The 22 Feb MRO allocation came in at 166 billion EUR, 23 billion EUR more than the 15 Feb MRO of 143 billion EUR. All is not lost for those expecting another outsized allocation for the upcoming 3 year LTRO on 29 Feb. But interpreting a small or large number is not straightforward.

The size of the 3 year LTRO will not be known or estimable until the eleventh our, literally the day before. In the 22 Dec 3 year LTRO, 292 billion of MRO stood ready to rollover into the LTRO, then, a day before, a further 142 billion was allocated for the overnight repo. The next day, a full 489 billion EUR was allocated.

We will have to wait till a day or two before the settlement date to gauge the size of the 29 Feb LTRO. The implications will be interesting to say the least.

The first 3 year repo took away the stress in the banking industry and the LIBOR market, leading to a sharp relief rally in European bank stocks and risk assets in general. It was a relief rally in the true sense of the word since there was no direct link between the money thus created and the risk assets that rallied. What can we expect of the upcoming LTRO.

The market expects a big number, several surveys indicate an allocation circa 600 billion EUR. Anecdotal and ad hoc guesstimates offered by soothsayers and witchdoctors have ranged as far as 1 to 2 trillion EUR. We may yet get a large number, but we are certainly not seeing the momentum in the MRO rollovers to expect a particularly big number. The proceeds of the previous loans stew in ECB cash deposits earning 0.25% while the loans themselves cost 1%. Its not very good business. So far this warchest has only been deployed in peripheral Europe’s sovereign bond auctions, surely a case of doubling down into a precarious carry trade. The German banks have eschewed borrowing at the LTRO arguing that they do not need to (although some of them actually do) and that the stigma of doing so might actually hurt their karma.

A big allocation at the next 3 year repo may actually be a bad thing. But I would still expect the reaction to be positive for stocks as traders routinely misinterpret the facts. More morphine does not a healthy patient indicate. Besides, how would the loans be deployed. Demand for credit is slow, Basel 3 is unfriendly, buying more sovereign bonds only ties the banks more closely to their sovereigns, and leaving it at the ECB for pure liquidity reason is uneconomic. Yet one can safely bet that a big number will likely lift bank stocks and indeed the Euro, a clear loser in this stratagem of debt monetization by stealth.

What about a small number? This would be a sign of strength, that the first LTRO was successful and that no further large scale money printing was necessary. Unfortunately, it is necessary. Yet we may not get the large number we seek. If the banks believe that the 3 year repo has become recurrent and routine, it may not need to hoard liquidity. As always, it pays to bet on a behavioral basis. Myriad recreational traders will likely sell the market if the LTRO is small. And the Euro is likely to fall.

I may not get my predictions about the markets right, but I would always bet on my understanding of human behaviour. This is how we are.

The US economy consolidates its economic recovery while Europe slips into recession. China eases as its economy cools and the rest of the BRICs begin to loosen policy to bolster slowing growth. Amid this landscape, equity markets and other risky assets have rallied. The surge has been concentrated in the BRICs and in the cyclical and previously distressed corners of the global economy such as banking and consumer discretionary companies, especially luxuries. Defensive companies with stable and predictable cash flows have lagged.

The LTRO of the ECB, surely a sign of the weakness of the European banking system and clearly dilutive of the Euro have sent both European bank shares and the Euro surging. If one understands the psyche of the investor, more, of humans, this is to be expected and was envisaged in my article of mid December 2011 when the ECB had just cut its refinancing rate by 50 bps and announced its 3 year repo. It was as if the ECB provided a massive dose of morphine and suddenly the corpse sat bolt upright, and people thought this was a good thing.

I have never purported to be better at forecasting or predicting the future prospects of markets than the next drunk at the bar. But I always have a thesis, supported by signposts which serve as the evidence as time unfolds, and I am impatient with losses and patient with winnings. I’m probably right half of the time. That’s life. This is a bit of a warning to all who read these articles. There are times when I have stronger belief in my own expectations and times when I have less conviction.

Look at the world today. Apart from the US, the world economy is slowing, dangerously so in some areas such as Europe. Even the BRICs are slowing. The US economy’s recovery is a lagged effect from China’s voracious appetite for Keynesian fiscal railway track building. That and an out of phase inventory cycle which is likely to drive US manufacturing for another 6 months.

But the future is very much unclear. This is no way to write an investment article but it’s the truth. We often sound more confident than we are. We are so used to behaving like that, especially with other peoples’ money. But now the stakes are especially high. Investors, wrong footed by the December LTRO which they grossly underestimated in size and market impact, now expect the Feb 29 LTRO to be 2 to 3 times larger than the 489 billion EUR of the previous one. They might be disappointed and at risk of being whipsawed. I do not see the collateral accumulation in the MRO or short term 1 week repos these past weeks as I saw in the run up to the Dec 22 LTRO. The market impact if the Feb LTRO is below the expected size might be quite bad.

While the US looks to be in recovery there are always mini cycles within the longer term cycles. The colossal Federal debt is a problem for the US. At 15 trillion USD it outstrips US GDP. It is remarkable that sovereign debt has effectively become PIKs (payment in kind), a type of financing reserved for cash strapped and highly geared borrowers, which of course actually makes sense. The fiscal drag for the next decade is ominous. Somehow money has to be found to pay down existing debt and to cover medical care, pay for pensions for the aged, maintain military infrastructure, provide for unemployment insurance, fund education etc etc. All this at a time when the banking system, globally, is going through a process of restructuring existing assets as well as restructuring the standards of future credit provision.

If banks have been given a reprieve, it is not a long term solution. Now that the frailties of fractional reserve banking have been exposed, and patchwork solutions such as Basel III have been introduced, how will we get capital, money, from over here to over there? Central banks have liquefied the banking system with massive loans at artificially depressed costs in the hope that this money will find itself into the hands of enterprises and households so as to fund economic growth and consumption. Capital requirements whether under Basel or local regulations deter banks from lending to all but the highest rated borrowers, even if these borrowers turn out to be deadbeats. Healthy, cash flow generative private businesses may not find it so easy to borrow. Households may not find it so easy to refinance their mortgages, or get home equity loans or lines of credit.

If banks were meant to de-leverage their balance sheets, they certainly have a strange way of doing it. Tier One Capital Ratios are still widely seen as the metric of financial stability even as the problem assets carry a zero risk weight while healthy corporate assets carry a full 100% risk weight. With the provision of credit from the central banks, banks have chosen to shore up Tier One Capital ratios by loading up on sovereign bonds while eschewing more capital intensive corporate loans. In this way, commercial banks are co-opted into monetizing sovereign debt on behalf of their central banks. Artificially depressing interest rates and inflating asset prices are excellent strategies in debt management. The trick is in sheltering the inflationary pressures from public scrutiny. This two pronged strategy of regulation and credit extension also drives a direct substitution away from private credit provision towards quantitative easing and is a perverse example of crowding out at low interest rates.

Since 2008, China has been a major driver of global economic growth. The fortunes of Latin American and
Australian resource companies, of German equipment manufacturers, of US brands and intellectual property owning companies, of European luxury purveyors, can be traced ultimately to a credit induced, infrastructure investment binge driven spurt of economic growth from China. The restructuring of China into a more balanced consumption driven economy has been slow. The acute income inequality does not help. Until the distribution of wealth is more equitable China will remain an investment and government driven economy. The Keynesian policies have already driven up inflation and despite a slowing of top line CPI growth, food prices remain stubbornly high, confounding government efforts at reflating a slowing economy. With an upcoming change of management at the top of the Party, China’s policy makers are faced with addressing inflation, managing the massive credit creation in the shadow banking industry and keeping economic growth sufficient to absorb new entrants into the labour market. Short term considerations will likely force China into further infrastructure investment. Any ideas about investing in resources should be tempered by the massive stockpiles that the Chinese have accumulated directly and indirectly.

And then there is just the total debt including unfunded public liabilities globally. There is simply too much debt in the system. Focusing just on the US before turning one’s attention to Europe and Japan, is enough to discourage the most bullish investor. Total Federal debt is roughly 100% of GDP, that’s 15 trillion USD. Private debt is over double that. So all in we are looking at over 300% of GDP. The Federal debt needs further adjustments for social benefits and healthcare which add another 50 over billion USD to the bill. And soon we are staring at public liabilities alone of over 300% of GDP. The USA’s debt to GDP ratio stands at over 3.5X. The numbers in Japan are similarly poor. Public debt is circa 200% and while we are told that this is not a problem because it is domestically funded, it is a huge fiscal drag and an accident waiting to happen. Private debt in Japan is over 300% of GDP, down from almost 400% in the late 1980’s when Japan’s bubble burst. The impact of debt on Japan is clear to see; decades of slow growth and stagnation. And in the UK and the Eurozone, the situation is worse than in the US. The way in which GDP is measured results in debt financed expenditure being counted in the national income accounts as GDP. If then we expect that debt levels need to be reduced then we should also expect muted if not falling GDP in the future. High debt levels also encourage savings, at least in the private sector where unlimited credit growth is not viable.

To summarize these random and highly equivocal thoughts:

• The rally in risk assets is liquidity driven. Long run fundamentals remain in acutely poor condition.
• Each central bank will attempt debt monetization and stoking inflation to the extent that they can.
• Each country will try to debase their own currency in rounds of rotational devaluation.
• It is not a long term viable solution to solve a debt crisis with credit creation. This is analogous to attempting to extinguish a fire with gasoline.
• Long term debt reduction is the only viable solution not to create more booms and busts.
• The US recovery has another 3 months or so to run. Beyond that we have no visibility. It is likely to stall.
• Europe is likely to remain in recession for some time despite liquidity infusions.
• China will concentrate on local issues until the handover is complete. Political sensitivities such as food price inflation come first.
• Resource economies may benefit from further infrastructure investment by China but given the volatility of this single offtaker and current stockpiles, this is a risky bet.
• The current rally in risk assets is not expected to extend too much further. (Japan’s stimulus may drive Japanese equities a bit further.)

The long term is not so relevant from a trading perspective. And the forecasts and expectations need to be discounted with a higher level of uncertainty the farther we look out on the horizon. My gut feel is the following:

The risk surrounding over optimistic expectations over the ECB’s LTRO could hurt risk assets. I would not hold a large net position, in fact I would not hold a large gross position over the next 2 weeks. The market has swung from a heavily oversold position at the end of last year, and an acutely pessimistic view, to an unreasonably rosy view of economic growth in the BRICs and recovery in the US.

Over a slightly longer horizon, say 6 months, I expect the lack of diabolically game changing good or bad news to maintain the status quo of uncertainty, thus also maintaining the upward pressure on risk assets. Reality is likely to rear its head later in the year once equities have reached higher valuations. A US Presidential election looms, the changing of the guard in China has already begun, Europe’s political landscape may change as economic issues spill over to the political landscape. All these complicates matters. I expect weakness in ri
sk assets to set in only in the latter part of the year. In the meantime, the only viable strategy is NOT to buy and hold, but to actively trade, as much for profit as to manage exposure and risk.

At the end of the day, I too struggle in the fog of uncertainty as I try to cope with each piece of news and each new development. I wish my crystal ball was Baccarat and not Lalique.

The ECB’s QE(stealth) has worked a treat since the printing presses were deployed 22 Dec 2011. The 3 year repo saw a 489 billion Euro allotment, equal to over 620 billion USD.

The signs that the market’s analysts would get this one wrong, they had expected a maximum allotment of circa 250m Euro were clear. The weekly allotments prior to 22 Dec were snowballing with the 14 Dec allotment totaling 291m Euro. That should have been the minimum forecast. A better estimate would have been 433m given the maturities of the 14 Dec 291m and the 21 Dec 142m.

On 29 Feb 2012, the ECB has another shot of morphine in the form of yet another 3 year repo. The size of the allotment is the multi-billion Euro question. Having got the allotment size forecast wrong first time round, the market is looking for double or triple the 489 billion Euro. They may not get it. The 1 week repos are not snowballing as quickly and at last count we can see 150m Euros. Of course between now and the end of the month things may change and the Open Market Operations of the ECB have to be monitored. This is just the latest tally as at 8 Feb.

My bullish call on equities, particularly European equities, since 14 Dec 2011, has been predicated on the ECB’s QE(stealth). The massive size of the 3 year repo on 22 Dec 2011 provided confirmation to the view and it has been a view that has worked out. This all does not imply that the European or Global economy has recovered or is in recovery. Far from it. Instead, it has been a market call based on psychology and an understanding of human emotional frailties.

My market view is therefore sensitive to the 29 Feb LTRO. The market is pricing in a large allotment, in the region of 250m to 500m Euro. Some forecasts range as far as a trillion Euro.  If the banks and the ECB disappoint, it would certainly invalidate or weaken the thesis.

One part of the thesis remains, that bank funding stress has been unequivocally relieved. This alone should have some support for risky assets in Europe.

The outlook therefore is now quite uncertain. I would remain long and cautious, monitoring the 1 week repos for signs that the banks are hoarding collateral for the 29 Feb LTRO. If the number threatens to be big, I would add risk and if the number looked to be missing its target, I would reduce risk. These are the signposts.

From a fundamental perspective, the economies of Greece, Portugal, Ireland, Italy and Spain operate at productivity levels inconsistent with factor prices prevailing in the market. Some of these rigidities stem from the use of a common currency, the Euro. You cannot leverage a fundamentally flawed business model (or economy) into viability. The strategy above therefore is akin to a game of chicken.

Equity markets have rallied since mid Dec 2011 as the ECB began its QE(stealth) and the US economy continued to recover. It appears that equity markets want to take a breather. This could last between a matter of days to a couple of weeks. The trend is up.

Investing or trading, call it what you will, is tricky business. One thing for sure is that if one is wedded blindly to fundamentals, losses lie in store. Asset prices are linked to fundamentals through psychology. Unless you intend to redeem a bond at par, buy out an entire company, wrest control of one or practice arbitrage, fundamentals are only useful insofar as it provides all the possible viewpoints available to all investors. Understanding which viewpoint will ultimately motivate the marginal buyer or seller provides insight into future price movements. One only buys (shorts) something with the expectation that someone else will buy (sell) it from (to) them at a higher (lower) price.

This can mean that some of the most profitable trades seem to be the least rational ones.

• when there is a bailout buy the lowest quality and short the highest quality.

• as the ECB prints money, implying a debasement of currency, the immediate relief reaction is a stronger Euro.

• buy European sovereign bonds as the ECB prints money. Front run the banks who are the agents of the ECB’s printing press.

• the US is recovering, buy China exporters.

• China is slowing, buy resource companies. Unable to restructure its economy towards domestic consumption, under pressure in a change of management year, China will flex its fiscal muscles the only way it knows how. Having built staircases going up, it will now build staircases going down. And railways and highways.

Do look at technicals but never in isolation. Causality is far more important than correlation. It is also far more difficult to envisage and validate.

Pre-empt the news and events. Don’t trade in anticipation, at least not in size. Build plausible scenarios based on common sense and understanding the motivations of all participants in the game. Then set milestones that confirm or confound the thesis.

For example, in Dec 2011, with the thesis that the ECB was printing money, trade long. Set signposts to validate and stay long as long as these signposts are met. In the meantime look for a reason the market might reverse. Set signposts again. If signposts are not met and the market turns, its likely a buying opportunity. If bear signposts are met, reduce exposure and possibly turn short.

Constantly build scenarios, set milestones and signposts, trade as planned and use the milestones and signposts to validate or invalidate the thesis. If in a trend, build the reversal scenarios and look for the signs that validate.

And even then you’ll get it wrong. But your mistakes and losses will at least be unavoidable ones. It is wasteful to make avoidable mistakes.

And to the value investors who chant the value mantra as their portfolio NAVs keep falling, I agree totally that the value is getting better but here’s the thing, where is your purchasing power?

By the way, even as risky asset markets rise and are likely to continue to rise, in my view, the real economy is in real serious trouble and there will come that point in time, again, when reality bites. On fundamentals alone, one would either be short risky assets or simply out of the way of the coming train wreck. The psychology tells us to play this game of chicken with all the other players in the great game.

Good luck at the tables…

Brace