Credit - Pascal's Wager

"One person with a belief is equal to ninety-nine who have only interests." - John Stuart Mill

Watching with interest the results of the ECB's AQR (Asset Quality Review), we reminded ourselves of our July 2012 title "No test, no stress, no stress no test..." given the lack of deflationary scenario in the ECB's assessment. We also followed the minutes of the FOMC from the Fed in conjunction with the end of QE in the US while Japan launched another huge round of QE, which will no doubt export somewhat a "deflationary impulse" to the rest of the world in the process rest assured.

When it came to choosing this week's title, we decided to veer towards philosophy this time around with the end of QE in the US (which we think is temporary) and with the Bank of Japan adding 80 trillion yen ($720 billion) of QE (given core inflation dropped to 1% from 1.1% in October). Once again central bankers are challenging investors' belief in their "omnipotence" which we touched in our conversation the "Omnipotence Paradox" in November 2012 where we discussed central bankers and the market's perception of their "omnipotence" in sustaining asset price levels.

In fact, in our conversation "Perpetual Motion" we mused around the notion of "perpetual motion" and its physical impossibility. As far as deities and omnipotence go:

"1. A deity is able to do absolutely anything, even the logically impossible, i.e., pure agency.

2. A deity is able to do anything that it chooses to do.

3. A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie).

4. Hold that it is part of a deity's nature to be consistent and that it would be inconsistent for said deity to go against its own laws unless there was a reason to do so.

5. A deity is able to do anything that corresponds with its omniscience and therefore with its worldplan." - source Wikipedia.

So you might be already wondering why we chose Pascal's Wager as our title in this week's conversation. 

Pascal's wager was devised by 17th century French philosopher, mathematician and physicist Blaise Pascal (1623-1662). It posits that humans all bet with their lives either that God exists or not. In the investment world, we think investors are betting with their "life savings" that central bankers are either gods or not. 

Pascals Wager is of great importance and was groundbreaking at the time because it charted new territory in probability theory, making the first use of decision theory.

Pascal's Wager in the form of a decision matrix:

"Given these values, the option of living as if God exists (B) dominates the option of living as if God does not exist (~B), as long as one assumes a positive probability that God exists. In other words, the expected value gained by choosing B is greater than or equal to that of choosing ~B.

In fact, according to decision theory, the only value that matters in the above matrix is the +∞ (infinitely positive). Any matrix of the following type (where f₁, f₂, and f₃ are all finite positive or negative numbers) results in (B) as being the only rational decision" - source Wikipedia

In similar fashion since 2009 investors have followed somewhat a similar decision matrix which we have tweaked for further explanation relating to our current choice as a title:

Therefore the only "rational" explanation coming from the impressive surge in stock prices courtesy of QEs and monetary base expansion has been to choose (B), belief that indeed, our central bankers are "Gods". 

Central bankers' omnipotence and balance sheet expansion:

- source Bank of America Merrill Lynch

Rest assured that at some point in time "belief" that "Central Bankers are not Gods" will ensure finite loss and in the end it might be the pagans who could have the final laugh in their "belief" in gold, this "relic of barbarism" to paraphrase Charles M Howell author of the book "Civilized Money "(1895) but that's another story...

In the meantime, the "barbaric relic" has indeed taken the proverbial spanking as illustrated by the sell-off in the ETF GDX - 1 year graph source Bloomberg:

ETF GDX from 31st of October 2007 until 31st of October 2014 - graph source Bloomberg:

In this week's conversation we will again focus our attention on central banks and the impact of their diverging monetary policies as well as the implications.

When it comes to stock prices, QEs, as displayed by a chart from Bank of America Merrill Lynch Thundering Word note entitled "The QE is Dead, Long Live the E!" from the 30th of October 2014 have been great propellers in conjunction with US corporate earnings:

"QE ends with deflation fear not inflation

As has been well-documented here and elsewhere, the Fed's QE has been the key driver of higher financial asset prices in the past 5-6 years (Chart 3). A recent US Treasury paper calculated that between Jan'09 and Apr'13 the S&P500 index rose 570 points in the weeks the Fed bought $5bn or more securities, 141 points in the weeks it bought up to $5bn, and fell 51 points in the weeks the Fed sold securities.

But the end of QE is coinciding with historically low levels of government bond yields and collapsing inflation expectations, rather than a surge in global growth. 10-year US Treasury yields are 50bps lower today than at the start of QE1, French 10-year yields are the lowest they have been in over 250 years (Chart 4),

and economists are cutting inflation forecasts rather than raising growth targets. All of this is great fodder for the Liquidity Bears who see QE as a failure, secular stagnation everywhere and warn of great, imminent bear markets in both credit and equities. For the bears the recent bout of volatility was merely a warning shot, in coming months will reveal unambiguous evidence that QE has failed to eradicate deflation and a loss of credibility in central bank policy will send asset prices into a tailspin in early 2015. "

- source Bank of America Merrill Lynch

For those who have listened to our musings from our last conversation, they should have applied the Pascal's Wager and its decision matrix to Japan. The recent big move by both the GPIF and the Bank of Japan have indeed been handsomely rewarding those short JPY (like ourselves) and long Nikkei FX hedged as indicated by the latest move in both the Japanese Yen and the Nikkei index:

"Given the Nikkei index is particularly more sensitive to away earnings, than by domestic earnings, going long again on the Nikkei currency hedged (Euro hedged) could make sense if ones would like to front-run again the Bank of Japan and their GPIF friends (we admitted in 2013 that we enjoyed being long Nikkei hedged in Euro)." - source Macronomics

In regards to Japan, we will reiterate what we posited in November 2013 in our conversation "Cold Turkey":

"While some recent "trade fatigue" did materialized in recent months on the Japan rocket "lift-off", we think that we are in an early second stage for the Multistage Japan rocket"

When it comes to adding rocket fuel to the Japanese rocket, the latest decisions by the Bank of Japan will accentuate further both the rise of Japanese equities and the fall of the Japanese yen as displayed by the below graph from Barclays displaying the size of the balance sheet expansion of various central banks as a percentage of GDP:

- graph source Barclays.

In terms of the implication for Europe (as discussed in the "Coffin Corner"), the aggressiveness of the Japanese reflationary stance spells indeed more deflation for Europe, unless the ECB of course decides to engage as well in a QE of its own:

"Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think." - Macronomics - 27th of April 2013.

Japan has already been the subject of numerous posts already on Macronomics, such as "Big in Japan", "Japan - the rise of the Kagemusha", "If at first you don't succeed..." or  "Have Emerging Equities been the victims of currency wars?".

When it comes to the end of the tapering from the Fed and the impact on some asset classes, all "inflation hedge" trades such as Gold, Gold miners and Tips have been impacted as displayed by Bank of America Merrill Lynch Flow Show note entitled "Death of the inflation" trade from the 23rd of October:

"Death of Inflation trade: flows into Gold & TIPS collapsed past 18 months…now Floating Rate outflows (Chart 2)"

- source Bank of America Merrill Lynch

In continuation to European woes, the much vaunted AQR and ECB's support, many pundits believe that the move towards the European Banking Union will enable credit growth to resume and therefore help economic growth in the process. We beg to disagree on this subject. We have long argued that no credit, meant no loan growth and no loan growth meant no economic growth and no reduction of budget deficits. 

The only thing that matters is QE being launched or not in Europe as we have argued in November 2013 in our conversation "In the doldrums" where we discussed the possibility of a credit-less recovery:

"So for us, unless our  "Generous Gambler" aka Mario Draghi goes for the nuclear option, Quantitative Easing that is, and enters fully currency war to depreciate the value of the Euro, there won't be any such thing as a "credit-less" recovery in Europe and we remind ourselves from last week conversation that in the end Germany could defect and refuse QE, the only option left on the table for our poker player at the ECB:

"The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in German's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe."

When it comes to credit growth in Europe, Citi published an interesting note on the 31st of October entitled "Credit and The Eurozone Malaise":

"Overall, we expect the fall in credit growth to continue to moderate and for credit conditions to gradually improve from restrictive levels, with a modest boost from the end of the CA. However, we expect credit conditions to remain subdued. This is because private sector debt in many Eurozone continues to be very high, business sentiment is falling and the outlook remains very uncertain, which will continue to weigh on credit demand, while some pockets of credit supply constraints will probably persist even after the CA.

Credit availability matters, and particularly so in countries that do not benefit from strong FDI inflows and strong private liquidity positions such as France and Italy. But the relationship between credit growth and GDP growth has weakened in the post-financial crisis period and we therefore caution against using historical and in particular pre-crisis relationships between credit growth and GDP growth as good lead guides in the Eurozone. 

We also stress that the Eurozone malaise is unlikely to be resolved by improving credit conditions alone. Stronger aggregate demand is needed, and fixing credit supply is only one of many required steps. Additional measures required to reinvigorate the Eurozone economy include further monetary easing (including through large-scale asset purchases by the ECB), a looser fiscal stance, a restructuring of the debt of excessively indebted households and businesses as well as structural reforms to boost animal spirits." - source CITI

We have repeatedly highlighted the weakness in aggregate demand in the Eurozone. We argued in the past that the growth divergence between US and Europe were due a difference in credit conditions. This can be further illustrated by the following comments from the same CITI report displaying bank lending growth:

"Across countries, differences in credit growth remain large, with private sector borrowing still falling quite sharply in Greece, Ireland and Spain whereas it is growing at around 3%YY in France (Figure 5). 

Overall, however, credit trends remain very subdued in the Eurozone, both in historical comparison (growth in private sector borrowing in the Eurozone was 9% pa in 2003-07 and 7% pa in real terms) and relative to GDP growth (nominal private credit growth is running at 3pp below nominal GDP growth, whereas it was 4-5pp higher than GDP growth in 2003-07).

The question is why credit growth is so weak? ECB President Draghi has 

highlighted on various occasions that credit growth tends to lag GDP growth in 

recoveries and that the Eurozone’s current experience fits this pattern. By contrast, 

the IMF recently argued in its Global Financial Stability Reports that at least in 

stressed Eurozone countries credit growth is lagging behind the average experience 

in historical countries (see Figure 6). Whether the current experience in the 

Eurozone is in line with the historical evidence or not, that still leaves open the 

question of what holds back credit growth."

Indeed, bank lending standards in the Eurozone have tightened for most of the period between 2007 and 2014. However, there seems to be some light at the end of this tunnel: the ECB’s quarterly Bank Lending Survey published on 29 October showed that Eurozone banks‘ lending standards in Q3 eased for all loan categories for the second survey in a row (see Figure 7). 

Nevertheless, the level of lending standards is probably still very tight, at least in comparison with the pre-crisis period, given that lending standards tightened 26 quarters in a row until Q2 this year. Banks also recorded growing loan demand for all loan categories, for the third survey in a row, and banks expect credit standards to ease further and demand to rise further in the coming three months. But, again, having fallen 10 quarters in a row including Q1, the level of credit demand is probably still very low.

Interest rates are also still high, at least in some countries and in real terms. The 

ECB’s composite cost of bank borrowing measure for Eurozone NFCs was at 2.7% 

in August. This is roughly 150bp below the 2003-07 average in nominal terms and 

100bp lower than in 2011. However, in real (CPI-adjusted) terms, NFC borrowing 

costs are in fact 20bp above the pre-crisis average and have not fallen much at all 

recently, as Eurozone inflation has fallen faster than nominal borrowing rates (see

Figure 8). 

Cross-country divergences in real borrowing costs are also very high, 

with borrowing costs of 0-1% in Austria, Finland or Germany vs 5-6% in Cyprus, 

Greece or Portugal. The ECB’s Coefficient of Cross-Country Variation in bank 

borrowing costs of NFCs across Eurozone countries remains near all-time highs. In the periphery countries, the fall in inflation rates has meant that real borrowing costs have in fact risen in the last 12 months." - source CITI

The disinflationary factor and deflation risk of course have not been taken into account in the AQR. 

As we indicated in our conversation relating to the growth divergence between the United States and Europe ("Growth divergence between US and Europe? It's the credit conditions stupid..."), it is all about Stocks versus Flows:

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

When it comes to Europe and Pascal's Wager, we have to mention once more the issue of circularity as pointed out previously by our friend Martin Sibileau (who used to blog on "A View From The Trenches"), here is a reminder from his work which we quoted in our conversation "The law of unintended consequences" in Macronomics on the 25th of January 2012:

"With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance."  - Martin Sibileau

And as indicated by Martin Sibileau:

"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."

While the depreciation of the Euro is a welcome respite for European companies, the latest merry go round of Japanese QE risk offsetting an already precarious economic situation which has been aggravated by the sanctions taken against Russia and impacting particularly German exports in the process.

We are therefore coming back in full circle towards the need for QE in Europe as posited as well by our friend Martin Sibileau (which we quoted on numerous occasions in our posts):

"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility." - Martin Sibileau

By tying itself to Europe via swap lines, the FED has increased its credit risk and exposure to Europe:
"If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU." - Martin Sibileau

Back in November 2013, in our conversation "Squaring the Circle" we argued:

"Markets being extremely feeble creatures in the face of uncertainty will obviously react "rationally" when it comes to being provided with "explicit guarantees".

Obviously the lack of German Constitutional support could indeed prevent the whole "whatever it takes" European moment from moving from the "implicit guarantees" towards more "explicit guarantees" we would argue.

As pointed out by Bloomberg editors in their column from the 6th of November 2013 entitled "Europe's unfinished business threatens another recession",the European Banking Union is a must have. For us Europe is just trying to "Square the Circle:

"The most important stalled reform is in banking. Another round of bank “stress tests” has just been announced -- and this time, the ECB says, it’s serious. But there’s still no agreement on what happens to the banks that fail the tests. It’s universally agreed that the euro area needs not just a single bank supervisor -- which it now has in the form of the ECB --but also a single bank-resolution mechanism. That won’t fly, because Germany and like-minded countries won’t hear of bailing out failing banks or their financially stressed national governments.

This reluctance is understandable. But without a single bank-resolution mechanism, the euro project remains fatally flawed. The toxic link between distressed banks and distressed governments will remain. So long as that’s true, recovery will be held back and the euro area’s supposedly integrated capital market will be at risk of further splintering into separate zones. If the euro is to survive and its member countries prosper, a real banking union is indispensable." - source Bloomberg

To illustrate further the horrible issue of circularity and European banking woes, we think the failing of Banca Monte dei Paschi in the AQR will be a proxy of what happen to a European bank that fail sthe test as well as the application of "bail-in" for bondholders.

Since the AQR MPS stock price has been down by more than 35%. MPS's capital shortfall is put at €2.1 billion and has until November 10 to deliver its solution to the ECB. MPS's market capitalization is now €3.1 billion compared to the €5 billion raised in right issues this year. Placing Contingent Convertible notes (CoCos) also called AT1 to cover the capital shortfall is impossible. On this specific issue we read with interest Bank of America Merrill Lynch's note entitled "Numbers do actually matter" published on the 31st of October:

"€38.4bn

This is the level of impaired assets that Monte Paschi was carrying in its balance sheet at the end of June. At the end of 2012, it was €29.5bn so in the last year and a half it has gone up by 30%. These impaired loans account for 25.8% of the loan book. With such a vast portfolio of impairments, it doesn’t surprise us that there was scope for extra provisioning. The large portfolio of impaired positions undermines MPS’ viability, in our view.

Note that the NPE ratio used by the ECB is the much more benign 18.1% on which there is apparently 40.1% coverage. The sample analysed by the ECB, on which they found such severe provisioning needs, is in fact a smaller one that what we would consider to be the full portfolio of impairments. However, it does extrapolate, to a degree, in an attempt to cover the whole book.

€4.2bn

€4.2bn is the ECB’s assessment of the gross impact on capital from risk in Monte’s credit portfolio. The adjustments come from large corporate (an adjustment of €711m), real estate (€1.6bn) and large SMEs (€1.9bn) in Italy. Recall that, for the Italian banks in particular, we’d always thought that the stress test wasn’t even that stressful – so this is a poor result arguably for the bank.

In our view, it ends once and for all the idea, recently propagated in some quarters, that Italian banks’ NPL numbers are ‘optically’ worse only because they are more strictly classified vis-à-vis other European banks. We have never subscribed to that view and neither does the ECB, it appears. Italian NPLs are not more strictly classified. In fact the ECB exercise has found that they are consistently under-recognised.

€1.4bn

€1,394.8m is, apparently, the offsetting tax impact at Monte Paschi, which reduces the capital needs to €2.9bn in the ECB’s analysis. It’s equivalent to a large (33%) ‘benefit’ to the bank. We’ve heard doubts expressed about its reliability, because it is a large offset.

€4.2bn

Coincidentally, €4.2bn is the gross aggregated capital shortfall that the ECB has identified in the adverse scenario for Monte dei Paschi.

€2.1bn

The Bank of Italy has put MPS’s capital shortfall, including all capital strengthening measures, at €2.1bn. This seems to us to be a minimum number – for a large bank such as Monte’s solvency to be supportive of economic growth, we’d imagine that its capital would have to be much higher than this basic shortfall would suggest. The difference between this number and the previous number is the €2bn rights issue that was retained in the bank.

-0.09%

This is the adjusted capital ratio for MPS in the adverse scenario under the EBA analysis.

-3.5%

The EBA discloses the fully phased CET1 of MPS as -3.5%. The market will judge the robustness of the capital of the bank on a fully phased basis, so we’d argue that any capital actions taken need to be robust and credible, not papering over the (rather large) cracks.

These two negative ratios together underline the work that needs to be done to ensure MPS is robust to get through a reasonable stress scenario.

€5bn, €3bn and €1bn

€3bn is the amount of capital that the bank returned to the Italian Government this year after the €5bn capital raise. Had it not done so, we would be writing a different note about MPS now. However, €3bn was the amount that was in the repayment schedule for 2014 for the state aid, so the bank had to repay it. 

There is still €1bn or so of state aid outstanding and the Italian Government, as a first step, could convert this into equity now. However, we believe it is reluctant to do so, and the State may instead sell on the Monti bond to a third party that could trigger the conversion and own 30% of the bank on the cheap, potentially. Perhaps there is a certain reluctance to do this, because of the dilution of the investors that provided €5bn to the bank earlier this year.

More likely, we are mindful that the state aid approvals relied on the repayment of the New Financial Instruments according to the following schedule (see Table). Whilst conversion of the state aid to equity is foreseen, it would be a major derogation from the agreement between Italy and the EC and we think could potentially necessitate the re-opening of the MPS file by the EC. See for example, paragraph 134 of the state aid approval which reads:

If MPS is unable to repay the new instruments, MPS commits to re-notify a modified restructuring plan with additional measures. The Commission welcomes that commitment as it underlines the credibility of the repayment plan.

The original plan was premised on the return of MPS to viability and seems to explain the problems of the bank in terms of its over-exposure to Italian sovereign debt, which was having a bit of confidence problem at the time. This is now obviously not the case – it is the significant amount of impairments that is causing the bank’s solvency problems, and the Bank of Italy has itself acknowledged a €2.1bn capital gap at the bank. Obviously the current plan as approved does not restore MPS to long-term viability because it focused on the wrong areas. Given the work that the ECB has now done, we think the opening of the file would necessitate some significant changes to MPS, perhaps quite drastic ones, with far reaching implications for the bank. We can quite understand the reluctance to re-open the file; yet we struggle to see how else it could be if there is a desire that MPS should survive in anything resembling its current form.

Zero

Zero is apparently the amount of capital that the Italian Government wants to give 

the banking sector to help it overcome the deficiencies that have been elucidated 

in the stress test – hence its insistence on a private solution. This reminds us of 

the Portuguese authorities’ hopes for a private solution in the recent restructuring 

of Banco Espirito Santo." - source Bank of America Merrill Lynch

As we argued in our conversation - "Peripheral Banks, Kneecap Recap"

"We believe debt to equity swaps will likely happen for weaker banks as well as full nationalization for some."
As our good credit friend said in November 2011:
"The path will be very painful for both shareholders and bondholders."

When it comes to MPS, for us it is the most likely option to happen. From the same Bank of America Merrill Lynch note:

"€5.4bn

We estimate that MPS has about €5.4bn of Tier 2 subordinated debt outstanding, about €2.6bn of LT2 and €2.8bn of UT2 (dated). It also looks like there was a further €406m of Tier 1 securities in circulation, though this may be even harder to track down and there’s the issue that they are deferring at the present time. Equitizing or part-equitizing these bonds in some way would resolve the capital problems of the bank, we think, but it doesn’t appear to be on the agenda at the moment. The old Tier 1 bonds (the old 7.99% ISIN XS0121342827) appear to have dropped 20 points from their summer highs though – and appear to trade rarely.

We believe the base of the problem is the undertakings given by the Italian Government to the European Commission at the time that the State Aid for the MPS restructuring was approved just over a year ago. These would have to be revisited, which could be embarrassing. In particular, amongst the commitments given by Italy to the EC, we read that:

BMPS will not undertake any Liability Management Exercise (including calls) unless it is implemented at conditions by which it occurs at a […] discount in percentage points from nominal value and at no more than […]% above the market price. Any Liability Management Exercise will be timely submitted to the Commission services for approval. (Commitment #11 from the State Aid approval, November 2013) " 

This commitment effectively limits the ability of the bank to do a generous debt-for-equity swap, we think. It appears it would have to be punitive. Our assessment is that there is also effective lobbying from a major holder of the UT2 bonds – remember that the EC, very exceptionally, allowed an UT2 coupon when it should have been deferred if precedent had been followed?

This seems more powerful to us than the argument that perhaps some of the 

bonds are held by retail and there are fears of contagion. But if the Government 

doesn’t want to put extra cash into the banks, perhaps this should be revisited, as 

options look very limited outside the subordinated debt to us. And it is not as if 

this hasn’t been a well-trodden path to help bank with limited capital options to 

recapitalize throughout the rest of Europe. However, reopening the MPS state aid 

file, which would effectively be what they would have to do to get a generous LME 

away, may not be considered appetizing.

The sub bonds usually have large minimum denominations which don’t 

necessarily suggest a big retail presence, we’d argue, with the possible exception 

of the €2.16bn issue of UT2 bonds which does appear to have been placed 

directly to retail.

Moody’s downgraded the senior subordinated bonds of MPS to Ca on Thursday 

evening. 

According to the agency:

"In addition, MPS's senior subordinated ratings were downgraded and placed on review for further downgrade. This reflects an increased likelihood that the bank may require public support, in Moody's opinion, which would trigger state aid rules and bail-in of subordinated debt. Further, given the repeated instances of bailouts using state aid over the past years, the rating agency does not rule out the imposition of more extensive restructuring measures for MPS which could affect all creditors of the bank."

-34%

Since the AQR/stress test, MPS stock has fallen about 34%, from €1.03 to €0.68 on Thursday evening.

Credit has been more measured, mostly because the technicals are more favourable, we think. Monte senior cash bonds were still trading well above par (3.625% bonds at €101.3), in spite of the fact that this is quite a distressed bank, though spreads do look to have widened 15-20bps today. It is one thing not to believe that anything too nasty can happen to senior bonds in Italy, quite another to look at these levels and believe we are seeing anything like fair value. Also, Moody’s talked, in their review for downgrade, of the imposition of more extensive restructuring measures for MPS which could affect all creditors of the bank."  - source Bank of America Merrill Lynch

We believe that the path will be very painful for both shareholders and bondholders of MPS and that not only subordinated bondholders but seniors as well will face the music in the case of MPS, making MPS the precedent for future bail-in processes in the European banking landscape.

On a final note we leave you with a graph from Nomura from their recent report entitled "The coming cycle of higher volatilities" displaying the need for investors for a higher rate of return in their "Pascal Wager" making it most likely that if US productivity cannot deliver, then there is indeed room for disappointment and price decline:

"While the current cycle is not too different from past secular bull markets, investors are requiring a higher rate of return (i.e. earnings yield)"

- source Nomura

"The risk of a wrong decision is preferable to the terror of indecision."- Maimonides, Spanish philosopher

Stay tuned!

Credit - The European Polyneuropathy

"Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies." - Groucho Marx

Following up on our June conversation "Deus Deceptor" where we indicated our deep concerns relating to France's economic situation, we think it is time for us to revisit our negative stance on France. On a side note we share Charles Gave from Gavekal latest views on this very "French" subject. Given it is the 14th of July and France's national day, it is time, we think to look at the growing evidence of a slowdown and turmoil brewing in the quarters ahead.

In relation to our chosen title, with problems brewing at the core of Europe, in France in particular, and continuity in banking woes in the periphery, we thought our title should reflect the continuation of European woes using a medical analogy such as "Polyneuropathy" which is a damage or disease affecting peripheral nerves, which can be acute or chronic, but we ramble again...

In this week's conversation we will discuss France in general and peripheral European banking woes in particular. (we already discussed France in 2012 in our conversation "France's Grand Illusion").

As we posited back in June on our main subject France:

The story for  the remainder of 2014 in Europe is still France:

This is what we argued in January 2013 and this is still what we are arguing now. While French politicians are benefiting from low rates on French debt issuance courtesy of on-going Japanese support, but, on the economic data front France is increasingly showing signs of growing stress. 

France should be seen as the new barometer for Euro Risk. With Industrial Production at -3.7% (implying a negative GDP print, see below), the French government is seriously in denial when it comes to growth assumptions: 1% in 2014 (down from 1.2%) and 2% in 2015 is way over optimistic we think. 

A sobering fact, services in the French economy represent around 80% of the GDP versus 76% for the rest of the European union. the latest read at 48.2 for Services PMI is indicating contraction (the lowest level reached in February 2009  was at 40.2).

France appears to us as the weakest link if we take for example World Manufacturing PMI (50 = no change on prior month) as an illustration of the troubles brewing ahead as illustrated by our friends from Rcube Global Asset Management with France standing clearly at the bottom:

Another worrying trend illustrated by our friends at Rcube Global Asset Management lies in the growing financing gap between France versus Europe:

Or one could also look at the Corporate Financing Gap as a percentage of GDP in various European countries as displayed by Rcube Global Asset Management:

"Investment will keep plunging since French corporates' debt to value added ratio is so high. Furthermore, the French corporate financing gap is massive (as per above chart). It means that French companies' financing needs are extremely high, not only historically, but also compared to other countries in both Europe and the rest of the world. With France in such a difficult situation, the ECB will be under increased pressure to join the WE club

Corporate margins are thus decreasing, and are the weakest in Europe:

The high corporate debt to added value ratio suggest also that investment will soon turn negative

The French housing sector looks also mispriced compared to the rest of core EU:

- source Rcube Global Asset Management

We would like to add some more illustrations on France being the weakest link in Core Europe.

The recent evolutions of European house prices in some European countries seem to illustrate the start of a weakness in French real estate prices - graph source Bloomberg:

In blue: France

In red: United Kingdom

In yellow: Spain

Also, French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) tell the story on its own, we think - graph source Bloomberg:

An industrial production at -3.3% equals zero growth. With industrial production at -3.7% you can expect a negative GDP print for France.

As we argued back in June:

"If the Services PMI contracts, it doesn't bode well for France's unemployment levels. Services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).

Normally "entrepreneurial economy" can do that well as long when they are entrepreneurs in the picture but in the special case of France, given French civil servants have done their best to "kill" the entrepreneurs in France with great success, the economy will continue to linger.

A tight credit channel, high inventory levels vs. order books, depressed consumer sentiment and a forced fiscal tightening create a dangerous economic environment for an already weak economy."

We have also plotted France Consumer Confidence against GDP and the evolution of the French government debt to GDP (inverted) - graph source Bloomberg:

Deteriorating Debt to GDP level rising while French Consumer Confidence Indicator sliding, it doesn't bode well for growth and unemployment levels.

On numerous occasions we have discussed France and our growing concerns such as in our conversation "In the doldrums" where we touched the subject surrounding credit-less recoveries:

So for us, unless our  "Generous Gambler" aka Mario Draghi goes for the nuclear option, Quantitative Easing that is, and enters fully currency war to depreciate the value of the Euro, there won't be any such thing as a "credit-less" recovery in Europe and we remind ourselves from another conversation "Squaring the Circle" that in the end Germany could defect and refuse QE, the only option left on the table for our poker player at the ECB:

"The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in German's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe." - Macronomics

The reasons for Germany's racing ahead have all been explained not only in the title of a previous post of ours "Winner-take-all" in February 2013 but also in the contents should you want to dig further on the subject:

"In similar fashion to the winner-take-all computational principle, when ones look at the growing divergence between France and Germany when it comes to PMI, in the pure classical form, it seems only the country with the highest activation stays active while all other see their growth prospects shut down" 

On the topic of France and the "overvalued"  Euro, French Industry Minister Arnaud Montebourg has most recently validated our Groucho Marx quote from above as indicated by his latest staunch attack on the ECB as reported by Mark Deen and Helene Fouquet on their July 10 article in Bloomberg entitled "France's Montebourg Hits Out at ECB in Campaign-Style Speech":

French Industry Minister Arnaud Montebourg hit out at the European Central Bank, calling on it to buy bonds and weaken the euro in order to boost growth.

“We have the most depressed region in the world with a currency that has appreciated the most globally and a European Central Bank that has not respected its mandate,” Montebourg told an audience of executives in Paris, citing the risk of deflation. “No one should leave the economy in the hands of moralists and accountants.”

The remarks were made against the backdrop of a screen reading “economic patriotism” and “fight for growth” in a packed and darkened room that resembled Montebourg’s campaign meetings in the Socialist primaries of 2011 in which he placed third. He pledged to run again after his defeat to Francois Hollande. France’s next presidential election is due in 2017.

With a French economy that has barely grown in two years and euro-area inflation that remains at less than half the ECB’s target level, Montebourg is taking aim at policies that he says are letting France and Europe behind the rest of the world. “Growth is a political problem that will be achieved through political action,” he said. “To allow unemployment to remain high is to help the National Front and destroy Europe.” The National Front, which led the European parliamentary elections in France, is an anti-euro, anti-immigration party. “I only have one enemy; it’s conformism,” Montebourg said. Conformism “is not a candidate, it is ruling” the country, he said.

Hollande’s approval rating at less than 20 percent is at a record low for a French president" - source Bloomberg

From our conversation  "Squaring the Circle" here is the simple answer to Arnaud Montebourg's euro concerns in a very self-explanatory diagram:

As pointed out previously by our friend Martin Sibileau (who used to blog on "A View From The Trenches"), here is a reminder from his work which we quoted in our conversation "The law of unintended consequences" in Macronomics on the 25th of January 2012:

"With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance."  - Martin Sibileau

Europe's horrible circularity case - Martin Sibileau

By tying itself to Europe via swap lines, the FED has increased its credit risk and exposure to Europe:

"If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU." - Martin Sibileau

As a reminder from our previous conversation  "Squaring the Circle":

As a side note and in relation to the EU private sector seeking USD funding as displayed in Martin's chart above, in 2012 over a third of the US Investment Grade supply (net issuance in $430 billions) was from non-US issuers up from 25% in 2011. In 2013 we have seen about a third of the new issuance from non-domestic issuers (estimated net issuance for 2013 $400 billions).

Arguably in recent months, thanks to the US Fed tapering, the 1 year/1 year forwards for the US dollar and the Euro have increasingly diverged as displayed in the below Bloomberg chart:

But it looks to us that what the market is pricing indeed is a trigger at some point of QE in Europe because when it comes to the European Polyneuropathy, we think our friend's Martin Sibileau's above diagram depicts clearly the situation particularly when ones take into account that a huge amount of euro denominated assets remain to be sold. For instance, Société Générale reported on the 7th of July reported in a specific report on European banks entitled "Rise of the "zombie" assets", non-core banking represents a €1.5 trillion industry:

"Non-core banking: A €1.5trn industry 

European banks have become highly skilled in separating off the unwanted, the unsellable, and the unexplainable. Across our coverage, there is now €1.5trn of non-core banking balance sheet, consuming €80bn of tangible equity. These operations have had a major impact on profitability, dragging a full 4ppts off sector ROTE in 2013. Cleaning up the non-core will have a major bearing on when profitability will creep higher for the sector, in our view.

The major operations 

Five banks account for €1trn of the non-core balance sheet currently. This is where we believe restructuring the “bad parts” of the book has the most potential to drive profitability higher. These banks are UBS, Barclays, CBK, ING, and UCG. We are seeing progress, with ING recently completing the NN Group IPO and CBK disposing of a block of assets.

Raising the bid for “bad” assets 

We believe that the combination of ECB liquidity, lower funding costs, and improving confidence should raise the level of attractiveness for noncore operations. We have seen more robust financials IPO deal flow, and decent returns for distressed debt funds. This should help banks to run down the “bad”, and focus on the

“good”.

Further assets could become non-strategic 

We expect restructuring and consolidation to become a major theme for European banks after the AQR. This could bring further operations into question, particularly if the disposal process becomes easier (or even profitable). There is the potential for further restructuring at CS (CIB), DBK, and UCG (CEE)." - source Société Générale.

We can also point out that European banks need to sell another $795 billion worth of property assets as reported by Bloomberg by Neil Callanan and Patrick Gower on the 14th of July in their article entitled "European Banks needs $795 billion Problem Property Loan Solution":

"European banks and asset managers plan to sell or restructure 584 billion euros ($795 billion) of riskier real estate as they try to clean up their balance sheets, Cushman & Wakefield Inc. said.

The region’s lenders, asset managers and bad banks, such as Spain’s Sareb, sold 40.9 billion euros of loans tied to property in the first six months, 611 percent more than a year earlier, the New York-based broker said in a report today. Transactions including foreclosure sales will reach a record 60 billion euros this year, Cushman & Wakefield estimates.

Lenders such as Royal Bank of Scotland Plc are accelerating loan-portfolio sales as borrowing costs fall from a year ago and economic sentiment improves. Lone Star Funds and Cerberus Capital Management LP are among U.S. investors that are taking advantage as sellers opt to offer bigger groups of loans, making it more difficult for smaller firms to make purchases, Cushman & Wakefield said." - source Bloomberg

As we have argued in our conversation "Mutiny on the Euro Bounty" in April 2012:

"More downgrades mean more margin calls, more margin calls means more liquidation and more Euros being bought and dollars being sold, with a growing shortage of AAA assets, Europe is moving towards mutiny on the Euro Bounty ship..."

Unless of course Mario Draghi goes for the nuclear option, Quantitative Easing, that is.

And as indicated by Martin Sibileau from his note from the 17th of October "The EU must not recapitalize banks":

"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."

What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

Of course it is! QE being the only card left but we have our doubt Germany will agree to play that card.

Moving on to the subject of lowering value of European peripheral banks liabilities generating further losses to same banks, needing more capital, the Banco Espirito Santo is a clear illustration once more of the above diagram. 

We already touched at length in our past credit conversations on the liability exercise management taken by many weaker peripheral banks in relation to raising capital to reach the 9% Core Tier 1 Capital target set up by the European Banking Association for June 2012 (see our conversations, "Peripheral Banks, Kneecap Recap", "Subordinated debt - Love me tender?" and "Goodwill Hunting Redux"):

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

In fact in our conversation "Peripheral Banks, Kneecap Recap", Banco Espirito Santo was prominently featured given October 18 2011 Banco Espirito Santo had announced a capital increase in effect via its bond tender which meant at the time a 83.5% dilution for shareholders. This was followed by another capital increase of 1 billion euro announced mid-April, to be completed by early May (see our conversation "All Quiet on the Western Front").

We argued at the time:

"We believe additional debt to equity swaps will have to happen for weaker peripheral banks, similar to what we witnessed with Banco Espirito Santo in October 2011, as well as for German bank Commerzbank ("Schedule Chicken" - 25th of February 2012)."

As our good credit friend said in November 2011: 
"The path will be very painful for both shareholders and bondholders."

The BES (Banco Espirito Santo) situation, is indeed a reflection of the European Polyneuropathy and is by no mean without "consequences" as shown in the above diagram from Martin Sibileau and the effect of "margin calls" given that Espirito Santo's board as not only appointed a new CEO but its largest shareholder was forced to sell a stake in the Portuguese bank to meet a margin call on loans as reported on the 14th of July in Bloomberg by Joao Lima: in his article entitled "Espirito Santo Owner Sells Stake to Meet Margin Call on Loan":

"Banco Espirito Santo SA’s largest shareholder was forced to sell a stake in the Portuguese bank to meet a margin call on a loan, heightening market concerns about the group’s finances. Espirito Santo Financial Group SA said today it sold 4.99 percent of the bank, reducing its holding to 20.1 percent, to meet the call on the loan taken out during the bank’s 1.04 billion-euro ($1.4 billion) rights offering in June. Banco Espirito Santo, Portugal’s second-biggest lender by market value, fell as much as 11.9 percent in Lisbon trading.

The sale came as Chief Executive Officer Ricardo Salgado, the 70-year-old great-grandson of the bank’s founder, was replaced by Vitor Bento after the Bank of Portugal urged the lender to speed up changes to its executive management. The Espirito Santo family’s hold on the bank slipped further as

Moreira Rato, 42, head of the government’s debt agency, was named as chief financial officer.

Banco Espirito Santo roiled global markets on July 10 after another parent company, Espirito Santo International SA, missed some payments on commercial paper. The stock plunged 36 percent last week and its credit rating was cut by Standard & Poor’s and Moody’s Investors Service on July 11. German Chancellor Angela Merkel said at the weekend the market turmoil caused by the Portuguese bank underlined the euro region’s fragility." - source Bloomberg.

Of course what has started in earnest is the application of "bail-in resolutions" of subordinated bondholders of weaker European financial institutions if one looks at the BES story - graph source Bloomberg:

"Banco Espirito Santo's June capital raise boosted its regulatory capital buffer to 2.1 billion euros ($2.9 billion), according to a press release from the bank. This buffer may be considerably smaller under the macroeconomic assumptions of the adverse scenario in the forthcoming ECB stress tests. Concerns will also mount on the application of bail-in rules for bank debt, suggesting that investors may re-examine reported capital and debt prices for periphery lenders." - source Bloomberg

It isn't only happening in Portugal if one follows the events surrounding Austrian Hypo Aldria issues given the first Chamber of Austria's parliament, the Nationalrat, has given the green light to wipe-out subordinated lenders despite the debt being guaranteed by the state of Carinthia. When the game changes, you can expect politicians to change the rules. This is what makes the difference between "implicit" guarantees from "explicit" guarantees (The German Constitution is more than an "explicit guarantee" as stated above). The rest of Hypo Aldria's network such as its Balkan banking network has been put on for sale. Yet another effect of "margin calls".

For now it seems subordinated bondholders and shareholders are getting the "kneecap" treatment to raise much needed capital with the surge of "margin calls". When one looks at the debt distribution of Banco Espirito Santo with a small cushion of perpetual subordinated debt, one can legitimately wonder if senior bondholders will not suffer at some point a similar "treatment" - graph source Bloomberg:

"The reopening of senior subordinated debt markets to many periphery banks and nations has alleviated funding and deposit-cost pressures since 2013, though recent discussions on bail-in rules and the ECB stress tests have damped investor appetite. Banco Espirito Santo's plummeting debt value and share price suggest the cost of refinancing its 2.76 billion euros ($3.76 billion) of senior subordinated notes maturing in 2015 will have risen, likely also driving up funding costs for peers." - source Bloomberg

It appears to us that the cost of maintaining "zombie" entities afloat is getting pricier by the day. On a final note given European Growth and Consumer Confidence go hand in hand, we think we have reached a plateau as per the below Bloomberg graph:

"If there must be trouble, let it be in my day, that my child may have peace." - Thomas Paine

Stay tuned!

Credit - Third time's a charm‏

"Luck is a matter of preparation meeting opportunity." - Lucius Annaeus Seneca 

As we move into 2014, our chosen title reflects the third time strategists put forward the case for a weaker euro. So could indeed 2014 see finally the much anticipated weaker euro forecasted by so many pundits?

In terms of our prognosis in both 2012 and 2013, we did not believe in a weakening of the Euro versus the dollar and we reiterated our stance in numerous occasions such as in our conversation from April 2013 "Big in Japan":

"In terms of the EUR/USD, we still think in the second quarter that it should remain in the 1.30 region versus the US dollar, which were our views for the 1st quarter. As we posited in January 2012, when most strategists were bearish on the EUR/USD, the Fed swap lines in conjunction with the FOMC decisions at the time did put a floor to the euro and are delaying a painful adjustment in Europe. The latest decision by Japan will as well prolong the European agony. In the process the European recession can only be prolonged and the European economy will continue to suffer (unemployment rate now at 12%)."

When it comes to Europe, we will not change our stance in 2014 either. As we pointed in a "Tale of Two Central banks", we would like to repeat our friend Martin Sibileau's view we indicated back in October 2011 when discussing circularity issues:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

Unless Mario Draghi unleashes in Europe QE to fight off the growing deflationary risks we have been tracking and warning about, we do not see a weakening of the Euro in 2014. Therefore we do not fully agree with Bank of America Merrill Lynch's recent take on the subject in their note entitled "Will the Euro stop defying gravity in 2014?" published on the 9th of January:

"Our case for a weaker Euro in 2014...

We argue that real economic indicators, inflation differentials, rate differentials, technicals and quant analysis, all point towards a weaker EURUSD in 2014. Indeed, we project EURUSD at 1.25 by the end of the year. Our analysis suggests that the strength of the Euro in 2013 was because of forces that are either losing steam, or will be absent in 2014, including: the Fed’s much more dovish monetary policy stance, the substantial adjustment from short Eurozone positions in FX and in European assets more broadly, and an improving current account balance in the Eurozone.

..and the case against us

The risks to our thesis for a weaker EUR in 2014 include: a slowing in US growth, a reduction in the inflation differential between the Eurozone and the US and an increase in the Euro share of global central bank reserves. We argue that these are low probability risks." - source Bank of America Merrill Lynch.

But, where we agree with Bank of America Merrill Lynch's take on the subject is no doubt on the importance of central bank policies, which are indeed the driving force behind many markets:

"In our view, one of the key forces supporting the Euro is relative monetary policies. Although both the Fed and the ECB loosened policies last year, the Fed remains much more accommodative. Indeed, the Fed has been reluctant to exit quantitative easing too early, while the ECB has been avoiding quantitative easing all along (see Global Rates & Currencies Year Ahead).

Relative central bank policies would actually justify an even stronger Euro. The strengthening of the EUR/USD during 2013 is consistent with the expansion of the Fed's balance sheet compared with that of the ECB (Chart 16).

Indeed, this correlation would be consistent with EUR/USD at 1.45. A comparison of the monetary policy stance between the Fed and the ECB based on a Taylor rule would justify a similarly strong EUR/USD (Chart 17).

We expect the ECB to continue being reactive rather than pre-emptive in 2014. We believe that the ECB will deviate from its current stance and loosen policies further only in risk scenarios, primarily linked to disinflation and deflation risks, such as:

-If liquidity conditions were to tighten further and for a larger number of banks in the wake of uncertainty generated by the bank asset quality review and the stress test that will follow. In this case, we expect the ECB to introduce a new LTRO, for more than a year and with fixed rate (possible within H1);

-If inflation was to stay below 1% for more than a quarter and 2015 projections were to decline towards 1%. We would then expect the ECB to cut by a small amount its refi and possibly its deposit rate (unlikely before Q2);

-If the euro zone was to show outright signs of deflation. Only in this case we would expect the ECB to move to asset purchases (most likely government bonds), a tail risk scenario in our view."

 After all, the "Growth divergence between US and Europe? It's the credit conditions stupid...", it is all about Stocks versus Flows. Yes, we ramble again in 2014:

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

When it comes to depreciation of liabilities and deflationary forces, credit conditions in Europe have yet to improve, as bank credit to companies and households in the euro area has shrank for the 19th month in November even after the ECB rates cut in 2013 while euro inflation has been below the 2% target for the last 11 months.

We have argued that improving credit conditions and severing the link between banks and sovereigns would amount to "squaring the circle". European Banking Union or not, we do not see it happening. Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation which is what we are seeing in Europe and what a 0.8% inflation rate is telling you. It is still the "D" world (Deflation - Deleveraging). As illustrated by Bank of America Merrill Lynch's graph from their note from the 6th of January entitled "The mixed blessings of better markets", we have yet to see any meaningful loan growth in the euro area and with the upcoming AQR in 2014 with continued deleveraging, don't expect improvements anytime soon:

And when it comes to the deflationary trajectory and continued deleveraging pressure the evolution of nonperforming loans in peripheral countries are clearly indicate of ECB liabilities having to depreciate further. The graph below from the previously quoted Bank of America Merrill Lynch note clearly underlines the issues faced by the ECB, which cannot sustain both the demand for sovereign government bonds and credit availability for the private sector, something will have to give unless Mario Draghi comes up with new "unconventional" tricks in 2014:

"That largest pool of problem credit is in Spain, where there is as yet no sign of NPLs slowing up in Spain: the last three months saw a €12.2 billion rise in system NPLs, compared with €11.6bn in the prior quarter" - source Bank of America Merrill Lynch

In relation to government bonds holdings, as we posited in our last 2013 conversation, it is after all, all about the carry which remains attractive for peripheral banks which have been soaking up on their domestic bonds at a rapid pace for the last couple of years. Third time's a charm as well when it comes to the carry trade.

The European bond picture, some convergence as of late, with Italy and Spanish continuing to perform and providing carry and earnings to their respective financial institutions - graph source Bloomberg:

Some additional convergence as well can be seen credit wise in the evolution between the spread of the 5 year CDS index Itraxx Main Europe (Investment Grade risk gauge based on 125 European entities) and the 5 year Itraxx Financial Senior index which has been trending towards zero - graph source Bloomberg:

With so much "Greed" and no "Fear", risky assets have rallied hard at year end, particularly in December, as displayed in the rally seen in High Yield and the continuous rally in the S&P 500, but increasingly the performances for credit  investment grade is being capped  - graph source Bloomberg:

The correlation between the US, High Yield and equities (S&P 500) is back thanks to "yield hunting". US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG.

The surge in risky assets has been of course driven by the fall in volatility as a whole in various asset classes as displayed in the below Bloomberg graph although the recent announcement of "tapering" in December has led to a surge in 1 month Treasury options volatility as of late:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

Of course, credit has not been the shining star of 2013 as it was the shining star of 2012. In 2013 the S&P500 delivered its best return since 1997.

The rise of the S&P 500 a story of growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:

Of course 2014 is already a continuation of 2013 in terms of multiple expansions when one looks at the recent announcement of FedEx which will issue $2 billion of bonds to speed up stock buybacks. While shareholders have been celebrating, bondholders have no doubt been licking their wounds given that FedEx’s  $500 million, 4.1 percent portion due April 2043 and issued last year traded Dec. 18 at 86.2 cents on the dollar to yield 5 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority and as reported by Bloomberg. For Apple's long bond issued last year it is a similar story of bond losses.

The "Cantillon Effects" at play, the rise of the Fed's Balance sheet, the rise of the S&P 500, the rise of buybacks and of course the fall in the US labor participation rate (inversely plotted) - source Bloomberg:

In red: the Fed's balance sheet

In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.

As we posited in our conversation "Misstra Know-it-all":

"By suppressing interest rates through ZIRP, the Fed has allowed risks to be "mis-priced" leading to global aggressive "mis-allocation" of capital in the search for returns."

In terms of the "dash for trash", it can be illustrated we think by looking at the performance of Small-Cap, Utility Stocks versus the S&P 500 since December 2012 - graph source Bloomberg:

Or by looking at  the S&P500 index versus High, Low Quality Stocks since March 2009 - graph source Bloomberg:

Looking at the S&P 500 against Margin Debt at NYSE members firms and the estimated annual interest cost for margin debt at broker call rate, we wonder at what point this rally induced more and more by leverage players will come to an abrupt end - graph source Bloomberg:

After all it is the third time central bank induced asset bubble does indeed seem to be working like a charm as our title goes.

And looking at the success by the Fed in "bending" the velocity curve and curbing the fall in the labor participation rate, we wonder if playing the "wealth effect" via asset prices inflation is worth the risk being taken - graph source Bloomberg:

Back in July 1997, velocity peaked at 2.13 and so did the US labor participation rate at 67.3%. Now at 62.8% the US is back to 1981 and velocity is still cratering (1.54), even lower than in the 1960s.

What investors fail to assess is the growing global deflationary risk which, we agree with CLSA Strategist Russell Napier, is significant:

“Investors are cheering the direct impact of QE on their equity valuations, but ignoring its failure to produce sufficient nominal-GDP growth to reduce debt. In a market where such bad news has been seen as good news (as it leads to more QE), the reality of QE’s failure will become bad news as we head towards deflation ….. The failure of monetary policy to defeat deflation is about to become apparent, with dire consequences for equity prices”. - CLSA Strategist, Russell Napier

Just note that the ThomsonReuters/Jefferies Commodities Index is now back to where it was at the end of 2009 and 25% below its early peak in 2011. Of course Gold's 28% decline in 2013 has been the worse since 1981.

Of course one of the principal culprit in exporting deflation on a global scale, has no doubt been Japan, as we have posited back in 2013. For the first time since 1992, as reported by Bloomberg, prices in Japan's consumer durables are indicating somewhat a tentative escape from the deflationary forces which have been plaguing for decades Japan - graph source Bloomberg:

"Prices in Japan of consumer durables such as computers and mobile phones rose for the first time since 1992, signaling progress in the nation’s campaign to defeat deflation.
The CHART OF THE DAY shows a 0.3 percent gain in November from a year earlier, after a 21-year slide, boosted by price increases for desktop and notebook computers. The gauge has a weighting of about 7 percent in the overall consumer-price index, which rose 1.5 percent.
The increase came seven months after the Bank of Japan unveiled record monetary easing in pursuit of a 2 percent inflation target. The jump defies a trend of technological improvements leading to lower prices and shows manufacturers are moving away from aggressively competing on cost, according to economist Yoshiki Shinke.
“Inflation is spilling across a whole range of products,” said Shinke, chief economist at Dai-ichi Life Research Institute in Tokyo. “The weakening yen has contributed to higher prices for these products as Japan is importing many final goods given that production is shifting overseas.”
Declines in the Japanese currency, which fell last month to its lowest against the dollar since 2008, led companies such as Apple Inc. to raise prices last year of computers and smartphones. Increases of 24 percent and 12 percent for desktop and notebook computers, respectively, in the November consumer- durables data outweighed a 0.3 percent fall in auto prices.
The narrower household durables index, which includes refrigerators and washing machines, fell 0.9 percent. Technological advances for such appliances lag behind those for gadgets, holding back demand and price gains, according to Naoki Murakami, chief economist at Monex Inc. in Tokyo." - source Bloomberg.

On a final note, as we posited in our conversation from December 2013 "All that glitters ain't gold", we still believe the following:
"2014 will also see Europe still facing the pressure from two tectonic deflationary plaques, which have been the US QE but more importantly in 2013 the outpacing of the Fed led by "Abenomics" which is indeed sending a tremendous deflationary force around the world which means that even the US is not immune to, hence our repeated doubts in seeing a "tapering" in 2014." 

Therefore unless, the ECB starts another round of QE or some additional "unconventional" policies, with Japan exporting deflation on a global scale, and the recent lackluster US nonfarm payroll numbers, we have a hard time seeing a much lower EUR/USD for the time being.

"Faith consists in believing when it is beyond the power of reason to believe." - Voltaire

Stay tuned!