Treasuries Still Not Cracking

Tyler Durden pointed out yesterday that just three weeks after Goldman made the case for equities relative to bonds, the muppets who had listened to their advice were getting skewered:

I wrote a while back that (unlike some others) I didn’t believe it was likely that  this was going to be a cataclysmic rate spike. Readers who want to detect one need to watch whether sovereign creditors especially Russia and China are selling, and at what pace — the faster the liquidation, the more rates may spike.

Of course, I am still convinced that the real fragility to America’s economy isn’t actually a rate spike or inflation.The Fed has a very good handle on both of these things (but not, perhaps on unwanted side effects. They can effectively do QE without really inflating the currency much; simply shoot the money to primary dealers for treasuries.

When volatility is artificially suppressed, there are always unwanted side effects. And that — the unwanted side effects, not the widely-reported fears of inflation and rate spikes — I believe, is the true danger.

One unwanted side effect could be provoking a damaging trade war with China, from which the West imports so much. That is my pet theory, and one I’ve devoted a few thousand words to over the last few months. But the trouble with side-effects is that it is very hard to tell what the weakest link (i.e. the point that will break) in a volatility-suppressed system is. Tyler Durden reports that systemic financial fragility (as measured by CDS) is at a recent-high, too:

Believers in technical analysis (I am very sceptical) are pointing to a head-and-shoulders top in the “recovery” (to go with the bigger head and shoulders top that is very much one of the stories of the last ten years):

I don’t know when the black swans will come home to roost and the strange creature that we call the present global economic order will go ka-put. I don’t even know if they ever will! But I see the fragilities caused by central planners suppressing the system’s natural volatility.

Greece Defaults

From Sky News:

The talking is over; it is finally happening. For the first time since World War Two, a developed nation is going into default.

That’s the significance of the events of the past 24 hours, with Greece’s debt being classified as in “selective default” and the European Central Bank banning it from its cash window. Months of planning by both banks and policymakers have gone into ensuring that Greece’s negotiated default will be a smooth painless process. We are about to find out whether that planning pays off.

Now, we shouldn’t be surprised by Standard & Poor’s decision to cut the rating on Greece’s sovereign debt from CC to SD (which stands for “selective default”). The ratings agencies had always said that, given private investors are about to lose just over half the value of their debt (through a complex bond swap), this downgrade would be a natural consequence.

Nor should we be shocked that the ECB says it will no longer accept Greek debt as collateral: in fact, the only surprise is that it’s taken this long – on the basis of the ECB’s previous policy, the bonds should have become ineligible when were first downgraded from investment status two years ago.

Peter Tchir thinks all the hullabaloo is a lot of sound and fury, signifying nothing:

So far there are no dramatic consequences of the Greek default. The ECB did say they couldn’t accept it as collateral, but national central banks (including Greece’s somehow solvent NCB) can, so no real change. We will likely get a Credit Event prior to March 20th once CAC’s are used to get the deal fully done. Will the market respond much to that? Probably not, though there is a higher risk of unforeseen consequences from that, than there was from the S&P downgrade.

It just strikes me that Europe wasted a year or more, and has created a less stable system than it had before. A year ago, Europe was adamant about no haircuts and no default. I could never understand why. Let Greece default, renegotiate terms, stay in the Euro and move on.

I suppose the magnitude of the problem depends on just which kind of credit event. And that mostly depends on how well-insulated the financial system is, and market psychology. A full-blown Lehmanesque credit shock? Who knows — certainly banks are fearful. Certainly, the problem of default cascades has been out in the open for a while. But most of the attempts to deal with the prospect of such things have mostly been emergency room treatment, and not preventative medicine — throwing liquidity at the problem. Certainly, it is possible the system is in a worse shape than 2008.

  1. The derivatives web is (nearly) as big as ever:
  2. There are still a myriad of European housing bubbles ready to pop.
  3. American banks are massively exposed to Europe.
  4. China’s housing bubble is bursting Surely their reserves will go into bailing out their own problems, and not those of Europe and America?
  5. Rising commodity prices — especially oil — are already squeezing consumers and producers with cost-push inflation.

Meanwhile, the only weapon central bankers have in their arsenal is throwing more money at the problem.

Will throwing more money at the problem work? Yes — in the short term. The danger is that creditor nations will not be prepared to throw enough to shore up balance sheets.

Will throwing money at the problems cause more problems in the long run? Yes — almost certainly.

Ultimately, we must look at preventative medicine — to stop credit bubbles expanding beyond the productive capacity of the economy. We should also look at insulating the economy from the breakdown of any credit bubbles that do form.