Credit - The Rebel Yell

"Those who excel in virtue have the best right of all to rebel, but then they are of all men the least inclined to do so." - Aristotle 

While watching the continuation of the US political stand-off, which as we argued last week, turned out to be more of a "False Alarm" than anything else when one takes into account the rally witnessed at the end of the week in most risky assets, we thought we would play with your mind again using a dual reference in this week's chosen title.

The first reference is a music reference from our beloved musically creative 80s period, namely Billy Idol's famous 1983 hit album Rebel Yell as we believe that, when it comes to the debt ceiling and Billy Idol's lyrics from the famous song, in the end, US politicians "in the midnight hour will cry- 'more, more, more' ", when it comes to raising the debt ceiling and issuing more debt in the process.

The second reference is more historical. The rebel yell was a battle cry used by Confederate soldiers during the American Civil War. Confederate soldiers would use the yell during charges to intimidate the enemy and boost their own morale in similar fashion to today's Republicans stand-off, although the yell had many other uses....but we ramble again. 

Some pundits have recently argued that the US government shutdown was a demonstration that the United States of America had never been more divided. On that point we agree with the recent rant of our old friend and mentor Anthony Peters in his column in IFR entitled "On civil wars". This kind of comments on how the United States of America is divided today is utter nonsense:

"Sometimes I feel like screaming. This morning it was a report on the wireless which quoted a newspaper dubbing the US government shutdown as demonstration that the country has never been more divided. I challenge this piece of nonsense on two counts.

The first count is that, as a keen student of the American Civil War (1861-1865) which over four years ended the life of around one in ten of the nation’s male population and which culminated with the assassination of the President, I find it hard in any way to hold up the events of 150 years ago against the petty posturing on Capitol Hill in 2013 and to see any measurable comparisons.

The second is that it is not the nation which is divided but the politicians who eat and sleep pork barrel politics and who do not seem to give a fig for the wellbeing of any citizen who is not a member of their respective parochial electorate.

In fact, if one takes a disciplined approach to American politics, it is not a polarisation of political opinion which is prevalent but a vicious, no holds barred, cat fight for the middle ground which is the cause of much of the current problem. It brings with it one very important question and one which is taxing the minds of both John Boehner, the Republican Speaker of the House, and of the President which is whether ultimate power should be vested in the legislature or with the executive." - Anthony Peters, SwissInvest Strategist.

Therefore in this week's conversation we will discuss the "Rebel Yell" and the US version of the "Scheduled Chicken" for the US Debt Ceiling but also look more into the implications for the future "tapering" stance of the Fed under the new leadership of "Chairwoman" Janet Yellen. 

While in recent years we have been more accustomed to European politicians playing the game of "Scheduled Chicken" on so many occasions that our head hurts, it is interesting to see the contagion spreading to the US with the senseless fear of impeding default. As the wise Lucius Annaeus Seneca" once said:"Every man prefers belief to the exercise of judgment."

As put it recently by Nomura in their recent special report from the 10th of October entitled "US Debt Ceiling: Countdown to Default?", here comes the US version this time around of the aforementioned "Scheduled Chicken":

"As the US government shutdown drags into a second week, the markets are now starting to take notice of the sobering reality that this impasse will most likely go down to the wire. Complicating the situation is the near-exhaustion of the extraordinary measures being used by the Treasury to avoid crossing over the debt-ceiling limit. Given that there is over a week to go until October 17 – the critical cross-over date at which when Treasury cash-flow management becomes less predictable – key aspects of the funding markets are experiencing a more pronounced move than during the 2011 debt ceiling run-up." - source Nomura

More pronounced? At least not in the CDS space.

It was interesting this week to watch the US 1 year CDS surge to 55 bid on the 10th of October before seeing it tighten by 25 bps the next day when the 5 year CDS level was flat at 34 bps on the bid side. So much for default risk...

When it comes to politicians shenanigans, the move seen as of late on the US sovereign CDS space has indeed been much benign than two years ago as indicated by the recent Bloomberg Chart of the Day:

"Investors appear less concerned about the wrangling over the U.S. government’s budget and debt ceiling than they were two years ago, according to Barry Knapp, Barclays Plc’s chief U.S. equity strategist.

The CHART OF THE DAY tracks one indicator that Knapp used to draw his conclusion, presented in an Oct. 4 report: the cost of credit-default-swap contracts that insure against default on U.S. Treasury securities.

Last week’s closing rate of 45.5 basis points was well below a peak of 64.4 basis points in July 2011, the last time the federal debt limit was almost breached, according to data compiled by McGraw Hill Financial Inc.’s CMA unit. Every basis point is equivalent to $1,000 a year for a contract protecting $10 million of debt." - source Bloomberg.

In continuation to the US CDS signals following the "Rebel Yell", Bank of America Merrill Lynch in their note entitled "The declining duration of fiscal concerns" from the 11th of October added the following in relation to volume in the US CDS sovereign space:
"The weekly DTCC data shows a fair amount of trading supporting the widening of CDS spreads on the US sovereign we have seen recently, as 1-year spreads widened to 60bps from less than 10bps. Specifically the net position in CDS increased by about $250mm during each of the past two weeks to about $3.6bn as of last Friday. That corresponds to about a third of the typical trading volume (not changes in net notional) in the most liquid corporate names. As trading volumes most likely exceed changes in net notional, clearly US sovereign CDS contracts have been fairly liquid over the past two weeks and the widening of spreads reflects real risk taking as opposed to a lack of liquidity. Note that the net notional is still dwarfed by what we saw in 2011, while spreads are similar. 

Assuming a 90% recovery in a CDS auction on the sovereign, at 60bps buyers of protection would need to assess a default probability higher than 6% over the next year to expect a profitable trade." - source Bank of America Merrill Lynch

Arguably the "Rebel Yell" has had more terrifying effect on the 1 month TED and in the T-bill volatility space, as displayed by Nomura in their recent special note:

"Stresses have begun to show across various subsectors of the money markets. One need not look further than the extreme moves in the 1m TED spread which inverted this past week (Figure 3). The pressure sitting on the very front end of the T-bill curve remains a function of fear over owning securities that are in the “default window.” The quick spike higher in the front end after quarters of stability is also showing up in the rolling realized vol of 1m T-bills (Figure 4)." - source Nomura

Of course the consequences of the "Cantillon effects" and the surge in all risky asset prices with dwindling liquidity on banks books, have led to consequently much more risk for heightened volatility as illustrated by not only the violent surge in T-bills volatility but no doubt in the spike in 1 month bill yields as illustrated by Bank of America Merrill Lynch in their note from the 8th of October entitled "From financial to fiscal crisis":

"The more idiosyncratic concerns this time about being repaid by US Treasury was highlighted by the huge jump today in 1-month Treasury yields to 34bps, more than double yesterday’s level of 16bps as Treasury sold $30bn of new 1-month bills (Figure 4). Clearly, given the political circumstances, the likelihood of being repaid a 1-month maturity by the private sector may well exceed the likelihood of being repaid by the public sector (though both probabilities are very high). However, in the unlikely event that it really came to a public sector default we doubt the financial sector would continue to outperform – despite banks having finally recovered from the financial crisis - amid potential systemic concerns. Such concerns include liquidity and haircut requirements of Treasury collateral supporting the short term market. This perhaps explains the small spike in FRA-OIS the past two days (Figure 1)."

- source Bank of America Merrill Lynch

After all, it does seem that, courtesy of Central Banks' generosity we do live in a Bayesian world: "For subjectivists, probability corresponds to a 'personal belief'"- source Wikipedia

Like the wise Seneca, we prefer the exercise of judgment. On that sense we agree with the comments from Bank of America Merrill Lynch from their note from the 10th of October 2013 entitled "No Apocalypse Now":

"While we have recently suggested (see "Get CRASHy") that investor behavior is becoming more exuberant, right now there are two factors that we believe reduce the risk of a major market decline in coming weeks.

First, investors have already taken out substantial protection against a sharp debt-default inspired decline in equities in the form of SPX puts and VIX calls.

Second, in a classic debt default crash, the value of equities, bonds as well as the currency is simultaneously impacted. In our view a US apocalypse trade in October would require lower equities (in particular bank stocks), a lower US dollar and higher bond yields. We believe that combination would suggest investors are questioning the credit-worthiness of the US government and/or expecting inflationary consequences of QE4 (i.e. another liquidity policy response by the Fed) and a devaluation of the US dollar. Should the Fed be forced to "extend" or "magnify" liquidity and bond yields rise, in our view risk assets would likely be severly impacted.

Despite the debt ceiling situation, both inflation expectations and interest rates do not appear to be acting in an apocalyptic manner. Aside from a sharp move higher in the 1-month T-bill, fixed income markets have been very well behaved and volatility in both stocks and currencies has been low. And Washington is now piecing together a plan to extend the debt ceiling for up to 6 weeks." - source Bank of America Merrill Lynch

So if you still want to play the "Bayesian subjectivist" here comes from Bank of America Merrill Lynch note, another bout of  "Scheduled Schedule" for you to peruse:

"-As of Monday, October 7th, the Treasury had $35 billion of cash and $92 billion in debt maneuver capacity, giving the government $127 billion in cash to deal with upcoming liabilities.

-October 17th is the date specified by the US Treasury that debt capacity will run out (BofAML estimates that payment capacity will still be $70bn).

-October 31st a $6bn coupon payment is due (BofAML estimates payment capacity at that date will have fallen to $22bn).

-November 1st the payment capacity completely runs out due to large Social Security, Medicare, defense, & veterans payments of $67bn (BofAML estimates only half payments could be made).

-November 15th a further $31bn coupon payment is due and a potential default could then be announced if the debt ceiling is not raised before this date." - source Bank of America Merrill Lynch

Moving on to the subject of the potential "tapering stance" of the new "Chairwoman" Janet Yellen, back in June 2013 in our conversation "Lucas critique" we argued:
"QE tapering"soon? We do not think so. Markets participants have had much lower inflation expectations in the world, leading to a significantly growing divergence between the S&P 500 and the US 10 year breakeven, indicative of the deflationary forces at play".

The divergence between the S&P 500 and the US 10 year breakeven, graph source Bloomberg:

The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year has weakened dramatically. US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:

In addition to inflations expectations, shipping has always been for us, the best significant example of the reflationary attempts of our "omnipotent" central bankers. For instance, containership lines have announced 6 rate increases in 2013, but have failed to maintain the momentum because of the weak global economy and the excess capacity which has yet to be cleared in similar fashion to the housing shadow inventory plaguing US banks balance sheet, graph source Bloomberg:

"The Drewry Hong Kong-Los Angeles container rate benchmark fell 5.3% to $1,786 in the week ended Oct. 9, the lowest level since March 2012 ($1,771). This marks the 13th week in 2013 that rates are below $2,000. Rates are about 29% lower than the July 2012 high of $2,519. Even with six increases in 2013, rates are 34.1% lower yoy and down 19.3% ytd, as slack capacity continues to pressure pricing." - source Bloomberg.

Weak global economy, with weak global demand as illustrated by shipping rates as indicated by data from the World Container Index data - source Bloomberg:

"Shipping rates for 40-foot containers (FEU) fell 3.8% sequentially to $1,601 for the week ending Oct. 3, the fourth straight decline, according to World Container Index data.
Weakness continues to be driven by Asia, as rates from Shanghai to Rotterdam fell 7.3%, followed by Shanghai to Los Angeles (down 4.8%), Shanghai to Genoa (4.7% lower) and Shanghai to New York (down 3.2%) routes. Rates rose for Rotterdam to Shanghai (4.7%) and to New York (1.6%)." - source Bloomberg.

While the recent range break-out in the Baltic Dry Index is supposedly indicative of a strong economic rebound, we think the respite is temporary - graph source Bloomberg:

Some pundits as well have become more upbeat on iron-ore freight and scrapping levels as indicated in the below Chart of the Day from Bloomberg depicting fleet expansion versus ships' scrapping. We remain wary given the deflationary forces at play - graph source Bloomberg:

"The biggest rally in iron-ore freight costs since 2009 is prompting shipowners to end the industry’s biggest scrapping program in at least three decades as older vessels bring in more money.
The CHART OF THE DAY shows how rates, in blue, for Capesize ships hauling 160,000 metric tons of iron ore rose to a 34-month high of $42,211 a day on Sept. 25. Scrapping levels are in red.
Owners have paid off debt used to buy older vessels, making them cheaper to run, so they won’t opt for scrapping as long as the rally allows them to profit from the ships, according to Erik Nikolai Stavseth, an analyst at Arctic Securities ASA in Oslo. Chinese investment in rail, buildings and infrastructure will rise 20 percent this year, creating demand for another 135 million tons of steel, Shanghai-based Citic Securities Co. says. That would require 200 million tons of iron ore, used to produce the alloy, enough to fill 180 Capesizes, according to Fearnley Consultants A/S, a research company in Oslo. Capesize fleet capacity is up 75 percent since 2008, says IHS Maritime, a Coulsdon, England-based maritime researcher. “Freight rates are expected to return to profitable levels- even for older tonnage,” said Stavseth, whose recommendations on shipping company shares returned 26 percent in the past year.
“This will potentially lead to higher net fleet growth.” World trade in iron ore will grow 6 percent to 1.17 billion tons this year, with China taking two-thirds, according to Clarkson Plc, the biggest shipbroker. Earnings for Capesize carriers sailing to China from Brazil at a $40,000 daily rate assuming a voyage time of 45 days will equate to $1.8 million, spurring owners to keep trading their ships, Stavseth said." - source Bloomberg

We remain wary because we have yet to see a clear reduction in the number of ships being broken-up - graph source Bloomberg:

We remain wary because we have not seen a confirmed rebound in Chinese Iron Ore imports which are correlated to the Australian dollar - graph source Bloomberg:

As displayed in Deutsche Bank weekly Shipping note from the 7th of October 2013, Chinese Ore Inventory remains well below 2012 levels:

- source Deutsche Bank

But there are some improvements in monthly Chinese Iron Ore Imports as indicated by Deutsche Bank:

"August iron ore imports declined by 5.6% m/m, but is still up 7.2% y/y. Given recent chartering trends, we expect to see improved imports in September." - source Deutsche Bank

We have already touched on "the link between consumer spending, housing, credit growth and shipping":
"If there is a genuine recovery in housing driven by consumer confidence leading to consumer spending, one would expect a significant rebound in the Baltic Dry Index given that containerized traffic is dominated by the shipping of consumer products."

The worry for us as of late is that consumer sentiment in the US has fallen in October to a 9th month low making us questioning the strength of the rebound in shipping, as per Ben Schenkel's article from the 11th of October entitled "Consumer Sentiment in U.S. Fell in October to Nine-Month Low":
"Consumer sentiment in the U.S. fell in October to a nine-month low as the government’s partial shutdown and the debt-ceiling debate caused outlooks to sour.
The Thomson Reuters/University of Michigan preliminary consumer sentiment index of decreased to 75.2 this month from 77.5 in September. Economists in a Bloomberg survey projected a drop to 75.3, according to the median estimate.
Households are becoming pessimistic about the economy as the shutdown heads into a third week and the deadline looms for raising the debt limit and avoiding a default. Nonetheless, improved stock values and home prices have lent support to balance sheets, especially for wealthier Americans.
“Since the shutdown began, consumer sentiment has taken a hit,” Brian Jones, senior U.S. economist for Societe Generale in New York, said before the report. “The average person is sensitive to the headlines about the debt ceiling and the adverse impact of a technical default.” Projections of the 68 economists surveyed by Bloomberg ranged from 65 to 80. The index averaged 89 in the five years leading up to the economic slump that began in December 2007, and 64.2 during the 18-month recession that ensued." - source Bloomberg.

This leads us not to believe the Fed will "taper" in 2013. For 2014, we are not too sure either...That's our own "Rebel Yell".

"What is a rebel? A man who says no." - Albert Camus 

Stay tuned!

Markets update - Credit - Rates - Equities - The Fast and the Furious...and unintended consequences of the US downgrade.

The Fast and the Furious...

Markets update:

In the equity space, it has been volatile to say the least and given sometimes pictures are worth more than words, we'll go through some of the action today.

CAC40 intraday movement, welcome to Disneyland Magic Mountain!

Around 6.5% intraday movement.

But the German Dax index was even more volatile:

EUR/CHF - the trend is your friend and the Swiss National Bank might start printing soon, and join the debasing currency club because it must be starting to hurt exports:

In this "Risk Off" mode, Gold is continuing its uninterrupted rise, from new record to new record:

VIX index - Houston we've got a problem...

Some other risk indicators
Our friend Ted Spread is cooling off a bit:

But it isn't the case for OIS Libor spreads in Euro:

European Government Bonds update:
Shock and awe doctrine in full force on 10 year Italian and Government bonds!
Italian BTP 10 year bonds

But most of the action was on the Spanish 10 year bond!

Is it going to restore confidence in the markets? We still need long term solutions which have yet to be addressed by European politicians. The EFSF will have to be increased or spell the demise of the Euro.
Greece 2 year Government bonds - Zombie Zorba is staying put:

Since the ECB started buying Greek bonds, the 5 year Sovereign CDS for Greece went from 617 bps to 1690 bps according to Bloomberg.

In the credit is getting crushed and liquidity is extremely poor in the cash market.
CDS spreads continue to widen significantly, making everyone feeling extremely nervous. That Lehman feeling all over again...Not good.
Itraxx Crossover 5 year index, drifting wider and wider:

In the sovereign 5 year CDS space, France is widening still:

Australian Banks have also started widening in this sell-off:


Unintend consequences of the US dowgrade = global repricing of risk.

Since the downgrade, U.S. government bonds rallied, with
the yield on the benchmark 10-year note tumbling to an 18-month
low of 2.28 percent. Flight to what is still seen as a safe haven in this brutal environment.
S&P followed up with the downgrade of Fannie Mae and Freddie Mac, DTCC and others, and municipals bonds.
Fannie Mae’s current-coupon 30-year fixed-rate mortgage-backed securities rose 0.14% point to 1.22% points more than 10-year U.S. government debt, according to Bloomberg. A gap of 0.87%, highest gap since April 2009.
Fannie and Freddie have so far received 170 billion USD in federal aid since being placed in conservatorship in September 2008.
AA+ has been assigned by S&P to municipal bonds, a market of 2.8 trillion USD.
The premium paid by European banks to borrow in dollars through the swap market has increased the most since January this year according to Bloomberg. The cost of converting euro-based payments into dollars as measured by the one year cross-currency basis swap fell to 43.6 bps below the euro interbank offered rate (EURIBOR) yesterday according to Bloomberg.

Banks are therefore affected the most by the US downgrade because of the implied support of the US government since 2008. Also given the economic slowdown, they are indeed more affected.

The Markit ABX index tied to subprime-mortgage bonds rated AAA when issued in 2006 fell 2.8 point to an equivalent cash price of 47. The biggest fall since May 2010 according to Markit.

Leveraged Loans, the S&P/LSTA US leveraged Loan index 100, declined by 1.77 cents to 90.66 cents on the dollar, the 11th consecutive fall and lowest level since October. The highest point was 96.48 cents to the dollar on February 14 according to Bloomberg.

Emerging Markets: The JP Morgan EMBI Global Index, mostly used benchmark for Emerging Markets bond funds jumped 34 bps to 354 bps, highest level since 2010.

Basel III is raising capital standards for banks, so quite a few banks need to raise capital. But, with the current market sell-off, the new issue market is essentially shut down, meaning down the line, it is going to be very crowded at some point when the markets cool-off and opens up again. Given countries, banks and others will be coming hard to the market to raise capital, it is going to cost more. Simple as that.

Companies are still hoarding cash and sitting on a hefty pile of 963.8 billion USD in the US according to S&P data. Companies are in great shape to weather the storm. They have paid down debt and are to some extent quite lean with healthy balance sheets.

Finally, unintended consequences on China - Bloomberg:
The Yuan and the Dollar index

Charts of the day - Bloomberg:
Portuguese citizens like Irish citizens, are leaving their countries for a new life, leaving behind their battered and bruised economy:

Migration might fall in negative territory in Portugal unless the government can end the exodus of workers seeking employment abroad. But it isn't only happening in Portugal, it is also happening in Greece and in Ireland.

And as a conclusion, Bank of America's market cap as of yesterday's close was 73 billion dollars, Apple has enough cash to buy it outright in cash with 76 billion USD in the bank account...
Bad news keep piling up for Bank of America since the very ill-fated acquisition of Countrywide...

Markets update - Credit - Rates - Equities - Kneecapped...

Another day in the trench and not even the better than expected employment figures at 9.1% and Nonfarm payrolls (NFP at 117K versus 85K)have been able to sustain a strong rally in the equity space.
The intraday move on some European indices made everyone fill dizzy, or sick. It was fast and furious. In these markets you can clearly age in dog years as in 2008...
In relation to the NFP numbers, while June had come in at a horrible 18K jobs, it was revised upwards to 46K. Very slight improvement but nothing great about it. The average duration of unemployment increased to 40.4 weeks from June's 39.9 weeks as it continues to make a new high each month. 44.4% of those unemployed and still looking for work have been searching for 27 weeks or more. This is not a recovery.

The US economy looks like muddling through but the worries in the European space in relation to the ongoing contagion to Spain and Italy, make the outlook for 2012 look grim, if the situations spiral out of control in 2012.

Credit got whacked kneecapped (the joys of rebranding) and while there was some small relief in the peripheral government space, it started off with the usual flight to quality mode in the morning with German 10 year government bonds even touching 2.22% then bouncing back up to close at around 2.35%.

Here are some markets updates:
10year German Government Bond:

Greek 2 year bonds:

Creeping up again.

Vix index shooting up:

Credit Markets:
Itraxx Financial Sub 5 year CDS index reaching a new record:

Itraxx Crossover 5 year CDS, going up fast:

"In Europe, the cost of insuring corporate debt rose to the highest since June 2010. The Markit iTraxx Crossover index of credit-default swaps linked to 40 companies with mostly high-yield credit ratings increased 29 basis points to 545.5, according to JPMorgan Chase Co. at 10 a.m. in London" - source Bloomberg.

EUR/CHF, the trend is your friend and the Swiss National Bank is powerless:

Intraday volatility on the CAC40 index, you bet!

CAC40 index, that European stock index sinking feeling...

Some serious risk indices are flaring up, OIS/Libor spread and our friend TED, it is a short-term indicators of bank liquidity:

OIS/Libor spread:

We will need to monitor closely these two indicators in the coming days and weeks. Given the market is currently shut down for both Italy and Spain, their banks might need as well to curtain lending, because, like their sovereign issuer, the access to the market is as well shut down for these banks.
According to Bloomberg, the five biggest banks in each of the two countries have about 240 billion euros of debt maturing by 2013. It appears as the two graphs displayed above that the interbank market is freezing up again, as it did in 2008.
At the same thime, the average yield on high-grade corporate debentures fell
to a record 3.45 percent yesterday, according to Bank of America
Merrill Lynch index data. Investors are seeking the relative safety of corporate bonds, but we are talking about A rated companies and above, particularely high quality industrials companies in the US.

I have already discussed the issue of the wall of maturity in the following post Crowding Out. Banks and countries alike are competing to raise money. Banks will have to go to the ECB for their funding needs for the time being.

All of this means that the cost of funding will rise significantly in the years to come.

A double-dip is not that sweet...

You cannot bring about prosperity by discouraging thrift.
You cannot strengthen the weak by weakening the strong
You cannot help the poor man by destroying the rich.
You cannot further the brotherhood of man by inciting class hatred.
You cannot build character and courage by taking away man's initiative and independence.
You cannot help small men by tearing down big men.
You cannot lift the wage earner by pulling down the wage payer.
You cannot keep out of trouble by spending more than your income.
You cannot establish security on borrowed money.
You cannot help men permanently by doing for them what they will not do for themselves.

written in 1916 by the Rev. William J. H. Boetcker, a Presbyterian clergyman and pamphlet writer



It becomes clearer and clearer that a risk of a double-dip recession is alive and well.

Equities have continued the trend down and credit risk has risen as well, as reflected by the current CDS market spreads.

http://www.businessweek.com/news/2010-05-21/credit-swap-investors-increase-bets-on-double-dip-recession.html

"The cost of protecting against default on high-yield and financial companies rose today, JPMorgan prices show. Contracts on the Markit iTraxx Crossover Index of 50 companies with mostly junk credit ratings increased 13.5 basis points to 619. The Markit iTraxx Financial Index of 25 banks and insurers rose 5 to 174 and the subordinated index rose 15 to 265."

The risk is being priced in the market. Most of the risk indicators, CDS, VIX, Ted Spread and Libor-Ois are on the rise.

According to Jeffrey Miron in Street Talk in Forbes, the sign is ominous:

http://blogs.forbes.com/streettalk/2010/05/20/a-double-dip-warning-sign/

"The news that claims for unemployment insurance rose unexpectedly last week - and by the largest amount in three months - will no doubt spark fears of a double-dip recession. Most economic indicators point to a consistent if perhaps lukewarm recovery, however, so is double-dip really a possibility?

Yes, because policymakers in the U.S. and Europe are likely to choose the wrong approaches in responding to their fiscal imbalances. The U.S. has been adding expenditure (Obamacare) and may soon consider a VAT; Europe appears ready to monetize its debt rather than curtail excessive spending. So fear of higher taxes and inflation may discourage new investment and hiring, allowing the U.S. and others to slide back into recession."

Unfortunately, recent events have shown we can expect indeed a double-dip because our politicians are most of the time making the wrong decisions.

Angela Merkel's knee jerk reaction triggered a panic in an already very dysfunctional and nervous market. It was a very bad decision. By banning short selling on financial companies in Germany, it is as if Merkel is telling the market that there are some major poblems with these companies. Rather than alleviating the market's concern, it has had the complete opposite effect and exacerbated the ongoing sell-off.

http://www.washingtonpost.com/wp-dyn/content/article/2010/05/21/AR2010052104489.html

"It was especially strange that her government also banned naked short-selling of shares in Germany's largest banks, which are heavily exposed to Southern Europe's sovereign debt. That can only make investors more suspicious of those ostensibly sound institutions.

Ms. Merkel needs to remind herself that "markets" are mostly made up of money managers doing their best to protect pension funds and other savings of ordinary people. She says that she is trying to rescue the euro, but excessive rhetoric stimulates a flight by investors to other currencies. She says she is trying to save Europe, but erratic action feeds the impression of a continental political class that may be losing its nerve and its way."

This another fine example of why a double-dip can be expected because of the complete inability of our politicians to grasp the complexity of the problems at stake and the wilingness to tackle rapidly and decisevely the structural imbalances which have plagued Europe due to lack of fiscal discipline and public spending restraints.

This is not a time for haggling. It is decision time. A time for reform, a time for public spendings cuts and review, in most of the European countries.

Some countries have already started acting, Ireland, Spain, Portugal. But, some countries have not really started the process, like France. France is just starting to "think" about following the steps undertaken by Germany a few years ago in relation to introducing specific rules relating to budget deficit in its constitution. This fine line was drawn in order to protect its citizen from politians, who, as we all know from experience, tend to drift towards a spending spree when elected. The UK is a good ilustration of binge drinking, but also in binge spending. Under Labour, in ten years spending on the NHS increased from 53 billions GBP to a massive 120 billions GBP in the budget.

Here are the details relating to Germany's introduction of the stability law as detailed by Wolfgang Münchau in the Financial Times:

http://www.ft.com/cms/s/0/4e63cb22-5e8b-11de-91ad-00144feabdc0.html

"From 2016, it will be illegal for the federal government to run a deficit of more than 0.35 per cent of gross domestic product. From 2020, the federal states will not be allowed to run any deficit at all."

"Anchoring the stability law at the level of the national constitution is an extreme measure – like locking the door, and throwing the keys away. It can only ever be undone with a two-thirds majority – and even a future Grand Coalition may not be able to deliver this as both of the large parties are in a process of secular decline. It means that future fiscal policy will be in the hands of the justices of Germany’s Constitutional Court."

"France has more or less followed Germany’s lead at every turn, but I suspect this may be a turn too far. Deficit reduction has not been, nor will it be, a priority for Nicolas Sarkozy, the French president."

The issue is that France doesn't have the luxury (apart from its industry...) to postpone anymore structural reforms similar to the ones undertaken by its closest business partner.

Unfortunately, the political system in France make the country very difficult to reform. Politicians are moving from one election to the next and cumulate various electoral mandates which means, that their interest is never aligned with the best common interest as they move to one election to the next, buying votes on unrealistic promises (35 hours week, etc.) by issuing more debt, and increasing in the process the already crippling burden of the debt.

The only way to reduce the debt levels is by starting first to balance the budget. It is a simple question of accounting principle but very unpopular with politicians.
Austerity is a foul word in France but it is has become critically urgent as well.

I agree with Wolfang Muchau relating to Sarkozy's lack of willingness in tackling deficits. Given Sarkozy is already thinking about the oncoming elections of 2012, you cannot expect decisive structural reforms to be undertaken. I expect a Socialist government will be elected in 2012, probably led by current IMF president Dominique Strauss-Kahn. It will be easier for a Socialist government in France to led the reforms, although to some it might appear completely counter-intuitive.

Where I completely disagree with Wolfgan Muchau is on the following:

"While the balanced budget law is economically illiterate, it is also universally popular. Average Germans do not primarily regard debt in terms of its economic meaning, but as a moral issue. Der Spiegel, the German news magazine, had an intriguing report last week on the country’s young generation. One of the protagonists in its story was a young woman who had borrowed a little money to set up her own company. The company turned out to be a success, and she had began to repay the loan. And yet she said she had not felt proud of having taken on debt.

This general level of debt-aversion is bizarre. Many ordinary Germans regard debt as morally objectionable, even if it is put to proper use. They see the financial crisis primarily as a moral crisis of Anglo-Saxon capitalism. The balanced budget constitutional law is therefore not about economics. It is a moral crusade, and it is the last thing, Germany, the eurozone and the world need right now."

Having a balanced budget dear Wolfgang is not economically illiterate, it is not only a moral issue but also it is the right thing to do for a government. It is a matter of responsibility for the government. Having a balanced budget reduces the risk of inflation and monetizing debt.

If the young generation of Germans regard debt as morally objectionable to some extent, there is hope. The protection given by the stability law is as well a deterrent to politicians tendency of spending more what a country can afford. Canada has had the right attitude in tackling its public spending and reducing its debt level very successfully. It can be done.

The most worrying part in today's turmoils is the current tussle between Germany's willingness to impose strict fiscal discipline in the Eurozone which does not coincide with France political agenda.

This creates a risk for a Euro break up. It is a fight between the disciplined members of the Eurozone and the lesser ones such as Greece, Italy and France.

As pointed by Professor Nouriel Roubini in Daily Finance, "Politics are now the main problem".

http://www.dailyfinance.com/story/investing/roubini-politics-are-now-the-big-problem/19480567/

Anterograde Amnesia or Retrograde Amnesia? Or both?

Definitions:

Anterograde amnesia refers to the inability to remember recent events in the aftermath of a trauma, but recollection of events in the distant past in unaltered.

Retrograde amnesia is the inability to remember events preceding a trauma, but recall of events afterwards is possible.

"To slightly modify Alexis de Tocqueville: Events can move from the impossible to the inevitable without ever stopping at the probable."

David Einhorn, President of Greenlight Capital, in John Mauldin' "Outside the box" on the 26th of October 2009

The market moved dramatically tighter following the announcement of the 750 billion euros package and bank share rallied massively in double digits on the Monday.

"Monday, in fact, saw the biggest one-day change in the history of the Markit iTraxx Europe index – tightening from 142bp to 102bp."

http://ftalphaville.ft.com/blog/2010/05/14/232156/cds-report-volte-face/

Well, the euphoria did not last very long...

Itraxx Main CDS 5 year has move again at around 110 bps. Corporate default risk as measured by the Itraxx index is on the rise again after a strong respite:

"The Markit iTraxx Financial Index of swaps on the senior debt of 25 banks and insurers jumped 15 basis points to 147 and the subordinated index rose 19 to 215, JPMorgan prices show."

http://www.businessweek.com/news/2010-05-14/greece-leads-surge-in-credit-risk-as-ackermann-doubts-debt-plan.html

It is very interesting to see that the Itraxx Financial index senior is trading wider than the Itraxx Main Europe as historically, it should trade tighter. Corparate debt is seen safer than bank debt for the time being.

You just can't get rid of a problem by throwing money at it and Deutsche Bank chief Josef Ackermann did not help our politicians by raising doubt on Greek debts currently being snapped up on the secondary markets by European Central banks in a concerted effort.
As a result the Euro currency took another massive beating Rocky Balboa style and broke through a very important support at 1.2450 against USD from March 09 lows:



Euro did fell to lowest level since Lehman Brothers collapse as finally people envisage the probability of a Euro break up:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aqquuYOAN_sE&pos=2

Sounds familiar does it? Be nice, please rewind...

I discussed this exact subject on the 9th of December last year in my post The importance of being earnest, about the Eurozone in general and the Euro in particular.

http://macronomy.blogspot.com/2009/12/importance-of-being-earnest-about.html

I stated at the time:

"The virtues of joining a single currency doesn't coincide with the vices of some European governments, who issued more debt and ran larger and larger budget deficits. It is a game you cannot play forever unless you can devalue and make your own citizens poorer in the process, which used to be a regular tool used by Italy before joining the Euro."

Looks like Volcker shares my views...

http://www.bloomberg.com/apps/news?pid=20601010&sid=a8CjGqGASv9E

“You have the great problem of a potential disintegration of the euro,” former Federal Reserve Chairman Paul Volcker, 82, said yesterday in London. “The essential element of discipline in economic policy and in fiscal policy that was hoped for” has “so far not been rewarded in some countries.”

Quizz time:
In the above quote, Paul Volcker was thinking about which country?
A. Greece
B. France
C. Spain
D. Portugal
E. Italy
F. All of the above


In this previous post as well I indicated the possibility of a Euro break up. You will find the links to the analysis which had already been made by Nouriel Roubini and Macro Research house Gavekal.

But back to this week price action.

By tearing up the sacred rule book and resorting to the Nuclear Option of Quantitative Easing (the politically correct definition for what really means "screwing your currency"), the Euro could only go down from there. There was the same result for the GBP when the Bank of England resorted to "Quantitative Easing" (I hate these two words).

VIX is now much higher than in my previous post on the 10th of April:



And Gold? New record high as well. The only way is up now that the US, UK and now Europe are all equal in the "Debasing Currency Club".



On the employment front in the US you have the following:

Source Creditsights.com:

https://www.creditsights.com

"There are a total of 10 million claimants receiving some type of unemployment benefits. Furthermore, there are a growing number of individuals (referred to as ‘99ers” in some circles) who have exhausted all 99 weeks of benefits and are waiting for tier 5."

290,000 increase in NFP (Non Farm Payrolls) for April.

But unemployment is still rising and you have, as Creditsights mentioned a growing number of 99ers.



Clearly deleveraging is still in full play which means further headwinds for employment levels in the near future in the US

So much for the "anticipated" V recovery...

Update on the bond vigilantes: FLIGHT TO QUALITY (at least perceived quality...)

http://www.bloomberg.com/apps/news?pid=20601087&sid=a3uJ_8cLNk.A&pos=3

"U.S. two-year notes had their first three-week winning streak since January as demand for the safest assets rose on speculation Europe’s sovereign-debt crisis will damp growth and lead to disintegration of the euro."

BONDS PRICE YIELD (Bloomberg)
10-Year UK 108.13 3.75 yield
10-Year German 101.20 2.86 yield
10-Year French 103.23 3.12 yield
10-Year Italian 101.12 3.90 yield

Bund is the safe haven in Europe.

Spreads of German 10 year Bund versus other European countries 10 years government bonds is on the rise:

Spread BUND VS French OAT 10 year (Bloomberg):



Spread BUND VS Italian BTP 10 year (Bloomberg):



Spread BUND VS Spain 10 year (Bloomberg):



Spread BUND VS Greek 10 year (Bloomberg):



And good old TED spread is moving up as well:

http://en.wikipedia.org/wiki/TED_spread

"The TED spread is the difference between the interest rates on interbank loans and short-term U.S. government debt. The TED spread is an indicator of perceived credit risk in the general economy."
"
When the TED spread increases, it is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. Interbank lenders therefore demand a higher rate of interest, or accept lower returns on safe investments such as T-bills."



No need to panic yet given long term average of TED is around 30 bps but definitely something to watch.

The theme is still the same deflation then inflation down the road as we are still ongoing the painful deleveraging process which goes with the reduction of public spending and tackling the debt burden. GDP growth will be slow, and slightly positive to negative in some European countries.