Author: Vincent Fernando, CFA

BP’s ‘top kill’ solution, which involves pumping cement into the leaking Macondo well, will be executed Wednesday, and the results should be clear by Wednesday evening according to BP’s chief operating office Doug Suttles.

Let’s hope it works, but nothing is certain at 5,000 feet below the sea.

One potential risk is that preparatory ‘drilling mud’, which would be injected ahead of the cement, could fail. Which would force the company to use a ‘junk shot’:

Rig Zone:

He said the biggest risk is the possibility that the drilling mud would be forced from the wellhead into the water instead of forcing the flow of oil and natural gas back down into the wellbore. If that occurs, Suttles said the company could then deploy what it calls the “junk shot,” using tire shards, golf balls and other odd-sized debris to force it back. “That is one of the options we would have available,” Suttles said. “If we saw the right conditions and felt like that would be the right next step.” He said BP decided to use top kill prior to the junk shot for fear that the junk shot might clog the lines and eliminate the top kill option altogether. “If that happened, we couldn’t follow with top kill,” Suttles said.

Even if the junk shot fails, there are still other backup solutions such as trying to place a new containment device over the entire leak, in addition to the relief wells currently being drilled. You can find more details on the risks behind the top kill and its alternatives here.

Don’t miss: these amazing pictures of the oil rig explosion >

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See Also:

• WHOA: Oil Spill May Be 5X Previous Estimates, And Could Pass Exxon Valdez TOMORROW
• MAP OF THE DAY: Deepwater Oil Spill Is About To Slam New Orleans, And It Freakishly Resembles A Hurricane
• Here’s What Happens To US Oil Production Now

Roubini is predicting a British pound collapse caused by rampant U.K. inflation, and inflation is soaring right now.

It’s all a head-fake, if Adam Posen of the U.K.’s Bank’s Monetary Policy Committee is right.

He’s broadly bearish sort of like Roubini, but he actually expects the U.K. to fall into a deflationary trap similar to what befell Japan.

Yet this ‘remake’ will be worse since the U.K. lacks many of Japan’s previous advantages.

Telegraph:

“The UK worryingly combines a couple of financial parallels to Japan with far less room for fiscal action to compensate for them than Japan had.”

Britain faces an uncomfortable trio of obstacles, none of which faced Japan in the 1980s or 1990s. Unlike Japan, Britain has to sell a large proportion of its debt to overseas investors, who are more likely to exit the market if they become scared of Britain’s fiscal prospects. The UK also faces the challenge of having to boost a troubled manufacturing sector if it is to recover sufficiently. Unlike Japan, it does not have the luxury of having a worldwide market with a large and growing appetite for exports.

Read more here >

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The Australian dollar has been falling over the last few hours, but now just hit a new air-pocket:

On a longer-term chart, it looks as if it’s just cratering. It probably has something to do with the fact that the futures market is predicting an interest rate cut, despite the fact that Australia led the global rate-hike cycle since last year.

(Charts via Finviz)

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South Korea has ended trade links with North Korea, in response to the sinking of a South Korean ship allegedly by a North Korean torpedo.

According to the Chosun Ilbo, North Korea could lose 10% of its income immediately as a result, and then suffer further problems via unemployment further out. South Korea will barely feel the effects given that North Korean trade represents just 0.1% of its external trade.

Chosun Ilbo:

North Korea is expected to take a direct hit from reduced employment and purchasing power. The $31.75 million Seoul paid Pyongyang in processing trade last year is close to the wages paid to over 40,000 North Korean employees at the Kaesong industrial park. No government statistics are available on the number of North Korean workers engaged in the processing trade, but assuming they earn half or a third what workers are paid at Kaesong, there may be up to 120,000 of them.

North Koreans employed in the seafood trade with the South will also lose their jobs. “Huge unemployment will deal a serious blow to the already impoverished North Korean economy,” said Lee Jo-won, a professor at Chungang University.

The state-run Korea Development Institute in a report Monday said a halt in inter-Korean trade will reduce the North’s purchasing power and deal its economy a direct blow. Pyongyang has managed its economy by purchasing necessary goods from China with the dollars it earned from inter-Korean economic cooperation. When that stops, it will have difficulty in securing money to buy goods from China. The North will attempt to diversify its export markets, but that will not be easy. It may try to divert goods it exported to the South to China, but most of them only fetch a high price in South Korea or are identical with Chinese export products.

Will trade restrictions just result in a more belligerent North Korea? Hopefully sanctions will collapse the regime without leading to violent death throes.

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Update 6:46 AM ET: Dow futures are now of 215. All indices pointing downo ver 2%.

Original post: Stocks have been hammered around the world. Britain’s FTSE is down 2.9% while Germany’s DAX and France’s CAC 40 have fallen 2.8% and 3.4% respectively. The euro is tanking.

Asia has been rattled by North Korea conflict fears, with Japan’s Nikkei down 3%, Hong Kong’s Hang Send down 2.9%, and China’s CSI 300 down 2.1%. Korea’s KOSPI has recovered somewhat from an earlier 3.3% drop, but is still down 2.7%.

Australia is down 3%, and MSCI Asia’s Apex 50 is down 3.4% as a whole.

Gold is slightly weaker, at $1,189 while the dollar index (DXY) is rising again, at 87.12. Oil has fallen further, hitting $68.2 for light sweet crude.

Futures are pointing to an ugly U.S. open, with the S&P 500 and Nasdaq down 2% and 1.75% each:

UPDATE: Futures now off by even more:

From FinViz:

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The London Interbank Offered Rate (LIBOR), which is a benchmark rate at which banks borrow money from each other, has been rising.

WSJ:

While the current Libor, at just above 0.5%, is far below the sky-high levels of 4.81875% reached at the height of the financial crisis in 2008, it is still a significant jump from 0.25% as recently as March.

Yet as shown in the Wall Street Journal graphic to the right, 3-month LIBOR, which is a measure of trust in banks, is higher for European banks vs. U.S. ones, thus showing less trust.

On Monday, German state-controlled lender WestLB AG said it cost 0.565% to borrow dollars for three months, up from 0.38% a month earlier. U.S. banks are reporting lower costs: Bank of America Corp., said its three-month dollar Libor stood at 0.48%. J.P. Morgan Chase & Co. reported a 0.47% rate.

Higher borrowing costs cut into profits, and could add further strain to troubled European banks, pushing more over the edge.

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Apartment building loans are experiencing soaring default rates, in what could be a signal of things to come for the broader commercial real estate sector.

The default rate for apartment building mortgages held by banks soared to 4.6% in Q1, which is nearly twice what it was in Q1 of 2009.

Bloomberg:

Defaults on so-called multifamily mortgages rose from 4.4 percent in the fourth quarter and from 2.4 percent during the same period in 2009, the New York-based real estate research firm said today. Commercial-mortgage defaults also rose in the first quarter for loans against office, retail, hotel and industrial properties, Real Capital said.

“Apartment defaults are leading other commercial real estate,” Sam Chandan, global chief economist at Real Capital, said in an interview. “Banks tended to make more aggressively underwritten apartment loans earlier during this last cycle. Credit and pricing reached their peaks for office properties and other commercial assets later.”

Here it comes.

See why commercial real estate is helplessly waiting to be slaughtered this year >

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The euro is tanking once again, breaking $1.23.

The IMF came out with a fresh report on Spain today warning that Spain must make tough reforms to its economy. Yet the nation is at the same time challenged with a weak economic recovery as well, which can make reforms harder to push through.

IMF:

Spain’s economy needs far-reaching and comprehensive reforms. The challenges are severe: a dysfunctional labor market, the deflating property bubble, a large fiscal deficit, heavy private sector and external indebtedness, anemic productivity growth, weak competitiveness, and a banking sector with pockets of weakness. Ambitious fiscal consolidation is underway, recently reinforced and front-loaded. This needs to be complemented with growth-enhancing structural reforms, building on the progress made on product markets and the housing sector, especially overhauling the labor market. A bold pension reform, along the lines proposed by the government, should be quickly adopted. Consolidation and reform of the banking system needs to be accelerated. Such a comprehensive strategy would be helped by broad political and social support, and time is of the essence.

The euro’s about to wipe out its entire rally from the end of last week, perhaps due to the fact that markets aren’t confident Spain will be able to make the hard reforms mentioned above.

Still, the Spanish ten year bond yield is holding steady and actually eased back slightly, to 4.03% according to Bloomberg. So Spanish default isn’t the concern, but the costs to the Eurozone of a Spanish rescue could be.

See Spain’s choice: A double dip recession or financial crisis >

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Despite the fact that U.S. inflation seems to be dying right now, PIMCO’s Mohamed El-Erian remains concerned about the future explosion of inflation.

He’s worried about an even larger scale use of central bank balance sheets, similar to what was done in the U.S. and more recently in Europe.

We may have gotten away with such activities once, but in the view of Mr. El-Erian, we’ve used our ‘spare tire’ and won’t be able to repeat these kinds of central bank resources without substantial inflationary effects, among other consequences.

PIMCO:

Some argued that given the output gap in industrial countries, it would be very difficult to generate inflationary pressures for the next three years. Indeed, the risks were tilted toward further disinflation. A larger group warned that while the output gap framework was applicable to the next 12 months, the period beyond that could witness the impact of increasing monetization of debt, gradually rising inflation rates and a worsening of inflationary expectations.

This potential evolution – from disinflation to inflation – will likely proceed at different speeds in different parts of the globe. It is already well in train in emerging economies and will remain so. Over the medium term, the U.S. will be next, with Europe and, even more, Japan lagging.

So in fact, he appears to believe that current U.S. disinflation (low, falling inflation) is only the lull before the storm. If that’s the case, then a lot of people have been tricked, as shown by the low treasury yields right now. The ten-year treasury is at just 3.21% right now, which doesn’t leave much room for inflation over the next ten years.

Also, check out our easy guide to Quantitative Easing And Why It’s One Of The Largest Risks Right Now >

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The Federal Reserve propped up the housing market after the financial crisis by buying mortgage-backed securities in the market, in a bid to keep mortgage rates low for American homeowners.

Yet when the $1.25 trillion buying program came to an end during the last week of March, many market observers worried that mortgage rates would rise, hurting the U.S. housing market.

It turns out that mortgage rates are still extremely low despite the passing of the Fed’s buying program.

Why? One unexpected reason is that Europe’s financial problems have sent droves of investors into U.S. treasuries, in a ‘flight to safety’. This has depressed U.S. treasury yields, through rallying treasuries, which has flowed through into lower mortgage rates for American homeowners.

WSJ:

Many in the industry now say rates could drift as low as 4.5% this summer from 4.86% now, instead of rising to 6% as some economists projected, making for significantly lower payments for Americans buying homes or refinancing their mortgages.

Refinance business “exploded” last week, says Jeff Lazerson, chief executive of Mortgage Grader, a brokerage in Laguna Niguel, Calif. “It’s schizophrenic. We all had this expectation of higher interest rates and no more refinances.” He says he helped a borrower lock in a 30-year loan with a 4.25% fixed rate last week, the lowest in his 24 years in the business.

Rates on 30-year mortgages averaged 4.84% last week, according to a survey by mortgage-insurance titan Freddie Mac. Rates were quoted late Friday at 4.86%, the lowest since December 2009, according to a survey by financial publisher HSH Associates, and down from a high of 5.27% for the week ended April 9. Rates on 15-year mortgages averaged 4.24% last week—the lowest since Freddie began its survey in 1991.

Thus Europe’s pain has oddly created a broad-based form of economic stimulus for the U.S., since it saves families around the country money on their mortgage payments. It’s a great time to refinance.

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April existing home sales rose 7.6%.

This amounted to an adjusted rate of 5.77 million units, which was higher than the expected existing home sales of just  5.65 million units.

—

WASHINGTON (May 24, 2010) – Existing-home sales rose again in April with buyers motivated by the tax credit, improving consumer confidence and favorable affordability conditions, according to the National Association of Realtors®.

Existing-home sales, which are completed transactions that include single-family, townhomes, condominiums and co-ops, increased 7.6 percent to a seasonally adjusted annual rate of 5.77 million units in April from an upwardly revised 5.36 million in March, and are 22.8 percent higher than the 4.70 million-unit pace in April 2009. Monthly sales rose 7.0 percent in March.

Lawrence Yun, NAR chief economist, said the gain was widely anticipated. “The upswing in April existing-home sales was expected because of the tax credit inducement, and no doubt there will be some temporary fallback in the months immediately after it expires, but other factors also are supporting the market,” he said. “For people who were on the sidelines, there’s been a return of buyer confidence with stabilizing home prices, an improving economy and mortgage interest rates that remain historically low.”

…

The national median existing-home price3 for all housing types was $173,100 in April, up 4.0 percent from April 2009. Distressed homes accounted for 33 percent of sales last month, compared with 35 percent in March.

See the official release here >

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Oil has recovered from its flash crash last week, but it has by now breached key psychological levels.

Moreover, lower prices could counter-intuitively beget increased supply as many OPEC members could now be forced to cheat on their production quotas even more so than before in order to support their national budgets:

Hellenic Shipping News:

According to OPEC’s leading official, now that oil prices have fallen to $68-70 per barell, the first line of defence will be a better compliance. But if OPEC members cheat on exporting volumes when prices are high, things are more difficult when prices falling under the psychological level of $70 per barrel as their revenues are also falling.

At the same time, another problem for OPEC members is that non-OPEC supply is rising in a fast way especially from Russia.

Lower prices could push higher production beyond quotas, which push down prices even further, etc. Could this create a self-reinforcing cycle for the next, say $10, of downward action for oil prices?

There’s probably a limit to this kind of behavior, but some OPEC members aren’t in the best of shape, such as Venezuela. Thus OPEC non-compliance could increase until it gets too obvious, via crashing oil prices, at which point OPEC members would be forced to come back into line with their cartel.

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Here’s one reason to believe that bearishness is getting long in the tooth. Less than 2% of S&P 500 stocks are above their 52-week moving average.

Basically the entire market has been creamed and historically this has been a decent trading opportunity.

Traders’ Narrative:

“…a number of significant buying opportunities have been identified in the past after periods of market weakness have caused the percentage of stocks above their 10-day moving averages to drop below 10%.”

…

I mentioned the financial and energy sector in passing yesterday as being extremely oversold with just 1% (or less) of stocks closing above their 50 day moving average. Today the banks got a major boost, rising much more than the general market proxies. Most are attributing this to the passing of the Wall Street regulation bill in the Senate on Thursday night. As a technically oriented trader I prefer to think of it as an expected reaction to the extremely oversold condition in that sector.

Even if you believe we’re heading lower in the long-term, perhaps we’re in for a near-term bounce.

(Via Abnormal Returns)

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Brazil’s economy just clocked 10% annualized GDP growth over the last six months. Even though the world’s economic rebound is expected to slow in the second half of this year, Brazil is still expected to log a China-like 7% GDP growth for 2010.

That’s the fastest growth Brazil has experienced since 1986. 

Problem is, it’s not sustainable and could create painful side effects:

The Economist:

The problem is that while it may be growing at Chinese speeds, Brazil is not China. Because it still saves and invests too little, most economists think it is restricted to a speed limit of 5% at the most, if it is not to crash. The growth spurt is partly the result of the stimulus measures taken by President Luiz Inácio Lula da Silva’s government when the world financial crisis briefly tipped the country into recession late in 2008. The trouble, say critics, is that much of the extra government spending is turning out to be permanent—and so the economy is starting to resemble a Toyota with the accelerator stuck to the floor.

The strain is showing. Businesses are chasing after scarce skilled labour. Inflation for the 12 months to April reached 5.3%, above the Central Bank’s target of 4.5%. Imports are set to top exports this year, for the first time since 2000, and the current-account deficit should widen to 3% of GDP.

Read more here >

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Just as it was starting to look like China might try and see if its economy could stay afloat without massive fiscal and monetary stimulus, this now seems to be off the table.

Chinese Commerce Minister Chen Deming latest comments don’t give much indication of tightening.

China Daily:

“The Chinese government will continue to implement a proactive fiscal policy and a moderately easy monetary policy,” he added.

“There are still a lot of uncertainties in the world economy. Therefore we believe it is too early for us to talk about an exit strategy from our stimulus package,” Chen told reporters after a meeting with European Union (EU) Trade Commissioner Karel De Gucht.

Europe’s the largest uncertainty there is right now. Moreover, a plummeting euro has put pressure on Chinese exporters, thus also hurting the chances of a yuan hike. Europe just gave China another excuse to keep putting off hard decisions.

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Thomas Kaplan of Tigris Financial is probably world’s ultimate gold bull.

Even George Soros and John Paulson take notes from him, following him into certain investments.

He’s virtually gone all-in on the yellow metal.

WSJ:

He has gone further than perhaps any other major investor, betting the majority of his wealth on gold and other precious metals. And it reflects his deeply held conviction that global economic instability could bring rising demand for gold.

Through his firm, Tigris Financial Group, and affiliates, Mr. Kaplan has loaded up on bullion and bought up properties in 17 countries on five continents, where geologists are exploring for more. Tigris subsidiaries have taken stakes in mining companies, including tiny firms that have yet to produce an ounce.

Though he won’t disclose how much physical gold he owns, Mr. Kaplan, who is 47 years old, controls up to 30% of the shares in some so-called junior miners. Together, his holdings amount to a nearly $2 billion bet on gold, more than the Brazilian central bank’s bullion is currently worth.

Having more the Brazil means he has more than most countries’ central banks out there.

“You’ve got a perfect storm with no apparent solution,” he said. “If the world does well, gold will be fine. If the world doesn’t do well, gold will also do fine … but a lot of other things could collapse.”

The most interesting question we’d like to ask him is in what potential scenario he could envision gold falling.

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According to EPFR Global, investors yanked $4.81 billion out of European equity funds and $7 billion out of U.S. funds during the week ending May 19th. This probably isn’t too surprising given the negative market action we experienced.

What is surprising is that the flight from stocks wasn’t global in the most recent week. Pacific equity funds saw net inflows of $147 million, which was the highest level in 30 weeks. As shown by the chart below, the cumulative fund flow into Asia is now moving towards an all-time high.

While Asian stocks have been under substantial pressure during the last month, sentiment is starting to turn around… even if prices haven’t quite yet. MSCI Asia shown below.

Meanwhile, commodity funds saw net inflows of $1.03 billion, though most of this was gold. The majority of commodities experienced outflows.

A final notable segment was high yield bonds, which enjoyed a substantial bout of investor love last year. Outlfows remain ugly, at over -$1 billion despite overall positive inflows into global bond funds.

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Proposed austerity measures in the U.K. involve tax hikes or the removal proposed tax breaks, across a wide range of issues.

For stocks, most worrying is the capital gains tax hike being discussed:

Telegraph:

The document confirmed that it would push ahead with plans to increase sharply capital gains tax on the sale of second homes, shares and buy-to-let properties.

The plans, which could see the tax more than double from 18 per cent to 40 or even 50 per cent, will be set out in detail in next month’s Budget.

50%? That would tank the valuations of all U.K. shares, at least for local investors. Driving, flying, and even marriage will be taxed, or not given planned relief, in order to help plug the budget deficit.

The coalition agreement also pledged to increase the proportion of tax raised from green levies.

Conservative plans to cut fuel duty when oil prices are high have been abandoned, leading to fears that motorists will be targeted.

More money is expected to be raised by changing the way flights are taxed, which could add more than £300 to the cost of a long-haul family holiday.

…

The Liberal Democrats refused to support Conservative plans to offer new tax breaks to married couples. Although the Lib Dems agreed not to vote against the plans, the Prime Minister may face a struggle to introduce the necessary legislation.

The U.K. needs to address its fiscal problem, but it seems some of these measures could put economic activity into a coma. Especially the disincentive towards investment and travel.

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Despite yesterday’s mayhem in the U.S. and Europe, and Japan’s over 2% drop right now, mainland China and Asia are doing okay. Shanghai’s CSI 300 is slightly in the green, while MSCI Asia is down just half a percent. Hong Kong is closed. Australia is down just 0.6%.

Not pretty, but not bad either, for a day after the S&P 500 and Nasdaq shed 4% in a session. It’s as if China is in a driver’s seat here.

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Morgan Stanley has an interesting model that attempts to gauge the likelihood of currency intervention by the G3 economies (United States, Europe, and Japan). While there hasn’t been coordinated currency intervention since 2000, the potential for a repeat is rising due euro volatility, which appears excessive.

Morgan Stanley’s Sophia Drossos:

Based on our estimates, the model currently predicts a 30% probability of coordinated currency intervention compared with the long-term average of 12% (Exhibit 1). According to our framework, probabilities below 20% are consistent with a low level of intervention risk, probabilities between 20% to 30% are considered a signal of caution, while probabilities above 30% suggest a high risk of FX intervention.

Still, Morgan Stanley believes the euro remains over-valued against the dollar, thus mitigating other factors, such as the excessive momentum shown above which argue for coordinated currency market intervention from the G3.

Thus it could take more currency volatility than in the past to push to G3 into action, because from the look of the model above, probabilities are historically high yet we haven’t seen any intervention. (We’d also suggest the hypothesis that perhaps the model needs a tweak!)

Yet for traders, just be aware that government intervention is a growing risk.

(Via Morgan Stanley, G3: High threshold for FX Intervention even as risks rise, 20 May 2010)

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