Credit - Pareto Efficiency

"This is no time for ease and comfort. It is time to dare and endure." - Winston Churchill

While in last week conversation we mused around our "uneasiness" in the current "easiness", the latest round of Quantitative Easing iteration number 3 courtesy of Dr Ben Bernanke at the Fed, made us wander towards an important economic as well as engineering concept for our title, namely the Pareto Efficiency:

"In a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off. Given an initial allocation of goods among a set of individuals, a change to a different allocation that makes at least one individual better off without making any other individual worse off is called a Pareto improvement. An allocation is defined as "Pareto efficient" or "Pareto optimal" when no further Pareto improvements can be made." - source Wikipedia

The impact QE2 has had on commodity prices has been clearly analyzed in a very interesting paper from the Bank of Japan - Recent Surge in Global Commodity Prices back in March 2011.

Given that in a Pareto efficient economic allocation, "no one can be made better off without at least one individual worse off", looking at the causality between the Arab Spring and the rise in commodity prices, one has to wonder what will be this time around the impact worldwide of this latest round of "easing" from the Fed, hence our title.

Historically the highest prices touched by wheat prior to the French Revolution were in 1789. Between 1780 and 1788, the average price for  a "setier" of wheat (setier was an old French units of capacity equating to 156 liters), was stable between 19 pounds and 13 shillings and 25 pounds and 2 shillings. Between 1786 and 1787 the price was stable at 22 pounds a setier. In 1788 it rose by 15% but in 1789 it rose by 36% in one year, touching 34 pounds and 2 shillings. The harvest for 1788 was one third lower and this impact was sufficient enough to trigger the doubling of prices in the period 1788-1789. Just before "Bastille Day" on the 14th of July, there was a tremendous storm on the 13th of July 1789 which caused massive destructions to crops. 

Wheat prices in "pounds per setier" units on the 24 of June every year from 1728 until 1789, source - "Le prix du blé à Pontoise en 1789" by Dr Florin Aftalion.

The proper French revolutionary period (1789-1794) was characterized by poor harvests and very similar meteorological factors witnessed in 1788 and 1789, namely very hot spring-summer periods with very bad weather followed by very cold winters (-21 degrees Celsius in Paris during the winter of 1788), of course any similarities with this year's meteorological events are purely fortuitous given we are rambling again...Are we?

In similar fashion to QE2, QE3 has already triggered a significant rise in Inflation Expectations - source Bloomberg:

"The CHART OF THE DAY shows the gap between yields on 10- year Treasuries and same-maturity inflation-protected notes, a gauge of consumer-price expectations, jumped to the widest since May 2011 after Bernanke said the central bank will buy $40 billion of mortgage debt a month. It also charts five-year U.S. inflation swaps that let holders exchange fixed interest rates for returns equal to price gains. The figures suggest inflation will climb after dropping to the lowest since 2010. “We will see higher inflation pressure in the next few years,” said Hiroki Shimazu, an economist in Tokyo at SMBC Nikko Securities Inc., a unit of Japan’s third-largest publicly traded bank by assets. “It will be difficult to control.”

The breakeven rate -- the difference between yields on 10- year notes and Treasury Inflation Protected Securities -- widened to as much as 2.54 percentage points today, the most in 16 months. The swaps climbed 12 basis points to 2.50 percent yesterday, the biggest one-day jump since February 2011, data compiled by Bloomberg show. Annual inflation was 1.4 percent in July, about half the 3 percent pace at the end of 2011." - source Bloomberg

Those who follow us know that we have been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 was announced - source Bloomberg:

QE2 saw a surge of the SPX (Standard and Poor's 500) as well as a surge in oil prices as well as significant surge in US Treasuries yield, which surge by 100 bps from 2.50% to 3.50%. 2011 saw a significant correlation with SPX, Oil and US treasury yields falling significantly during the "risk-off" period triggered by liquidity. This time around, one can expect during the on-going "risk-on" period to see as well rising US Treasury yields in conjunction with surging SPX and oil prices.

We discussed asset correlation back in May in our conversation "Risk-Off Correlations - When Opposites attract". Whereas in "Risk-Off" periods the dollar acts as a powerful magnet for investors seeking safe haven, whenever there is a Fed meeting week, it ultimately weighs on the Dollar index as indicated by Bloomberg:

"The CHART OF THE DAY shows the gauge, which measures the dollar against the currencies of six major trading partners, has fallen the week of FOMC meetings four out of five times this year. The Dollar Index fell 1.7 percent in the week of Jan. 25 when the central bank extended its pledge to keep interest rates near zero until 2014. The measure declined 0.3 percent in the week of the March 13 gathering even as the Fed raised its assessment of the economy." - source Bloomberg.

This time was not different. The Dollar Index fell to around 79 with Gold rising in the process as indicated in the below graph displaying the Dollar Index versus Gold since June 2011:

"Pareto efficiency is an important criterion for evaluating economic systems and public policies. If economic allocation in any system is not Pareto efficient, there is potential for a Pareto improvement—an increase in Pareto efficiency: through reallocation, improvements can be made to at least one participant's well-being without reducing any other participant's well-being." - source Wikipedia.

Therefore in this week credit conversation we would like to delve into the diminishing returns QE has on the real economy following our usual credit overview.

The Itraxx CDS indices picture displaying yet another very significant rally in the credit derivatives space below the March lows for some indices - source Bloomberg:

The High Yield risk gauge indicated by the Itraxx Crossover index (50 European entities) is tighter this week by another 40 bps courtesy of the third round of QE triggered by the Fed. The move tighter for credit derivatives indices was significant on Friday with the Itraxx Crossover index tighter on the day by 35 bps and with the Itraxx Financial 5 year subordinated index closing below its March lowest point of 313 bps at around 300 bps. It wasn't only the Itraxx Financial Subordinated 5 year index falling to the lowest levels since the series 17 was launched in March, the Itraxx SOVx index (15 Western Europe sovereign CDS including Cyprus) declined by 10 bps towards 173 bps, retreating for a 10th straight week, the longest-ever streak.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

Clearly, the HY risk gauge indicated by the Itraxx Crossover is moving towards expensive territory close to 400 bps falling in synch with volatility. The gap between the Itraxx Crossover and Eurostoxx volatility has closed.
As well as the European High Yield market, the US High Yield market continues to perform and becoming a cause for concern as a market maker put it bluntly:

Why has the market rallied and stayed bid? Here's one reason.....Massive credit issuance continues. Monday was the LARGEST day of US corporate issuance ever (14 deals, $19bn) and the largest day for European corporate issuance this year (9 deals, E7.5bn). Yield! Yield! We know that companies are using this money for one thing more than any other: Buybacks. Non directional activity in US stocks (gamma hedging, liquidity providers, quant strategies) has become over 65% of activity...."

From a credit point of view, we believe buybacks are credit negative.

Yes, the last two weeks have seen an "avalanche" of new issues coming to the market given the prevailing tone in markets leading to 19.3 billion euros worth of new issues coming to the markets with 12 billion alone last Monday. While core non-financial issues are getting more and more unattractive, there was a flurry of new issues coming from peripheral countries, such as Energias de Portugal on Friday which came to the market with 750 million euros worth of bonds which drew 7.5 billion in orders from 475 investors at a yield of 5.875% from an initial 6.25%. It was the first issue for Energias de Portugal (EDP) in the last 18 months. Effectively EDP had been shut out of the markets since February 2011.

This directly a translation of the pressure easing on Portugal sovereign CDS 5 year spread, as indicated in the below graph displaying Portugal 5 year sovereign CDS versus Ireland sovereign 5 year CDS:

Both Ireland and Portugal's respective CDS continue to Converge from -891 bps apart early 2012 towards -170 bps apart.

But, the severing of the link between Sovereign risk / Financial risk has yet to happen. The main concern of European authorities as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index has been trying to break that close relationship, expecting that the European Banking Union will finally break this relationship. We doubt it will - source Bloomberg:

The ECB is to be given new powers in the framework of the single supervisory mechanism for Eurozone banks. The EBA and national supervisory authorities will continue to carry out day-to-day tasks. While this change in profile is akin to an additional step towards a banking union, it is as well a precondition of the ESM's ability in lending directly to banks and part of the move towards fiscal, economic and political union. Given our "bipolar disorder" markets are in a positive "mania" phase, this ECB expanded role has been so far well received leading to further tightening in Itraxx Financial Spreads, sovereign CDS spreads and rising European financial stocks. The "unelected" President of the European Commission José Manuel Barroso set out this week his "vision" for Europe, namely a "federation of nation states". CreditSights recent report entitled - ECB Bank Supervision - The Road to Banking Union, indicated the following important points: "According to the commission between October 2008 and October 2011, European countries "mobilised Euro 4.5 trillion in public support and guarantees to their banks". It wants to break "the vicious circle between banks and sovereigns". However, whether this is achievable through a banking union is doubtful. The majority of most banks' assets are located in their home country and therefore intertwined with their local economy, and banks tend to hold large (and increasing) portfolios of home country government securities, which itself makes the link between the sovereigns and banks difficult to break. However the Commission is more concerned with removing the burden on national governments of bailing out their banks. It would probably be more logical to reduce sovereign risk first, but that is more difficult, practically and politically, than trying to fix the banks".

In relation to the European bond picture, the move was less dramatic for peripheral bonds this week with Spanish 10 year yields around 5.80%, slightly below 6% whereas Italian 10 year yields still well below 6% around 5.00% whereas German government yields continued rising, this time around towards 1.70% levels with other core European bonds yields rising as well in the process - source Bloomberg:

As far as "Flight to quality" picture is concerned, it is clearly pointing towards "Risk-On" with Germany's 10 year Government bond yields rising towards 1.70% and the 5 year CDS spread at 52 bps converging - source Bloomberg:

Both the Eurostoxx and German 10 year Government yields are still moving in synch in "Risk-On" mode in with rising German Bund yields towards 1.70% yield level and a stronger Eurostoxx 50 at the end of the week converging with the Itraxx Financial Senior 5 year index - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

It's definitely called capitulation in the credit (bear?) space. The flattening of CDS curves is indeed happening with forward prices collapsing especially on 2/5 CDS curves, 3/5 and 1/5. On top of that the Itraxx Crossover 5 year CDS index versus the Itraxx Main Europe 5 year index is compressing, meaning the bull is back for now.

As a market maker rightfully commented: "Pure capitulation from Macro Funds is round the corner".

Back in our previous conversation "The Uneasiness in Easines" we argued:

"The lag in European stocks given the very recent negative tone in Europe has made them much more volatile. Should the "Risk-On" scenario persist in the coming weeks it should lead to an outperformance of European stocks versus US stocks."

We stick to our call.

We have been tracking over the months the growing divergence in the performance of the Standard and Poor's 500 index and the Eutostoxx in conjunction with Italian 10 year government yields - source Bloomberg:

In fact Spain's falling CDS may indicates additional extension of the on-going rally as displayed by Bloomberg:

"As the CHART OF THE DAY shows, Spain’s benchmark IBEX 35 Index has moved inversely to credit-default swaps on the country’s five-year bonds since 2010. The CDS contracts have tumbled since Sept. 6, when European Central Bank policy makers agreed to implement an unlimited bond-buying plan to boost confidence in the euro. The IBEX 35 has jumped 34 percent from this year’s low on July 24 as ECB President Mario Draghi pledged to do whatever it takes to preserve the single European currency and Federal Reserve Chairman Ben S. Bernanke said he would provide further

Moving on to the subject of the diminishing returns QE has on the real economy, we recently commented in the blogosphere our discontent with Dr Bernanke's latest round of QE and for obvious reasons we think. Namely that QE3 will only prove that monetary policy alone cannot prop up the labor market because in normal times triggering inflation expectations should trigger a credit boom, but given this is not your normal recession but a Balance Sheet Recession (BSR), it will eventually fail again.

We could not agree more with Cheuvreux's latest Microscope publication by Nicolas Doisy namely that:
"So far, only QE-2 is actually a quantitative easing as it has elicited banks into pure cash hoarding, while QE-1 (an emergency action) was credit easing. But QE-2's ability at capping nominal yields is stumbling against the law of diminishing returns: the impact of QE-2 is just around half that of QE-1.
While unmistakably signaling a real credit crunch, the QE-2 cash-hoarding also elicited an actual but temporary pent-up in inflation expectations.
If it has thus managed to reduce real interest rates, QE-2 has proved unable to prop up wage inflation, the effective driver of trend price inflation. Likewise, a QE-3 would just prove that monetary policy alone cannot prop up the labor market, as banks would keep hoarding cash and not lend it."

Indeed QE2 was arguably a period of credit crunch due to banks hoarding cash and QE2 did trigger inflation expectations upwards (via resumption of credit) but insufficiently to sustain credit expansion according to Nicolas Doisy's recent note:

We already touched on the impact credit conditions have had to the US growth versus Europe back in our conversation with the help of our friends from Rcube Global Macro Research in our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid...":

But avoiding a non-deflationary growth would entail fiscal stimulus in order to avoid a Japanese style deflation.

"The CHART OF THE DAY shows the yield on the benchmark Treasury 10-year note since 2005 has closely tracked the first seven years of Japan’s slow-growth period that started in 1990. That is a correlation central bankers should keep in mind when formulating policy, said Porter, deputy chief economist at BMO Capital Markets in Toronto. “It’s a tad unnerving,” Porter said in an interview. U.S. rates have followed Japan’s even as the Federal Reserve has been more successful than the Bank of Japan in fighting deflation, or a protracted drop in prices. “This could be a long-grinding episode where yields bounce around at low levels for an extended period of time,” he said. While there are plenty of differences between the two countries -- such as their rates of inflation, the aging of the population in Japan and the relative strength of U.S. financial institutions -- there are also similarities, said Porter. These include severe financial crises and protracted periods of weak growth that are difficult to shake off, he said. If U.S. Treasuries were to continue following the trajectory of securities for the world’s third-largest economy, the yield on the 10-year note over the next 15 years would decline to about 0.75 percent -- in line with the current level of Japan’s 10-year bond." - source Bloomberg.

Because, a decline in wage inflation is indeed a clear deflationary sign (paradox of thrift). Wage inflation has kept trending down since November 2008 with the exception of a short-lived plateau in November 2010 to August 2011 according to Nicolas Doisy' s recent report. QE2 has been running out of steam since with wages driving price inflation down again:

"The continued decline in wage inflation is a sign of deflation taking root as it is translating into rising household saving rate and decelerating consumption. Both reflect the impact of paradox of thrift / paradox of toil.

-aggregate demand is insufficient to kick-start growth (paradox of thrift).

-labor productivity gains are not accurately compensated (paradox of toil).

The final lesson is that any QE3 is pretty unlikely to ever be able to turn wage inflation around with no other pro-active policy aimed at the labor market. This is yet another sign of the paradox of thrift / paradox of toil: even unconventional, monetary policy is pushing on a string as long as fiscal policy does not come to the rescue to prop up the labor market. This one of Bernanke's recurrent messages."

"The central reason behind the QE's inability at durably triggering upward inflation expectations is that the Fed's cash does not leave the banking system. In simpler terms, the Fed's cash sits idly on the commercial banks current account at the Fed. It thus never sees the light of the real economy, just as if banks were anticipating an indefinitely continued decline in wage inflation and, thus aggregate demand." - Nicolas Doisy, Cheuvreux.

Fed's new easing will do little to lift bank lending:

"As the CHART OF THE DAY illustrates, banks reduced the amount of reserves held at the Fed’s regional banks and made more money available to businesses in the past 12 months. The shifts took place even though the central bank’s total assets were little changed, as Michael Shaoul, CEO of Oscar Gruss and Son Inc's wrote on the 11th of July in a report.

“This point is sadly missed by those looking for a new round of quantitative easing,” the report said. Between 2008 and last year, the Fed bought $2.3 trillion of debt securities in two rounds of easing to support economic expansion. Bolstering reserves through a third round of purchases “will not increase the supply of or demand for credit,” the New York-based analyst wrote. Reserves for the week ended July 4 were $179.2 billion lower than their peak last July, according to data compiled by the Fed. The decline coincided with a $171.2 billion increase in commercial and industrial loans, based on central-bank data. “This is precisely how monetary policy can affect domestic activity,” wrote Shaoul, who also helps oversee more than $2 billion as Marketfield Asset Management LLC’s chairman. “What it cannot do is magically increase employment.” - source Bloomberg

In addition to cash sitting idling on the commercial banks current account at the Fed, the business bank-balances boom is as well hurting the US economy (yet another sign of the paradox of thrift at play):

"Companies may have to tap into their bank balances in order for U.S. economic growth to accelerate, according to Pierre Lapointe, Brockhouse and Cooper Inc.’s global macro strategist.

As the CHART OF THE DAY depicts, U.S. non-financial companies held a record $931 billion of checking and savings deposits as of March 31, according to figures compiled by the Federal Reserve for quarterly flow-of-funds reports. Deposits more than doubled from June 2009, when the latest recession ended, as the economy grew 6.3 percent. “Corporations are still cash rich and could provide a much-needed boost to the economy,” Lapointe wrote on the 12th of September in a report that presented a similar chart. “We need companies to come in and start spending.” Cash is rising as companies guard against the risk of another slump, the Montreal-based strategist wrote. Data on capital spending, dividends, stock repurchases and takeovers

point toward the same conclusion, according to Lapointe, who prepared the report with two colleagues. “Even though they have cash in the bank, companies do not feel as rich as they used to,” he wrote. The ratio of cash to assets for the Standard & Poor’s 500 Index has declined about half a percentage point in the current economic expansion and now stands at 8 percent, according to the report. Checking accounts held 40 percent of non-financial companies’ deposits at the end of the first quarter, and the

other 60 percent was in savings. Deposit figures at the end of the second quarter will be included in the Fed’s next flow-of-funds report, due Sept. 20." - source Bloomberg.

Nicolas Doisy concluded is recent note with the following important point which we agree with:

“All in all, the US strategy to exit the current deflation(ary) trap misses the point by focusing only on monetary policy, while a fiscal stimulus is also needed. In other words, labor is insufficiently compensated for the sole reduction in real interest rates to kick start growth. So, either labor is given a larger bargaining power or it must receive massive money transfers to start spending again.”

Given that in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off, investors are facing indeed an increasingly strong dilemma, due to the growing number of US retirees and a falling yield environment:

"The Baby Boomers Generation is that huge post-war cohort born between 1946 and 1964. The first wave of baby boomers turned 65 in 2011. It is estimated that during the next 20 years, roughly 74 million "boomers" will retire in the United States. That is an average of more than 10,000 new retirees a day!
The rest of the world also had their own "baby booms". The United Kingdom, France, Denmark, The Netherlands, and Australia are just some of the other countries considered to have had Baby booms starting around 1946." - source Keenan Overseas Investors.

As far as consumers and The Wealth effect is concerned courtesy of yet another round of QE, as indicated by Keenan Overseas Investors:
"- Many US and European property markets have significant unsold inventories.
- New generation of young adults in the US weighed down by student debt.
- Consumer demand reduced when people consider themselves poorer.
If interest rates increase, all of these problems get worse!"

The fight against deflation goes on...

"Trouble springs from idleness, and grievous toil from needless ease." - Benjamin Franklin

Stay tuned!

Credit - The Uneasiness in Easiness

"No testimony is sufficient to establish a miracle, unless the testimony be of such a kind, that its falsehood would be more miraculous than the fact which it endeavors to establish." - David Hume (1711-1776), Scottish philosopher, historian, economist, and essayist.

Epic capitulation in the credit space following the ECB's conference and our "Generous Gambler" aka Mario Draghi. Back in December 2011 we made a reference to Charles Baudelaire magnificent 1864 poem the Generous Gambler, we could not resist quoting it again:

"If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!"

Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864."

"Please make Mario Draghi keep his word!", we mused in our conversation "European Derecho" back in July, which is exactly the reaction witnessed in the markets, consequences of the significant rally in credit, following the ECB's conference and announcements.

You will not find us playing the devil's advocate in relation to the ECB's latest round of announcements, we leave this role to mainstream media. We chose to start our most recent credit update with a quote from the great David Hume because he observed that belief in miracles is popular:

"The gazing populace receives greedily, without examination, whatever soothes superstition and promotes wonder".

On that latest ECB OMT (Outright Monetary Transactions) miracle, we would like to concur with David Hume's approach:

"People often lie, and they have good reasons to lie about miracles occurring either because they believe they are doing so for the benefit of their religion or because of the fame that results.

People by nature enjoy relating miracles they have heard without caring for their veracity and thus miracles are easily transmitted even where false."

Hence our title and our "uneasiness" in this "easiness.

"Hume discusses everyday belief as often resulted from probability, where we believe an event that has occurred most often as being most likely, but that we also subtract the weighting of the less common event from that of the more common event. In the context of miracles, this means that a miraculous event should be labeled a miracle only where it would be even more unbelievable (by principles of probability) for it not to be." - source Wikipedia.
As we pointed in a "Tale of Two Central banks", we would like to repeat Martin Sibileau's view we indicated back in October last year 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."

Therefore in this week's credit conversation we will focus on the ECB's most recent policy recent which undoubtedly is leading to a switch to a "Risk-On" phase for now, but we will as well delve into the reasoning behind our increasing "uneasiness" in this "easiness" process with some significant indicators of growing weaknesses in fundamentals. But first our credit overview!

 The Itraxx CDS indices picture displaying a very significant rally in the credit derivatives space towards the March lows as we approach the next roll date for credit indices which roll every 6 months (20th of September 2012) - source Bloomberg:

What a difference a week makes! The Itraxx Crossover 5 year index (High Yield risk gauge based on 50 European entities) is tighter by around 90 bps and in similar fashion both the Itraxx Financial Senior 5 year index and Itraxx Financial Subordinated 5 year index (indicative of financial stress on banks) are both as well significantly tighter (respectively by around 50 bps and 90 bps in a week, and by around 18 bps and 33 bps on the day). For the first time since July 2011, the Itraxx Crossover index fell below 500 bps.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

The gap between the Itraxx Crossover 5 year index and Eurostoxx volatility is closed, as it was in 2011.

Both the Eurostoxx and German 10 year Government yields are still moving in synch in a "Risk-On" with rising German Bund yields towards 1.60% yield level and a stronger Eurostoxx 50 at the end of the week with falling volatility. Both the Eurostoxx and the Itraxx Financial Senior 5 year index have been converging fast courtesy of the ECB's announcements - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

Interestingly we have been tracking over the months the growing divergence in the performance of the Standard and Poor's 500 index and the Eutostoxx in conjunction with Italian 10 year government yields - source Bloomberg:

The lag in European stocks given the very recent negative tone in Europe has made them much more volatile. Should the "Risk-On" scenario persist in the coming weeks it should lead to an outperformance of European stocks versus US stocks.

Our "Flight to quality" picture pointing towards "Risk-On" with Germany's 10 year Government bond yields rising again towards 1.60% and the 5 year CDS spread for Germany falling - source Bloomberg:

As far as the EUR/USD is concerned we told you in our conversation "Sting like a bee - The European fight of the Century" to watch out for political "sucker punches" during this summer "lull" because they do sting like a bee!:

Gold also delivered another "sucker punch" - source Bloomberg:

In relation to the European bond picture, the move was dramatic for peripheral bonds with Spanish 10 year yields falling towards 5.74%, slightly below 6% whereas Italian 10 year yields are now well below 6% around 5.00% and German government yields rising towards 1.60% levels with other core European bonds yields rising as well in the process - source Bloomberg:

The severing of the link between Sovereign risk / Financial risk has yet to happen. The main concern of European authorities as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index has been trying to break that close relationship - source Bloomberg:

Although the fall of the Itraxx Financial Senior CDS 5 year in conjunction with the  Itraxx SOVx Western Europe 5 year index (15 western European countries including Cyprus) is indicative of the respite provided to Sovereign CDS provided by the recent announcements by the ECB and upcoming intervention.

The SOVx 5 year Sovereign CDS index comprising Cyprus replacing Greece since March and the relationship with Eurostoxx Volatility (6 month Implied Volatility at 100% Moneyness Default Model), from divergence to convergence - source Bloomberg:

But what in effect our "Generous Gambler" did previously with the two LTRO operations has been reinforcing in effect the link between weaker peripheral financial institutions with their sovereign country, causing some to pile up on their domestic sovereign bonds and in effect precipitating their demise for some. Italian oldest bank Monte dei Paschi di Siena SpA, was encouraged to "gamble" by committing too much money to Italian bond holdings, (in similar fashion Greek banks were over exposed to Greek Sovereign debt and we know how well it ended...) as indicated by Bloomberg:

"The CHART OF THE DAY shows Italian government bond holdings of the nation’s biggest banks by percentage of tangible capital and average maturity. Monte Paschi, founded in 1472 and rescued
twice in the last three years, made a treasury bet that was four times bigger than one by UniCredit SpA, the nation’s largest lender, and lasts three times longer than Banco Popolare SC’s.
The bank’s exposure to a single asset class cost it a capital shortfall of 3.3 billion euros ($4.2 billion), according to the second round of stress tests completed last year by the European Banking Authority. The world’s oldest bank is borrowing an additional 1.5 billion euros by selling bonds to the state after it asked for 1.9 billion euros in 2009." - source Bloomberg.

So thank you ECB, the LTRO gamble, courtesy of our "Generous Gambler", was indeed an offer too good to refuse but too toxic to defuse, for some:
"Italian banks doubled their treasury holdings in the last three years even as Europe’s debt crisis eroded their country’s credit quality. That strained regulatory capital that was already stretched by a round of banking mergers. Monte Paschi Chairman Alessandro Profumo, hired this year to clean up the bank, said it was government debt and not a 9 billion euro purchase of Banca Antonveneta SpA that damaged his company." - source Bloomberg.

The LTROs have had so far a debilitating effect on the strength of weaker peripheral financial institutions we think contrary to many beliefs.

Our increased "uneasiness" on the ECB's most recent policy recent "easiness" policy announcements would arguably sounds like a party spoiler in the phenomenal recent rally witnessed. In our last conversation "Structural Instability" we indicated the following:
 "European credit has been outperforming significantly U.S. credit."
Citi, in their recent US Credit Outlook on the 5th of September entitled "Back to work, back to reality" displayed the performance on this interesting graph:

In fact should the performance for European credit in 2012 continue, we would be on track to come close to 2009 record year in terms of Total Return (above 12%). We are currently above 9% in terms of Total Return Performance.

Interestingly enough even the basis is positive on Euro credit being the difference between cash bonds and matched CDS as indicated by Citi in the same report:

The basis represents the difference in spread between credit default swaps (CDS) and bonds for the same debt issuer and with similar, if not exactly equal maturities. In the credit derivatives market, basis can be positive or negative. A negative basis means that the CDS spread is smaller than the bond spread.

An example of positive basis, French cement company Bouygues. Bouygues straights vs CDS - a symptom on how credit has become expensive.
New straight 10 year Bouygues bond (in price vs CDS 5 year in spread)- source Bloomberg:

The New 10 year straight bond issued in April still holding up, now yielding 3% z-spread +140 bps with the CDS spiking recently following poor H1 results, 190 bps bid for 5 year CDS on Bouygues.

That eerily 2007 feeling is indeed an additional cause for our "uneasiness". The importance of tracking the Bond-CDS basis is indeed an important matter, as indicated by Monika Trapp in her November 2009 research paper entitled "Trading the Bond-CDS Basis - The Role of Credit Risk and Liquidity".
"Deteriorating overall market conditions (lower interest rates due to central bank intervention, higher market-wide credit risk) are associated with a widening long and a tightening short basis and thus with converging asset swap spreads and CDS bid quotes. The adjusted R2 is large, and maximal for the short basis and the subinvestment grade segment, suggesting that divergences between the bond and the CDS market for these are explained to a large extent by firm-specific and market-wide factors."

Yes, arguably the basis is an additional indicator of liquidity in the credit markets, given that by trading on the pricing differences between bonds and CDS, basis traders are important providers of liquidity to both the bond and the CDS markets. In recent conversations we have been indicating our "uneasiness" in relation to the "easiness" and "The Unbearable Lightness of Credit":
"The unintended consequences of banks deleveraging and increased regulations means banks are in risk reduction mode leading to lower inventories provided to the market place which are at the lowest levels since 2002. Traders are as well jumping ship towards Hedge Funds. We already touched in liquidity issues in our conversation "Yield Famine".

When we read the following comment from Marc Ostwald at Monument Securities on Friday, as reported by FT Alphaville:
"Total dealer positions in corporate bonds fell to $58.5b as of Aug 29 vs $60b the previous week. It was the lowest level since $55.1b March 13, 2002. The all-time high was $286b in Oct 2007."
These simple facts can only reinforce our "uneasiness" in this sea of "easiness" courtesy of our "Generous Gambler". Should the credit market experience a consequent sell-off, losses are going to be fast and furious.

Moving on to the subject of the ECB's recent policy response, we think our "Generous Gambler", in similar fashion to the two LTRO rounds, is yet again taking an aggressive bet given the debt profile for both Italy and Spain as shown by Bloomberg:

"European Central Bank President Mario Draghi’s pledge to buy unlimited quantities of short-dated
government bonds risks tying him to an increasing debt burden. The CHART OF THE DAY shows that Italy and Spain have 846 billion euros ($1.07 trillion) of securities due between 2013 and 2015, about 37 percent of the nations’ outstanding debt, according to data compiled by Bloomberg. With Draghi saying yesterday that the ECB will target bonds with maturities of one to three years, the percentage may increase, said Mohit Kumar, the head of European fixed-income strategy at Deutsche Bank AG in London." - source Bloomberg.

Although our "Generous Gambler" insisted that the latest program entitled OMT (Outright Monetary Transactions) will be fully sterilized, meaning the overall effect on the money supply will be neutral. In addition to the question of seniority of OMT, Mario Draghi indicated:
"The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds."

"Please make Mario Draghi keep his word!", we could argue again. Reading through Nomura's recent note on the ECB's decisions entitled - Policy response to buy 3 months at best, published on the 7th of September, we could not agree more with their comments below:
"This is one of the scenarios we had discussed before (see How the ECB can address the seniority problem). We called this approach “Believe me, we are no longer senior”, remarking that the market‟s reception of this promise to deal with seniority concerns hinges entirely on investors' goodwill vis-à-vis the central bank. However, an added layer of credibility is that the ECB will likely clarify this issue in “the legal act” of OMT, potentially giving the promise more teeth.
In any case, for now this is a verbal commitment about future behaviour of the ECB, without dealing with the non-market friendly behaviour of the past (i.e. in the case of Greek holdings), which would have been a more convincing policy option. In any case, the subordination effect in Italian and Spanish yields is rather low at this point (as discussed below) and given the low share of SPGBs and BTPs in the SMP portfolio, the seniority issue need not concern the markets in the short-term. If, however, the OMT leads to SPGB and BTP holdings for the Eurosystem going above 15-20% of the debt stock of these countries, then the issue of how credible is that commitment will become more relevant.

The ramifications of the SMP seniority issue for the various countries are different. As far as Portugal and Ireland is concerned, the holdings of the SMP are a larger share of their respective debt stock (about 12% and 9% respectively), meaning that there is some non-negligible subordination effect in their yields. We have argued on a number of occasions, however, that while this situation implies higher haircuts for a given level of debt relief, it also implies a lower probability of PSI."

ECB Bond Buying Program May Avoid Limits, Scrap Seniority - Source Bloomberg:

"ECB bond buying could be unlimited, reports suggest, with the Central Bank refraining from setting a cap on sovereign yields. To counter German concerns on inflation, purchases may be sterilized, to avoid the buildup of excess liquidity. Following investor concerns after the Greek restructuring program, the ECB may relinquish seniority on bonds." - source Bloomberg.

Could we rely this time around on our "Generous Gambler"?  "My word is my bond" as brokers say (or "my word, my bond!"). The Draghi "bond" factor as displayed by Bloomberg:

"My word is my bond" being a maritime brokers' motto. Since 1801 the motto of the London Stock Exchange (in Latin "dictum meum pactum") where bargains are made with no exchange of documents and no written pledges being given but here we go, we ramble again...Oh well...

Purchases are to be conditional, with buying halted should the government renege on fiscal discipline when it comes to the "modus operandi" of the OMT. It looks like our comments from the 4th of August (Sting like a bee!) were proven right after all namely that the OMT is akin to an operant conditioning chamber:
"It seems to us, that Germany has learn from the Greek "experiment" in the sense that buying indiscriminately bonds on the whole term structure not only put the ECB's balance sheet under great risk, but, it also alleviates significantly the pressure from politicians to make good on their commitments which they made in order to garner financial support. In fact we think the ECB has set up the stage for an operant conditioning chamber (also known as the Skinner box):"When the subject correctly performs the behavior, the chamber mechanism delivers food or another reward. In some cases, the mechanism delivers a punishment for incorrect or missing responses. With this apparatus, experimenters perform studies in conditioning and training through reward/punishment mechanisms." - source Wikipedia


"There is nothing without conditionality. Conditionality is what gives credibility to these measures.” - Mario Draghi.

 "By targeting the short end of peripheral yield curves. It will permit the ECB to study behavior conditioning (training) by teaching Italy and Spain to perform certain structural reforms in response to specific stimuli/bond purchases. Truth is cognitive–behavioral therapy has demonstrable utility in treating certain pathologies such as "motivating a 5 years old child" or a European politician (but we ramble again...)." - source Macronomics, 4th of August 2012.

Arguably, once again the ECB has indeed bought some additional time for Spain to delay its request for help until October. In our August 4th conversation we wrote:
"As far as Spain is concern, it looks increasingly more and more obvious to us that the ECB, by putting on hold bond purchases until further "notice", and, by focusing on the short end of the Eurozone periphery curves, will be forcing Spanish Prime minister Rajoy to "tap out" submission and ask for support sooner rather than later."
The ECB has conclusively delayed the Spanish "tap out".

But as Nomura indicated in their recent note, this additional delay could be a cause for concern for Italy:
"If Spain is expected to delay requesting support, we would anticipate an even longer wait for Italy. In addition, there may be greater problems in getting Italy to agree to strict conditionality which may muddy the negotiation process. Then there is the issue that Spain alone can have the potential to strain the resources of the EFSF/ESM, especially if it requests a full package, and yet Italy is a far larger market. With 2yr BTPs trading at 2.268%, close to what we consider the likely low for front-end yields when the ECB buys, the risk reward for being long the front-end of Italy appears unattractive. Meanwhile, Italy could notably lag Spain if the later asks for aid and the former does not. In many respects, Italy is more of a risk than Spain since official support is more distant."
Yet another example of unintended consequences...

Budget Balances and GDP forecast for the EU in 2012 - Focus Shifts to Spain and Italy After Draghi Unveils Bond Plan - source Bloomberg:

"Now that the ECB unveiled its bond-buying plan, the question is whether Spain and Italy will request a formal sovereign bailout from the euro-area's rescue fund. With IMF involvement touted for the design and monitoring of conditions necessary for ECB purchases, intervention in bond markets will be suspended if governments fail to comply." - source Bloomberg:

While we argued that the two previous LTROs amounted to "Money for Nothing" in February, as far as the real economy was concerned, our "Generous Gambler" bond buying plan will provide little relief to sluggish loan demand as indicated by the on-going trend for retail lending in Europe - source Bloomberg:

"The ECB cautioned that loan growth may remain sluggish, even with its revamped bond-buying plan in place. As demand wanes, growth momentum is set to be more anemic. The ECB forecasts a deeper economic contraction in 2012 of 0.4% vs. 0.1% previously. Heightened risk aversion pushed euro zone retail lending down 0.3% yoy in July. Corporate loans shrank 0.8%." - source Bloomberg

What our "Generous Gambler and other central bankers fail to understand is in fact fairly simple as indicated by another credit friend of ours:
"They think it is the credit supply that is an issue. In fact its more the lack of demand. Large industrials can borrow at some of the cheapest rates ever. Siemens raised a billion 2 weeks ago for 2%. The fact is that large companies have plenty of cash and do not have projects to invest in. It is probably true for smaller companies and individuals that direct bank lending is now subject to harsher standards. This is one of the things that are puzzling the central bankers: "We have pumped money into banks why aren't they lending?" Because there is a lack of demand for said lending. That and new regulation which makes it less worthwhile for banks to lend."
Hence the flurry of buybacks taking place in the corporate space!

Not only this simple fact but, fragmentation fears in Europe are indeed justify, even if the ECB is seeking to wrest back control has indicated in the growing fragmentation of euro area economies and lending rates. The evolution of deposits in Europe - source Bloomberg:

"While 10-year Spanish and Italian yields have fallen more than 100 bps from highs on the promise of ECB action, the goal is to sustainably reduce rates. With growing fragmentation of euro area economies, there is widening disparity on lending rates paid by businesses between countries. Spanish savers are also beginning to flee domestic banks, deposits falling 4.2% yoy in July." - source Bloomberg.

As far as Spain is concerned, Spanish business lending is still sliding as foreign capital ebbs away as indicated by Bloomberg:

"Spanish business lending fell 10% from FY10 through to end-July, as loan rates surged and foreign banks pulled capital out. With GDP growth at 0.4% in 2011 and forecast by consensus to contract until 2014, lending may continue to tumble as the economy grapples with austerity to shrink the deficit. EU banks have cut exposure to Spanish businesses by $36 billion since 2010 (BIS)." - source Bloomberg.

While August saw a flurry of new issues coming to the market as indicated by CreditSights recent August Euro Issuance Review - Summer Madness published on the 6th of September, the lack of competitive lending rates in peripheral countries will mean that every "Risk-On" period will see peripheral domiciled issuers coming to the market at very attractive levels (Spanish telecoms giant Telefonica priced a 750 million euros five-year deal at 485 bps over mid-swaps last week, more than 400 bps more than France Telecom paid on a 500 million euro long 10-year issue):
"There was a total high grade issuance of 19.1 billion in August and HY issuance was 1 billion, that is relatively light issuance for any non-vacation month but it set new records for an August.
But despite the improvements in conditions, issuance was mainly from credits outside the stressed country of the Eurozone.
The unwillingness of banks to lend, or at least to lend at competitive rates, will mean that periods of stability in the credit markets will continue to see credits exploiting periods of stronger market sentiment to fulfil their refinancing requirements. That may be particularly true for higher-beta credits, especially those domiciled in the stressed-Eurozone countries."

So yes, we feel there is indeed a lot of "uneasiness" in the credit markets in all that recent false sense of "easiness".

"Nothing is more surprising than the easiness with which the many are governed by the few." - David Hume (1711-1776), Scottish philosopher, historian, economist, and essayist.

Stay Tuned!

Credit - Structural Instability

"The markets don't like instability and they don't like uncertainty." - Peter Mandelson

"In numerous fields of study, the component of instability within a system is generally characterized by some of the outputs or internal states growing without bounds. Not all systems that are not stable are unstable; systems can also be marginally stable or exhibit limit cycle behavior.

In control theory, a system is unstable if any of the roots of its characteristic equation has real part greater than zero (or if zero is a repeated root)." - source Wikipedia

Zero being a repeated root in terms of monetary interest rate policy (ZIRP) it is leading to "Structural Instability", we thought we would follow up on our recent computational analogy (Banker's algorithm) and delve into control theory this time around in our title analogy. The great Hyman Minsky thesis was "stability leads to instability", we would argue that dwindling liquidity and excessive spread tightening in core quality credit spreads courtesy of zero interest rates policy in both the US and Europe is extremely concerning and are already indicative of a great build up in structural instability. Back in July in our conversation "Hooke's law", we indicated that Hooke's law of elasticity says in simple terms that strain is directly proportional to stress: "The level of stress that can be ascertained from the level of core European yields making new record lows (Germany, France, Austria, Netherlands), which we think is indeed, directly proportional to the aforementioned stress. But it not only in Europe, we are seeing an extension of the "negative yield club", the United Kingdom as well poised for joining the club."

"In structural engineering, a structure can become unstable when excessive load is applied. Beyond a certain threshold, structural deflections magnify stresses, which in turn increases deflections. This can take the form of buckling or crippling. The general field of study is called structural stability." - source Wikipedia

Hence our title. But reading through Hyman Minsky's 1982 paper "Can "It" Happen Again? A reprise (H/T Zero Hedge), the roots of instability according to Hyman Minsky  are: "...velocity-increasing and liquidity-decreasing money-market innovations will take place. As a result, the decrease in liquidity is compounded. In time these compounded changes will result in an inherently unstable money market so that a slight reversal of prosperity can trigger a financial crisis".

The ever growing lack of "liquidity" in the secondary credit markets which we discussed at length in our previous conversation (Banker's algorithm), as well as the ever tightening spread levels of quality investment grade corporate bonds (-30 bps in August 2012 as per Iboxx Euro Corporate Index) is a cause for concern in relation to the "structural stability" of credit markets. For instance,  very high quality German corporate issuer Siemens (rated Aa3 by Moody's Investors Service Inc. and A+ by Standard & Poor's Corp) is paying investors 20 basis points over the reference midswap rate for its 7.5-year latest euro-denominated bond. To put that in perspective, French government bonds maturing in April 2020 are trading around 34 basis points over midswaps, and its 500 million euro 2 year bonds was issued at midswap rate -10 bps instead of the initial +5 bps guidance given the demand, equating to a coupon of 0.40%. With inflation coming at an annual pace of 2.6% in the Euro Zone, now you also have negative yield in the high quality corporate bond space. A negative yield means investors who hold these notes to maturity will receive less than they paid to buy them.

The proceeds of the new issues raised by Siemens will be used to buy-back up to 3 billion euros worth of shares. This is a negative development from a credit perspective indicative of this growing structural instability we think. In our previous "Hooke's law" ending remarks we argued:

"Given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates."

As indicated by John Glover and Andrew Reierson in their Bloomberg article - Europe Trounces U.S. as Corporate Gains Reach 9%":
"Corporate bonds in Europe last outperformed U.S. debt in 2008, when they lost 3.3 percent, less than the 6.8 percent drop in value of American company debt. Last year, Europe gained 1.99%, while the U.S. soared 7.51%."

 

Yes, one might argue that given the U.S. two-tear interest-rate swap spread, a measure of stress in debt markets has extended its third straight monthly decline to 16.46 bps, down from this year high of 48.32 bps on the third of January and returns in 2012 on Europe corporate bonds are on pace to total about 14 percent which would be exceeded only by the 14.9% gain in 2009 all is well and stable. We do not think this complacency or stability in "instability" can remain for an extended period of time.

"Measures showing U.S. financial market conditions have improved put little pressure on Federal
Reserve Chairman Ben S. Bernanke to signal added monetary stimulus this week, according to Credit Suisse Group AG. The CHART OF THE DAY shows the Bloomberg U.S. Financial Conditions Index moved above zero on July 27, a threshold that signals receding market risk. It was below negative 1 last year when Bernanke spoke at the Kansas City Fed’s annual economic symposium in Jackson Hole, Wyoming. The bottom panel shows the spread between the rate to exchange floating for fixed-interest payments and Treasury yields for two years, a gauge of investors’ perceived risk in the banking sector, fell yesterday to the lowest since May 2011. Bernanke speaks at this year’s Jackson Hole conference on Aug. 31." - source Bloomberg.

But, this false sense of "stability" is increasingly indicative of growing signs of "instability". Back in our July conversation "Hooke's law we argued: "The fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets. The conjunction of low interest rates with higher taxations will undoubtedly damage companies, particularly in Europe, and in a country like France, for instance, where public expenditure as a % of GDP is much higher (56%) than in Germany (45%)."

 

We would like to use again a reference to Bastiat in relation to liquidity and Credit Markets (from our conversation "The Unbearable Lightness of Credit"): "That Which is Seen, and That Which is Not Seen"

 

In similar fashion to what Hyman Minsky posited, this  false sense of "stability" is in fact indicative of rising "instability" in the monetary system with the "improbable" being inaccurately priced in the US rates markets.  In Citi Research US Rates and MBS weekly note from the 30th of August, they indicated the following:

"Large Moves in a Low Yield Environment

Over the last three months, we have seen 10y swap rates move lower almost 40 bps within two months and subsequently move higher 40 bps over the following three weeks. Much of this movement was not driven by a slow grind, but rather through a series of violent single-day moves interspersed with a series of benign moves. We’ve also seen significant moves in volalitility vs rates, where implied vols tend to fall when yields fall."

- Source: Citi Research, Bloomberg. Average moves are calculated as avg(x|p) = sum(abs(x)|x>=p)/count(x|x>=p) for upper tails, and done similarly for lower tails., for a given data point x and a percentile p.

"Over the last several years, it is somewhat surprising to see that, despite the steady move lower in 10y swap rates, the magnitude of a single-day or a one-month tail event (as defined above) has stayed relatively constant, or has even become somewhat larger over time. In general, we would like to note that 10y swaps have moved at least 7bps/day 20% of the time (cumulative probability of the two extreme deciles). Similarly, they have generally moved at least 30bps per month, with a probability of 20% based on the past 22 years of data."

 

This growing false sense of stability is clearly indicated in the current US swaptions market given the "improbable" is currently "equally priced" by the market at the same level of the "probable" according to Citi:

"Here we can see that markets have priced in roughly a 30bp move/month with a 20% probability, which is in-line with historical levels. Indeed, we use this data to compare with realized tail moves to create an implied-to-realized ratio on 10% and 90% moves. In this case, we compare the market-implied moves given probabilities with historical percentiles of various time periods." - source Citi.

 

"The degree to which the implied/realized ratios tend towards one, especially using two-year realized percentiles, is quite surprising. Not only do we see that rate volatility in the past, where yield levels were as much as 200bps higher, to be good indicators for percentiles in the future, but also that considering implied levels of high and low strikes are similar, the market expects that the probability and magnitude of a large move higher are almost equivalent to that of one lower. In other words, the market implies that large moves in yield today are not impacted by the perceived lower bound on rates. A 30bp move higher is equally probable as a one move lower, regardless of whether current rate levels are at 2% or 4%. Even under more stringent criteria of a “tail” move, despite small differences between the implieds on high and low strikes, we see very similar results – the chances of a 50bp move higher or lower are roughly the same. It is equally surprising to see that implied/realized ratios still tend towards one.

Given this data, we can see that it is impossible to simultaneously have a bounded market where tail risk isn’t valued separately evaluated by its direction. In other words, one can only make one of the following two conclusions:

a) Market levels are incorrect, and a move in rates lower should be viewed differently from a move higher.

b) Market levels are correct, and the supposed lower bound on rates currently has no impact on the size and directionality of a move.

Given recent moves in the market, we are inclined to take the latter conclusion. Potential tail risk scenarios seem to abound, varying from Jackson Hole to the Grexit to a hard landing in China. In any of these scenarios, it is easy to imagine large rate moves higher or lower, regardless of current levels. As a result, we would be cautious in placing trades in duration based on beliefs that rate markets are bound, especially considering that it is not clear on what level that bound would come into play." - source Citi.

Our equities friends would be well advised to remain cautious September wise and take a few chips off the gambling table, September being statistically volatile (September: The Worst of Months - Cullen Roche - Pragmatic Capitalism). The lower earnings estimates will be the biggest risk to come in coming months as indicated by Bloomberg Chart of the day:

"Lower earnings estimates may be the biggest risk for stock investors in the next couple of months,
according to Barry Knapp, head of U.S. equity strategy at Barclays Plc’s securities unit.
As the CHART OF THE DAY shows, analysts lowered profit projections for companies in the Standard & Poor’s 500 Index more often than they raised them in the months of September and
October since 2000. The figures were compiled by Barclays and exclude periods in which the U.S. economy was in recession. October was the worst month for earnings revisions in the past 12 years, according to Barclays data. Based on the number of changes made by analysts, estimate cuts surpassed increases by 5.2 percentage points. September tied for the second-worst month with December. The gap between lower and higher estimates was 3.2 points on average. January was the only other month of the year in which reductions predominated." - source Bloomberg.

Back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

Following our usual Credit Overview, we would like to turn our attention again between the relationship between credit and equities correlation given the significant outperformance of U.S. equities indices versus their European peers, whereas in contrast, European credit as indicated earlier, has been outperforming significantly U.S. credit. As a reminder, we already discussed the reasons behind the performance of the US economy versus Europe  back in May 2012 in our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid...".

 The Itraxx CDS indices picture, ending this month on a weaker note in the credit derivatives space - source Bloomberg:

In similar fashion to last week, Credit indices were overall wider on Friday, ahead of the long week-end in the U.S but around the exact same levels as the previous week. Itraxx Crossover 5 year index (High Yield risk gauge based on 50 European entities). While Credit Indices have had a weaker tone in the last two weeks, cash credit has continued to perform, supported by a flurry of new issues which came to the market, quickly absorbed by yield starving investors in the need of placing their cash to work courtesy of dwindling liquidity and rarity of quality paper in the secondary corporate bonds market. For instance, although Cargill (A2/A/A), top trader in the commodity space as well as the leading food processor, grain and meat exporter reported an 82% drop of quarterly earnings on the 9th of August, making it the company's worst quarter in more than 20 years, it nevertheless managed to place its 500 million euros 7 year issue at mid-swap +57 bps equating to a meager coupon of 1.875%. A similar scenario consequent of the on-going "Yield-Famine" environment played out, namely that as the book grew in size (4 billion euros worth of orders), and the guidance was tightened, from mid-swap +70 bps to end up mid-swap +57 bps.

 

So what does that mean for credit? We would have to agree with UBS recent Credit Strategy morning comment from the 29th of August:
"We are downgrading our stance on corporate credit, moving to underweight in Europe and to neutral in the US. The prevailing lack of confidence among agents amounts to an uncertainty shock, one that is taking its toll on economic growth and appears unlikely to abate soon. Recent data points on the macro (Europe, China PMIs) and micro (guidance from Cisco, Caterpillar, Hewlett Packard) fronts suggest growth, particularly in Europe, is running at stall speed.
Risks to the outlook are skewed to the downside, in our opinion. A confluence of factors constrains the outlook for economic growth and corporate profitability, particularly in Europe. They include: the Eurozone crisis, the US fiscal cliff and election uncertainty, political instability in Greece and Italy, doubts over the vitality of the Chinese recovery and rising geopolitical tensions in the Middle East.
In the meantime, the susceptibility of markets to a downside shock is high in an environment of weak growth.
On the other hand, the prospects for policy upside appear constrained versus expectations. In Europe, we expect clarification on the tenor and timeline for bond purchases. However, additional details would run into two major obstacles. First, the Eurozone is a heterogeneous bloc; peripheral countries have disparate problems which require different solutions in terms of aid and conditions, making a “one size fits all” programme an ineffective remedy. Second, there is a moral hazard issue associated with a fully transparent programme; if the terms are too generous, the incentives to reform swiftly would vanish. In the US, we expect Chairman Bernanke to explain the mechanisms the Fed would use to ease further at Jackson Hole, but avoid promising easing is forthcoming. Our economists peg the odds of QE in September at roughly 50/50.
Credit valuations look extended, particularly in higher beta European corporates. Our regression models using economic indicators (Europe composite PMIs, global manufacturing PMIs) suggest iTraxx Xover spreads are c100bp rich to fair value (Chart 1). Given substantial, albeit well flagged, event risks in September, we recommend investors set shorts in higher-beta European credit and take some profits in credit globally."

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

As we posited in "Yield-Famine": "Credit is increasingly becoming a crowded trade, forcing yield hungry investors to get out of their comfort zone and reaching out for High Yield as well as Emerging Markets in the process. While everyone is happily jumping on the credit bandwagon in this "yield famine" environment, we would advise caution given liquidity, as we discussed on numerous occasions (and liquidity mattered a lot in 2011...), is an important factor to consider in relation to investor confidence and market stability."

Both the Eurostoxx and German 10 year Government yields are still moving in synch but most likely towards "Risk-Off" in the coming weeks with fast falling German Bund yields towards 1.30% yield level and a slightly weaker Eurostoxx 50 at the end of the week - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

Our "Flight to quality" picture marking pointing towards "Risk-Off" with Germany's 10 year Government bond yields falling again towards 1.30% and the 5 year CDS spread for Germany rising above 60 bps - source Bloomberg:

As far as the EUR/USD is concerned we told you in our conversation "Sting like a bee - The European fight of the Century" to watch out for political "sucker punches" during this summer "lull" because they do sting like a bee!  Friday's "sucker punch" on EUR/USD as displayed by the significant intraday move - source Bloomberg:

In relation to the European bond picture, Spanish 10 year yields climbing towards 6.70, slightly below 7% whereas Italian 10 year yields are still below 6% around 5.80% and German government yields fell towards 1.36% - source Bloomberg:

The recent rise in Spanish government yields is related to the recent request for bailout by three Spanish regions, Catalonia, Valencia and Murcia in quick successions. Catalonia asked for 5 billion euros, Valencia asked for an additional 3.5 billion euros and southeastern Murcia asked for 700 million. Valencia has already borrowed 25% of the 18 billion euro-bailout fund set up by Prime Minister Rajoy, amounting to 4.35 billion euros. The size of the bailout fund will soon prove to be insufficient. Catalonia region was subsequently cut to junk on Friday by Standard and Poor's with a negative outlook.

The regions were responsible in 2011 for most of Spain's overspending, 8.9% of GDP (unchanged from 2010) while the debt level of the regions as a percentage of GDP are still rising as indicated by Bloomberg:

"The total debt outstanding of Spain's 17 regions doubled from 4Q08 to 1Q12 and now stands at 145 billion euros, equivalent to 13.5% of GDP. With 15 billion euros of maturities due by year-end, the 18 billion fund announced in July to support the regions may prove insufficient, and addressing this will form a pivotal part of any Spanish request for a bailout." - source Bloomberg.

In addition to the rapidly debt picture, for the three Spanish regions asking for a rescue, unemployment has been rising as well in all three:

In addition to Regional woes, Spain has been busy as well with its banking sector woes this week, given Bankia Group announced 4.45 billion euros of losses for 1H2012 versus a 205 million profit in 2011 (year of its nicely priced IPO...). Bankia had 6.63 billion euros of provisions for 1H impairments costs, and its group clients funds fell 37.6 billion euros from December to 173.8 billion euros. Consequences for Bankia was that its banking rescue FROB has had to immediately inject capital given Bankia group's BIS II Core Capital ratio fell to 6.3% and its bad loans ratio jumped to 11% from 6.3% in 1H 2012.

During the same week, we had the secretary of state for the economy, Fernando Jiménez Latorre, telling us that there was no significant drop in Spain bank deposits. Reading the following comment from HSBC made us wonder about the delusional state of some members of the Spanish government:
"ECB deposit data out and the usual health warnings apply, for anyone of a remotely nervous disposition. This latest set of data show an alarming increase in the pace of deposit flight from Spain - see the graph below. After what appeared to be something of a moderation in June, with 'only' EUR8.6bn disappearing vs EUR30bn+ in both April and May, last month saw EUR74bn leave the Spanish financial system. This brings the YoY pace of decline to a rather Greek 12%. Deputy Finance Minister Latorre is on the tape this morning saying that there's no significant drop in deposits, which one would have to assume refers to this month, as the July data is alarming."

'Other financial institutions' are responsible for the bulk of the outflows, with 50% of the deposits being of an 'agreed maturity', so presumably these depositors are so keen to get their money out of the country that they'd take an early withdrawal penalty (which would presumably be cheaper than hedging any redenomination risk). Unless there was a large seasoning of term deposits in the numbers, but that seems an unlikely coincidence. Given that Spanish bond yields were getting a little hairy in July, this shouldn't be a huge surprise.
 
Since Draghi's verbal Chuck Norris intervention and subsequent spread tightening, however, one would imagine that the pace of deposit flight would moderate, so August's data should mellow. Yet the MoM flow in domestic govt bonds held by Spanish banks has been declining again, consistent with the trend this year since the LTRO induced peak. Makes you wonder who is there in the background buying these assets given the headlines and risks, as the domestic bank bid has been so supportive over the last few years.

Were the Spanish financial system capable of shedding assets at the same rate, or ideally, faster, all would be well. But look at the loans to deposits graph  below and note that the Spanish system LDR is still climbing. It's not as large a funding gap as you might see elsewhere in Europe (currently 117% LDR, vs e.g. Finland on 143%, Ireland on 129%, Italy on 122%, or the Netherlands on 120%), but more the trend that's concerning, as Spain belong to the unfortunate minority of countries where the funding gap is widening - Greece, Cyprus, and more recently, Portugal. No wonder there's a sense of urgency at the ECB these days." - source HSBC

Back in our conversation "Agree to Disagree" in June we wrote:
"If our European politicians had studied carefully what had happened in Argentina before their default in 2002, they would not be pressing for a "Banking Union" but should rather be more concerned about a deposit guarantee scheme if they are "really serious" about keeping Greece in the Euro. Back in March we argued the following in our conversation "Modicum of Relief":
"A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios.
Unless our European politicians rapidly introduce European laws guaranteeing depositors money ("insurance for depositors against the risk of euro exit" is qualitatively different from "deposit insurance"), capital flight might start in Spain as it has already in Greece."

As far as Spain is concerned, deposit outflows have been confirming our June call:
"The dangers of deposit outflows. While complacency is prevailing so far in relation to Spanish deposits, it cannot be taken for granted, as shown by the situation in Argentina which quickly spiraled out of control and led to its default in 2002:
"the most puzzling aspect of the crisis so far is the relative complacency of the public. This is starting to be tested." - CreditSights, 31st of July 2001 paper "Defining the Default Path".

We might be rambling again in our longer than usual conversation but we have long argued   the impact the LTRO has had on the Spanish banking system. amounted to "Money for Nothing":

 - source HSBC - Spain - Loans growth month to month.

 We hate sounding like a broken record but: no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits (All Quiet on the Western Front - April 2012):
"In August 2011 we wrote in our conversation "It's the liquidity stupid...and why it matters again...":
"Lack of funding means that bank will have no choice but to shrink their loan books. If it happens, you will have another credit crunch in weaker European economies, meaning a huge drag on their economic recovery and therefore major challenges for our already struggling politicians.

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.

"So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans."- "Subordinated debt - Love me tender?" - Macronomics, October 2011

One can easily conclude that not only will the regional bail-out fund will need to be recapitalized but FROB as well given the Bankia group will certainly need additional capital injunctions as the economic outlook deteriorates further in Spain because no loan growth means no earnings, rising non-performing loans and rising deposit-outflows mean rising loan-to-deposits level. Capital injections mean additional strain on the budget with weaker tax receipts.

Back in our conversation "Modicum of Relief" we indicated the following:
"On the subject of systemic risk diagnosis, wholesale bank deposits flights and tracking the loan-to-deposit ratio of banks can be used as a simple gauge of risk profile. It is as well a good indicator of banks 'capacity in supporting lending in their respective economy. Maintaining lending and credit flows is paramount to avoid a credit crunch which would essentially impair GDP growth in the process (as per our "car" analogy used in our previous conversation)."
As far as similarities between Spain and Argentina and in relation to capital flight:
"the lack of liquidity in the system has forced the central banks to provide unprecedented level of repos to the system and also relax reserve requirements. The problem is that this is very unclear whether that additional liquidity is funding anything but capital flight at this point." - CreditSights 31st of July 2001 paper "Defining the Default Path"

Moving on to the subject of  the relationship between credit and equities correlation, the significant outperformance of U.S. equities indices versus their European peers, is interesting given the outperformance of European credit versus U.S. credit.

We have been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:

We have on various occasions discussed the relationship between credit and equities. Back in January 2011, in our credit conversation "A tale of two markets - Credit versus Equities", we indicated the following in relation to credit and the relationship with equity volatility:
"In theory Credit can be assimilated to a long OTM (Out of the Money) equity option. A Credit Default Swap (CDS) is a proxy for a Put Option on the Assets of a Firm. This means that by going long on bonds the bondholders are long the face value of the bond and short a put option on the assets of the firm with the strike price being the face value (principal) of the bonds.

In recent years, according to a research published by Morgan Stanley in March 2009 by Sivan Mahadevan, correlations between changes in credit spreads and changes in various implied volatility metrics, have been very similar to short-dated ATM (At The Money) equity options. Liquidity being an important factor and short-dated ATM being the most liquid in equities, whereas the 5 year point being the most liquid CDS point (Credit Default Swap). Given there is an extremely low probability of an entire equity index going bankrupt, Morgan Stanley's research team further comment that ATM volatility can be used to make comparisons between equity and credit. The cash equity/credit relationship is apparently less stable than the volatility/credit relationship according to Morgan Stanley's study."

We would like to go further given the R2 (coefficient of determination of a linear regression) between Credit/Spot equities and Credit/Equities Volatilities (ATM for At The Money) in both Europe and the U.S. tell a different story courtesy of our good cross-asset friend. An elevated R2 level indicates a significant relation. One can see in the below table the higher correlation between European Itraxx Credit indices (Itraxx Main Europe being the investment grade risk gauge and Itraxx Crossover being the European High Yield risk gauge) and the Eurostoxx 50 equity index. In the U.S. in the table below you can see the relationship between CDX IG (Investment Grade) and CDX HY (High Yield) with the Standard and Poor's 500 (SPX) and the Russell index.

The correlations between Credit Indices in Europe versus Spot equities remain very significant in Europe and in Japan but less so in the U.S. At current levels the relationship between the Standard and Poor's and Credit is weak, whereas the Russell Index is more positively correlated to Credit in the U.S. The fact that the Standard and Poor's volatility is strongly correlated to Credit is counterintuitive.

The overall underperformance of Japanese credit spreads which continue to weaken is at present the only notable disconnect between credit spreads and spot equities:

According to our good cross asset-friend, this weak Japanese relationship warrants monitoring and could be played by selling CDS and buying Nikkei Put Options, which benefit from absolute low volatility levels. Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Japan 5 year CDS since March 2010 until the 21st of August 2012 - source Bloomberg:

Monitoring levels of correlation in the short-term is fundamental if you are looking at adding relative value positions or if you would like using historical signals to position yourself on either credit or equities.

"If you want stability, prepare for instability" - Martin T - Macronomics.

Stay tuned!