Tuesday, 16 August 2011

Macro update - Killing the Cretan Bull - European update

The Seventh Labour of Heracles:
"In Greek mythology, the Cretan Bull was either the bull that carried away Europa or the bull Pasiphaƫ fell in love with, giving birth to the Minotaur."

This week's analogy follow up on the two posts relating to our hero Heracles 12 labours to save Europe.
We previously had a look at our hero's task in cleaning the Augean stables, relating to the amount of toxic greek debt plaguing the Augean stables (European banks...) as well as his task of "Scaring off the Stymphalian birds (or bond vigilantes)".

While the European plan decided on the 21st of July in Brussels, included haircuts, private participation, coupon reductions and maturity extensions, it has not been enough yet for our hero to fully clean the Augean stables. The new plan has yet to be agreed by other European parliaments, and the 90% participation rate relied on, from the private sector, which amounts to 50 billion euros has yet to be enacted. The new plan is also made of 109 billion euros from the Euro-zone and the IMF as a reminder. The EFSF is still not up to the daunting task of supporting Italian and Spanish woes.

In relation to our "Stymphalian birds" (namely our bond vigilantes), they have recently turned their attention to France, leading to a risk of dislocation of the core of Europe and consequent spread widening in France 5 year sovereign CDS spread as indicated in Bloomberg chart below:
France 5 year Sovereign CDS spread climbed on the 10th of August to 175 bps according to CDS data provider CMA, whereas Germany 5 year Sovereign CDS spread was at 82 bps.

Sovereign CDS spreads in Core Europe as of the 12th of August:
[Graph Name]
France 5 year Sovereign CDS spread was at 148 bps as of the 16th, 35bps tighter than on the 10th of August.

Although president Sarkozy is pressing for an increase in the EFSF mechanism and even for Euro Bonds, Germany is still not in agreement with it, casting serious doubt on the strength of the European mechanism and the future of the European currency in the process.

But our "Stymphalian birds" attack last week wasn't only targeted at Sovereign CDS spreads of France, most of the banking sector took a pounding as clearly shown by the latest CDS spreads for Subordinated debt of some European banks:
[Graph Name]

The Itraxx Financial Subordinate 5 year Index is still very high:

Same with the Itraxx Crossover 5 year index, it remains still very elevated:

Truth is, liquidity is very poor, and not only in the credit space, it is also at the most extreme level since the credit crisis of 2008 as indicated by the swaps market. The premium paid by European banks to borrow in US dollars is at very concerning levels.
Bloomberg Chart of the day as displayed below shows the cost of converting euro based payments into dollars as measured by the three-month cross-currency basis swaps.
There is an ongoing true euro-zone liquidity crunch. According to a market participant as reported by Bloomberg, we are in a large European bank failure zone anywhere over minus 150 bps. Given banks are on everyone's radar as per the above reported CDS spreads, it is of no suprise banks are reluctant to lend to one another. Also banks have been leading the recent sell-off, an 18% drop in the benchmark Stoxx Europe 600 Index. Since July 26, 6 trillion US dollars have been wiped out in the equity space.
These have lead to the recent ban in short selling imposed by France, Spain, Italy and Belgium.
So, please, pay attention to the above.

In relation to the macro update, the latest releases are not great. Europe's second quarter growth figures are less than expected. GDP in the Euro-zone rose only 0.2% from first quarter which was at 0.8%. The worst performance since late 2009. 0.3% was expected according to the median estimates. European exports dropped a seasonally adjusted 4.7% in June from previous month, when they rose 1.6%. Imports slumped 4.1% and the trade deficit in the Euro-zone widened to 1.6 billion euros from 800 million euros. German GDP rose only 0.1% in the second quarter after increasing 1.3% in the first quarter. The Fench economy is stalling as well, following UK's steps. Italy's GDP increased 0.3%.
Cracks are starting to show and the double-dip scenario has been an ongoing theme on this blog.

Europe is struggling as America is turning more and more Japanese.

Another Bloomberg Chart of the Day - US Treasuries "Butterfly" shows the US economly is tracking Japan:
The “butterfly” spread formed by "The gaps between short-, medium- and long-term U.S. Treasury yields has dropped to match the level for Japanese government bonds, suggesting the world’s largest economy faces a similar outlook to Japan, according to Mitsui Sumitomo Insurance Co." - Source Bloomberg.

"The CHART OF THE DAY shows the butterfly spread for two-,
five- and 10-year Treasuries was negative 0.53 percentage point
on Aug. 12, down from positive 0.262 on March 31. That’s the
least since November and is less than the level for Japanese
debt. The measure is calculated by doubling the 5-year yield and
subtracting 2- and 10-year rates. A negative reflects bets the
Federal Reserve will stick with its Aug. 9 pledge to hold
interest rates through mid-2013." - Bloomberg

So there you have it, slow growth, lack of political leadership and concerns over the credit rating and fiscal policy challenges for the US, UK Stagflation with inflation coming at 4.4% meaning another letter to the chancellor, courtesy of Mervyn King, Euro troubles going unresolved still with no Euro Bonds.

The labours of our European hero Heracles are indeed appearing more and more like unfinished business.

To be continued...

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