Renewed VIX Sell Signal

by Trader Craig

The VIX has triggered a renewed sell signal based on yesterday’s breakout above the July 18 high. Despite the large rally off of the June low there was no intervening buy signal, which would seem to confirm that the rally was a fake based mostly on extreme short term bearish sentiment and short covering. At this point it could take 4 weeks or more to get a valid buy signal based on the conservative method used on the chart. In general this method has worked fairly well in confirming intermediate trends, but not so well over the last few months with extremely choppy market conditions.

IBD has called the “Market In Correction” on its Big Picture column as of yesterday’s close. Regardless of the extent of downside follow-through it could take several weeks to setup a new intermediate term rally due to the amount of distribution that has occurred in the last 4 weeks irrespective of any pattern that might be developing.

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A Greek Catch-22

by Eduardo Levy Yeyati

Desperate times bring desperate measures. The latest package to cope with Greece’s insolvency offers a bond buyback to lighten the country’s debt burden. In essence, this is a back-door debt restructuring: Europe’s bailout fund, the European Financial Stability Facility (EFSF) would lend the money for Greece to buy back its own debt in the secondary market at deep discounts, thereby imposing a loss on private bondholders without the need to declare a default.

A recurrent characteristic of Europe’s debt-crisis debate is a Latin American precedent. Indeed, many highly indebted countries in Latin America conducted similar debt buybacks in the late 1980’s. Bolivia’s 1988 buyback of close to half of its defaulted sovereign debt, an operation funded by international donors, is a classic example. But the most relevant Latin American experience with debt buybacks is a more recent and far less studied case: Ecuador in 2008.

President Rafael Correa had been toying with default since the 2006 presidential campaign (debt repudiation was part of his platform), and quickly earned a CCC rating from Fitch. The reasons invoked by Correa (legal concerns about how the bonds were issued in the 2000 debt exchange) were beside the point. The default threat was a way to depress bond prices in secondary markets, only to buy them back at a discount through the back door. That task was outsourced to Banco del Pacífico, which bought the soon-to-be-defaulted Ecuadorian paper at 20 cents on the dollar and above – a level low enough for a deep haircut but high enough to fend off “vulture” investors.

To speed things up, after the default was declared in December 2008, Ecuador completed the buyback with an inverse auction for the remaining bondholders, to be settled in cash – rather than a regular exchange in which the legality of undercover purchases was likely to be questioned. With the larger part of the outstanding stock in friendly hands, and institutional bondholders pressed to liquidate their positions in the midst of the post-Lehman Brothers selloff, the operation was a success.

This episode offers a few preliminary lessons on debt buybacks. The first concerns the market response. Judging from the recent evolution of Ecuadorian bond yields, it appears that markets have not punished Ecuador’s behavior: Ecuador, an oil exporter blessed by the 2009 recovery in oil prices, could have returned to the capital markets shortly after the exchange. This is particularly notable, given that Ecuador’s was perhaps the first opportunistic default (triggered by unwillingness, rather than inability, to pay) in recent history.

The second lesson, and the one most pertinent to Europe now, concerns the crucial role played by the default scenario. Indeed, almost two years of default threats by Correa were not enough to elicit a deep discount. Ecuador needed to go all the way to a “credit event” in December 2008 to be able to purchase the bonds at bargain prices.

The premise that only a credible default ensures significant private-sector involvement (that is, that private bondholders take a real hit) is apparent when we compare the market-friendly Uruguayan debt exchange in 2003 with the draconian Argentine restructuring of 2005. In Uruguay, what the authorities presented as a voluntary transaction produced no nominal haircuts and only minor debt relief; in Argentina, a four-year debt moratorium was essential to achieving nominal haircuts above 50%.

So the question arises: how are private bondholders to be convinced to get rid of their Greek bonds at a loss if there is a credible buyer of last resort? If Europe credibly volunteered funds to buy back all Greek debt, the Greek risk premium would disappear and private investors would be fully bailed out. Only the probability of a default – and the goal of avoiding even deeper haircuts – can induce investors to liquidate their positions at a discount. But the buyback can succeed only if the market perceives it as the last chance before a unilateral debt restructuring. In other words, a successful buyback is a preamble to default.

Can Greece, with the EFSF’s help, obtain debt relief while avoiding default? Small purchases at current panic prices, vulture-fund style, are always possible, but they do not promise substantial debt relief. Large purchases would drive up prices in the secondary market, defeating the point of the whole operation. And the opaque Ecuadorian methods are not possible in Europe, both for legal reasons and because a transaction of this size could hardly be disguised or outsourced.

But what if the EFSF were to mimic Banco del Pacífico in a transparent way, say, by setting a threshold spread level above which it would fund buy-backs of any Greek bond in the market? Naturally, the spread would automatically converge to the threshold, but how much would be sold? Would the EFSF be retiring Greek debt at bargain prices or would it be providing insurance to current bondholders?

If the threshold spread is set reasonably high in order to achieve a significant discount, the stock of debt retired by the buyback would be marginal. After all, by capping spreads, the buyback facility would limit the downside risk while providing incentives to hold the bonds and wait for the upside – a good reason, perhaps, to make the facility a temporary offer. By contrast, if the threshold is set low enough to bring spreads down from panic levels, purchases will be more substantive, but at the expense of reducing considerably the effective haircut on private holders.

A debt buyback is something of a Catch 22: to succeed in inducing a haircut, it needs to profit from the default fears that it intends to alleviate. Without Ecuador’s gimmicks, buybacks do not seem to be the solution to Greece’s debt overhang.

Eduardo Levy Yeyati is Professor of Economics at Universidad Torcuato Di Tella and Senior Fellow at the Brookings Institution.

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America’s Fiscal Isolationism

by Christopher Hill

Patience might be a virtue, but not necessarily when it comes to American foreign policy.

Consider “the long war,” a bold concept embraced a few years ago to describe the continuing struggle against terrorism, the grudging progress that could realistically be achieved, and the enormous financial burden that it would impose for years to come. It was also a realpolitik acknowledgement of the setbacks to be expected along the way (the “slog,” as then Defense Secretary Donald Rumsfeld put it).

Above all, the term was an effort to communicate to Americans, accustomed to waging war with speed and decisiveness (and insistent on it since Vietnam), the long-term sacrifice and commitment needed to win a war of survival. Its proponents also understood that the war would not be limited to weapons, but would need to be a sustained effort, involving, as they put it, the “whole of government,” with civilian agencies marshaled behind military – or paramilitary – objectives.

Daunting as the effort would be, its advocates assumed a sustainable political consensus to support it. After all, the United States had been attacked.

Today, that consensus is unraveling as America’s politicians wrestle with a federal budget that is itself turning into a long war – one with its own casualties. The battle lines in this struggle suggest that there is little accord among political elites for any spending, let alone for a long war with far-flung commitments.

As a result, basic assumptions are being questioned at every turn. Indeed, the current budget war seems to be reopening old divisions about America’s view of itself and the world. The outcome is far from certain, but even isolationism, a perennial American malady, seems to be making a comeback.

Isolationism is a familiar refrain in US foreign policy among those elements of the right that consider the US too good for the world, as well as among those on the left who consider America a destructive global force. But this time, as perhaps never before, a bipartisan isolationist impulse is being driven by the budget.

America’s fiscal crisis is profound, and it is not just about numbers. As the emotions in Washington today suggest, the aversion to tax increases runs far deeper than concern about their effect on current economic performance and job growth. In part, it represents a fundamental – some would say fundamentalist – view that taxes are to government what a bottle of whisky is to an alcoholic. Government, as Ronald Reagan told us, is the problem, not the solution.

That message is bad news for American diplomacy. The linkage between politicians’ unwillingness to fund domestic programs and the imperiled commitment to “the long war” might elude those in US foreign-policy circles, but it is not lost on the rest of the country. Opinion surveys suggest that Americans want to maintain many of the “discretionary” domestic programs – schools, hospitals, transportation infrastructure, recreational parks, etc. – that are now on the chopping block in budget negotiations.

In places like rural El Paso County, on the eastern plains of Colorado, far from the federal budget debate’s epicenter, spending cuts are the order of the day. School districts are increasing class sizes as they shed teachers, as well as deferring maintenance projects and curtailing the school-bus service. These cuts are having a very real and immediate impact on El Paso County’s residents. Can they, and other Americans who are losing vital services, really be expected to rise above it all and support funding to build new schools in Afghanistan?

Not only are America’s public schools starting to look second-rate, but so is its infrastructure, which had long been a source of national pride. How many travelers nowadays can fail to note the difference between Asia’s new, efficient airports and the aging, clogged antiques in some major US cities?

The budget war is not producing any consensus on fixing America’s infrastructure, but it is beginning to produce a view that Afghanistan and Pakistan are far from being core US national interests. Why, people ask, are schools and roads in Afghanistan and Iraq more important than those in Colorado or California? At one point in 2008, the US military picked up the cost of transporting a tiger for the Baghdad zoo. When was the last time the US government did that for a US zoo (outside of Washington, of course)?

How this debate sorts itself out will have profound consequences for how America conducts itself in the world. But it might also take a toll on how the world reacts to America’s fastest-growing export: unsolicited advice.

Countries take others’ advice for many reasons. Sometimes they respect the adviser’s wisdom and insights (fairly rare in diplomacy). Or they might fear the consequences of not taking the advice (an offer one cannot refuse, so to speak). Or, as is true of many of America’s diplomatic transactions, accepting advice could open the way to a better relationship and to additional assistance. In short, diplomacy – and US diplomacy, in particular – often involves money.

But what if there is no money to offer? What if Americans, tired of the budget cuts in their neighborhoods, refuse to support funds even for “the long war”? At that point, senior US officials might well arrive in a country, offer advice, and find that nobody is bothering to listen.

Christopher R. Hill, a former US Assistant Secretary of State for East Asia, was US Ambassador to Iraq, South Korea, Macedonia, and Poland, US special envoy for Kosovo, a negotiator of the Dayton Peace Accords, and chief US negotiator with North Korea from 2005-2009. He is now Dean of the Korbel School of International Studies, University of Denver.

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Brazil: Growth and Policy Mismatch?

By Arthur Carvalho

Brazil’s central bank's 25bp rate hike last week brought the Selic rate to 12.5%. But in contrast with most Brazil watchers, we believe that move could be the central bank’s last move for the year. We interpret recent comments by the central bank as suggesting that it will end the rate-hiking cycle by August and possibly as early as this week.

And given the growing uncertainty in the global environment, it would be easy to imagine a decision at the end of August indicating that it is time to hold off on additional rate hikes even if such a decision is not clearly telegraphed at the July meeting.

Our forecast of the central bank’s likely path – last rate hike in July to 12.5% and then on hold through next year – is not set in stone. We have held for nearly a year now that the hiking cycle would end at 12.5% and do not see enough reason to adjust our forecast. If we had held, as many now do, a hiking cycle ending at 12.75% we would probably not adjust our forecast either: there is simply not enough evidence to date to define with greater certainty if the central bank’s overnight interest rate target is set to reach 12.5% or 12.75%.

But what does seem clear is that the central bank is approaching the end of the hiking cycle: that can be seen in the central bank’s diagnosis of inflation, its assessment of its action’s success and its understanding of the usual policy lags.

The View from the Central Bank

Look at the central bank’s diagnosis of inflation: inflation is largely a supply shock that erupted in the last months of 2010 in international commodity markets, combined with supply disruptions in a few localized domestic markets (most prominently beef) and compounded by weather-related shocks at the beginning of 2011. Did robust demand play a role in adding to inflationary pressures? Most certainly, and the central bank clearly recognizes that. But at the core, the origin of the uptick in inflation at the beginning of the year was a string of supply problems.

Now look at the central bank’s assessment of the success of its actions: inflation has plummeted after averaging 0.73%M during the first five months of the year. Indeed, the central bank’s models are forecasting monthly inflation at half that pace in the last seven months of the year. Certainly, the drop-off at mid-year is in part due to seasonal factors and there will likely be a gradual uptick towards the end of the year as seasonality works in the other direction. But inflation is on a path that the central bank believes is consistent with a return towards the 4.5% target.

Of course, the return to a 4.5% path does not mean that inflation is set to reach 4.5% this year – the central bank’s own modeling puts inflation at 5.8% for end-2011. And the central bank seems to have contemplated that the August inflation reading, if measured on a year-on-year basis, is likely to show a peaking of the annual readings near 7% (above the 6.5% upper limit of its inflation band).

Finally, look at the central bank’s understanding of the usual policy lags: it is not likely to be until September or 4Q11 that the ‘full force’ of its actions are felt. While it is possible that the central bank keeps hiking throughout the remainder of the year, we believe the much more likely outcome is that the central bank decides to stop and argue that it is time to wait and assess the full impact of its actions. Monetary and macroprudential policies work with a lag, and the central bank believes that the six to nine-month lag remains in place.

Service Pressures

We remain concerned about Brazil’s inflation picture. On the one hand, we agree with the central bank’s emphasis on the role that supply disruptions played in the inflation scare at the end of last year and the beginning of 2011. We argued then that inflation was being misdiagnosed: Brazil had an inflation problem, just not the one that most analysts were focusing on.

We argued that the uptick was concentrated in a handful of food items and that the risk of inflation spiraling ever higher was being overplayed by many. But our concern then is our same concern now: the rapid growth in domestic demand has pressured services or non-tradeable prices during the past two years. With unemployment running at record lows, an overheated labor market is producing pressure in wage inflation and service prices. Is inflation likely to spiral ever higher? We don’t think so. Is it consistent with a return to 4.5% inflation? We doubt it.

We believe that Brazil’s inflation problem is the outgrowth of the Growth Mismatch (robust demand facing sluggish supply) and the policy response to date. While the central bank has hiked interest rates by 150bp this year (and we expect total hikes this year of 175bp after this week’s meeting) and implemented macroprudential measures, we are concerned that much more needs to be done on Brazil’s fiscal and quasi-fiscal fronts.

With demand still growing much more rapidly than potential and easily outstripping supply, Brazil needed to engage in counter-cyclical fiscal policy in 2010. The efforts to rein in spending announced this February are a valuable step, but as long as Brazil is set to run a significant overall budget deficit, we worry that not enough is being done.

Can the Growth Mismatch Self-Correct?

For a year now, we’ve been arguing that a multi-decade strong exchange rate is simultaneously boosting consumer demand while damaging local production (the Growth Mismatch). Even as demand has remained robust, industrial production has stalled out during the past year. Output in May – the latest month for which we have data – was just 1.0% above the peak set in April 2010. During that same period, retail sales were up 8.2% in real terms.

And the impact on the broadest measure of activity – GDP – is also being seen. May’s GDP proxy released this past week was up only 0.17%M, the second-weakest sequential reading in the past year. Shouldn’t the damage to Brazil’s productive plant begin to feed through to hiring decisions and wages? We believe it is, but are not sure if it will be enough to tame inflation.

Let’s look at the recent signs of softening in labor markets. Although formal job creation was still a relatively healthy 150,000 seasonally adjusted in May, it is not nearly as strong as the 190,000 generated at the beginning of the year or the average of 185,000 during 2010. And real wage growth also appears to be slipping. Real wages rose on average 5.4% in 2H10 and 4.3% in the first three months of the year before slowing to 4% in May.

And while an uptick in inflation at the beginning of the year explains part of what has been happening to real wages, it doesn’t explain the full picture. Nominal wages are also slowing despite the powerful forces of indexation still present in the Brazilian economy. What’s behind all of this?

Domestic-focused enterprises have largely stopped providing positive real wage increases in recent months. Instead, the bulk of the high real wage settlements within the industrial base appear to be coming from commodity-related, large exporters. A growing wedge is being formed within Brazil’s industrial sector between commodity-related enterprises and more domestic-focused companies – that wedge is yet another manifestation of the Growth Mismatch. A strong currency is hurting domestic producers as imports are increasingly replacing local production.

At first glance, our findings that exporters are doing well might seem surprising to some. After all, if we argue that the strong currency has been a major factor harming Brazil’s industrial base, why then are exporters still able to pass on high real wages? We suspect that exporters are still in relatively good shape because strong export prices have helped to offset the damage from a stronger exchange rate. In contrast, domestic-focused, non-commodity-related industries are most likely being hit by the strong currency that has attracted import competition.

The damage to Brazil’s domestic-focused producers is reason for concern. We estimate that domestic-focused sectors make up for nearly 40% of Brazil’s manufacturing sector and manufacturing in turn makes up nearly one-fifth of all formal employment. But is this weakness among domestic-focused manufacturers enough to begin to work through demand channels throughout the economy? We are not sure.

The problem is that Brazil’s largest sector, services, appears to be gaining new entrants from the more troubled manufacturing sector. Broad services represent roughly half of formal employment, but have begun to gain share during the past year just as industry has begun to suffer. Unlike merchandise markets where strong demand can be met in part by growing imports, the most likely response in services to strong demand is simply higher prices and hence higher wage pressures.

While the service wage picture is mixed – we are seeing significant pressure in education services, domestic help, civil construction and ‘other services’, but not in financial or retail wages – the best-performing sectors account for almost 50% of GDP. And that likely explains why we are still seeing strong real wage growth.

If, as we expect, industrial output remains sluggish in Brazil, we would expect to see continued weakness in those sectors hit by growing imports. But it is not clear that this will self-correct and significantly reduce the Growth Mismatch as long as services remains robust and a benign external environment allows Brazil’s largest exporters to benefit from strong commodity prices.

Despite our global team’s recognition that the risks to the pace of the global recovery are rising, it is not clear that the global outlook will produce enough of a slowdown to cause a large enough correction in commodity prices to reduce increasingly sticky wage pressures in certain high-profile sectors in Brazil.

Bottom Line

The central bank appears to be preparing to end its hiking cycle. Whether it is one more hike (our view) or two more hikes (the view of many), the end may leave some puzzled. The good news is that the risk feared by many at the beginning of the year of inflation spiraling ever higher is highly unlikely. The bad news is that we expect inflation to be persistent for longer.

Brazil is facing a powerful wealth shock in the form of the strongest terms of trade in decades, which in turn is producing the strongest currency in decades. Unless the global economy turns down suddenly, we expect the strong currency to continue to have a powerful impact on consumer purchasing power.

And this means that while so much of the focus has been on what Brazil’s central bank will do next and how far it will move, the real challenge for Brazil is for the central bank to be joined by a much more concerted counter-cyclical fiscal policy. Brazil may be facing the challenge today from a Growth Mismatch, but structurally it continues to face a policy mismatch.

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Brazil Charges 1% Tax on Bets Against US Dollar, Threatens 25% Tax; Brazilian Real Overvalued, FDI Will Reverse

by Mike Shedlock

The global imbalances continue to grow and the reactions to those imbalances is nothing short of madness.

As a case in point, Brazil Charges Tax on Bets Against Dollar as Real Rallies to 12-Year High.

Brazil imposed a tax on bets against the U.S. dollar and warned it may boost intervention in the nation’s derivatives market in a bid to weaken a currency that reached a 12-year high this week.

As part of a new round of currency measures unveiled today, the government levied a 1 percent tax on short dollar positions in the country’s futures market above $10 million in notional value. The government may increase the tax up to 25 percent if needed, according to the decree signed by President Dilma Rousseff and published today in the Official Gazette.

Finance Minister Guido Mantega said that the measures give the government a “bigger arsenal” of tools to defend itself from “speculation” that the real will continue to rally amid global economic uncertainty. “We’re reducing the advantages enjoyed by speculators, and we expect the real will weaken or stop appreciating,” Mantega told reporters in Brasilia.

The measures, the latest attempt by policy makers to ease capital inflows behind a 48 percent rally in the real since the end of 2008, are unlikely to reduce the attractiveness of Latin America’s biggest economy to foreign investors, said Jankiel Santos, chief economist for Espirito Santo Investment Bank in Sao Paulo.

Investment is pouring into Brazil as the nation develops offshore oil finds and prepares to host the 2014 World Cup and 2016 Summer Olympics. Foreign direct investment jumped to a record $69 billion in the 12 months through June, the central bank said yesterday.

Today’s measures, while applicable to all investors, will primarily affect foreign investors who hold the bulk of about $25 billion in bets against the dollar on Sao Paulo’s future exchange, said Nelson Barbosa, executive secretary at the Finance Ministry.

Brazil's Currency Regulation Knocks Real Off 12-Year Highs

The Wall Street Journal reports Brazil's Currency Regulation Knocks Real Off 12-Year Highs

Brazil's currency slumped Wednesday as the Brazilian government introduced harsh controls on currency derivatives, knocking the real off 12-year highs against the U.S. dollar.

The real has gained 7% against the greenback so far in 2011, and has advanced about 20% over the past two years. The strong real undercuts manufacturers and exporters, which struggle to compete with cheaper alternatives both at home and abroad.

Some analysts and economists also question whether the latest measures will once again prove unable to stem the real's rise, given the inherent weakness in the dollar because of the ongoing U.S. debate over spending cuts and raising the debt ceiling. Europe's difficulties with sluggish economic growth and heavy debt loads also have weighed on the euro in recent weeks.

"If the [Brazilian real] is strengthening versus the [U.S. dollar] because of the perception of adverse developments in the U.S., there is little that the Brazilian government can do other than implement measures that will increase domestic competitiveness," Goldman Sachs said in a report. Such items could include reducing local tax burdens and productivity-enhancing reforms, the firm said. The full impact of the measures is unclear right now, especially given that they will likely be followed by others, Goldman Sachs added.

Credit Crisis Brazil Revisited

I am sticking with analysis as posted in Credit Crisis in Brazil: Consumer Loan Rates Hit 47%, Defaults Soar, Debt Service Tops 50% of Disposable Income

Reader Otavio, from Brazil writes ...

Hello Mish

Otavio here, a Brazilian follower of your blog. Today I want to express my satisfaction as I read you latest post entitled Preposterous Statements - Jim Rogers: "No Food at Any Price"; Barton Biggs: " U.S. Needs Massive Infrastructure Program".

When I hear statements like these, it feels like the move up in commodity prices might be near the end. I cannot stress more the fact that high prices fueled by zero interest rates in developed and many emerging markets (for many years now) are a fruit of rampant speculation.

We have our own credit bubble here, which in my opinion has a good chance of busting sooner rather than later, via one or more of the following:

1. Central Bank over-tightening local rates
2. Slowdown in China, which would change our terms of trade and contract global capital flows to EM and Brazil (as we are suppliers of commodities to China), tightening monetary conditions here as a result
3. Deterioration of credit crisis in Europe (and US), would also contract global capital flows and tighten monetary conditions here

I took the liberty of forwarding you a FT article about Brazil.

I think you might appreciate this as maybe a topic for future posts of yours, since you are keen in identifying and warning readers and investors of potential bubbles around the world that may be close to busting. For the record, I will say that in my opinion, Brazilian real estate, many local stocks, and our currency (the Real), are extremely overvalued as well.

Cheers
Otavio

With thanks to Otavio, please consider a few highlights from the Financial Times article Brazil risks tumbling from boom to bust

Cash Flow Burden Astronomical and Rising

• Average rate of interest on consumer loans 47%, up from 41% in 2010
• Consumer debt service burden was 24 per cent of disposable income in 2010, slated to rise to 28 per cent in 2011. This compares with 16% for an “overburdened” US consumer and a mid-single digit reading for other emerging markets such as China and India.
• Debt service burden for the so-called “middle class” in Brazil has now breached 50% of disposable income
• Delinquencies in Brazil (defaults in excess of 15 days) have begun to move up rapidly, from 7.8 per cent to 9.1 per cent of total loans between December 2010 and May 2011.
• Delinquencies are now rising at a very hectic rate. They have risen at 23 per cent in the first five months of this year in absolute terms or at an annualised rate of 55 per cent.
• Normally credit indicators cyclically lag the economic cycle. When they begin to deteriorate before any economic weakness it usually represents a structural problem relating to underlying cash flow or underwriting weakness in the quality of credit – Brazil has both problems.

FDI Will Reverse, Real Overvalued
My comment at the time : I am inclined to agree with Otavio who says the Real is "extremely overvalued".

I see no reason to change my stance now.

It's important to realize Brazil is not a passive victim. Inflation is rampant and government spending is a "whopping 40 percent of gross domestic product" according to Alberto Ramos, Latin America economist at Goldman Sachs in New York, as noted in Guido Mantega Mulls New Currency Measures

At some point FDI and hedge fund bets on the Real will reverse in a spectacular way. I suspect it will be when China slows taking commodity prices with it. However, reversals can happen at any time.

Certainly the situation is unstable, much like it was with the the Icelandic Krona before Iceland imploded.

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It is all Relative

by the trader

We all know it is the not the absolute amounts that matter in life. All things are relative, especially large sums of money. Maybe Obama is a really good guy, or? Chart by NYT.

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Another European Market Implosion On Weak Italy Auctions, Tremonti Resignation Rumors, Deteriorating Economic Data And Earnings Misses

by Tyler Durden

On the one week anniversary of Europe's second bailout one may be tempted to ask "what bailout" looking at the across the board deterioration in European market metrics: Spanish 10 Year bonds over 6.00% again, Italy CDS surging to 330 bps, Italy Bunds spreads at 331 just inches away from all time wides of 353 bps, EURUSD plunging by over 100 pips overnight, CAC, DAX, OMX all falling by more than 1 standard deviation as VW, chemical maker BASF, and Credit Suisse all missed earnings estimates, and, of course, numerous Italian banks (don't disappoint us UniCredit) once again on the verge of being halted after plunging by a solid 5-6%. Several reasons for the weakness: i) Italy auctioned off €8 billion in 3,4,7,10 and year fixed and floating rate notes generating weaker than expected results with the 10 year bond gross yield rising to 5.77%, the highest since 2000, and just under the all time record of 5.81%, and the 3 year gross yield of 4.80 pushing to the highest since 2008, ii) more rumors of Tremonti resigning, iii) European retail sales declining for a third month according to Markit, and iv) a decline in Euro-area economic confidence more than estimated, dropping from 105.4 to 103.2, below the consensus of 104.0. German bunds are once again well bid with September futures rising 0.2% to 129.63. But not before rumors of ECB buying peripheral bonds via the SMP spooked bunds lower, with the resulting rise being only a result of the flight from Italy. And putting a cherry on top of it all was ECB's Mersch who once again resumed the old party line, saying that fears of a "premature end to euro are unfounded." And to think that just a week earlier the ECB told us we would never have to worry about the end of the euro.

Below we break down the Italian auction. Recall that as we reported two days ago, the Tesoro decided to scrap its August mid-term auction. Now we can see why.

• 3-yr auc avg yld 4.8% vs 3.68%, bid/cover 1.31 vs 1.39
• 7-yr auc avg yld 4.65% vs 3.38%, bid/cover 1.76 vs 1.59
• 10-yr auc avg yld 5.77% vs 4.94%, bid/cover 1.38 vs 1.33
• 4-yr auc avg yld 4.58% vs 3.17%, bid/cover 1.79 vs 1.63

Reuters' summary:

Italy's borrowing costs soared on Thursday as it sold nearly 8 billion euros of bonds, with jitters about its debt pile pushing its benchmark 10-year bond yield to the highest in 11 years.

The premium investors demand to hold 10-year Italian debt instead of safe-haven German Bunds widened after the auction and Italy's blue-chip index extended losses as analysts warned Rome could not afford to pay these kind of rates for a long time.

"These are not sustainable levels of yields in the long run," said Marc Ostwald, a bond strategist at Monument Securities in London.

The auction gross yield on the 10-year bond rose to 5.77 percent, the highest since February 2000 and just a shade under a euro lifetime record of 5.81 percent.

The yield on a new three-year bond jumped to 4.80 percent, the highest since July 2008.

Still, Italy managed to sell nearly 8 billion euros of bonds against a maximum target of 8.5 billion euros -- a sign of healthy demand.

"It is positive that they sold nearly the full amount of BTPs. The bid-to-cover is not great but still in line with the last few auctions," said Alessandro Giansanti, a rate strategist at ING in Amsterdam.

"What's worrying is that the spread keeps rising, and so do the auction yields," he said.

The spread between the Italian 10-year BTP and the German Bund rose to 331 basis points after the auction after hitting a euro lifetime high of 353 basis points earlier this month.

As for the deterioration in Eurozone sentiment:

Economic sentiment in the euro zone worsened more than expected this month with optimism fading in all sectors, data showed on Thursday, signalling slower expansion of the economy in the second half of this year.

The European Commission's monthly sentiment index, based on a survey of businessmen and consumers across the 17-nation euro zone, fell to 103.2 in July from 105.4 in June. This month's figure was the lowest reading since 102.2 in August 2010.

The index has been falling every month since February. Analysts polled by Reuters had expected a fall to 104.0 in July.

"It is a clear soft patch, worse than expected. Bad news, clearly. We are on a downward trend since the start of the year," said Carsten Brzeski, economist at ING.

The Commission said sentiment in industry worsened to 1.1 from 3.5, in services to 7.9 from 10.1, and among consumers to -11.2 from -9.7.

"Today's data signal that the slowdown is set to continue in the second half of the year. The Composite Purchasing Managers Index for activity released last week showed a similar trend," said Clemente De Lucia, economist at BNP Paribas.

The sentiment data, as well as market jitters about Italy's ability to cope with its sovereign debt, pushed the euro down to around $1.4280 on Thursday morning from $1.4370.

As for Tremonti, we are not sure if he will or will not leave, but based on our on the ground sources in Italy, a major shake up in the Italian government, which may have a far wider impact than just the departure of the FinMin is now imminent.

As we said last week when we summarized the euro bailout: we expect the need for another bailout by the end of the year, and most certainly the forced expansion of the EFSF to at least €1 trillion as Europe has no choice but to increase the size of the ponzi pyramid with each passing day.

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Special report: Goldman's new money machine: warehouses

By Pratima Desai, Clare Baldwin, Susan Thomas and Melanie Burton

In a rundown patch of Detroit, enclosed by a cyclone fence and barbed wire, stands an unremarkable warehouse that investment bank Goldman Sachs has transformed into a money-making machine.

The derelict neighborhood off Michigan Avenue is a sharp contrast to Goldman's bustling skyscraper headquarters near Wall Street, but the two operations share one important element: management by the bank's savvy financial professionals.

A string of warehouses in Detroit, most of them operated by Goldman, has stockpiled more than a million tonnes of the industrial metal aluminum, about a quarter of global reported inventories.

Simply storing all that metal generates tens of millions of dollars in rental revenues for Goldman every year.

There's just one problem: only a trickle of the aluminum is leaving the depots, creating a supply pinch for manufacturers of everything from soft drink cans to aircraft.

The resulting spike in prices has sparked a clash between companies forced to pay more for their aluminum and wait months for it to be delivered, Goldman, which is keen to keep its cash machines humming and the London Metal Exchange (LME), the world's benchmark industrial metals market, which critics accuse of lax oversight.

Analysts question why London's metals market allows big financial players like Goldman to own the warehouses which store huge quantities of metal even as they trade the commodity.

Robin Bhar, a veteran metals analyst at Credit Agricole in London says the conflict of interest is so acute he wants U.S. and European anti-trust regulators to weigh in.

"I think it makes a mockery of the market. It's a shame," Bhar said. "This is an anti-competitive situation. It puts (some) companies at an advantage, and clearly the rest of the market at a disadvantage. It's a real, genuine concern. And I think the regulators have to look at it."

Goldman said its warehouse subsidiary Metro International Trade Services has done nothing illegal, and abides by the LME's warehousing rules. "Producers have chosen to store metal in Detroit with Metro," a Goldman spokeswoman said. "We follow the LME requirements in terms of storing and releasing metals from our warehouses."

The London Metal Exchange defends its rules. "There is a perception that consumers have not been able to get to their metal when the reality is that it is big banks, financing companies and warehouses that are not able to get to their huge tonnages of metal fast enough," said LME business development manager Chris Evans.

BUSINESS MODEL

Goldman's warehouse business relies on a lucrative opportunity enabled by the LME regulations. Those rules allow warehouses to release only a tiny fraction of their inventories per day, much less than the metal that is regularly taken in for storage.

The metal that sits in the warehouse generates lucrative rental income.

Little wonder that so many want in. Metro was acquired by Goldman in February 2010, while commodities trading firm Trafigura nabbed UK-based NEMS in March 2010, and Swiss-based group Glencore International acquired the metals warehousing unit of Italy's Pacorini last September.

Henry Bath, a warehousing firm and founding member of the London Metal Exchange in 1877, has been owned for about 40 years by traders or banks including Metallgesellschaft in the 1980s and failed U.S. energy trader Enron at the turn of the century. It now comes under the umbrella of JP Morgan, which bought the metals trading business of RBS Sempra Commodities in July last year.

Despite its rental income, Goldman's warehouse strategy apparently hasn't been enough to snap a slumping performance in commodity trading, with the company reporting a "significant" drop in revenues from a year ago in its latest quarter, the sixth time in the past 10 quarters that it has failed to expand.

CONSUMERS FUME

The long delays in metal delivery have buyers fuming. Some consumers are waiting up to a year to receive the aluminum they need and that has resulted in the perverse situation of higher prices at a time when the world is awash in the metal.

"It's driving up costs for the consumers in North America and it's not being driven up because there is a true shortage in the market. It's because of an issue of accessing metal ... in Detroit warehouses," said Nick Madden, chief procurement officer for Atlanta-based Novelis, which is owned by India's Hindalco Industries Ltd and is the world's biggest maker of rolled aluminum products. Novelis buys aluminum directly from producers but is still hit by the higher prices.

Madden estimates that the U.S. benchmark physical aluminum price is $20 to $40 a tonne higher because of the backlog at the Detroit warehouses. The physical price is currently around $2,800 per tonne.

That premium is forcing U.S. businesses to fork out millions of dollars more for the 6 million tonnes of aluminum they use annually.

It has also had a knock-on impact on the global market, which is forecast to consume about 45 million tonnes of the lightweight, durable metal this year.

Also pushing aluminum costs higher are bank financing deals, which are estimated to have locked up about 70 percent of the 4.4 million tonnes of the metal sitting in LME-registered warehouses around the world. LME inventories hit an all-time record above 4.7 million tonnes in May.

In a typical deal, a bank buys aluminum from a producer, agrees to sell it at some future point at a profit, and strikes a warehouse deal to store it cheaply for an extended time period.

The combination of the financing deals and the metal trapped in Detroit depots, means only a fraction of the inventories are available to the market.

Premiums for physical aluminum -- the amount paid above the LME's cash contract currently trading at $2,620 a tonne -- in the U.S. Midwest hit a record high of $210 a tonne in May, up about 50 percent from late last year. In Europe, the premium is at records above $200 a tonne, double the levels seen in January 2010.

The ripple effect into Asia has seen the premium paid in Japan increase 6 percent to $120 a tonne in the third quarter from the previous quarter, the first rise in nearly six quarters.

COLLECTING THE RENT

You won't hear banks like Goldman complaining. Rental income continues to pour in at the 19 Detroit area warehouses run by Metro as of June.

From the outside one recent afternoon, a depot in the Detroit suburb of Mt Clemens appeared to be deserted. But neighbors say the place is a whirl of activity in the early hours of the morning when metal is usually delivered for storage.

The LME sets the maximum allowable rent at 41 U.S. cents per day per tonne. At that rate, Goldman's warehouse operation in Detroit -- said to be holding more than 1.1 million tonnes -- could be generating as much as $451,000 per day or about $165 million a year in revenue.

An exact figure cannot be calculated because many clients negotiate lower rental rates and Goldman declined to detail its income from its warehouse business. But when Swiss-based trading company Glencore listed earlier this year it revealed that its metals warehousing unit generated $31 million in profit on $220 million in gross revenue in 2010.

LONG HISTORY

Caught between consumers and warehouse operators is the 134-year old LME, one of the world's last exchanges with open-outcry trading. Sessions take place in a trading ring with red padded seats while visitors can watch from a gallery. Traders juggle multiple telephones and use archaic hand signals to fill orders from consumers, producers and hedge funds.

The ring is a perhaps more civilized version of the tumultuous trading pits made famous in Chicago. Each of six major industrial metals including copper and nickel are traded for five minute bursts in the morning and afternoon. Only 12 firms have access to the ring, arranged in fixed positions in a circle, with many others involved via the ring dealers and on the LME's electronic trading system.

Longer sessions in the late morning and afternoon allow trading of all metals simultaneously and are known as "the kerb" from the days when dealers continued to trade on the kerb, or sidewalk, after leaving the exchange.

The LME certifies and regulates the Detroit sheds as part of a global network of more than 640 warehouses. The network is meant to even out swings in volatile metals markets. During recessions, surplus metal can be stored until economies recover and demand picks up, when the metal can be released.

But that function is now being undermined by the backlog in Detroit.

LME rules stipulate that warehouses must deliver a certain amount of metal each day. However the rules apply not to each warehouse but to each city that a company has warehouses in. At the moment, a warehouse operator needs to deliver just 1,500 tonnes a day per city, whether it owns one warehouse there or dozens.

That means each of Metro's Detroit warehouses need to release only 79 tonnes of aluminum a day. At that rate, it would take two years to clear the stocks held by Goldman's Detroit warehouses.

The backlog sparked outrage last year, prompting the LME to task London-based consultancy Europe Economics to look into its rules. Europe Economics recommended the exchange raise its minimum delivery rates and earlier this month the exchange announced a new regime for operators with stocks of over 900,000 tonnes in one city.

From April 2012 the minimum delivery rate will double to 3,000 tonnes a day.

Critics dismiss the move as too small to have any real effect, especially because of the delay until it comes in.

"The move is too little and too late to have a material effect in the near-term on an already very tight physical market, particularly in the U.S.," Morgan Stanley analysts said in a July note.

A senior executive at a metals brokerage told Reuters "the recommendations won't change anything. The problem will still be there six, nine months down the line."

"If Detroit has 1.1 million tonnes at the moment, what's to say it won't have 2 million tonnes next year," he said.

MOVING MORE METAL

One obvious solution would be to impose minimum delivery requirements per warehouse or per square meter of warehouse space rather than per city.

It's not as if the warehouses can't cope with delivering more stock: large operations can shift much more than 3,000 tonnes a day, warehousing sources say. An experienced forklift driver takes about 20 minutes to load one 20-tonne truck with aluminum in the United States. That means one warehouse in Detroit with two doors, two forklifts and an eight-hour working day could move out as much as 1,920 tonnes of metal every day.

"If you take Detroit in particular, those warehouses historically extracted metal at a faster rate ... the infrastructure is there," a senior analyst in the metals industry told Reuters.

Madden at Novelis said: "I don't know the specific details of every warehouse but our view is that they seem to be able to absorb metal coming in at almost an infinite rate and so we feel there's a lot more they can do on the output side to push up the (load out) rates."

The LME could also crack down in the same way it did in 1998 when it banned Metro from taking any more copper into its Long Beach and Los Angeles warehouses. Then the complaints were said to have come from copper consumers worried that 80 percent of total copper stocks in LME-approved warehouses were held in California.

The exchange argues that any change right now might disrupt the market.

"Changes to the delivery out rate have required careful consideration because it will impact the cost structure for those holding metal, and were those costs to rise sharply it could affect the way that metal is stored and traded," said the LME's Evans.

The exchange could also rule that a warehouse cannot charge rent once aluminum has been purchased, no matter how long it takes to ship it. But a change like that would hit the LME itself as it receives about 1 percent of the rental income earned by the warehouses it approves.

LEGAL FEARS

Nobody at the LME will say whether the Europe Economics study -- industry sources said it talked to more than 40 companies -- advised more radical measures, arguing that such information is "proprietary".

In any case, say metal markets sources, LME officials may be hesitant to make bigger changes because they fear legal action from the likes of Goldman, which could argue that Metro's business model has been based on existing LME warehouse rules.

The LME declined to comment on possible legal challenges, but its Chief Executive Martin Abbott said at a recent briefing that the warehouse delays were not causing market and price distortions.

"No, I don't believe it is," Abbott said, when asked if the situation was causing distortions in the market.

Abbott said the exchange had received no official complaints from consumers about bottlenecks at warehouses. The LME also dismisses concerns about banks trading metal and owning the warehouses where it is stored.

While a British parliamentary committee raised the issue in May, Britain's Office of Fair Trading declined to open a probe.

The U.S. Commodity Futures Trading Commission, which regulates the futures and options markets, said it would not comment.

Britain's Financial Services Authority, which regulates exchanges where commodity futures are traded but not warehouses that store physical material, declined to comment.

WHAT NEXT?

The lack of real change has some in the industry questioning the very structure of the LME, which, unlike its publicly owned U.S.-based rival commodities exchanges, is owned by many of the financial institutions that trade there.

"The belief is that they are focused on serving their shareholders; most of them being the banks ... We see our clients and contacts trying to avoid the LME as much as possible now," said Jorge Vazquez, Managing Director of the Aluminum Intelligence Unit at HARBOR Commodity Research.

That concern is growing. Critics of the exchange point to a potential problem with zinc supply though New Orleans, where inventories now account for 61 percent of total LME-registered stocks.

Most of the warehouses in New Orleans are owned by Goldman and Glencore.

Metal industry sources believe regulators should take a closer look at the possible conflict of interest that arises when trading houses also own the warehouses.

"If the whole thrust of regulation and regulatory reform is increased transparency and open and above board operations, letting banks own warehouses seems to run entirely counter to that," said Frances Hudson, global thematic strategist at Standard Life Investments said.

The LME says it enforces a strong separation between warehouses and the trading arms of their owners. Just this week it proposed that companies which own warehouses should engage an independent third-party to verify the robustness of Chinese walls.

"We enforce it through regular audits of warehouses," said the LME's Evans. "If people say Chinese walls are leaking then they should bring us evidence and we'll investigate."

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Industrials and Technology: Two Roads Diverging

by Bespoke Investment Group

The overall market is only modestly down in the last three weeks, but there have been some major shifts in sector leadership. The most notable among these shifts is the decline in the leadership of the Industrials sector. Relative to the S&P 500, Industrials have fallen off a cliff and are now near peak levels of underperformance in the last year.

While Industrials have seen notable weakness in recent weeks, Technology has seen a sharp rebound and has essentially erased all of its underperformance over the last year. Given the fact that both Industrials and Technology are considered cyclical in nature, it seems odd that both sectors are moving in completely opposite directions, although one could make the argument that Industrials are more tied to capital intensive companies while Technology is typically tied to companies that enhance productivity.

A new bottom may be emerging for silver in upper $30 level

By Dr Jeffrey Lewis

The commitment of traders is released each Friday by the futures market regulator, the CTFC. Whereas there are plenty of concerns with the CTFC’s involvement in the futures market, generally the COT data proves to be a very important tool in understanding market highs and lows.

The real function of the futures market, outside of finance, is to allow buyers and sellers to exchange fungible products (commodities) on a central exchange. Buyers and sellers can also hedge their future purchases, thus keeping the namesake of the futures market.

COT Momentum

In each release, there are three types of traders listed. These are commercial traders, noncommercial speculators, and the non-reportables, which are too small to meet regulatory expectations.

As Silver buyers, we should focus on the commercial traders and noncommercial speculators. Commercial traders are generally those who use silver in their business. An example of a commercial trader would be a silver miner, which produces silver for sale on the open market, or a jeweler who purchases large amounts of silver for making jewelry.

(Of course, somehow, and at some point, the bullion banks entered the ‘commercial space’ – where they now currently maintain a very concentrated (relative to any other market) short position).

Then we have the noncommercial speculators, which (should) comprise large investment (bullion) banks, but do include investment management firms, and occasionally an individual investor with a larger than average bankroll. These buyers and sellers are in the market for purposes of speculation, and they do not directly interface with silver in their daily operations. They buy to resell, or they sell early (sell short) to rebuy at a lower price – often using sophisticated computer programs or trading strategies based on algorithms.

Market Mechanics

Ideally, the silver market is one where buyers and sellers can meet for future sales of a commodity. It is also a market where companies can hedge their future costs. Silver is deliverable in physical form, though market players can sell their futures before delivery day to others who will make claim on the silver, allowing for possibilities in paper profits.

In other markets, commercial traders tend to be the most accurate in predicting the market’s future direction because they are, at the end of the day, the entities that produce the commodity itself, or use it in the production of an end-user good. Commercial entities tend to pick tops and bottoms with excellence.

Normally, when the commercial column increases its long positions while speculative interest is increasing shorts, the market tends to cool. When commercials increase their shorts while speculators cut back on long positions, a market top tends to follow.

This is a natural trend that appears when you have commodity producers, who can greatly affect a commodity’s supply, and speculators in the same market. We can also observe that commercial interest is demonstrably more bearish at market tops, and bullish at market bottoms.

This question is this:

With the silver market, if the bullion banks were not active (short) participants in the commercial category, with investment and industrial demand for silver increasing and competing for an ever diminishing supply, where do you imagine the price would be – or who would or could afford to be short?

Of course, the other burning question is when will the bullion banks exit their (commercial-selling) position?

There are two layers in a normal futures market, one which makes the noise (non-commercial speculators) and one which drives the market (commercial traders.) Off the peak formed in spring 2011, the net commercial short position in silver has declined, and the price has risen accordingly.

A new bottom in the upper $30s is forming for silver.

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West Africa prospects may help global cocoa output

by Commodity Online

Rising hopes for West African Cocoa production this year could help balance out an expected deficit in 2011-12, the head of the International Cocoa Organization said.

Ivory Coast, the world's largest producer, could reach 1.4 million metric tons in the current 2010-11 crop year, Executive director Jean-Marc Anga told Dow Jones Newswires.

Neighboring Ghana is also "on course" to reach its target of 1 million tons by the end of the season, despite flooding in cocoa-producing regions in the east of the country, he said.

Anga said he expects the ICCO will increase its current estimate of a 189,000 ton surplus for 2010-11, leaving markets in "more of a balance" than many forecasters currently expect next season.

"Most analysts are still expecting a deficit next year but we can see the surplus increasing between now and then," Anga said.
However, increasing consumption is likely to keep prices supported at $3,000/ton for the next six months, he said.
Demand is expected to rise to a record high of more than 3.9 million tons in 2011-12, up from 3.8 million tons this year, driven by Asia and the developing world as well as "robust" consumption in traditional markets, he said.
Cocoa grinding is also expected to rise in Ivory Coast following a bloody conflict there earlier this year. The country lost its place as the world's second-largest processor as companies fled during the political turmoil.
But going forward, he remains concerned that the proliferation of uncoordinated projects to expand Cocoa production in several parts of the world could have a severe impact on prices.
"We do not believe that production should go all out in meeting demand--and go beyond--as the impact on prices will be severe," he said.
With the new government of Ivory Coast due to launch initiatives to boost production in the near future, including tackling structural issues such as aging trees and little use of inputs, Anga said production there could rocket.
"If they go all out to increase investment in the next five to 10 years they could reach 1.8 million to 2 million tons," he said. Neighboring Ghana, considered a major cocoa success story, is expected to produce 1.2 million tons by 2012-13.
He added that the ICCO won't lift its estimate for Indonesia, another key producer, where production has been severely damaged by rain and disease.
"The pest and disease situation there is quite worrying," he said.

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