International Interests: Run on Sterling

News that one of the UK’s largest mortgage lenders was tapping the BOE and an ensuing run on the bank’s deposits sent sterling lower on Friday and is ominous in front of this week’s massive commercial paper roll (see Ex Ante Factor). We have been advising traders who needed a place to hide that the tightness of the BOE was reason to sit in sterling while the volatility was elevated but at this point we are uncomfortable with that position as the downside risk is rising v the upside.

We are getting the DXY flush that was expected to correspond with a Fed ease and now are looking for long positions in the greenback. We aren’t pulling the trigger yet but are certainly close and looking for spots.

Cost of Capital: Well Bid

The short end of the yield curve remains well bid despite the settling of equity markets. Stronger than expected economic data hasn’t been enough to drive profit taking and leads us to believe the market is discounting multiple eases. Tuesday we will receive the first in what should be a round of rate cuts to at least get to a neutral policy which we estimate to be 4.25% at a minimum. 5YR notes are a buy above the 4.25% level, but below that yield is currently expensive unless stocks fall apart. That will change as the economy slows but we are expecting a pullback and thus a better entry opportunity.

Beta Maximus: A balanced approach

We are currently using a barbell strategy that is long technology on one end and consumer staples on the other. We will intertwine some industrials and health care in between but will continue to add tech and staple exposure to the wings. We think these sectors are poised to outperform in various scenarios and think these internationally exposed companies offer prudent diversification and liquidity.

Duke & Duke: Fire up the helicopter

It’s no surprise these benchmark commodities are soaring in the face of a Fed rate cut but we think the rally is in the late stages and would be defensive on a reversal. Be patient and see how they react upon a bottoming of the dollar.

The Ex Ante Factor: This isn’t Monopoly money

When EUR reversed from the July 138.50 high I kidded my friend, Dominick that his long standing target of 1.40 was eerily close but maybe the market wouldn’t let him get the official print. Well it didn’t take long and after a 30 day sell-off that corresponded with a global risk premium correction in credit, equities and carry trades, we are now back staring square at the 1.40 level, trading fractions away Wednesday at a high of 1.3927. That number must be a magnet and if it turns EUR back in a major change in trend, there could be a massive asset allocation shift occurring.

The timing of this move back to the highs is intriguing and maybe even raises the level of its importance considering next week’s convergence of US broker/dealer earnings reports, a FOMC meeting on Tuesday and maybe the most important event, the rolling over of approximately $140b in European commercial paper, much of it collateralized by mortgages. According to this Bloomberg article, Bank of America London estimates that 59% of the $230b asset backed paper in Europe comes due this month and that the peak will be Monday 9/17 when the equivalent of $48b matures. Friday we saw a glimpse of the seriousness in this CP roll as British mortgage lender, Northern Rock, could not refi their paper and had to tap the BOE for emergency funds which in turn drove a run on the bank’s deposits (reportedly an astounding $2b withdrawn) similar to what transpired at US thrift Countrywide just a few weeks before. NRK stock lost 30% in Friday’s trade and is down 65% from the highs in June. The run on deposits adds insult to injury as lenders are forced to replace even more capital in money that was borrowed in CP market and from customer’s deposits. If they can’t access enough money from central banks or the penalty rate is too high, they may be forced to sell assets at a discount, further eroding book value. Trouble in the European banking system not only poses problems for individual bank’s share holders but also a more systemic crisis of confidence in the solvency of the market economy which could ripple across the globe.

When we discussed the price of crude a few weeks ago, we thought that much of the petrodollars were being recycled through European banks which can explain some of the out-performance of euros and sterling v the dollar and yen so naturally we found it ironic that EUR would be pushing the 1.40 level while crude made a new high above $80 this past week. The run on the bank at NRK is very ominous and could spiral into a much larger problem if this 1.40 level is real. The sheiks would be getting nervous if they think their deposits are at risk and we could see a run on banks unlike the global capital markets have ever had to endure. The NY Fed study we cited in our crude article reported, oil export revenues jumped from $535b in 2002 to $1.5t in 2006, a number greater than 10% of US GDP. The same report notes that roughly $480b has gone into the purchase of financial assets. Like Mortimer Duke stressed, “this is not Monopoly money we’re playing with” as these vast sums have been one of the main drivers of asset prices for the past five years. It’s difficult to handicap where the petrodollars would flow, but the unwinding could be very disruptive to European bourses and credit markets. We will be closely watching the reaction around Dom’s multi-year target and if we get a reversal would become very defensive on risk premiums.

As with any important price target left by “the Dead Italian”, Dom expects the market to recognize the level by vibrating around, potentially between 1.3969-1.4139, before reversing. If we are seeing a major top in EUR there must be something important unfolding in the markets. Failing to print 1.40 on the previous high and knowing how important it was to Dom, kept many of us from becoming too bullish on the greenback as we thought a Fed ease would drive one more flush. We were hoping to simultaneously get our capitulation low in the dollar while finally seeing a 1.40 top print on EUR. That appears to be what is happening with the Fed on deck this week, but just as we thought a major dollar low would result from the de-leveraging of credit, we now must consider the larger ramifications of a major high in EUR and the asset allocation shift that could accompany such a reversal of this long-term trend.

What is the discount?

This week we look to expand our asset allocation risk premium model to include monetary and economic growth rates to judge the current state of real growth and inflation as it compares to the market’s discount.

This week equities clearly benefited from their relative cheapness and saw money push their yields lower v bonds. High grade bonds continue to outperform medium grade which is benefiting the equity risk premium. We are about to see the market’s appetite for risk and it’s conceivable that more re-pricing will need to occur. Stay defensive until the market can prove that risk is being deployed. For starters we want to see LIBOR spreads narrow.

Bottom Line: We may be setting up for a major EUR trend reversal with far reaching implications. We advise all investors to keep an eye on the price action in euros and sterling and their respective LIBOR rates for indications of banking system dislocation.