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What's This All About?

By: Michael Ashton | Monday, December 5, 2011

For most of this year, market action has not been about the economic news. It has been about the Fed. It has been about Greece. It has been about Portugal. It has been about Italy. It has been about France, French banks, and the relationship between the French President and the German Chancellor. It has been about Germany.

It has been about the U.S. debt ceiling and the Swiss zero interest rate floor. It has been about the IMF and what they said most lately. It has been about the ECB. It has been about offhanded remarks by Trichet or Draghi or Monti or Berlusconi. It has been about the rating agencies. It has been about the IIF (the who?).

And now, not even those things matter.

Over the weekend, the Italian Prime Minister announced mild austerity measures that prompted the former PM to immediately declare that a confidence vote is needed. Gee, that's a good start on the road to sustainable fiscal policies! The IMF approved a €2.2bln loan tranche but expressed an opinion that Greece is in a "difficult phase" at the moment. And Merkel and Sarkozy had a pre-meeting before the Euro summit later this week - it was to be a secret discussion, and word was released that there would be no 'result' from the meeting until whatever was released later in the week after the summit.

Somehow, they forgot that last part. Merkel and Sarkozy came out in favor of a 'new' treaty for the European Union. Or maybe for the Eurozone. Sarkozy says they'd like the rules to apply to the entire 27 members of the EU, but it was essential that the new treaty - which is likely to be considered an unconstitutional restraint on sovereignty in a number of countries - with automatic penalties for breaching terms would apply to all 17 Eurozone members.

I still don't see anything bullish in those news items. Making the rules for participation in the EU or EZ more stringent, even if it was the right thing to do, isn't anything that will affect the economy in the next, oh, two or three years at a minimum. It would probably be a Euro-bullish event, even though it is hard to believe given the coddling that Greece has gotten that an economy in crisis would ever be threatened with expulsion for breaching an "automatic penalty" provision (or for refusing to pay the penalty). In any event, the current treaty took many years to get into place. It is going to be hard to swap out. (Maybe a money center bank could do a "treaty swap," receiving the current terms and paying the desired terms?)

Yet, stocks shot higher on the open. Related markets moved in sympathy although less convincingly. Year-end illiquidity cuts both ways. Late last month, with stocks poised at 1200 in the middle of the multi-month range, I thought that the technical situation favored a potentially messy selloff since selling might beget selling into a market where no one had interest in buying at year-end. We got a selloff, but there was enough liquidity (and enough engineered 'good news') to arrest and reverse momentum. Now equities are rallying, and for no other reason than that they're already rallying - and equity fund managers are being forced to buy in lest they miss a year-end 'melt-up' that is becoming more and more plausible even though the reasons for it are more and more elusive.

Evidence for the momentum-driven nature of this rally appeared in the afternoon. S&P announced that 16 of the 17 Eurozone nations have been placed on CreditWatch negative (it would have been 17 of 17, but they think they're already on top of Greece) pending the outcome of the EU summit on December 9th. Doubtless the result of the CreditWatch, which ordinarily means there is a 50% chance of a downgrade within 90 days, may also have something to do with the amount of political pressure brought to bear...but then, I'm a cynic. This is shocking, if only because it includes all of the AAA countries on whose joint and several credit all plans seem to depend. Everyone knew that considering France a AAA was questionable at best. Some felt that Germany might be dragged down eventually depending on how much they played t he role of being the Sherpa of Europe. But the Netherlands, Finland, Austria, and Luxembourg must be seriously annoyed, because they have assiduously defended their fiscal positions and resisted committing treasure to the defense of the European dream. All of which to say: this is going to be a fun summit!

Stocks initially reacted sharply, with the Dow dropping 140 points or so. Bonds rallied back to near-unchanged and commodities erased the early gains. But then stocks started to rally again. This is nonsensical. The odds of something productive coming out of the summit, which is now more critical than ever, just dropped substantially (to be sure, there may well be some cheerful talk, but the probability of getting the Dutch and Finns to go along even with a pro forma announcement has got to be lower today than it was yesterday). S&P just told Europe that if they want to save the periphery, they do so at the peril of their sovereign ratings and the ratings of their corporations as well (since a corporation cannot have a rating above that of the sovereign).

But the market is illiquid, and that means it is likely to keep on going until the eventual outcome is so obviously bearish that fund managers are willing to take some tracking error on the chance that the market might break before year-end. I know that if I was compensated on the basis of my relative performance I personally wouldn't want to be very far from my benchmark on December 9th. However, if the next zig-zag becomes obvious that day, it will be hard to change positions very quickly in an illiquid market. I suppose the thing I'm really sure about is that I wouldn't want to be short gamma!


Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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