Credit - In the doldrums

"There are many countries in the world that when they reached the middle-income stage, they witnessed serious structural problems such as growth stagnation, a widening wealth gap and increasing social unrest." - Li Keqiang 

Looking at France's recent PMI print for manufacturing coming at 48.5 but most importantly services coming at 48.8 which in the French economy represent around 80% of the GDP versus 76% for the rest of the European union and given it has been a while since we have not used our beloved maritime analogies, we thought it would be nice to re-acquainted ourselves in our chosen title this week:

"The doldrums is a colloquial expression derived from historical maritime usage, in which it refers to those parts of the Atlantic Ocean and the Pacific Ocean affected by the Intertropical Convergence Zone, a low-pressure area around the equator where the prevailing winds are calm. The low pressure is caused by the heat at the equator, which makes the air rise and travel north and south high in the atmosphere, until it subsides again in the horse latitudes. Some of that air returns to the doldrums through the trade winds. This process can lead to light or variable winds and more severe weather, in the form of squalls, thunderstorms and hurricanes." - source Wikipedia

Colloquially, the "doldrums" are a state of inactivity, mild depression, listlessness or stagnation which we think clearly characterizes for us the French situation in particular and the European situation in general. 

Therefore this week we will focus our attention on France and ask ourselves an interesting question, can you have a credit-less recovery in Europe?

In relation to France, if the Services PMI contracts at such a rapid pace, it still doesn't bode well for France's unemployment levels with president Hollande hoping to overturn the trend by year end. In that specific case the trend is definitely not the friend of French president Hollande as services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).

We were not surprised either to see Germany's Flash Composite Output Index jumping to a 10-month high of 54.3 from 53.2 in October. The services index also climbed to a 9-month high of 54.5 from 52.9, the manufacturing PMI climbed to a 29-month high of 52.5 from 54.5, and the manufacturing output index increased to a 3-month high of 54.0.

The reason for Germany's racing ahead have all been explained not only in the title of a previous post of ours "Winner-take-all" in February 2013 but also in the contents should you want to dig further on the subject:

"In similar fashion to the winner-take-all computational principle, when ones look at the growing divergence between France and Germany when it comes to PMI, in the pure classical form, it seems only the country with the highest activation stays active while all other see their growth prospects shut down" 

We have updated the graph displaying Manufacturing PMI for both Germany and France - graph source Bloomberg:

As a reminder, in our first credit post of the year, namely the "Fabian Strategy", we sounded the alarm in relation to France being clearly in the crosshair in 2013:

The story for 2013 in Europe we think, will be France:
In relation to France, in our conversation "A Deficit Target Too Far" from the 18th of April 2012, we argued: "We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections. Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").

Back in November 2012 in our credit conversation "Froth on the Daydream" we argued:

"Should industrial production print fell to -3.3%, we believe France will no doubt be in recession, putting in jeopardy its overly ambitious target of 3% of budget deficit in 2013 (A Deficit Target Too Far")."

We also indicated in  our February 2013 conversation "Winner-take-all" the following:

"While the French government has decided to revise its growth outlook for the year, the overly ambitious fiscal deficit in France of 3% will not be met and even the revised growth outlook of 0.2% to 0.3% will not be reached."

To that effect we justified our negative stance using a definitely scary graph displaying, French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) which we thought was telling the story on its own at the time and still is, we think - source Bloomberg:

Of course the divergence story between Germany versus France, is not only a growth divergence story, it is also an unemployment divergence story - source Bloomberg:

We concluded our February note with this statement at the time:

"After all the "Japonification" of Europe is a story of a broken monetary policy transmission channel, leading to liquidity constraints to the private sector with and therefore no impact whatsoever to the real economy, so no potential for economic growth to resume in France in particular and Europe in general."

In relation to Europe's PMI data from November, France we think is the worrying outlier, as indicated as well by Nomura from their recent note from the 21st of November 2013 entitled "Modest recovery ongoing as trend stabilises":

"In France the PMI data for November were disappointing, suggesting the economy is losing momentum. The composite output PMI was 48.9 (from 50.5 previously), the lowest reading in five months and consistent with the three-month moving average declining marginally to 49.8 from 49.9 in October. While almost negligible in size, the fall in the three-month moving average of the French composite index is the first in eight months and it points to some possible downside risks to our French GDP forecast of 0.2% q-o-q for Q4. 

The weakness in the French data was evident in the manufacturing and services sectors. The manufacturing PMI dropped to its six-month low of 47.8 in November from 49.1 previously (consensus: 49.5). There was no bright spot in the detailed report. In particular, manufacturing new orders fell by more than 2 points to 46.1, signalling little chance of revival in the sector in the near term. Moreover, new export orders dropped by 3.6 points to 48.5 and the employment index slipped to its five-month low at 48.2.

In the services sector, the headline index declined by 2 points to 48.8 (consensus: 51). One element of concern was the sharp 4 point fall in the employment service index to 46.7, which underpins the subdued nature of the recovery in France. The new business sub-index is the only bright spot in the services report, which rose to 49.3 from 48.5. However, it remained below 50, thus not sufficient to bring the sector out of contraction in the near term." - source Nomura

and Nomura to conclude their report:

"The data also show a greater divergence in economic performance between Germany and France, with the data for France confirming the services sector remains the laggard as we have highlighted in the latest edition of our business cycle positioning tool Galileo" - source Nomura

If indeed the services sector remains the laggard, then at some point the French president will have to stop being delusional about the probability of reversing the unemployment trend before year end. It will not happen.

Moving on to the subject of the possibility of a credit-less recovery in Europe, Bruno Cavalier from French broker Oddo, came-up with an interesting report on the 20th of November. We have long argued that no credit, meant no loan growth and no loan growth meant no economic growth and no reduction of budget deficits. In his note Bruno Cavalier argues that the argument relating to the possibility of having a recovery without bank lending is incorrect in his note. He indicates that the credit ratio to GDP has fallen from 55% since 2009 to 46%. Obviously this credit ratio varies tremendously from one European country to another. For instance, since the peak figure of 1st quarter 2009, it is down by 50% in Ireland, 30% in Spain and 20% in Greece.

EMU: Loans to the private sector - graph source Thomson Reuters, ECB, Oddo Securities:

EMU: Loans to the non-financial corporations - graph source Thomson Reuters, ECB, Oddo Securities:

Bruno Cavalier quotes a report that shows that out of 388 economic recoveries identified in 50 countries on several decade from researchers of the IMF (Abiad, Dell’Ariccia & Li (2011), “Creditless recoveries”, IMF working paper 11/58). They have established that one out of five recoveries is credit-less. He indicates that often, these credit-less recoveries have been preceded by financial crisis. The work of Abiad and Dell'Ariccia, shows that although credit might be constrained, a recovery is possible. Another study by the BIS, quoted by Bruno Cavalier (Takats & Upper (2013), “Credit and growth after financial crises”, BIS working paper 416), shows that in recoveries following a financial crisis, correlation between credit and growth are non-existent for the two first years following the crisis and turn slightly positive (but weak) in the consequent two years.

The on-going financial fragmentation in Europe can be seen in the differences in loan rates between core countries and peripheral countries - graph source Thomson Reuters, ECB, Oddo Securities:

Where we agree with Bruno Cavalier from Oddo Securities is the importance of tracking Bank Lending Survey which are done on a quarterly basis by the ECB. 

EMU: Credit conditions (z-score, supply & demand mixed) - graph source Thomson Reuters, ECB, Oddo Securities:

We argued in the past that the growth divergence between US and Europe were due a difference in credit conditions.

The divergence between US and European PMI indexes is all about credit conditions. This is why the US is ahead of the curve when it comes to economic growth compared to Europe. We have shown this before but for indicative purposes we will use it again, the US PMI versus Europe and Leveraged Loans cash prices US versus Europe - source Bloomberg:

The widest level reached since 2008, between both PMI indexes was 8.90. Whereas investor sentiment combined with an excess of demand over supply pushed the average price of S&P/LSTA Index loans up a quarter-point to a fresh post-credit-crunch high of 98.88 cents on the dollar in 2013.

Another survey we have been using specifically on France to track financial conditions has been a monthly survey in French published by the AFTE (Association of French Corporate Treasurers). In our conversation "The European crisis: The Greatest Show on Earth", we indicated:

"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."

In order to comprehend the opinion of French corporate treasurers on the evolution of banks' margins, the AFTE calculates a difference between the average interest rate applied to new corporate loans and the 3 months Euribor rate. The series below stopped in October and continue to indicate some stability in banks' margin on new corporate loans below one year. New credits above a one year maturity provided  to French corporate treasurers remains at elevated levels:

What has been improving though for French corporate treasurers according to the latest November survey is access to financing. There is a slight improvement in the latest survey, but conditions remain tough for French companies:

While the rebound from the lows of the end of 2011 (which was due to the acute liquidity crisis faced by the European financial system), the LTROs have somewhat improved financial conditions for French corporate treasurers, nevertheless conditions remain tough at -6.2% of negative opinions still.

The latest AFTE survey ties up with Bruno Cavalier's note indicating the difference of opinion between bankers and small to medium size enterprises (SMEs) treasurers. Bankers indicate a lack of demand, while corporate treasurers indicate that financial conditions are still too restrictive, too tight.

SMEs which cannot get or accept a bank loan because cost was too high - graph ECB, Oddo Securities:

Share of SMEs which only get part of the loan they ask for - graph ECB, Oddo Securities:

Bruno Cavalier in his note concludes that given the on-going fragmentation in Europe and the credit rationing that follows, it reflects three parameters, risk aversion, difficulties of refinancing for banks and the balance between their risks and recapitalization needs. While the ECB will remain accommodative and the upcoming Asset Quality Review (AQR) in 2014, he thinks we cannot expect a strong rebound for credit availability in the coming months or quarters, but as balance sheets get cleaned up, the following credit cycle that will follow should comfort the economic recovery.

Touching again on the subject of credit-less recovery, another paper from the World Bank published in May 2013 by Naotaka Sugawara and Juan Zalduendo entitled "Credit-less recoveries - Neither a Rare nor an Insurmountable Challenge" made some interesting points:

"Private sector credit plays a crucial role in helping a country to recover from an economic recession. For instance, credit provided by commercial banks can re-energize the investment expenditure of enterprises and is an important option in handling household finances. While a recovery without private sector credit is possible, the empirical evidence suggests that such recoveries occur at a much slower pace. Indeed, a credit-less recovery, defined as a recovery from recession without a pick-up in real bank credit to the private sector, is not an unusual event but has been observed both among advanced and emerging economies.1 Even with different samples, the literature tends to find that the share of credit-less recoveries is around 20 to 25 percent of all recoveries." - Naotaka Sugawara and Juan Zalduendo, Credit-less recoveries - Neither a Rare nor an Insurmountable Challenge

Growth Performance, eight quarters before and after trough - source Credit-less recoveries - Neither a Rare nor an Insurmountable Challenge:

"In both country groups, though especially in the group of advanced economies, growth rates two years (or, eight quarters) before a trough, t-8, are similar between credit-less and credit-with events. However, the growth gap gets wider and becomes quite noticeable at least a year (i.e., four quarters) prior to the trough t. In the year the recovery occurs, credit-less episodes experience slow growth rates; however, this gap narrows after a year from the trough. By eight quarters after the trough, growth in credit-less recoveries is 1.5 percentage point lower than that in credit-with recoveries in developed countries. For emerging markets, the growth gap is even wider four and five quarters after the trough, but it also narrows during the rest of the second year following the trough. As a result, the growth differential in the group of emerging markets ends up at broadly the same level as in advanced economies." - Naotaka Sugawara and Juan Zalduendo, Credit-less recoveries - Neither a Rare nor an Insurmountable Challenge

They concluded their paper with these points:

"Credit-less recoveries are neither rare nor insurmountable challenges. The empirical evidence suggests that such recoveries occur at a much slower pace and are only somewhat more common among emerging markets. But recoveries do eventually occur. In fact, economic performance is in large measure correlated with the depth of the correction triggered during the economic adjustment that precedes the trough; specifically, the size of the downturn and the extent of external adjustment that typically accompany a recession (from the current account adjustment to developments in exchange rates). Also, openness has a dual role. Trade openness decreases the likelihood of a credit-less recovery as trade is a more stable source of financing. Conversely, capital account openness might have a large impact by the deleveraging process that typically follows a recession. But one must also be careful as to what this implies for countries going forward as the pre-recession period might have also meant large benefits in terms of growth.

As to policies during the recession, policymakers must be aware that excessive fiscal loosening might end up exacerbating the likelihood of a credit-less recovery, though more research would be needed to understand better their medium- to long-term implications. In contrast, monetary policy seems to play a more beneficial role by not increasing the likelihood of a credit-less event, especially in advanced economies. Finally, the country choice to avail itself of an IMF-supported program is negatively correlated with the likelihood of a credit-less recovery. Seeking an IMF program tends to help countries recover with an increase in private sector credit. The relationship becomes statistically meaningful when the economic conditions at the trough are controlled for. 

And what can be concluded from the estimation about the likelihood of credit-less events in ECA? Here the model seems to suggest that indeed many countries in the ECA (Europe and Central Asia) region were likely to experience a credit-less recovery—and they indeed did. But one must also draw hope from the fact that investment—and presumably eventually growth—typically recovers 8 quarters after a trough. This would suggest that a credit-less recovery is not a reason for extreme concern. More worrisome is that the region is now facing a renewed negative external shock."

But when it comes to Europe, the situation is more complex due to the single currency than warrants the World Bank and Oddo Securities. In a Bruegel Policy Contribution of February 2013, the author Zsolt Darvas in his note entitled "Can Europe Recover Without Credit?" argues the following:

"Data from 135 countries covering five decades suggests that creditless recoveries, in which the stock of real credit does not return to the pre-crisis level for three years after the GDP trough, are not rare and are characterised by remarkable real GDP growth rates: 4.7 percent per year in middle-income countries and 3.2 percent per year in high-income countries.

• However, the implications of these historical episodes for the current European situation are limited, for two main reasons:

• First, creditless recoveries are much less common in high-income countries, than in low-income countries which are financially undeveloped. European economies heavily depend on bank loans and research suggests that loan supply played a major role in the recent weak credit performance of Europe. There are reasons to believe that, despite various efforts, normal lending has not yet been restored. Limited loan supply could be disruptive for the European economic recovery and there has been only a minor substitution of bank loans with debt securities."

• Second, creditless recoveries were associated with significant real exchange rate depreciation, which has hardly occurred so far in most of Europe. This stylised fact suggests that it might be difficult to re-establish economic growth in the absence of sizeable real exchange rate depreciation, if credit growth does not return." - Zsolt Darvas - Bruegel Policy Contribution.

One of the most important point which has sustained credit markets in Europe, has been the strong issuance levels in the bond markets and the arrival of new issuers due to the on-going deleveraging process of European Banks and the acceleration of "dis-intermediation" as large corporates become more reliable on bonds for financing rather than on bank loans which are generally more difficult to get due and service due to covenants. 

Zsolt Darvas made this very important points in his paper:

"Using US firm-level data, Becker and Ivashina (2011) interpret switching by firms from loans to

bonds as a contraction in credit supply, conditional on the issuance of new debt. They find strong evidence of substitution of loans by bonds during periods characterised by tight lending standards, high levels of non-performing loans and loan allowances, low bank share prices and tight monetary policy. They also find that this substitution behaviour has predictive power for bank borrowing and investment of small (out-ofsample) firms, which are not able to issue bonds.

In a related paper, Adrian, Colla and Shin (2012) also document the shift from loans to bonds in the composition of credit in the US, and argue that the impact on real activity comes from the spike in risk premiums, rather than contraction in the total quantity of credit. Gertler (2012) adds, by sketching a simple conceptual framework, that credit spreads are a more useful indicator of credit supply disruptions than credit quantities. Gertler (2012) cites Gilchrist and Zakrajsek (2012), who conclude that the increase in spreads during the recent financial crisis was likely symptomatic of unusual financial distress, and not just the reflection of the increased default risk faced by borrowers.

Certainly, the above-mentioned studies analysed data that was available at the time of writing and therefore their sample periods end between 2009 and 2011. Since then, a number of attempts were made by European governments and the European Central Bank to help restoring normal lending and therefore the finding that credit supply was limited up to 2009 or 2011 may not

necessarily imply that such limitations exit now as well. However, European banks still suffer from a large, €400 billion, capital shortfall according to the OECD (2013); the share of non-performing loans continues to be high; bank share prices are low even after the recent increases; and banks need to meet tight capital, liquidity and leverage requirements, even though some of the Basel III requirements were relaxed in January 2013 (Basel Committee, 2013). These factors suggest that credit supply may remain constrained in the EU." - Zsolt Darvas - Bruegel Policy Contribution.

We also agree with the author's final conclusion:

"If credit growth does not return, economic recovery may prove to be difficult in the absence of sizeable real exchange rate depreciation." - Zsolt Darvas - Bruegel Policy Contribution.

For illustrative purposes, we looked at Spain's non-financial loans versus GDP growth to illustrate the case of a the credit-less recovery discussed - graph source Bloomberg:

But Spain being in the colloquial "doldrums", namely a state of inactivity, mild depression, listlessness or stagnation, some of that air returns to the doldrums through the trade winds, could lead to light or variable winds and more severe weather, in the form of squalls, thunderstorms and hurricanes ahead in Europe, when one looks at the unemployment issues particularly hindering the economic prospects for peripheral countries.

One just has to glance casually at the Spanish "Misery" index to fathom the uphill struggle face by our European politicians - graph source Bloomberg:

The misery index is calculated by adding the 12-month percentage change in the consumer price index to the jobless rate. Arthur Okun, an adviser to Presidents John F. Kennedy and Lyndon Johnson, created the indicator in the 1960s.

So for us, unless our  "Generous Gambler" aka Mario Draghi goes for the nuclear option, Quantitative Easing that is, and enters fully currency war to depreciate the value of the Euro, there won't be any such thing as a "credit-less" recovery in Europe and we remind ourselves from last week conversation that in the end Germany could defect and refuse QE, the only option left on the table for our poker player at the ECB:

"The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in German's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe."
 

On a final note, we think the outlook for the US could be further boosted by fall in Oil imports, making the exit strategy for the Fed as difficult as it was for the team of Apollo 13 and the heroin of visually stunning movie Gravity to land back to earth - graph source Bloomberg:

"U.S. oil imports are close to a 22-year low, a trend that is expected to continue through 2014 from increased domestic shale drilling. About 10.5 million barrels a day were imported in 2005, with about 8.5 million barrels coming from seaborne trade. That number has decreased to 5 million barrels, according to Teekay Tankers. Crude tanker ton-miles will decline, though product tankers should benefit from an increase in U.S. refined exports." - source Bloomberg.

"Happiness, to some, elation; Is, to others, mere stagnation." - Amy Lowell, American poet.

Stay tuned!

Credit - Cold Turkey

"Every form of addiction is bad, no matter whether the narcotic be alcohol or morphine or idealism." - Carl Jung 

While listening to future Fed in Chief Janet Yellen first public appearance as nominee to succeed Fed Chairman Ben Bernanke in front of the Senate Banking committee, who:

-could "see no evil" when questioned about the housing market:

"a rational response by the market" - Janet Yellen

- source Bank of America Merrill Lynch - The Thundering Word - 13th of November 2013.

and also added:

“I don’t see evidence at this point, in major sectors of asset prices, misalignments,”- Janet Yellen

- could "hear no evil" about QE being an elitist policy, favoring those holding financial assets failing to trickle down to Main Street:

“Stock prices have risen pretty robustly but if you look at traditional measures,” such as price-earnings ratios, “you would not see stock prices in territory that suggests bubble-like conditions,” - Janet Yellen

"Global stocks are annualizing 22% gains in 2013 (versus -2% for bonds, and -6% for commodities). Wall Street's boom in recent years has been caused by Main Street's bust and a “High Liquidity-Low Growth” regime." - source Bank of America Merrill Lynch - The Thundering Word - 13th of November 2013.

- could "speak no evil":

“Although there is limited evidence of reach for yield, we don’t see a broad buildup in leverage, where the development of risks that I think at this stage poses a risk to financial stability.” 

and added:
"It could be costly to fail to provide accommodation (to the market)". - Janet Yellen

- source Bank of America Merrill Lynch - The Thundering Word - 13th of November 2013.

she also said:

"I don’t think the Fed should be a prisoner of the market," - Janet Yellen

Given we are coming closer to "Thanksgiving Day" which is a national holiday to celebrate primarily in the United States and Canada as a day of "giving thanks" for the blessing of the harvest and of the preceding year, no doubt Wall Street could indeed be giving thanks for the blessing of QE and the Fed's unaltered generosity, which will of course continue in the near future, be rest assured.

So you might already see the relationship with this week chosen title in relation to upcoming "Thanksgiving Day". 

Our title is a clear reference to the addiction to QE as it seems the current Fed leadership and the future Fed leadership has no "appetite" for "cold turkey" as posited by the astute Christopher Wood from CLSA:

"There is no benign exit from QE and that the Fed is in a trap of its own making in the sense that stronger data will lead to renewed tapering concerns, leading to a tightening in financial conditions and a resulting reluctance on the part of the central bank to taper. In this respect, the correct analogue remains that of a heroin addict. The tapering concerns are the equivalent of withdrawal symptoms. Obviously, it is possible to exit an addiction if the addict is willing to go through “cold turkey”. But GREED & fear’s base case is that the current Fed leadership has no stomach for “cold turkey”." - CLSA - Christopher Wood - Greed and Fear - 14th of November 2013

Nota bene: "Cold turkey" describes the actions of a person who abruptly gives up a habit or addiction rather than gradually easing the process through gradual reduction or by using replacement medication." 

In the case of dependence upon certain drugs, including opiates such as heroin, going cold turkey may be extremely unpleasant, but less dangerous. Life-threatening issues are unlikely without a pre-existing medical condition." - source Wikipedia.

On a side note we chuckled when the future of the Fed stated the following in relation to Gold:

“Well, I don’t think anybody has a very good model of what makes gold prices go up or down,” - Janet Yellen.

It seems to us that Janet Yellen seems oblivious to "Cantillon Effects", and the return of the Gibson paradox, and as far as "tapering" is concerned we think that "the Buying will continue until moral improves" but we ramble again:

“A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases” - Janet Yellen

While everyone has been focusing on the Fed's "tapering" stance since May 2013, for us the "real game changer" in 2013 has no doubt been the true elephant in the room, namely Japan's truly aggressive reflation policy. Therefore this week, we will focus our attention back to Japan.

Japan has already been the subject of numerous posts already on Macronomics, such as "Big in Japan", "Japan - the rise of the Kagemusha", "If at first you don't succeed..." or  "Have Emerging Equities been the victims of currency wars?".

Of course when one looks at the relative performance of the MSCI Emerging versus the S&P 500, one can easily see that EM equities have been clearly lagging. Emerging markets (MXEF) have underperformed the S&P 500 - source Bloomberg:

But as we posited in early 2013, Emerging Markets have indeed been the victim of "Abenomics" given in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off.

It has clearly been the case for Emerging Markets which have been lagging as well the surge in the Nikkei index - graph source Bloomberg:

The aggressiveness in the reflation trade has once again been further illustrated by Friday's price action, which saw the Nikkei surge by 1.95% and the Topix by 1.68% - graph source Barclays / Bloomberg:

"UNSTOPPABLE! NKY went up another 2% pushed by USDJPY going through 100. Intraday was one way: NKY opened up 75bps to close up 1.95%. With realized volatility going higher and high demands for options from clients, VNKY remained elevated at 25.6. The volatility curve went up sharply today again with high correlation to the cash spot. 1Y +1.2% 5Y +0.5%. Option market was very busy as each move up of spot was triggering volatility moves. We saw a lot of interests on calendar spreads, call ratios and skew. Long term volatility remained well bid as Structured Products desks are looking to buy back volatility in the rally. Client flows were active: lot of interests in 2014 upside calls from Jan14 to Dec14. We saw a lot of risk reversal crossed on the exchange for clients getting exposure on the upside. At this level even if Bollinger bands & RSI suggest NKY is overbought, we should expect NKY to go higher and test the 16,000 level again very soon. Interesting to notice the dynamic between rates, FX and Equities at the moment. We saw a large drop in JGB around the close, triggering some weakness in USDJPY (yield adjustment)." - Barclays 

Dynamic between FX and Equities? Of course there is! As illustrated by this Bloomberg graph displaying the not only the surge of the Nikkei and the weakness in the USD/JPY but also the reverse Itraxx Japan CDS index:

And went it comes to expect more from the Nikkei until at least the end of the year, this is as well validated by the fall in the Nikkei 3 month 100% Moneyness Implied Volatility and the fall in the Itraxx Japan, representative of the credit risk perception for corporate Japan - graph source Bloomberg:

As per our January conversation, "If at first you don't succeed...", once again we will slightly break our Magician's Oath.
As a reminder on the Magician's Oath:
"As a magician I promise never to reveal the secret of any illusion to a non-magician, unless that one swears to uphold the Magician's Oath in turn. I promise never to perform any illusion for any non-magician without first practicing the effect until I can perform it well enough to maintain the illusion of magic."

Back in January we argued:
"We have to confide, that since our October post, we have continued "practicing" the effect of our magicians "secret illusions" by having been short JPY against USD (via proshare ETF YCS) and we have been as well long Nikkei but in Euros via a quanto ETF (currency hedged) but until you all become magicians, we have to stop revealing tricks unless, of course, dear readers, you all swear to uphold the Magician's Oath in turn*, but we ramble again..."

When it comes to going long Nikkei but in Euros, we must confess, we have been adding again. Reason being, and on that point we agree with Exane's note from the 8th of November entitled "The end", is that Japan might be high risk but worth it for now:

"Overweight Japan- but currency hedged

If markets have at times fought the Fed this year, and driven Treasury yields up, it looks very unwise to fight the Bank of Japan – that is busy hoovering up 70% of JGB issuance. Economic momentum in Japan looks robust – with little real obvious test to that momentum prior to the sales tax increase in April. If the economy suffers as a result of April’s tax change, the BoJ has stated its intention to respond with increased monetary stimulus.

Looking into Q1, if the USD strengthens as a result of tapering, the Yen looks one of the currencies liable to weaken as a result. A fall in the real effective exchange rate should feed back into more supportive domestic liquidity conditions. For us, the Yen still looks materially overvalued.

While the Japanese equity market has re-rated significantly over the last year, it still does not look particularly expensive and remains on course to provide one of the big earnings growth stories of 2014. We like the market on a currency-hedged basis." - source Exane

While Exane like the Japanese market on a currency-hedged basis, we like it too as the Nikkei keeps going one way with higher conviction, more volumes (highest in last 3 months) and more inclusive client/investor participation. JPY cemented 100 level as a strong support and went as high as 100.4 in the evening session. We have been liking it since January this year.

Furthermore Exane added on Japan the following points:
"After 6-months consolidation, corporate earnings have grown into share prices. Valuations are reasonable, and there is still plenty of upside to the earnings base. We see the Yen headed south and equity prices north.

From setting the investment world on fire in the first 5-months of the year, Japan has morphed into something of a forgotten story over the last 5-months. USDJPY has traded sideways over this period, as has the Nikkei. And after May’s spike higher, the 10-year JGB yield is back at April’s levels too.

After such an aggressive price move earlier in the year, a period of consolidation is understandable. But this has allowed the Japanese market’s earnings base to grow into the pricing move. EPS for the MSCI Japan is on course to advance almost 60% in 2013.

The dynamics of the Japanese equity market, as they stand on consensus numbers looking into 2014 are summarised in the following table:

Of course a large component of the Japanese policy framework involves weakening the Yen. This is an obvious and clear benefit to the Japanese corporate sector with a positive direct translation impact on overseas earnings and also potentially the secondary transaction impact – whereby improved Japanese competitiveness leads to market share gains. The following chart shows that the Japanese equity market’s EPS forecast has followed the path of USDJPY over the course of the last year:

The currency support for the Japanese economy, Japanese stock prices and for the earning base of Japanese companies is unequivocal. And in our view this is likely to go materially further than we have seen to date.
As the US cycle matures the downward pressure on the Yen is likely to intensify. The BoJ is likely to hold bond yields lower via direct asset purchases at a time when the US backs out of QE. Further as the Japanese start to have some success in creating a degree of inflation, the real yield on Japanese government debt is likely to fall.

As we show in the following chart the yield premium on 2-year JGBs deflated by CPI over the 2-year Treasury deflated by US CPI has captured pretty well the big directional moves in USDJPY. With the ‘real yield’ on 2-year JGBs likely to fall and the real yield on 2Y US bonds potentially rising this clearly points to downward pressure on the Japanese currency. That should feed straight back in to supporting Japanese shares.

Put simplistically we fail to understand how a 20% fall in trade-weighted Yen fully reflects the central bank’s commitment to double the monetary base. There must be, to our minds at least, further to go in this trade.

From a valuation standpoint, the rehabilitation of the Japanese economy combined with the boost to export earnings is helping the Japanese corporate sector lift ROE. The 12- month forward ROE – using consensus forecasts – has now reached nearly 9%. The uplift in the price-to-book value has been substantive – and now stands at around 1.2x 2014F." - source Exane

While some recent "trade fatigue" did materialized in recent months on the Japan rocket "lift-off", we think that we are in an early second stage for the Multistage Japan rocket:
"A multistage (or multi-stage) rocket is a rocket that uses two or more stages, each of which contains its own engines and propellant. A tandem or serial stage is mounted on top of another stage; a parallel stage is attached alongside another stage. The result is effectively two or more rockets stacked on top of or attached next to each other. Taken together these are sometimes called a launch vehicle. Two stage rockets are quite common, but rockets with as many as five separate stages have been successfully launched. By jettisoning stages when they run out of propellant, the mass of the remaining rocket is decreased. This staging allows the thrust of the remaining stages to more easily accelerate the rocket to its final speed and height." - source Wikipedia

On that point we agree with Exane's take for more Japanese upside:
"Potential catalysts
The underpinnings of the Japanese equity story are still there. It seems to us more likely the market has just got a little trade fatigue. In this respect, there are potential catalysts on the horizon that can re-create a degree of enthusiasm.
First, most clearly the sales tax increase of next April is seen by many economists as likely to prompt an acceleration in the pace of central bank asset purchases. That should clearly be helpful for the assets bought directly – but also in suppressing bond yields and forcing yield-seeking investors up the risk curve. Furthermore, this is likely to put more downward pressure on the Yen that should feed back into enthusiasm for the earnings prospect of Japanese companies. The stock market should respond.
Second, the missing link in the Japanese story this year has been some evidence that labour market reforms – a key component of PM Abe’s third arrow – can be pushed through the Japanese parliament. This is clearly the most controversial and politically difficult element of the policy suite. While so far Mr Abe has chosen to use his bullets on politically easier reform measures, progress on labour markets would be seen as a particularly important development by international investors." - source Exane

We don't see Japanese going "cold turkey" for the time being hence our stance.

Of course given everyone and his dog has been focused as of late on the "magician tricks" from the Fed, we would have to agree with David Bowers take in the Financial Times in his article from the 13th of November entitled - Monetary shock from Japan eclipses Fed taper concerns :
"If you cannot see the wood for the trees, then how do you expect to see the elephant in the room? One of the casualties of the market’s obsession with the Federal Reserve’s monetary easing “non-taper” has been a loss of perspective. The world has forgotten that the real monetary shock of 2013 has been the change in policy by the Bank of Japan. 

In the words of the Bank for International Settlements’ annual report, when the world’s third-largest central bank decides “to double the size of its monetary base, double its holdings of Japanese government bonds and exchange traded funds and more than double the average maturity of its government bond purchases”, investors ought to sit up and take note, especially when it comes with a 20 per cent currency depreciation. 

This is “unilateral QE” with a vengeance – of a similar magnitude to the Fed’s QE3 but applied to an economy a third the size of the US. Japanese monetary policy is never going to be the same again, with consequences that will extend beyond Japan’s borders. 

The main reason why Japan is still a sideshow in the minds of investors is because that is exactly where it has been for the past 20 years. Many asset managers have only known Japan as a taker, rather than a maker, of the global narrative. The sharp rise in the Nikkei in the first few months of this year may have been impressive, but it is the seventh occasion in 21 years when the market delivered six-month returns in excess of 30 per cent; the previous six were all false dawns." - source David Bowers Financial Times - Monetary shock from Japan eclipses Fed taper concerns.

"Have Emerging Equities been the victims of currency wars?" we wondered in March 2013:

"If Mr Kuroda is indeed serious about "reflating" in this on-going currency wars, the "rise of the Kagemusha", no doubt, represents a serious headwind for some Emerging Markets in general and their equities in particular."

It seems that David Bowers is indeed confirming our Pareto efficient economic allocation concept where no one can be made better off without making at least one individual worse off, in that case Emerging Markets:

"This year, many investors have chosen to focus on the strategic risks facing emerging markets instead. Over the past three years, EM equities have underperformed the global benchmark by almost 30 per cent, confounding the conventional wisdom. Fed tapering has been the catalyst for this soul-searching. But this year’s underperformance is in part due to Japan. 

One of the consequences of the BoJ’s policy shift has been to weaken the yen and boost the dollar. In recent years, dollar strength has been associated with soft commodity prices and weak pricing power in the traded goods sector. That has hurt emerging markets with their high exposure to commodities and global supply chains. 

In short, the initial impact of Abenomics has been to export deflation to the rest of the world. This can also be seen in the lower-than-expected inflation rates in the US and eurozone. These are the unintended consequences of the BoJ’s actions. You may not want to invest in Japan, but you do have to understand that it matters enormously whether Abenomics succeeds or fails. 

The initial shock may have been deflationary; but it could yet turn out to be reflationary if Japan succeeds in getting companies to save less and invest more. Japanese corporates have run themselves for cash rather than for growth; their saving has been the counterpart to the government’s borrowing. Were we to see double-digit capex growth next year – led by the non-manufacturing sector – the labour market would tighten to a point where real wage growth returns." - source David Bowers Financial Times - Monetary shock from Japan eclipses Fed taper concerns.

We also have to agree with David Bowers from Absolute Strategy Research, Japan is the real elephant in the room:
"For the past quarter of a century monetary policy has been run for creditors, not debtors. That favoured instruments such as Japanese government bonds. But if the BoJ succeeds in generating sustained inflation then the asset allocations of the past 20 years could quickly become obsolete. The launch of the Nippon Individual Savings Accounts, and the review of public pension funds’ asset allocation, are important developments. 

Japan has been practically invisible for the past two decades, a passive bystander to China’s rise. But Japan’s moves clearly have the potential to disrupt the Asian narrative. If Japan recovers, it would provide a new source of final demand for the region; if it fails, then the risk is it exports more deflation via further yen depreciation. It would be ironic if Japan’s attempt to reform ended up destabilising China’s own reform process. The stakes could not be higher."  - source David Bowers Financial Times - Monetary shock from Japan eclipses Fed taper concerns.

We would recommend you closely monitor Japan's foreign bond buying spree. Nomura in their 14th of November note indicated the following when it comes to foreign bond buying:

"Japanese investors were net buyers of foreign bonds last week for the fifth consecutive week. Net buying totalled JPY357bn (USD3.6bn), increasing slightly from JPY277bn the previous week. The strong US NFP data and following rises in US yields are likely to have increased expectations of a weaker JPY, encouraging Japanese investors to invest in foreign bonds" - source Nomura

Also, Nomura added:

"Retail investment in domestic and foreign assets via toshins remains stronger than the past five-year average, according to NRI"

- source Nomura

Furthermore, in another report Nomura also made the following points:

"Retail investors. risky asset investment activities via toshins have accelerated since the early 2000s, and they have preferred foreign assets to domestic assets owing to higher income returns. The foreign asset share of total toshin outstanding is now above 50%, but it was below 20% in 2000 (Figure 2). 

Thus, it is unsurprising that the liquidation of toshins before the capital gains tax hike is a bit concentrated in foreign assets selling. As a result, net purchases of foreign securities via toshins may continue to lag net buying of domestic assets by year-end.

At the same time, foreign investment activity via toshins has not been meaningfully weaker than the previous five-year average, even though the scheduled capital gains tax hike may be depressing momentum. Furthermore, total buying of domestic and foreign securities via toshins remains net positive, showing strong underlying momentum of toshin investment. The job market remains strong, while winter bonuses at large Japanese companies are estimated to have risen by 5.8% from a year ago, the biggest increase since 1990, according to a survey by business lobby Keidanren. Strong risk appetite supported by better income conditions, combined with the introduction of NISA next January, is likely to accelerate foreign investment activity via toshin next year." 

- source Nomura

As we posited in the "Coffin Corner" back in Europe, the aggressiveness of the Japanese reflationary stance spells indeed more deflation for Europe and we think the US will as well withhold its tapering stance, spelling more trouble ahead, unless the ECB of course decides to engage as well in a QE of its own:

"Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think." - Macronomics - 27th of April 2013.

On a final note the Euro curse is clearly illustrated by Bloomberg's recent Chart of the Day showing that the Euro remains the best performer this year:

"The European Central Bank’s surprise cut in interest rates last week failed to dislodge the euro from its position as 2013’s best-performing major currency, a potential blow to the region’s nascent recovery.

The CHART OF THE DAY shows the euro strengthened 6.2 percent this year, the biggest gain among 10 developed-nation currencies tracked by Bloomberg Correlation-Weighted Indexes.

That’s a reversal from four years of declines as the sovereign debt crisis engulfed the 17-nation currency bloc. The dollar appreciated 4.4 percent this year, while the yen slumped more than 10 percent, the indexes show.

The euro surged as the region exited its longest recession on record and central banks in the U.S. and Japan pursued bond-buying programs that tend to debase their currencies. While ECB President Mario Draghi said the exchange rate wasn’t part of the ECB’s decision to lower its main refinancing rate, French Industry Minister Arnaud Montebourg said on France Inter radio yesterday the currency is too strong. Inflation fell to the least in almost four years last month.

“Draghi knows his ability to control and steer the euro is woolly at best,” said Jane Foley, a senior currency strategist at Rabobank International in London. “Although he did say that the euro was not discussed in the policy meeting, it’s very clear that when you fight disinflation you really do want a weaker currency. The relief that the crisis is over has created another problem, which is a better euro.”

The euro traded at $1.3417 as of 4:14 p.m. London time on the 13th of November, after climbing to $1.3832 on Oct. 25, the highest since November 2011. The correlation-weighted indexes show the currency gained 1 percent since Nov. 7, the day the ECB cut its benchmark rate to a record 0.25 percent as predicted by only three of 70 economists in a Bloomberg News survey." - source Bloomberg

"A moderate addiction to money may not always be hurtful; but when taken in excess it is nearly always bad for the health." - Clarence Day, American author.

Stay tuned!

Credit - Squaring the Circle

"Evolution has long been the target of illogical arguments that use presumption." - Marilyn vos Savant 

While listening to Olli Rehn's recent comment relating to Greece, and seeing France's latest rating cut to AA, with aggravating industrial production pointing to a weaker GDP going forward, we reminded ourselves of the famous problem proposed by ancient geometers for this week's chosen title namely "Squaring the Circle".

“I’m sure that we will be able to find a satisfactory solution as regards to how to ensure the fiscal gaps will be filled and the fiscal targets will be met.” - Olli Rehn

The different steps taken to resolve the inadequacies of the euro have been strikingly similar with the problem proposed by ancient geometers, namely "Squaring the Circle" being the challenge of constructing a square with the same area as a given circle by using only a finite number of steps with compass and straightedge.

Although in 1882, the task was proven to be impossible, as a consequence of the Lindemann-Weierstrass theorem proving that pi is transcendental, rather than an algebraic irrational number, it did not prevent an amateur eccentric crank by the name of Dr. Edwin J. Goodwin to try to brace mathematical immortality by trying to have the legislature in Indiana in 1897 to redefine the value of pi through House Bill 246! We kid you not. It would have enabled the brave Dr Goodwin to solve the aforementioned problem of "squaring the circle".

In similar fashion to the brave Dr Goodwin, our European politicians such as Olli Rehn are trying to finalize the construction of the Euro through a "finite number of steps", and on that note we think about the upcoming AQR (Asset Quality Review) and the willingness of European politicians to secure the creation of a European Banking Union, through legislature.

By that point you are probably asking yourselves where we are going with all this but, our fondness for behavioral psychology reacquainted us with one of our past quote following our "Generous Gambler" aka Mario Draghi latest rate cut stunt:

"The greatest trick European politicians ever pulled was to convince the world that default risk didn't exist" - Macronomics.

In this week's conversation we will focus our attention once more on Europe and the impossibility of "Squaring the Circle" even through European Banking Union.

Our European "deceiver in chief" has pointed out the improving credit conditions in the money multiplier - graph source Bloomberg:

"ECB President Mario Draghi noted in comments following a rate cut that euro zone fragmentation had been improving from mid-2012, though progress halted three to four months ago. This echoes a north-south divide in wholesale bank funding costs that has again widened. Further, the money multiplier demonstrates how the flow of credit had begun to improve from mid-2012. September's 7.7x figure is the first month in a year that the multiplier has contracted." - source Bloomberg.

The issue of course is that, given the pending AQR, the Euro zone contraction in excess liquidity could no doubt counter the wishes of our European "generous gamblers" we think - graph source Bloomberg:

"Excess liquidity in the euro zone bank system is considered tight when below 200 billion euros ($267 billion) and a sustained period below this level has driven interbank rate increases in prior cycles. Even as the ECB has cut its main refinancing rate, which may lead to a steeper yield curve and income boost for some banks, an increase in wholesale funding costs could offset this. Euro zone excess liquidity may also fall as banks withdraw ECB deposits to reduce leverage."  - source Bloomberg.

Arguably what has been most beneficial as of late for European exporters has indeed been the proverbial "sucker punch" delivered by the surprise rate cut by the ECB on Thursday to 0.25% on the Euro currency versus the US dollar - graph source Bloomberg:

But, we have long argued that the previous LTROs amounted to "Money for Nothing". The latest round of "generosity" courtesy of the rate cut by the ECB will only favor more of the same, namely more carry trades for peripheral banks which have been gorging themselves with government bonds from their respective countries with the help of the two previous LTROs as displayed by the below Bloomberg table:

"A fringe benefit from today's ECB rate cut, beyond signaling an aggressive stance and longer-term low-rate environment, may be a steepening of the yield curve. Regionally, at 10.2% of bank-system assets, Italian banks have the greatest sovereign-bond exposures with 422 billion euros ($564 billion). They are followed by Spanish lenders at 312 billion euros (9.5% of assets) as at the end of September. Any steepening may benefit interest income." - source Bloomberg.

So we think that the willingness through "legislature" in severing the link between European sovereigns and their respective financial institutions amounts to "Squaring the Circle" in true Dr Goodwin fashion hence the path for this week's chosen title.

Throughout our numerous conversations, we have argued about the deflationary forces at play and the raging battle attempted by central bankers to ward off the threat of deflation. It is a losing battle we think when one looks at the crumbling inflation in Europe as displayed by Bloomberg Chart of the Day from the 6th of November:

"The CHART OF THE DAY shows the five-year consumer-price swap rate declined to 1.34 percent on Nov. 1. That’s within one basis point, or 0.01 percentage point, of the level reached in June last year, which was the lowest since December 2008 and was followed by a 25-basis point reduction in the ECB’s main refinancing rate the following month. Reports today showed euro-area services output rose in October and German factory orders increased in September. “Despite the recovery, there’s still a lot of slack in the euro-zone economy,” said David Mackie, chief European economist at JPMorgan Chase & Co. in London. “If the ECB doesn’t respond to falling prices, people will worry about its commitment to meeting its medium-term objectives. The risk is that inflation expectations will fall further and create problems for them.”" - source Bloomberg.

For those who have been following us, you know that like any good cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content. As we indicated in our conversation "The Dunning-Kruger effect": 

Not only do our central bankers suffer from the Dunning-Kruger effect but they are no doubt victim of the well documented "optimism bias" which we discussed in our "Bayesian Thoughts" conversation:

"Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, we underrate our chances of getting divorced, being in a car accident, or suffering from cancer. We also expect to live longer than objective measures would warrant, overestimate our success in the job market, and believe that our children will be especially talented. This phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics."

Tali Sharot - The optimism bias - Current Biology, Volume 21, issues 23, R941-R945, 6th of December 2011.

When it comes to "optimism bias", the surprised rate cut by the ECB was indeed a proper demonstration given only 3 out of 70 economists had predicted a rate cut of 0.25% on Thursday but we ramble again...

After all, one only need to look at the German 2 year yield to realize that credit wise Europe is indeed turning Japanese. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes indicative of the deflationary forces at play we have been discussing over and over again - source Bloomberg:

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation which is what we are seeing in Europe and what a 0.7% inflation rate is telling you hence the ECB rate cut this week. It is still the "D" world (Deflation - Deleveraging).

As pointed out previously by our friend Martin Sibileau (who used to blog on "A View From The Trenches"), here is a reminder from his work which we quoted in our conversation "The law of unintended consequences" in Macronomics on the 25th of January 2012:

"With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance."  - Martin Sibileau

Europe's horrible circularity case - Martin Sibileau

By tying itself to Europe via swap lines, the FED has increased its credit risk and exposure to Europe:
"If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU." - Martin Sibileau

As a side note and in relation to the EU private sector seeking USD funding as displayed in Martin's chart above, in 2012 over a third of the US Investment Grade supply (net issuance in $430 billions) was from non-US issuers up from 25% in 2011. This year we have seen about a third of the new issuance from non-domestic issuers (estimated net issuance for 2013 $400 billions).

As we have argued in "Mutiny on the Euro Bounty" in April 2012:

"More downgrades mean more margin calls, more margin calls means more liquidation and more Euros being bought and dollars being sold, with a growing shortage of AAA assets, Europe is moving towards mutiny on the Euro Bounty ship..."

Unless of course Mario Draghi goes for the nuclear option, Quantitative Easing, that is.

And as indicated by Martin Sibileau from his note from the 17th of October "The EU must not recapitalize banks":

"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."

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."

When it comes to the growth divergence between the United States and Europe ("Growth divergence between US and Europe? It's the credit conditions stupid...", it is all about Stocks versus Flows. We posited the following in various conversations:

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

As the ECB approaches the zero bound boundary in its "easing" process, the only tools left will of course will have to be "unconventional" as pointed out in our conversation "Fears for Tears" in August:

"Should Mario Draghi feel the urge to trigger is "nuclear" device, it will have to be "Brighter than a Thousand Suns", to quote, J. Robert Oppenheimer...

Oh well..."

The interesting issue as of late when it comes to the AQR and banks recapitalization in Europe is that Germany firmly opposes the use of the ESM for that specific purpose. Excluding the ESM from financing the winding down of troubled banks will raise the problem of a financial backstop for the SRM (Single Resolution Mechanism), possibly delaying its proper operation for years, which from our point of view is interesting as we think that Germany in the end will be the country putting the nail in the coffin for the Euro experience as we indicated in our conversation "Eastern promises" on the 9th of June:

"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed."

Squaring the Circle cannot be solved and the vicious cycle of banks and sovereigns cannot be solved either by a European Banking Union on its own.

Angela Merkel in this "Game of Century", while only appearing to be making material sacrifices, has managed to keep most of Germany's liabilities unchanged. So delaying the proper operational prospects for the SRM is in fact the application of what we said in our Chess analogy used in our "Game of Century" conversation in July 2012:

"In respect to the recent European summit, if European countries such as Italy, Spain and France gang up on Germany and ask for material changes in the rules and treaties of the "chess game" being played, we believe that "the only possible Nash equilibrium for Germany will be to defect""

Interestingly, Ambrose Evans-Pritchard from the Telegraph, in his article from the 4th of November entitled "Italy's Mr Euro urges Latin Front, warns Germany won't sell another Mercedes in Europe" reported on possibility of "Mutiny on the Euro Bounty":

"The plot is thickening fast in Italy. Romano Prodi – Mr Euro himself – is calling for a Latin Front to rise up against Germany and force through a reflation policy before the whole experiment of monetary union spins out of control.

"France, Italy, and Spain should together pound their fists on the table, but they are not doing so because they delude themselves that they can go it alone," he told Quotidiano Nazionale

Should Germany persist in imposing its contractionary ruin on Europe – "should the euro break apart, with one exchange rate in the North and one in the South", as he puts it – Germany itself will reap as it has sown. "Their exchange rate will double and they will not sell a single Mercedes in Europe. German industrialists know this but all they manage to secure are slight changes, not enough to end the crisis."" - source The Telegraph.

As a matter of fact funding for the ESM is capped at 700 billion euros and Germany is responsible for contributing about EUR190 billion by next April to the program but there is a snag. While the German Constitutional court has no legal authority on the ECB, it does have authority over the German parliament when it comes to committing German money to European programs (ESM and OMT included) given a debt of the ESM is a contingent liability of all the non-bailed out Eurozone countries.

As far the "optimism bias is concerned, a majority of analysts believe the German Constitutional court will allow the OMT to stand on the basis that EU treaty allows for purchases in the secondary bond market. We beg to differ. 

Once a debt is a contingent liability, for instance "super senior" there is no turning back, but the ESM being capped and the OMT yet to be firmly backed by Germany, the nuclear option is still an option rather than a reality.

We quoted Dr Jochen Felsenheimer in our conversation "The Unbearable Lightness of Credit" in August 2012, let us do it again for the purpose of the demonstration:

"The advantage of explicit guarantees is that the market can value them and that the guarantee can be taken up - even in a crisis! For this reason, we can quote the "last man standing" at this point, the president of the German Federal Constitutional Court, Andreas Vosskuhle:"The constitution also applies during the crisis". That is a hard guarantee, both for politicians and for investors!"

We will not discuss the issue of implicit guarantees and explicit guarantees from a credit valuation point of view as we have already approached this subject in our conversation quoted above. The only point you should take into account is that the advantage of explicit guarantees is that markets tend to "function" better under them. Obviously our great poker player "Mario Draghi" at the helm of the ECB has played with his OMT a great hand but based only on "implicit guarantee". That's a big difference.

An illustration on how distorted market can become when taking advantage of "explicit guarantees" has been the European car industry. We have extensively covered the subject as an illustration of the deflationary forces at play back in April 2012 in our conversation "The European Clunker - European car sales, a clear indicator of deflation" for those of you who would like to go deeper into the analysis. More recently, the effect of the latest Spanish Cash-for-Clunkers to support 70,000 new cars is illustrative of "explicit guarantees" we think as pointed out in the Bloomberg table below:

"Spain plans to support 70,000 new-car purchases under the fourth cash-for-clunkers scheme it has introduced in a year. Buyers will get 2,000 euros ($2,700), evenly funded by the government and dealer, when trading in a car between seven and 10 years old, and buying a new, more fuel-efficient vehicle costing up to 25,000 euros. Spanish auto sales through September were 51% below the average for the same period in 2000-07." - source Bloomberg.

Markets being extremely feeble creatures in the face of uncertainty will obviously react "rationally" when it comes to being provided with "explicit guarantees".

Obviously the lack of German Constitutional support could indeed prevent the whole "whatever it takes" European moment from moving from the "implicit guarantees" towards more "explicit guarantees" we would argue.

As pointed out by Bloomberg editors in their column from the 6th of November 2013 entitled "Europe's unfinished business threatens another recession",the European Banking Union is a must have. For us Europe is just trying to "Square the Circle:

"The most important stalled reform is in banking. Another round of bank “stress tests” has just been announced -- and this time, the ECB says, it’s serious. But there’s still no agreement on what happens to the banks that fail the tests. It’s universally agreed that the euro area needs not just a single bank supervisor -- which it now has in the form of the ECB --but also a single bank-resolution mechanism. That won’t fly, because Germany and like-minded countries won’t hear of bailing out failing banks or their financially stressed national governments.

This reluctance is understandable. But without a single bank-resolution mechanism, the euro project remains fatally flawed. The toxic link between distressed banks and distressed governments will remain. So long as that’s true, recovery will be held back and the euro area’s supposedly integrated capital market will be at risk of further splintering into separate zones. If the euro is to survive and its member countries prosper, a real banking union is indispensable." - source Bloomberg

The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in German's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe.

On a final note, and in relation to "markets" going forward, in our conversation "The Cantillon Effects", we indicated of one of our "outside the box indicator" namely Sotheby's stock price versus world PMIs since 2007 - graph source Bloomberg:

We have argued that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months.

It was interesting to see Sotheby’s stock price being down as much as 4% on the 6th of November, most intraday since Aug. 7, to lowest since Oct. 15, on 71% avg 3-mo. vol. as other auction house Christies flopped for a second consecutive night on the 6th of November in New-York with top-priced lots by Picasso, Modigliani and Leger failing to find buyers as reported by Bloomberg by Katia Kazakina and Philipp Boroff:

"Last night’s sale “also suffered from overestimation on several of the top lots,” said art adviser Mary Hoeveler. “Buyers don’t need to be told when something is a ‘masterpiece.’”

Alberto Giacometti’s portrait of his brother Diego, estimated at $30 million to $50 million, didn’t attract a bid in the room or on phone banks.

The painting was guaranteed by an undisclosed third party before the sale and the guarantor took it home for $32.6 million, a record for a Giacometti painting. Prices include commissions. Estimates do not.

The 1954 piece was sold by Jeffrey Loria, an art dealer and owner of the Miami Marlins baseball team, according to a state regulatory filing." - source Bloomberg.

So there you go the "explicit guarantee" did indeed lead to a sale in the end for Giacometti's portrait of his brother Diego, but we would not call this a "functioning market", somewhere, somehow someone took a hit.

As pointed out by our friend Cameron Weber in our conversation  "The Cantillon Effects", using art as a reference market in describing Cantillon effects and asset bubbles if of great interest as per his presentation entitled "Cantillon effects in the market for art":

"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.

This is as well confirmed by our good friends at Rcube Global Macro Asset Management in their recent monthly review:

"The Art market has always been an interesting indicator. The only major public auction house is Sotheby's since its floatation in the mid-1980s. It has proved a timely indicator of potential global stock markets reversal.

Whenever its price reached 50 or so with sky high valuations, a reversal was not far away. We can also take notice of the extremely weak jewelry and contemporary art auctions recently."

"To acquire knowledge, one must study; but to acquire wisdom, one must observe." - Marilyn vos Savant, American writer

Stay tuned!