Saturday, 30 July 2011

Macro and Markets update - Combat stress reaction (CSR), the Danish standoff and much more!

Combat stress reaction (CSR) or post-traumatic stress disorder. It is probably what most are feeling after an epic month of July.

From the dowgrades of Portugal, additional dowgrades on Greece and Ireland, contagion to Italy, ongoing debt ceiling debate in the US, European banking stress tests,new European plan for Greece, poor economic data, and now threat of downgrade on Spain from Moody's, I am glad it is the end of the month and the week-end.

On Friday we have had some poor data coming out of the US in relation to GDP. The stand off goes on for the US debt ceiling goes on and we had Moody's adding some extra spice whith a threat of downgrade on Spain. And of course in that relaxed and friendly environment, Gold is making new highs.

Can someone please press pause?

Markets update:
Sovereign 5 year CDS in core countries, Denmark starting to feel the heat...
[Graph Name]
Denmark's sovereign CDS is now at 86.83 bps, rising 18.29%, widening by 13.43 bps according to CDS data provider CMA.

Update on the Danish situation:
Denmark's risk perception has reflected by the CDS market, has been increasing after S&P said that as many as 15 Danish banks could default.
Denmark is at war with the rating agencies. Very recently Danske Mortgage Unit sacked Moody's and declared it might hired Fitch:

Danske Unit Sacks Moody’s, May Hire Fitch - Bloomberg
On the 23rd of June, another Danish banked at sacked Moody's:
"Realkredit Danmark sacked Moody’s on June 23 after being told to provide an extra $6.14 billion in collateral to keep its covered debt graded Aaa."

The fight is on.
"Moody’s argues that Denmark’s adjustable-rate mortgage bonds represent a bigger refinancing risk because they, unlike other Danish covered bonds, don’t match the maturities on the loans linked to them. The adjustable-rate bonds tend to have maturities of one to three years compared with an average loan maturity of 20 to 30 years."
Fact is Denmark has one of the best mortgage system in the world.

The issues relating Danish Mortages bonds are tied to BASEL III. Will the EU classify danish mortgage bonds as highly secure and liquid (level 1 securities) like government bonds?
Denmark has the third largest mortgage bond market after the United States and Germany. Excluding Danish Mortgage Bonds from "Level 1" securities would trigger a sell-off and put the entire Danish Banking system under pressure (the current liquidity pool of Danish banks is made of 85% of Danish Mortgage Bonds and only 15% of Government bonds).

So far the EU has postponed its decision until 2015:

EU postpones key decision for Danish mortgage bonds - Reuters

The rating agencies are taking a very agressive stance relating to the Danish Mortgage Bond markets which is not entirely justified given the ongoing discussions between the EU and Denmark about its very specific and unique banking system.
As a reminder, the Danish mortgage markets is based on the "Principle of Balance":
Every mortgage is instantly converted into a security of the same amount and the two remain interchangeable at all times. Homeowners can retire mortgages not only by paying them off, but also by buying an equivalent face amount of bonds at market price. Because the value of homes and the associated mortgage bonds tend to move in the same direction, homeowners should not end up with negative equity in their homes. The Danish model, which has withstood many tests since it was brought into existence after the great fire of Copenhagen in 1795. For more on the subject of mortgage systems, and housing, you can check previous post "Are Fannie Mae and Freddie Mac on the path to a crash à la Thelma and Louise?"

Back to our market update!
The SOVx, which represents the index for Sovereign risk in Western Europe and comprising 15 countries including Greece, is drifting wider again:

Same story for the index representing corporate credit risk, Itraxx Main Europe 5 year index (containing 125 names rated at least investment grade):

But in relation to corporate leverage and debt, although companies are already facing margin compressions due to rising commodity prices, company debt in 2012 will slide to its lowest level since 1996 according to a study made by Societe Generale. Some are still deleveraging but most are sitting on a pile of cash and have managed to control and reduce costs (lean and mean?).
Source: Company Debt in Europe Will Slide to Lowest Since 1996: Chart of the Day - Bloomberg.

"Companies’ net debt as a proportion of earnings before interest, taxes, depreciation and amortization will fall its lowest level since 1996 next year, according to Societe Generale."

"The ratio of European companies’ debt to Ebitda will fall to 0.8 in 2012, according to Societe Generale. The last time that corporate debt dropped below Ebitda, European stocks rallied 154 percent over the following five years."

But at the same time, there is a lot of uncertainties due to sovereign issues, with the ongoing European debt issues and the current US debt ceiling debate.
The US 1 year CDS spread is now trading above the 5 year point, although the curve is inverted, there is no need to panic given the level of the spread indicates a very low probability of default (around 6% over 5 years):

But with the ongoing turmoils, "Risk off" is still the game "du jour".
Vix climbing up steadily, not yet reaching March levels but getting close:

Time for some Macro updates:
The great shock was the release of the US GDP figures for the second quarter as well as the revised figure for the first quarter. Truly appalling. GDP climbed 1.3% at annual space, from an median forecast of 1.8%, but following a 0.4% revised gain in the prior quarter! Revisions to GDP figures indicates that the 2007-2009 recession shrank 5.1% from the fourth quarter of 2007 to the second quarter of 2009, compared to a previously reported 4.1% drop. The second worst contraction in post WWII era was a 3.7% decline in 1957-1958 according to Bloomberg.

Household purchases, which represent 70% of the GDP rose at 0.1%. Slower job growth increases the risk for the second semester. Next week employment figures with the NFP (Nonfarm Payrolls) will be essential and so will be the ISM figures release. There is an increased risk of double dip for the US economy. Massive spending cuts would strike another blow to a faltering US economy.
I pointed out we had stagflation in the UK in my previous post, the US is as well stuck in a stagflationay environment.

The Chicago ISM's business barometer fell to 58.8 in July from 61.1 in June. Figures above 50 signal expansion. The median forecast was for a 60 print.

The US debt ceiling debate will certainly add on company's reluctance to hire in this environment.

So, yes it still "Risk Off" for the time being.

To be continued...

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