Saturday 8 September 2012

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!

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