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Monday Market Review: Credit Event Accelerates

  • Written by Syndicated Publisher 363 Comments363 Comments Comments
    December 13, 2011

    ‘In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could’ – Rudiger Dornbusch.

    “This is a credit event that equity will be forced to acknowledge.” Remember the basis for this trade. It will bring clarity throughout the trade and keep you focused on what signals are real and which are false. The more “mechanical” you are with this trade the less emotional you will become and your decision making that much clearer.

    With that said this trade requires a constant view of the credit event which is the source of the trade and the currencies which are the transmission mechanism to the equity markets.

    Credit Event Update

    Once again we are about to get “schooled” on complex financial products and the inner workings of Wall Street and the Federal Reserve as “regulator.” The Federal Reserve is facing a rather complex decision. What is worse a run on the brokers or a run on shadow banking liquidity?

    I would argue the run on the brokers is the most dangerous scenario and if not addressed soon will become uncontrollable. After all if broker capital flees you will have a shadow banking deleveraging regardless.

    So what do I mean by a run on the broker? I mean you, me, all traders realizing the risks of losing their capital is simply to great and opt to leave the market. Commingling of customer funds and rehypothecation of customer assets means the brokers are now legally taking risk with your capital. It’s that simple.

    In the event of a default as with MF Global you become an unsecured creditor. You will be in line behind the secured creditors hoping to receive if lucky pennies on the dollar of your capital. Bank runs or in this case “broker runs” are not publicized but there is nothing to stop them other than to restore confidence. And that is quite possibly what the Fed will be forced to do. But that is not an easy proposition.

    Bruce Krastings (The Fed, MFG and Reg T) wrote an excellent piece about Regulation T which covers the hypothecation of assets by brokers and makes it very clear the risks facing investors.

    “In the event of the OTC derivatives dealer’s failure, the counterparty will likely be considered an unsecured creditor of the dealer as to that collateral;”

    “The Securities Investor Protection Act of 1970 (15 U.S.C. 78aaa et seq.) does not protect the counterparty.”

    His point is simple. Reg T needs to be changed. But herein lies the difficulty. The IMF estimates that for every $1 in credit created via rehypothecation only $.25 exits in collateral. In other words a massive deleveraging would be needed to “right the ship.” Those are two big choices facing the Federal Reserve who oversees such regulation in the market.

    Currency Markets

    Some big moves in the EUR, AUD and USD today (EUR and USD daily charts below). As a result of recent price action in the currencies the commodities and precious metals are once again leading equity markets to the downside.


    USD (DXY)

    Bottom Line

    The credit event is accelerating. The stress within the interbank lending market is growing. Sovereign debt yields are increasing causing a rise in collateral calls. Investor confidence is being called into question. The currencies and demand for USD are back to levels prior to the coordinated central bank swap lines.

    The trade therefore is still on. The “credit event which equities will be forced to acknowledge” is unfolding.

    Images: Flickr (licence attribution)

    About the Author

    Macro Story is designed as a one stop source for all of your macro related news and data.  From credit markets to economic data to geopolitics, you will find it all in a simple and organized fashion.  Content is presented in a format that allows you to read as little or as much as prefered.  Whether your goal is to do advanced research, a simple market overview or to become educated on macro subjects, the site has been designed with you in mind.