Saturday 24 March 2012

Markets update - Credit - The Spread Also Rises

"There is only one side of the market and it is not the bull side or the bear side, but the right side."
Jesse Livermore

Given finally everyone and the markets are finally focusing their attention on Spain, we thought this time around it would be interesting to use an appropriate literary analogy in our title, namely Ernest Hemingway 1932's masterpiece "The Sun also Rises" in our weekly ramble.
We already explained at length our discomfort with Spain in our credit conversation "Lather, rinse, repeat" where we argued:
"Given the ongoing deleveraging, in the light of the recent Sovereign CDS convergence between Italy and Spain, we might be viewed as contrarian but looking at the ongoing deleveraging process and the sectorial composition of debt as a percentage of GDP, Spain appears to us as being in a less favorable position particularly in the lights of its housing hangover"

The worsening credit crunch, particularly in the peripheral countries warrants caution. In our credit conversation "Money for Nothing" we voiced our concerns in relation to ECB quarterly bank lending survey and the impact impaired credit channels will have on economic growth:
"Although LTRO provides cheap funding to European banks, rising unemployment levels and deteriorating credit conditions should consequently lead to a significant rise in Non-Performing Loans (NPLs) on banks balance sheet."

We indicated recently that the latest Spanish banks ratio of non-performing loans to total loans came in at 7.61% in 2011, the highest percentage since 1994, the LTRO effect amounts to "Money for Nothing", at least to the real economy. Given the growing differential between Spanish Sovereign 5 year CDS and Italian Sovereign 5 year CDS we have been monitoring, in this weekly review, we will focus on the difference between both countries, namely our "stock" versus "flows core macro approach. But first our credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:
Since the rollover of the credit indices on the 20th of March, the Credit Indices have risen during the last three days. Itraxx Financial Senior 5 year CDS (25 European financial institutions, a gauge of financial risk, is still trading above corporate risk at 203 bps, namely Itraxx Main Europe 5 year CDS, currently at 120 bps. What really caught our interest, in the rollover of the new credit indices, was the SOVx index, which saw Cyprus, replacing Greece in the 15 members of the index. We already witnessed the impact Greece exit had on the SOVx index in our conversation "SOVx Western Europe - And Then There Were 14...".

Replacing Greece by Cyprus is the SOVx series 7 index might not be enough to preserve the 15 member's number status. On the 13th of March, Moody's rating agency joined its peer Standard and Poor's in slashing Cyprus to junk status on heightened concerns over its banking sector’s exposure to Greece. Only Fitch rating agency has maintained its rating for Cyprus one notch above junk.
"Moody’s downgrades Cyprus credit rating to junk status on fears over Greece exposure" Washington post:
"The downgrades have effectively shut Cyprus out of the international markets, prompting it to seek a €2.5 billion ($3.3 billion) low-interest loan from Russia to meet its financing needs for this year.
Moody’s said that apart from their significant Greek government bold holdings, Cypriot banks’ woes are compounded by their large Greek loan portfolios. It said those stresses on the banking system combined with weak private sector confidence and adverse external conditions will constrain the island’s growth potential in the next few years and add to the fiscal challenges facing the government."

But, Cyprus debt woes could be alleviated in the future thanks to recent exploration results undertaken by Texas-based Noble, indicating that the latest gas find could be worth in the region of 100 billion euros (gas resources in offshore area at between 5 and 8 trillion cubic feet (tcf) with a gross mean of approximately 7 billion tcf). According to Natural Gas Europe article, this is already creating tensions between Greece and Turkey:
"Amid the elation of Cyprus and Noble at the find, tensions between Cyprus and Turkey have once more come into play. Turkey has previously encroached on Cyprus's Exclusive Economic Zone (EEZ) in the Mediterranean Sea in response to the exploration of the area by Noble Energy. Turkey, which invaded Cyprus in the 70s and occupied a substantial portion of the island, refuses to acknowledge or accept the sovereignty of the Cypriot government."

Moving back to our credit overview, Itraxx Crossover has been rising while Eurostoxx Volatility has been subdued, as our friends at Rcube Global Macro Research posited in "The two main drivers of equity volatility", we do not think this disconnect is going to last long - source Bloomberg:

The pain in Spain - Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS widening to around 55 bps above Italy, (43 bps a week ago) - source Bloomberg:
In our conversation "Modicum of relief" we stated:
"We think Spain Sovereign CDS will drift wider, indicating increasing default risk perception given:
-Italy's shrinking budget deficit to -3.9% in 2011 from -4.6% in 2010,
-Spanish unemployment level expected to reach 24.3% in 2012,
-Spanish Prime Minister Mariano Rajoy has decided to side step the 4.4% deficit target for 2012, for 5.8%."

Spanish Banks CDS drifting wider this week as well. Spanish banks CDS have widened a lot during the last 7 days:
BBVA 5 years CDS Senior started the week at 275 bps and trades around at 357 bps.
BBVA 5 years CDS Sub started the week at 500 bps and trades around at 610 bps.
Santander 5 years CDS senior and sub moved from 265 bps and 411 bps respectively to 347 bps and 515 bps - source Bloomberg:
We discussed Spanish woes with our good credit friend:
"As expected, Spain is widening more versus Italy and the European core countries. The CDS 5 years trade at 440 bps, while it was trading at 340 bps on February 7th. The economy is not improving in Don Quixote's kingdom, and will not improve in the coming years as unemployment remains very high (24 %), particularly youth unemployment (around 50 %), the social risk is rising.
The government is trying to guarantee the debts of the Provinces which face a wall of refinancing, in exchange for more control on local finances. Considering that there are important regional elections this Sunday (Andalusia and Asturias), the game is still very open."

Our "Flight to quality" picture. Germany's 10 year Government bond yields receding below 2% yield and 5 year CDS spread for Germany now rising (ominous signs of upcoming stress in the markets?), falling back to the levels which had prevailed since the beginning of the year - source Bloomberg:

The ongoing drop in short term correlation (120 days) between the US 10 year yield and the German 10 year bund, falling below 50% to 45.77% - source Bloomberg:

The ongoing divergence between US and European PMI indexes - source Bloomberg:

The liquidity picture, as per our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:
Euro 3 months Libor OIS, one indicator of systemic credit risk continues to recede but very slowly, indicating that LTRO 2's impact is having a smaller impact than LTRO 2. Euribor is the rate for 3m uncollateralised interbank lending and OIS refers to a 3m swap contract whereby one exchanges EONIA(floating leg) for the 3m OIS rate (fixed leg).

The current European bond picture with Spain above 5.5% and Italian yields rising as well- source Bloomberg:

Moving back to weekly's core subject of the divergence between Spain and Italy, it is interesting to note that the tussle between Spanish Prime Minister Mariano Rajoy and European leaders have led on the 12th of March to a "deficit compromise" of 5.3% instead of the 4.4% previously agreed figure while Prime Minister Rajoy's initial deficit slippage target had been 5.8%. Spain's GDP is expected to shrink 1.7% in 2012.

"Money for Nothing" we have argued, relating to the very small impact on the real economy of the peripheral countries the second round of the LTRO will have. As indicated by Emma Ross-Ross Thomas, in Bloomberg in her article- Spain Torments Draghi on Deficit as Banks Tap Loans:
"Spanish banks increased holdings of the nation’s bonds to 202 billion euros in December, from 178 billion euros in November, Treasury data show. They borrowed 152 billion euros from the ECB in February, three times as much as they were taking a year ago."

Spain is indeed focusing more and more all the attention. Exane BNP Paribas in their recent Capital Structure Note from the 22nd of March, confirms what we have been monitoring in relation to Spanish Sovereign CDS spreads versus Italy Sovereign CDS spreads in recent months:
"Since early February, Spanish CDS are more and more expensive. The risk can and needs to be fixed.
While the cost of Italian CDS has reduced significantly, this is not the case in Spain where the cost of CDS has been increasing since early February. As feared, Spanish and Italian 5Y CDS crossed each other this month, and the trend is impressive: from a negative 100bp to a positive 50bp in less than 3 months."

Exane BNP Paribas in their notes, goes further in their analysis in relation to Italy vs Spain and the underlying factors and structural differences:
Structural difference number 1: "The money supply has been negative for a while in Spain, whereas it is still positive in Italy."

Structural difference number 2: "The Italian economy is more industrial than the Spanish one which is much more “concession-based”." - source Exane BNP Paribas:

Structural difference number 3: "The Spanish economy relies greatly on debt." Households and public administration debts (as a percentage of the GDP) - source Exane BNP Paribas:
"A large part of Spanish growth is due to the massive money supply, for example, through real estate loans. This was not sustainable growth." -  source Exane BNP Paribas
We have argued for a long time that a policy of achieving a high home ownership rate is the biggest threat for an economy, we in fact labeled this policy a "Weapon of Economic Destruction" but that's another subject.

If it were only households relying on debt in Spain...

Corporate debt as percentage of GDP - - source Exane BNP Paribas/BdF:

The core of our macro thought process is based upon the difference between "stocks" and "flows", which we highlighted when discussing the growing difference between Europe and US growth (see our post "Shipping is a leading deflationary indicator"). The same approach can be applied in relation to the growing divergence between Spain and Italy!
 The latest Cheuvreux Cross Asset Research from the 19th of March validates our macro approach we think:
"The sovereign debt constraint in Italy is that of a stock - a high accumulated indebtedness - rather than a flow due to operational deficits. Accordingly, the arithmetic of sovereign sustainability in Italy is much more sensitive to the ratio of the cost of debt to trend nominal GDP growth than in Spain. Consequently, Italy has derived enormous benefit from the LTRO-induced collapse of its debt servicing costs over the last three months. Our perception is that spreads of Italian debt over their equivalent German reference will continue to tighten through the weeks ahead, by as much as 50bpts for maturities to 3 years. In this context, and even assuming that GDP might decline by up to 2% this year, we think it unlikely that significant new measures of austerity will be required in order to meet the government's financial commitments. By comparison, it cannot yet be said that Spanish public finances are on a sustainable trajectory."

Cheuvreux also stated the following in their recent note relating to the divergence between both countries:
"The legacy of the years of cheap credit is far more damaging in Spain than in Italy. Spain is faced with a prolonged period of private sector de-leveraging in order to unwind the effects of a boom of residential and non residential investment that never occurred in Italy. There are three notable consequences. First, there are greater constraints upon the revival of domestic demand in Spain. Second, there is a greater degree of regulatory and fiscal risk, over a longer period, for Spanish corporates than for their Italian counterparts. Third, there is higher risk of deterioration of company balance sheets in Spain due to impaired assets than in Italy."

"Stocks" versus "flows"...

Hence the contrarian views we had taken in relation to Spain versus Italy, which seems so far to be confirmed by ongoing market movements. Indeed, "The Spread Also Rises"...

On a final note we will leave you with yet another Bloomberg Chart of the day from the 20th of March indicating that the ECB loans are helping Spain to mask its financial weakness:
"The CHART OF THE DAY shows that Spanish five-year note yields tumbled after the European Central Bank said on Dec. 8 that it would provide financial institutions with unlimited loans, offering them the chance to reinvest the cash in higher-returning government bonds. While yields have declined, the cost of credit-default swaps on the debt is higher than the day before the central bank announcement.
“The ECB’s non-standard measures are providing an important liquidity solution to what remains a solvency problem,” said Richard McGuire, a senior fixed-income strategist at Rabobank International in London. The loan provision “hides rather than addresses the systemic weakness driving the crisis,” he said." - source Bloomberg.

"In bull-fighting they speak of the terrain of the bull and the terrain of the bull-fighter. As long as a bull-fighter stays in his own terrain he is comparatively safe. Each time he enters into the terrain of the bull he is in great danger."
Chapter 18, The Sun Also Rises, Ernest Hemingway

Stay Tuned!

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