Friday, 20 January 2012

Markets update - Credit - The European Overdiagnosis

"Analysis does not set out to make pathological reactions impossible, but to give the patient's ego freedom to decide one way or another."
Sigmund Freud

Following on our meditations on Bayesian outcomes, and the "European Principle of Indifference", it appeared to us appropriate this time around to focus on the unintended consequences of applying nonsensical decisions to nonsensical results, hence, we have decided this time around to use the analogy of overdiagnosis relating to our European issues:

"Overdiagnosis is the diagnosis of "disease" that will never cause symptoms or death during a patient's lifetime. Overdiagnosis is the least familiar side effect of testing for early forms of disease – and, arguably, the most important. It is a problem because it turns people into patients unnecessarily and because it leads to treatments that can only cause harm." - source Wikipedia

Indeed, this analogy seems to us particularly right relating to the current European and American "Balance Sheet Recession" which has been a recurring theme from Richard Koo, chief economist at Nomura Research Institute, as pointed out by Cullen Roche on Pragmatic Capitalism - "DEFICITS ARE GOOD DURING A BALANCE SHEET RECESSION":

"This (austerity) is akin to a doctor telling a patient suffering from pneumonia to go on a diet and get more exercise. While exercise is important, it assumes a healthy patient. If the patient is sick, he must build up his strength until he is physically capable of exercising again."

So, in a longer credit conversation than usual, we will first have a credit overview given recent significant price action (tightening spreads and much better tone in the credit space), before dealing more directly with the current" European Overdiagnosis" and unintended consequences courtesy of my global macro friends at Rcube Global Macro Research, quantifying "The likelihood of a Euro Breakup" in their latest paper, which follows on their previous analysis of Eurozone's core issue, namely Unit Labor Cost Divergence, which we discussed in our "European Flutter".

The Credit Indices Itraxx overview - Source Bloomberg:

"The Markit iTraxx Financial Index of credit-default swaps linked to the senior debt of 25 European banks and insurers now costs a record 120.5 basis points less than the Markit iTraxx SovX Western Europe Index of swaps on 15 governments. That compares with a 28 basis-point gap at the end of November and a previous high of 118 in July. Historically, it costs more to insure banks than governments." - source Bloomberg news - Abigail Moses and John Glover.

The Year of the Dragon should be rebranded the Year of the European Central Bank, given the significant tightening in credit indices which we have witnessed in Europe since the beginning of the year as indicated by Bank of America Merrill Lynch research - The ECB trade - 17th of January:

"The ECB funding “put”
Away from S&P’s downgrade distraction, we think funding stresses in the credit market have improved significantly over the last month. Three themes paint a better picture. Firstly, ECB 3yr LTROs have had big take-up, and more is to come.
Secondly, fixed-rate senior unsecured bank issuance has reached €15bn YTD, half of the entire 2H supply last year. And finally, as our banks colleagues highlight, government guarantee schemes can be a powerful solution to a bank funding crisis. With the ECB helping to transform funding pressures in credit, we think short-dated spreads can keep rallying."

As indicated above the fall in the Itraxx Financial Senior 5 year index has been significant versus the SOVx 5 year index (relating to 15 European sovereign CDS) courtesy of the breakdown in the correlation between Sovereign and credit spreads, as indicated by Bank of America Merrill Lynch in their report:

"Sovereign and credit spreads - the correlation is finally breaking
Thanks to ECB intervention, credit spreads have been much less correlated to sovereign spreads over the last month (although still positive). In fact, our work shows that the correlation between bank and sovereign spreads has fallen from 90% in mid December last year, to 40% currently. This isn’t far from the lowest correlation between the two since the start of 2010. How long this lasts will ultimately be a function of the outlook for peripheral sovereign debt, given banks’big exposure to the periphery."

In fact as my good macro friend pointed out early January, it is interesting to track the relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):
Volatility has been falling faster than the Itraxx Crossover index and the index is clearly trying to catch up at the moment.

In relation to the liquidity picture, it has somewhat  improved as indicated in our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:
New reserve period for deposits started on the 18th. It will be significantly important to track upcoming peripheral government bonds auctions, given that, while the ECB's intervention is clearly supportive for banks, volatility will depend on the Greek PSI outcome, upcoming downgrades for banks and corporate rating downgrades (following up on sovereign downgrades and which have already started).

As Bank America Merrill Lynch put it in a note published on the 16th of January - "Perhaps it's not so bad after all":
"Banks better placed than sovereigns?
It is certainly the case that European banks have a lender of last resort who is dealing very flexibly with their needs – something the ECB has so far proved reluctant to do with sovereign debt."

But, there is a catch and Bank of America Merrill Lynch report from the 17th is on target:
"It isn't all about European banks' sovereign exposure - its also about private sector lending, not just sovereign bond holdings."
"How long the low correlation between bank and sovereign spreads lasts will ultimately be a function of the outlook for peripheral sovereign debt, and Standard and Poor’s sovereign downgrades don’t help. Despite the ECB’s welcome funding, European banks’ exposure to sovereigns remains vast, as chart 7 shows. Note European banks’ large private sector lending to peripheral countries." - source Bank of America Merrill Lynch.

And Bank of America Merrill Lynch to conclude their note with the following advice in relation to credit in 2012: "a more trading, "macro-driven" credit market."

Truth is, while everyone is anxious about the results relating to the Greek PSI, Sovereign CDS wise, Portugal looks to be the ideal candidate for some additional haircuts as we indicated in our last post "The European Principle of Indifference".
Sovereign CDS, between Ireland and Portugal, a new record between both countries with a spread difference of 604 bps - source Bloomberg:
Portugal 5 year Sovereign CDS is now at 1245 bps, which according to CDS data provider CMA equates to a cumulated probability of default of 65.67% within 5 years.

Meanwhile, the disconnect between the 10 year German Bund and the Eurostoxx is still noticeable but today we saw some widening courtesy of German Bund 10 year spread climbing 9 bps and closing on the 2% level, (we noticed this disconnect first time around in November in our post "Mind the Gap...") - source Bloomberg:

In relation to our previous conversations relating to bond tenders and other steps taken by banks to shore up capital requrements (BBVA benefiting from a tax credit courtesy of a goodwill impairment as discussed recently), it was interesting to see the Wall Street Journal catching up with us in relation to the unusual steps taken by some European banks to raise capital in order to reach the 9% Core Tier 1 Capital threshold set up for June 2012 -
"Banks Seeking Capital Ideas - European Lenders Are Taking Unusual Steps to Meet Their Cash Requirements". But what also caught our attention was seeing Bank of America entering as well the raising capital game of bond tenders, offering to buy back 1.5 billion dollars worth of subordinated bonds on the 19th of January. As reported by Zeke Faux in Bloomberg:
"Bank of America is reducing long-term debt as Chief Executive Officer Brian T. Moynihan, 52, seeks to cut holdings, expenses and staff while raising capital to meet demands from regulators for a larger cushion against losses."
So European bankers, please take solace, you are not alone.
"The bank is offering about 95 cents for those securities, it said in the statement", according to Bloomberg, on 6.22% Subordinated bonds due in September 2026, which amounts to a smaller haircut than what we have witnessed in Europe recently on some subordinated bond tenders last couple of months.

But back to our main story, namely European politicians' "Overdiagnosis". What could happen if austerity bites too much, could it lead to Euro Breakup? This is what my friends at Rcube Global Macro Reasearch have recently worked on:

The Likelihood of a Euro Breakup

Since late November, the 2 year yields of both too-big-to-fail PIIGS have crashed (by 350bp for Italy and 320bp for Spain). This indicates that the latest initiatives to save the Euro – most notably the LTRO – have succeeded in lowering the perceived short-term risk of a Euro breakup. This is undeniably a bullish signal for risky assets in the short term. On the other hand, 10 year yields remain stubbornly high, especially in the case of Italy (which is still trading at around 6.5%). This shows that the market believes (as do we) that the question of the Euro’s long-term viability remains unresolved. In order to quantify the likelihood of a Euro exit for each endangered country, we have built a simple model based on CDS spreads and excess unit labor costs. Before showing the model itself, let’s explain why we don’t believe that solving the PIIGS’ government debt problems (through ECB initiatives and fiscal austerity) will be sufficient to prevent a Euro breakup.
In our recent paper about unit labor cost divergence (Macro Analytics 19/12/2011), we suggested that the Euro’s issues went beyond the current debt crisis. The Euro created competitiveness imbalances between Eurozone countries by preventing currency adjustments, which were prevalent in the period between the end of the Bretton Woods system (in 1971) and 1999:

We see some occasional swings, but the dominant pattern is a rather regular fall of most currencies – at different speeds - against the Deutsche Mark, the only exceptions being the Austrian schilling and the Dutch guilder. Unsurprisingly, countries whose currency deteriorated the most during this 28 year period were the PIIGS (the Greek Drachma led the trend with an impressive 95% devaluation against the DEM). When we look at unit labor costs compared to Germany between 1995 and 2012, we notice that countries’ rankings are close to being the opposite of their former currencies’ strength:

If we more thoroughly analyze the relationship between the devaluation rhythm of former currencies’ (+: depreciation, - : appreciation) during the 1971-1995 period and unit labor cost increases between 1995 and 2012, we find a Pearson correlation coefficient of 0.70, and a Spearman correlation coefficient of 0.87. This indicates a strong (albeit non-linear) relationship between those two data items.

Despite the stories about the Mileuristas in Spain, the Milleuristi in Italy and the 700€ Generation in Greece, wage-earners in the PIIGS faired relatively well on a productivity-adjusted basis during the 1995-2008 period, as if they were still being paid in a weak currency that justified regular wage increases. As an illustration of this, we recently learned that Italians now have the highest net worth amongst G8 countries, despite the dismal performance of Italy’s economy over the last decade (this is also a byproduct of Italy’s housing bubble).

Had the Euro never existed, it is fair to assume that PIIGS’ currencies would have naturally adjusted to compensate for their high relative unit labor costs. As countries renounced their ability to devaluate, their competitiveness suffered considerably. Even in the case of France, which is not (yet) considered as one of the PIIGS, its balance of trade went from +3.2% of GDP in 1997 to –3.0% in 2011.

By eliminating currency crises, which were common until the mid-1990s (and at the same time preventing evil “speculators” from making billions on them), the Euro built an economic crisis of far larger proportions. Once again, economics provides a good illustration of the old proverb “the road to hell is paved with good intentions”.  
It is an understatement to say that finding a politically acceptable solution to restore labor cost balance within the Euro framework will be difficult. In addition to the deep cuts that are currently being imposed on government budgets, real wages will have to fall across the board (and not only minimum wages). As people tend to think about money in nominal terms (Keynes’ money illusion), it might end up being easier to find a smart (i.e. non chaos-inducing) way to return to a system of floating currencies, rather than to impose years of internal devaluations.

This is the main reason why we believe that the question of the Euro’s long-term survival goes beyond knowing whether the ECB will finally use its proverbial bazooka during the next 12 months. Even if Greece’s government debt was reduced to zero (which could end up being the case someday), it would not change anything regarding its current lack of competiveness (exports: 7% of GDP, imports 21%). As an anecdote, we recently read that Greece had to import olive oil from … Germany.

A simple model to assess market-implied Euro exit probabilities:

We believe that a large part of Eurozone countries’ CDS spreads reflect their long-term probabilities of exiting the Euro, rather than their default risk within the Eurozone. Indeed, even though we’re not sovereign debt experts, it seems evident to us that if a country was to exit the Eurozone and switch to a new currency, it would have to convert its government debts to the new currency. This would most likely constitute a default in legal terms for most countries[1], but we cannot imagine a country keeping a huge debt denominated in a foreign currency. This would create a Weimar-type vicious circle and would inevitably crush the new currency into oblivion.  Additionally, defaulting without exiting the Euro would not solve the competitiveness issue of many European economies (we’ll soon be able to check this theory with Greece).

If we assume that new currencies would have to devaluate to readjust their unit labor costs to their 1995 level, we can work out theoretical recovery values after redenomination (from which we take a haircut of 20% to take into account overshooting). We then calculate 1-year and 5-year Euro implied exit probabilities by using a simple formula for default probability (Default Probability = Spread / ( 1 – Recovery Rate) ]. This gives us the following implied exit probabilities for the main EZ countries[2] that have a 5 year CDS spread higher than 100:

Despite the rather simplistic assumptions we made in our calculations, these levels appear to be close to what we would have expected: in the short-term (1 year or less), exit probabilities are rather low for most countries, with the exception of Ireland and Portugal. Too much political capital has been invested in the Euro by the last two generations of politicians. Additionally, it would be a mistake to believe that the system is out of ammunition. In a fiat money world, the ECB cannot run out of Euros.  Everything ultimately depends on politicians’ (especially Merkel’s) willingness to “save the Euro”. On its own, the ultimate kick in the can (massive debt monetization) would certainly extend the Euro’s life for quite a few years.  

Consequentely, we believe that the Euro will muddle through for a while, in a climate of painful fiscal tightening for most European countries…

However, if as we fear will be the case, austerity plans do little to address the underlying competitiveness problems faced by many countries, their growth rates will remain anemic. Instead of the rosy “J curve” that would have been promised to justify deep cuts in government expenses, weak EZ countries will experience the dreaded “L”. Rather than going through another purge, some countries will then make the choice to exit the Euro. In this context, the 5 year implied exit probabilities do not appear to be exaggerated to us. 

[1] Under ISDA rules, G7 countries (Germany, France and Italy) could decide to redenominate their debt without provoking a credit event.
[2] Outside from Greece whose default/exit probability is already 100%

"The physician must give heed to the region in which the patient lives, that is to say, to its type and peculiarities."

Stay Tuned!

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