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Central Bank Bilateral Swaps Necessary But Not Sufficient

(December 1, 2011)

Dear Subscribers and Readers,

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I hope all of our American subscribers (those here and abroad) had a great time off last week.  The rest was definitely much needed, as the market continued its volatile phase this week.  That said, recent volatility (as exemplified by running 10- and 21-day annualized volatility) is still nowhere close to that in mid-August 2011, let alone the peak of the late 2007 to early 2009 financial crisis, as shown in the following chart:

Virtually the end of every market decline/correction has been accompanied by a volatility spike.  This makes sense, as investors tend to be fearful of volatility, thus getting out of stocks.  As of yesterday's close, however, the 10-day and the 21-day running annualized volatility of the Dow Industrials “only” stood at 30.48% and 28.26%, respectively—a far cry from the volatility spike in mid-August of this year.  Is the European Sovereign Debt Crisis going to be resolved in a whimper, or a bang?  My sense is that it'd end with a significant volatility spike (both actual and implied).  As I've discussed, the latest bilateral swap lines established by six of the world's largest central banks (along with a cut in reserve requirements implemented by the People's Bank of China) is not a game-changer.  It is necessary because of the lack of US$ liquidity (as we discussed in our November 4, 2011 commentary—the recent record low in the Indian Rupee is a direct consequence of the lack of US$ liquidity), but it will not resolve the underlying solvency/debt problems of members of the Euro Zone.

There are two major reasons for the huge upsurge in risky assets yesterday: 1) the coordinated central bank action gave investors hope that there could be coordinated moves by the governments of Germany, France, the US, China, etc. as well, although at this point, Germany does not seem to be budging from their hawkish position, and 2) Injecting US$ liquidity will give European policymakers more time to find a solution, although this could just encourage them to drag their feet even longer.  Nonetheless, the creation of bilateral swap lines was necessary, as many emerging market countries (e.g. India) were running short of US$ funding as a direct result of the European Sovereign Debt Crisis.  In the meantime, the traders at Intrade.com are pricing in a 46% chance that at least one Euro Zone country will drop the Euro as its currency by the end of next year.

Despite the strong job numbers yesterday, the chances of a U.S. recession next year can no longer be ignored, given the lack of a comprehensive/credible solution to the European Sovereign Debt Crisis.  My base case still calls for no recession: I see a slowdown early next year, then a reacceleration to real GDP growth of 3% or greater towards the end of 2012.  Intrade.com, however, is pricing in a 39% chance of a U.S. recession next year.

For now—the recent decline in bank stocks notwithstanding—bank lending remains decent (see below chart).  Year-over-year change in loans and leases is up 2.3% (highest growth rate since February 2011); and up $161 billion (to $6.92 trillion) on a YTD basis.  Given the banks' newfound conservative lending standards, this growth in lending should lead to higher profits and higher GDP growth in 2012.  As a result, the U.S. economy should do relatively well next year, and U.S. financials will be a buy soon—as long as the European Sovereign Debt Crisis does not get out of hand.

Signing off,

Henry To, CFA, CAIA

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