for financing. In turn, this cost will be borne by the customer, if the cost cannot be passed on to the customer then bank profit margins will get squeezed. At this point in time, demand for credit is waning, even at historically low rates…it is counter-intuitive to think that higher rates will result in more demand!!!
Our preferred play on this theme is a short position in the Regional Bank ETF (RKH). The RKH is currently poised at a resistance point and offers a great risk reward entry point.
Upon the opening of trade we shall be entering a short position and will be using a $81 stop loss.
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July 28th, 2010
With little fanfare, Harry Reid tabled the Cap and Trade bill in favor of a watered down version that has been dubbed “The Spill Bill”. While most of the attention will be focused on punishing BP, there is one part of the bill that could prove to be an investable catalyst.
The bill provides incentives to convert the nation’s 18-wheel trucks from diesel fuel to natural gas. This provision has been heralded by T. Boone Pickens, but the current version falls short of his preferred design. Nonetheless, it should provide an excuse for the “risk-on” crowd to look toward natural gas as the next transportation fuel.
Not only has the sweltering heat across the country contributed to higher use of A/C (powered by nat gas) but the price of coal has begun to rise. As a substitute for coal, nat gas tends to be the beneficiary of rising coal prices.
Technically our target for natural gas is a range between $5.40 and $6. Our preferred way to play this market is to buy the Natural Gas ETF (UNG).
Disclosures: long UNG
July 27th, 2010
Phew…Glad that is over! The European bank stress tests promised to be more invigorating than an episode of The Jersey Shore; it proved to be about as exciting as an insurance convention. So now what?
On
Fast Money last Friday, we were met with a healthy dose of skepticism when we asserted that the stress tests provided clarity. Our point then, and now, is that the market now knows the risk lies not in the trading book, but in the held to maturity bucket. Most importantly it gives investors a point of reference and increased visibility into the European banks. Prior to the tests, the European banking world was opaque at best – we would not call the tests an open window, but they did provide enough of a view for the markets to begin to sort out the winners and losers.
Now the task of recapitalizing the banks will commence and this is where the true stress test will be conducted. There has been enough analysis conducted prior to the test that the markets had already decided which banks were the strongest – Barclays and Santander were two of the standouts. Now when peripheral banks attempt to tap the market for financing the rate they must pay will indicate their level of stress.
One result of the test was that it rendered 3 Month Euribor insignificant as an indicator of financial fear. This morning, 3 month Euribor reset at a higher level than last week – the implication is that there is more stress in the system today than last week. We could not disagree more with the interpretation of a higher Euribor. This metric is an amalgamation of bank rates and now that the market has been left to sort out the winners and loser an average rate tells us nothing about individual levels of stress.
As the banks head to the markets for funding, we expect the gap between winners and loser to widen. Additioanlly, we expect the interest rate differential between Europe and the US to remain elevated – this in turn should attract risk capital to the Euro currency. A higher level of interest with increased clarity could be the catalyst for higher Euro prices.
We purchased EURUSD overnight in Asian trading and anticipate adding to the position on strength.
Disclosure: Long EURUSD and FXE
July 26th, 2010
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Yesterday was a news director’s dream – from 3:30 pm on ”Breaking News” dominated the headlines and the US equity markets. While capping the Macondo well is a societal victory and the GS settlement reduces uncertainty the equity market euphoria was not matched by the rest of the financial markets. One of the tightest correlations between “risk on” and “risk off” has been the relationship between the AUDJPY fx pair and the SPY.
The chart above show the SPY and the AUDJPY since January – the tight correlation is quite clear. Interestingly, yesterday there was a MASSIVE divergence between the two markets.
Given the anemic economic data, we side with the currency markets as they tend to be the leading indicators. As of this writing, the AUDJPY is telling US equity investors to expect lower prices.
Disclosure: short AUDJPY and US Equities
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July 16th, 2010
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Selling Short XLF
Over the last 18 months fortunes and reputations were built by betting the US government would stand behind the financial system. For its part, the Federal Reserve engineered one of the steepest yield curves on record allowing even the most inept banker to lend long at high rates and borrow short at artificially low rates. The following chart illustrates that as early as Q1 2010 the spread between the 2 year and 10 year US Treasury rates was close to 300bps.
However, in the last 2 months the European turmoil coupled with a global economic slowdown has resulted in a significantly flatter yield curve. The net result is lower profits at US financial institutions. In combination with Financial Regulation and new credit card regulations, the profitability of US banks appears to be dwindling. While the Federal Reserve can enact quantitative easing (again) we believe the market will react negatively to such a move. Moreover, the dissent within the Fed and political barriers present formidable obstacles to QE Round 2.
Given the increased headwinds we will be initiating a short position in US Financials via XLF.
Disclosure: short XLF
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June 29th, 2010
From the outset of the financial crisis the response by central banks and governments has been pure Keynesian – if you print enough money you can reflate anything. The fatal flaw in Keynesian logic is that Lord Keynes assumed a government could borrow at will. As we have seen in the last week, this is not always the case.
Our global financial system is based on the simple tenet of trust – one party contracts with another and trusts they will be made whole on the transaction. When that trust breaks down, the system breaks down…this is what we experienced Thursday in the financial markets.
While many will spend the weekend retracing the path that got us here, we find it more useful to look forward and determine the most likely path ahead.
The Eurozone Endgame – Debt Restructuring
As we wrote last week in our Special Report: Europe on the Edge of a Debt Crisis, we believe the ECB is negligently behind the curve and must act quickly and decisively to stem the panic. In this report we presented three scenarios from best to worst, unfortunately the ECB has chosen door #3 and the worst case scenario. The ECB and the EU have failed to properly address this crisis by immediately enacting quantitative easing, cutting interest rates and generally restoring confidence in the system.
Under our worst case scenario we opined that the market would punish Europe severely for this misstep and would push the Eurozone into a full blown debt crisis…unfortunately the Eurozone has arrived at its destination.
Now that confidence has been lost the end game for Europe is a debt restructuring for Greece, Portugal and potentially Spain. A voluntary restructuring is what the market is demanding and it will not relent until it is satisfied. The so-called austerity measures being enacted rely heavily on economic growth in Europe, given the events of this week we do not believe even mild growth is achievable in the Euro-zone.
The net result of a Eurozone debt restructuring will be a significantly lower Euro.We presented the chart to the right
to our institutional clients in January. At that time we added the caveat that if the ECB could short circuit the vicious spiral that was/is Greece then our targets may not be achievable.
The ECB has not only failed to short circuit the downward spiral they have added to the uncertainty. Given the social and political unrest in the Eurozone we believe a EURUSD rate at parity is well within the realm of possibility.
The “Flash Crash’ & The UK Endgame – Pound Devaluation
On Thursday the UK voters decided not to decide and stuck the UK with a hung parliament. It appears that the worst of all scenarios has played out with not a single party have a clear mandate. Over the next few days uncertainty will run rampant as the world watches the intracacies of a parliamentary system that will appear chaotic to the financial markets.
In the end, the UK has a formidable task on its hands – it must cut its budget enough to satisfy the ratings agencies -and more importantly the markets- while at the same time keeping the nascent economic recovery alive. The ‘Flash Crash’ may have been the straw that breaks the camels back. Confidence in the financial markets is shattered and any potential for the continuation of the bull run was deleted by yesterday’s robot ruckus. Given the fact that the UK economy is highly levered to the financial markets we do not believe the UK will be able to generate the GDP growth needed to keep its AAA rating.
The UK, unlike Greece, has the ability/luxury to print as many pounds as it wishes, therefore a debt restructuring is not likely. However we do believe the markets will continue to push the GBPUSD to our target of 1.2500.
US Equities? Lower
Simply put any hope that the retail investor would be the engine behind the next leg of the bull market vanished with the touch of a button. Moreover, we do not believe in the myth of decoupling. Therefore, unless a miraculous solution to the European crisis arises over the weekend we do not foresee new highs any time soon for US equities.
In the begining of April we presented this chart with our ‘line in the sand’ of 1073 – at that point in time we did not believe that level would be achieved in one day!
Our technical view is that a close below 1073 would signal the end to the bull market and the begining of a significant correction at best and new downtrend at best.
The ultimate manifestation – downtred or correction – depends wholly on market confidence. We are quickly approaching the point of complete loss of confidence – if left unchecked a new downtrend will develop pushing the S&P 500 below the March 2009 lows.
Disclosures: short GBPUSD, EURUSD
May 8th, 2010
The financial markets are finally figuring out that the so-called bail-out for Greece is flawed. Loyal readers will recall or March analysis of the three flaws- click HERE to read. In short, the bailout is based on increasing taxes, GDP growth and public acceptance…all of which appear to be long shots.
As the markets approach crisis, it has been reported that Greece has hired Lazard to give it financial advice.
The Consensus View – Lazard Will Advise Greece To Cut Its Spending
There is no doubt that Greece needs a financial adviser, after years of overspending they have gone beyond the point of no return. The party line is Lazard has been called in to help Greece cut its deficit and adhere to the required austerity measures. Presumably this means telling Greece what they already know – public spending is out of control and the unions don’t care.
We question whether Lazard – or any other banker – has the ability to convince a population (prone to violent protests) that they must accept wage cuts because the corrupt politicians squandered their resources. In our view, this is a Herculean task that is beyond the scope of an investment bank. Make no mistake, we by no means are disparaging Lazard’s capabilities, we just believe the job may be better suited for Blackwater.
The Divergent View – Lazard Will Advise Greece to Restructure Its Debt
In our view, Lazard will quickly see the path of least resistance is to restructure Greek debt – in plain English this means debt holders will be forced to accept less money. The ratings agencies have already downgraded Hellenic debt to a level that would suggest a 30-50% haircut on existing debt. While this move would shock the markets- in the long run, it would actually give Greece a fighting chance.
Several press reports and market chatter have implied that German private bankers have been meeting to discuss their role in the Greek bail-out. Presumably, these meetings have been less about how German banks can help Greece and more about how German banks can stem their losses. As US mortgage banks have discovered, it is much better to proactively negotiate with your debtors than to let the market’s invisible hand steer the vehicle.
We believe the combination of German bank meetings and Lazard’s mandate is the precursor to a voluntary debt restructuring. In light of this view, we are staying short the Euro and Deutsche Bank.
Disclosures: short Euro and DB
May 4th, 2010
So Greece received its bailout…yawn….the markets knew this would happen. In fact, those market participants who read The Divergent View, were alerted to this fete accompli weeks ago. As anticipated the EURUSD did not rally on the news…we expect the EURUSD to drop to at least 1.29.
As an interesting sidebar to the weekend deal, the ECB dropped its ratings threshold for Greek debt – this is important because a ratings cut from Moody’s could have shut Greek banks access to ECB funding.
The Consensus View – Greece Bailout Puts the European Fire Out
Prior to the weekend deal, the prevailing market view/hope was that a bailout for Greece would stop the contagion threat and provide Europe with some economic breathing room. At the core of this view is the assumption that the markets will applaud coordinated action and extrapolate this approval to other European nations.Moreover, the indefinite extension of lowered ECB ratings threshold is expected to keep the liquidity flowing.
Not surprisingly, we do not share this view.
The Divergent View – The Threshold Extension Paves the Way for a Downgrade
Before we get to the core of the matter.. a primer…
The ECB loans out money to member state banks and takes government bond holdings as collateral. Prior to the financial crisis those government bonds needed to be A rated by at least one of the three ratings agencies (Fitch, S&P, and Moody’s). As part of the response to the financial crisis, the ECB dropped the ratings requirement – this change was expected to expire at the end of 2010.
The Core
Both Fitch and S&P have already cut Greek debt ratings below ‘A’, leaving Moody’s with the all powerful vote at the tribal council. Last week, Moody’s suggested it would not cut the ratings until it reviewed any bailout that may come over the weekend – a cut prior to an approved bailout could have proved catastrophic. Presumably someone at Moody’s was working over the weekend.
The ECB decision to indefinitely suspend the ratings threshold means that Moody’s is now free to speak its mind and downgrade Greece without the reputational risk of being labeled the Euro killer. We expect this new found freedom will result in a Moody’s downgrade of Greek debt and could lead to further European downgrades.
While Moody’s et al now have the freedom to actually rate sovereign debt without the threat of being a world destroyer, we do not believe the markets are expecting more ratings news. In the long term, ratings downgrades would more accurately reflect the true risk associated with holding European sovereign debt – however – we believe the knee jerk reaction in the market will be a sharply lower EURUSD.
Disclosures: short EURUSD and FXE puts
May 3rd, 2010
Chinese officials have intimated that stimulating the domestic economy was job #1 and relatively loose monetary policy would remain. Furthermore, a report in China Business suggested a new economic stimulus plan could be enacted by August. While we do not view a new stimulus as necessary or prudent, the net result of the statements and speculation is continued growth in the Chinese economy.
Additionally, Investor’s Business Daily reports that NetEase (NTES) is in talks to buy a stake in MSN, thus becoming Microsoft’s (MSFT) partner in Chinese search. If this occurs it would place Baidu squarely in Microsoft and NetEase sights and create the most formidable threat to Baidu (BIDU) since Google. To be sure, we are not convinced these companies will succeed where Google failed, but even a modest gain in market share would impact NTES bottom line.
Furthermore, as of September 2009 World of Warcraft is back in the control of NetEase and has made large contribution to earnings. Finally, NetEase has commenced registration for its new social networking service. Once again even a small gain in market share should have a large earnings impact.
Valuation
Relative to its direct competitors, NetEase is fairly valued. However, we believe the continued growth in World of Warcraft coupled
with the potential for a deal with MSN will be the catalyst for multiple expansion.
As recently as September of 2009, NetEase traded at a 21 p/e. Using this multiple and average 2010 earnings of 2.59 yields a price target of $54.
Option Strategy
Over the last month the divergence between IV and HV has reached levels not seen since Sept-Oct 2009. Immediately following the last volatility divergence NTES price dropped almost 20%. Given our fundamental and technical outlook we believe the volatility divergence is a precursor to a significant move higher in the underlying equity. While IV has increased it still remains cheap on a historic basis.
Our short term (3 month) technical target for NTES is a range of $44-$50. The current IV level of ~40% suggests a move above $44 would be entirely within the realm of probabilities expected by the market. In fact, a move to $46.36 would only be a one standard deviation event.
The upper end of range falls within the 2 standard deviation band. To be sure this event would be expected less than 5% of the time. However, an increase in IV to 60% would move the upper 1 standard deviation band to $51 – adding to the probability that our target is hit. An IV increase to 60% in entirely possible as it hit this level in Sept-Oct 2009.
Disclosure: Long NTES
April 26th, 2010
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