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The Next Leg In The European Crisis? Money Markets Lead The Way With Puttable CDs

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The Next Leg In The European Crisis? Money Markets Lead The Way With Puttable CDs

Post  TBQ on Thu Jul 08, 2010 3:47 pm

From Nic Lenoir Of ICAP

Basically what strikes when looking at the recent sell off from 1,125 down to 1,006 is that EURUSD actually moved up during that period. One could say it's just a break in correlation, no big deal. I beg to differ. The last sell off occured because data was bad, and that made those who doubted realize that the top in economic activity is in and we are now rolling over. That is contrarily to the previous sell-off which was due to credit deterioration. Now a bad credit market always comes with a squeeze in USD funding which puts a bid behind the currency. Thus when I saw the lack of correlation between equities selling off and EURUSD, I immediately called a friend who happens to be a very smart credit trader who confirmed that credit was drastically outperforming equities during the move.

This is what bothered me in terms of the bear case. We have all the seeds for a proper credit collapse, we get the economic roll-over which is what will invariably trigger the refinancing difficulties and possibly defaults, and all of a sudden credit rallies. I feel a bit cheated. Clearly it cannot be the European stress test giving investors confidence, they can't possibly be that stupid. The test is made to be passed obviously so it's a farce "a la Geitner". However this is were talking to money market insiders helps. The last few weeks there have been a whole bunch of puttable CDs being issued by European banks, and overall apparently that has given money markets some confidence and money is being put to work. That also explains why people have been buying EDU0 99.50 and 99.625 calls or the future outright, a thawing of the funding market would clearly lead to lower Libor, and the Fed which had started pulling liquidity away has basically stopped with global liquidity indicators showing signs that cash has been added to the system. Those puttable securities allow money market funds to treat it as a trade of maturity the put notice, rather than the full duration of the CD is the option is not exercised: you basically get a 1Y rate for a 7 day deal yeeeehhaaaaw! So Money Funds love it, and even though the banks don't get credit for full duration liquidity but instead liquidity that has the put notice as duration, it allows them to fund themselves. No wonder European banks love it too. It then makes complete sense to see EURUSD doing a bit better even when stocks sell-off, and we get compressing swap spreads and lower vol as well (helped by both selling of the optionality by money market funds who only really care about going around their new SEC regulation not buying options, and a slew of agency issuance being digested).

That trend should probably continue and as a result I would not be surprised to see Libor come off a little bit, or at least a rally in the front eurodollar contracts. The 61.8% retracement in equities comes in at 1,080 and if credit keeps helping equities up that's where I would see the resistance come in. Ater all if the economy is rolling over there is just so much rallying in equities we can have...

Now for the bigger picture, I think these structures are poison. The remind me of the abominable auction rate securities. For those not familiar with this turd, auction rate securities were basically long term bonds (30 or 40 years in some cases) paying a rate decided at an auction every 28 days in general based on the demand at auction. Because supposedly auction never fail the rate was that of a 28 day deposit, so you get 40 year cash at a 28 day price. Everybody thought it was the most awesomest thing ever (actually as a trader I was asked to build a book of that stuff and I refused saying we were better off lending money for 28 days and rolling it... I never got a thank you note from my former employer). You were supposed to be paid a penalty rate if you could not sell it at the auction when you wanted to get rid of it like Libor + 120 basis points. Only thing people forgot to consider is the day when no one shows up at the auction getting Libor + 120 from a company which is most likely struggling to get cash is pretty crappy and your bond is worth 15 cents at that point. Sure enough the day one failed they quickly all did and a lot of people lost a ton of money. Now please meet the puttabe CD, a great proof that you can fool people many times contrarily to Georges W. Bush's belief. Now the day one of those gets called, and it will invariably happen because one of the toxic European banks is bound to go under (can you spell caja?): there is just so much you can extend and pretend, they will all get called into a giant tsunami which will be the modern financial engineering version of a run on the bank, except all the banks will get whacked at the same time. I wonder whether the guys will indeed get their money back... better be the first one to ask for it! So we are planting the seeds for a nice blow up, and until it happens, be sure to see a lot of these puttable CDs being issued and bought as it allows money funds to go around the new regulation and European banks to get funding. Be sure that absolutely nobody at the SEC understands any of this by the way, they will wait for the audit led by Congress post blow up to give it a thought.

Now because I have spoken of the EURUSD, I owe you a few charts. First we see on the weekly that we have almost come to retest the H&S neckline at 1.2750. Then on the daily chart we see that line joining the tops comes in around 1.2730. We have bearish divergence on the hourly chart, and on the 20 minute chart we see something that looks a lot like and ending triangle. I would suggest selling around 1.27 with a stop on a daily close above 1.28. The C=A extension since the lows comes in at 1.2750 as well, so we have a nice cluster of resistances here. I think we have moved quite a bit from the lows in EURUSD and even though as we discussed it is because of money market transactions in part, with the details of the European joke of a bailout coming up could be a good way to play buy the rumor sell the news.






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Re: The Next Leg In The European Crisis? Money Markets Lead The Way With Puttable CDs

Post  Guest on Thu Jul 08, 2010 3:51 pm

To make the slightly veiled message of the article a bit easier to decipher:

Credit is fallaciously improving due to yet another CB reach around manuever which is destined to fail in due time. Now we can all get back on our unicorns and live in the pipedream for a little longer

That said, if Nic is right, and I certainly have no reason to doubt him, he has crafted a plausible fundamental explanation for the meteoric rise of the Euro. As for his conclusion, I'm sure he's correct here, too. "Pretend & Extend" will only work for a period of time and when the music stops, the disaster will be much more to the point.

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Re: The Next Leg In The European Crisis? Money Markets Lead The Way With Puttable CDs

Post  Guest on Thu Jul 08, 2010 4:08 pm

Speaking of "Extend & Pretend", here are a few points made on the subject;

"The government must find an excuse to push another $5T (minimum) into the US economy."

A war, anybody?

I remember a source claiming last year that the elite bankers had put Obama against the wall and said that they would cease printing any further funny money dollars this year. If that is true and they havenĀ“t changed police in the meantime....well how about UNICEF forces entering Texas...

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