Charles Dickens, Great Expectations
Another reference to Charles Dickens, following on our conversation "A Tale of Two Central Banks", given the importance of the rally year to date in the credit space. Indeed, it seems to us markets have "Great Expectations", and although Charles Dickens decided to rewrite the end of his book as the ending was deemed too sad, we think it would be preposterous for us to revise our negative stance on Europe, given the current PSI overhang reminiscent of a Damocles sword and the acceleration in the deterioration of the Portuguese situation (which warrants cautious monitoring in the coming weeks/months).
In our credit conversation we will go through the significant tightening witnessed since the implementation of the LTRO supported by the latest FOMC decision by the FED.
The Credit Indices Itraxx overview - Source Bloomberg:
Itraxx Financial Senior 5 year CDS index, a significant tightening movement since the December tender by the ECB, as of the 26th of January - source Bloomberg:
Itraxx Crossover 5 year CDS index, a significant tightening movement as well, as of the 26th of January - source Bloomberg:
The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):
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:
The current European bond picture with Italy starting much tighter again in conjunction with Spain and France receding towards 3% yield for 10 years government bonds - source Bloomberg:
"Flight to quality" picture, with tighter Germany 10 year Government bond and falling 5 year CDS spread for Germany - Source Bloomberg:
Itraxx Financial Senior 5 year CDS crossing again with the Eurostoxx, indicating the strength of the rally so far year to date - source Bloomberg:
Ireland 5 year sovereign CDS versus Portugal 5 year sovereign CDS spread, a new record - source Bloomberg:
While the Greek PSI will be taking center stage on the 30 and 31st of January at the next European summit, all eyes are on the next LTRO, to see how the next carry trade will play out and how banks will participate. Given the trend is your friend, with Central Banks flooding the markets, we can expect to see tighter spreads still in the credit space thanks to the ongoing support.
Our subordinated bond tender theme initiated in 2011 is still playing out in 2012. BNP Paribas offered to buy back 3 billion euros worth of hybrid securities known as "Cashes" between 45% and 47% of par value, indicating more pain for subordinated bond holders. These securities were issued initially by Fortis Bank. BNP Paribas took control of Fortis in 2009, taking a 75% stake. BNP Paribas was not alone in tendering some subordinated bonds, Credit Agricole as well offered to repurchase subordinated debt. We expect all non-compliant Tier1 paper in Basel 3 to either be called or bought back.
In relation to the new issue space for Senior Unsecured space, given the positive tone in credit, it is not surprising to see a flurry of new issues. Lloyds came to the market to raise 1.5 billion euros, on 5 year. Lloyds priced its new issue 305 bps more than the benchmark swap rate. Last time Lloyds issued Senior Unsecured bonds was March 2011 at 190 bps more than the benchmark swap rate. A 244 bps premium. The game is still the same, conceding consequent large premiums in the race to raise capital.
But back to our title "Great Expectations", given we sit in the skeptical camp in relation to the outcome of the European crisis. It appears that Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008 and is now a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics had some interesting thoughts in his latest column published by Bloomberg on 23rd of January entitled "Europe’s Debt Crisis Is Still Likely to End Badly":
"History is full of fixed exchange-rate arrangements that broke down. In fact, a cynic might even point out that all attempts to fix exchange rates, whether against gold, the dollar or other currencies, ultimately fail.
Think about the gold standard in its various permutations: the post-World War II Bretton Woods system, attempts by East Asian countries to peg their exchange rates in the 1990s, or even the ultimately disastrous Argentine currency peg from 1991 to 2002. They all illustrate that holding on to an exchange peg for too long is a classic policy mistake. Usually when it ends, there is a great deal of concern about the future, but such worries are often overblown: A depreciation in the exchange rate can help an economic recovery, as long as the lid can be kept on inflation.
Good Times Over
But Europe’s problem isn’t just that some countries have the wrong exchange rate, and no way to adjust it within the existing system. The main issue is that governments borrowed heavily during the good times, which are most definitely at an end.
Italy has more than 1.9 trillion euros ($2.5 trillion) in debt outstanding. Bringing this under control through austerity alone is unlikely to work. In countries such as Greece and Ireland, the economic contraction is further undermining fiscal sustainability."
In our last conversation we were pondering whether the recent FOMC decision was in fact putting a floor under the Euro versus the US dollar. A weaker Euro would undoubtedly help European exports, and therefore boost growth, which would help mitigate current debt dynamics in various European countries. We would therefore have to agree with Simon Johnson that the Greek restructuring exercise will be followed by others, Portugal is of course the most likely candidate as highlighted by CDS levels, but others could follow...:
"But at some point in every fixed exchange-rate regime, even the most powerful people have to confront basic arithmetic. When budget deficits cannot be financed, when enough capital is flowing out, and when the central bank has gone beyond the limits of what is responsible, it is always time to move the exchange rate.
When the country that devalues has borrowed heavily in a foreign currency - as the euro effectively is for Italy at this point -- there is a sovereign debt crisis and usually a restructuring of the government’s obligations. Avoiding some version of this in the euro area will be hard."
In our last conversation we also argued that European growth would linger, putting additional pressure on unemployment and debt dynamics. With Spanish unemployment reaching 22.9%, the highest in 15 years, and with Spanish economy contracting 0.3 percent in the fourth quarter, we have a hard time believing in a happy ending, but contrary to Charles Dickens masterpiece, we currently see no need in rewriting the ending for our "European flutter" story.
As reported by Bloomberg, Stephen Roach from Morgan Stanley, seems to agree, the focus is going to be on rising unemployment in Europe and the recession:
"The euro area is in a “fairly protracted recession” and European leaders will shift their focus toward fighting rising unemployment, said Stephen Roach, non-executive chairman of Morgan Stanley Asia.
Stephen Roach also added in the same article:
“Europe is in a recession now, and it’s likely to be a fairly protracted one with a very limited recovery in the years ahead.”
On a final note, Bloomberg chart of the day:
The CHART OF THE DAY shows the price of Greek notes maturing on March 20 fell to a record-low 36.35 percent of face value on the 26th of January as Greece struggled to reach an accord with private creditors to cut its debt. A bond-swap agreement is needed for the nation to get a second financing package before the 14.5 billion-euro ($19 billion) payment comes due. “It’s pricing in an increased chance for either a forced restructuring before its maturity, or a fully-fledged default,” said David Schnautz, a fixed-income strategist at Commerzbank AG in London. “Chances for the bond to be redeemed in full have been scaled back.”
"The problems you sow, are the troubles you're reaping,
Still, my guitar gently weeps."
The Beatles - George Harrison - 1968 - While My Guitar Gently Weeps - unused line.