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Thursday May 20, 2010 - 22:19:02 GMT
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Confidence Crisis Rips Capital Markets (FXA)

I have spent most of the day on the phone, watching screens and financial news and I am totally convinced that no one has a clue about what is happening to markets – FX, asset prices and commodities.  This is one of those times when there may not be a good explanation and surely spending the bulk of your day trying to cobble together a narrative for what happened and not exiting risk would be problematic.  You don’t need to be Nouriel Roubini – a man with an answer for everything and often a lot of nothing – to know what to do…exit for safety…run for the bunker…go to cash…check counterparties…the world of finance is not safe and certainly not sound.


I think I have more wrinkles on my eyes today too after cringing so many times when experts asserted Washington’s fin reg progress (Senate) drove stocks down hundreds of points (fail to realize the DJIA was down few hundred points before the Senate voted for cloture).  Or how worries about Greece’s general strike set into motion a massive decline in equities, massive rise in Tsy prices and gutting of commodities and commodity currencies especially against the EUR.  EM was also eviscerated.  This is a run from risk day if there ever was one and trying to pin it down to one or two sound bites is unproductive.  How about we don’t know why with any certainty?   All we do know is that the financial system remains highly compromised and vulnerable to enormous instability with equally enormous consequences.  I feel like I did in the 1987 crash…like today at that time there were scores of efforts to explain why the market crashed.  None were adequate and perhaps there was no “reason” other than it was an unpredictable and uncontrollable event that in hours changed entire concepts of risk – feedback loop driving confidence and prices ever lower. 


No I am not in denial nor an apologist for Congress and the White House. – fin reg is an enormous challenge in best of times…in the current political and economic environment it is assured that fin reg will get many things wrong and some things right.  But these changes will look much different than the ones in the initial bills and following reconciliation in conference committees of the House and Senate bills in coming weeks, we will see very different law than the competing bills and amendments.  And the law making process is evolutionary and changes will be made to whatever gets signed into law by the president in coming years.  Don’t forget for a second that Wall Street still has an outsized influence on Congress. 


At the risk of sounding dumb, I don’t know why things are moving the way they are and if I don’t know it is likely that most officials don’t know either.  And if officials don’t know what is happening and why, there is little basis for believing they can generate a policy response that successfully stabilizes financial markets – yet that seems to be the demand coming from the financial markets.  This is what leads to flailing policy steps or missteps like those from Germany on Wednesday – again not a cause for today’s market gyrations nor for much of yesterday’s response. 


The crash of the economy and financial system in 2008 exposed a deeply flawed financial system (banking system).  The fact that it took under 2 years to experience another crash is not so surprising when one considers the main policy response to the last crash…unlimited and minimally constrained (access to) central bank liquidity and massive government spending.  I am not an Austrian schooled economist…these were the proper Keynesian responses.  But they were done on top of a compromised banking system and capital market.  Liquidity can raise the tide enough to again hide those swimming nude, but not indefinitely.  The tide has gone out in the last few weeks and it is exposing ever more suitless bathers, 


A number of people have noted that credit markets are showing some signs of strain, but hardly to the degree of what was seen in 2007-2008.  But that ignores the fact that central banks have put in place a perfect substitute to the interbank funding market for banks…central bank funding.  Moreover switching between these two types of funding has proven to be relatively seamless and hence it is natural that credit markets are not the place to look this time for strains in the financial system.  I think AUDEUR chart or bank stock prices are far better indicators of market stress now than credit spreads.  And for those few who bothered to notice (there were some), May06 and this week shared some common features…big unwinding in long AUD, short EUR trades (same for CAD longs vs EUR).  Something much more fundamental to the plumbing of the capital markets is happening and it has little to do with Greece debt (ring fenced for next few years), fat fingers or Washington botching fin reg. 


If this condition continues to snowball ahead I think the German actions of Wednesday will be added to and copied or not copied but done differently everywhere.  Capital controls aimed at stopping speculation is how officials who don’t know what is happening will respond…they will shut down CDS, short selling, leverage, OTC derivatives, high frequency trading, algo trading, off exchange trading in stocks, ETFs…you name it.  The system we have now has evolved far beyond any capacity to understand it and prevent black swan events.  The future will be all about walking the financial system back to simpler times…and this won’t be good for world growth or income in the short run.  But if it removes severe shocks to the financial system ahead, we won’t be facing potentially larger hits to growth and income from crashes like the one now and the one in 2008. 


Ideally – can’t and won’t be done – G20 needs to convene a 4-week convention with leading experts in capital markets, securities law and practitioners and hammer out a new robust financial architecture that must be adopted in every major financial center. 


Practically, expect more flailing and more of the same for financial assets, FX and commodities.  This is not the time to be trading.  This is the time to be battening down the hatches and preserving capital.  Confidence has been shredded for individual and institutional investors.  Cash has been recrowned.  Think globally and act locally…personal bank (risk) holiday…then again the system is built around forcing people to take risk…not self-imposed bank holidays.


David Gilmore


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