Credit - The World of Yesterday

"Every wave, regardless of how high and forceful it crests, must eventually collapse within itself."  

Stefan Zweig (1881-1942)

Our chosen title this week is a direct reference to the great writer Stefan Zweig's final masterpiece "The World of Yesterday". With the growing unrest in Europe and in particular Spain, we thought a reference to the great Stefan Zweig was appropriate given he remained all his life a pacifist and advocated the unification of Europe. It was unfortunately the growth of intolerance, authoritarianism and nazism and his feeling of hopelessness for the future that led to his suicide on the 23rd of February 1942 in the Brasilian city of Petropolis, but that's another story. 

Back in June in our conversation "Agree to Disagree", we indicated that until US Treasury Yields rose significantly in response to stronger growth and a healthier global economy, a secular bull market is not in the cards if history is any guide, although lower yields are indeed giving arguably more incentive to shift from bonds to stocks:
"When looking at the growing divergence between US stocks and US Bond yields, and softening US economic data, one can wonder our long US investors can "agree" to "disagree".

In our previous conversation we argued that the latest round of QE policy followed by the Fed would be hindered by US Corporate Borrowing given the already very low levels of funding which might overwhelm any growth in bond demand. Once again it seems to us that the latest policy enacted by the Fed looks farfetched and is that of engineering yet again another attempt in "wealth effect" in order to trigger shareholder spending as indicated by Bloomberg:

"Spending by households invested in stocks may determine whether the Federal Reserve’s efforts to bolster the economy bring more jobs, according to Jack Ablin, chief investment officer at Harris Private Bank. As the CHART OF THE DAY shows, the Conference Board’s consumer-confidence index has failed to keep pace with gains in retail sales during the past three years. Ablin cited a similar chart in a note yesterday after the board said the sentiment gauge rose to a seven-month high in September. The Fed is building confidence by holding down interest rates, which has lifted share prices along with home values, he wrote. The Standard & Poor’s 500 Index rose to its highest level since 2007 after policy makers agreed to open-ended purchases of $40 billion of mortgage-backed debt each month. “Retail spending is the next step in the Fed’s convoluted job-creation policy,” Ablin wrote. Sales growth brings higher corporate profits, which in turn lead to additional hiring, according to the Chicago-based strategist’s note." - source Bloomberg.

Yes, September's reading from the Conference Board, for the sentiment index was indeed at 87.4, more than any other time since January 2008, exceeding by 17.1 points the estimate. But, consumer "fear" might derail this plan and magnify the US fiscal cliff woes as indicated by Bloomberg:

"A slump in consumer spending may exacerbate any U.S. recession stemming from the so-called fiscal cliff of automatic tax increases and government spending cuts, according to Mike Englund, chief economist of Action Economics LLC. The CHART OF THE DAY shows Englund’s baseline forecast of a slow recovery in U.S. growth if the automatic fiscal changes are avoided, and his projection for gross domestic product if lawmakers fail to avoid the cliff. “I would assume that GDP growth would drop to a zero-to-1 percent contraction rate in first quarter and second quarter,” Boulder, Colorado-based Englund said in an e-mail. “A ‘fear’ or ‘panic’ effect might add to this if households pulled back in fear of the economic consequences of the news flow, and if stock prices fell and yields rose as markets feared sovereign defaults.” The economy expanded at a 1.7 percent annual rate from April through June after a 2 percent gain in the first three months of the year, Commerce Department figures showed Aug. 29. Consumer purchases, which account for about 70 percent of the economy, also grew 1.7 percent, the weakest in a year. Spending has cooled as the labor market struggles to improve. Employers added 96,000 workers to payrolls in August, less than economists projected, after July’s 141,000 gain, Labor Department figures showed Sept. 7." - source Bloomberg.

As far as we have seen as of lately, considerable data improvement has been priced in current stock prices, leading us to feel rather "uneasy" in this sea of "easiness". "Fundamentals" wise, economic support is indeed lacking for additional US stock gains as reflected by Bloomberg so "Mind the Gap":

"As the CHART OF THE DAY shows, the Standard & Poor’s 500 Index’s ratio to projected earnings has risen in the past four months as the Institute for Supply Management’s new-orders index for manufacturing has slumped. Knapp showed the contrast with a similar chart in a Sept. 14 report. Since June, the ISM gauge has been below 50, indicating more companies reported a drop in new orders than an increase. The index was last below the threshold in April 2009, when the U.S. economy was in recession. Indicators like this need to rebound for stocks to move higher, Knapp wrote in the report, because the economic outlook is one of two forces weighing on share prices. The other is the prospects for public policy, specifically regarding the federal government’s debt and deficits." - source Bloomberg.

Not only does the projected earnings have been rising but an upcoming earnings recession may soon put some additional pressure on US stocks as we moved towards the third quarter earnings season, hence our title give projected earnings as reflected in current stock prices look to us increasingly indicating "The World of Yesterday" and not 'The World of Tomorrow", sticking with our deflationary stance.

"Lower second-quarter profit has paved the way for an “earnings recession” that will hurt stocks, according to Jonathan Golub, chief U.S. equity strategist at UBS AG. As the CHART OF THE DAY illustrates, earnings at the Standard & Poor’s 500 Index’s non-financial companies fell in the second quarter and may drop again in the third. The result would be the first back-to-back declines since 2009, according to data that Golub presented yesterday in a report. “It’s very hard for the market to move forward when earnings aren’t progressing,” the New York-based strategist wrote on the 5th of September in an e-mail." - source Bloomberg.

On top of that the large Capital Good Orders drop at the end of August which have declined in four of the past five months is as well an early warning signal about future shipment growth turning negative in the near future:

“When the level of orders falls below the level of shipments, this tends to be a warning signal that future shipment growth will turn negative,” Feroli, chief U.S. economist at JPMorgan Chase and Co. in New York, said in a research note on the 24th of August. While orders have had a spotty record in predicting sales, when the degree of divergence gets this large, the correlation is tighter, Feroli said. He cited research by economists at the Federal Reserve in Washington that showed once orders are 1 percent to 2 percent weaker than shipments, the latter will probably shrink, hurting GDP. Bookings were 5.2 percent lower than sales in July, today’s Commerce Department report showed. Minutes of the Fed’s last meeting issued this week said many policy makers thought further action would probably be needed “fairly soon” without evidence of “substantial and sustainable” improvement in the recovery." - source Bloomberg.

While orders for durable goods slumped 13%, the most since January 2009, consumer confidence in the US climbed for a fifth straight week to -39.6 from -40.8. The "somewhat" improving housing market is indeed supporting the markets but as far as Europe is concerned Europe Economic confidence is in the doldrums, and dropped from 86.1 in August to 85 in September. Record unemployment and a deepening slump with euro-area contracting 0.2% in the second quarter are putting a strain on consumer confidence.

Following up on our previous conversation dealing with "Zemblanity" and why these Central Banks operations will eventually fail, we would like at this juncture to remind ourselves of what we wrote back in May 2010 in our conversation "The inflation debate or why you can have inflation in a deflationary environment":
The initial MV = PT Fisher equation means that a rise in ‘M’ leads in reality to a fall in ‘V’ leaving no net benefit.
Fisher's equation:
MV = PT where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place
"We are currently in a deflationary environment which poses no short term threat of massive inflation, but creates a risk of high inflation, if there is no debt restructuring at some point, as well as some profound structural reforms in public finances in the very near future, which will push us towards a double dip recession. It is unavoidable."

As a reminder:
"In Fisher's formulation of debt deflation, when the debt bubble bursts the following sequence of events occurs:
Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links:
1.Debt liquidation leads to distress selling and to
2.Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
3.A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
4.A still greater fall in the net worths of business, precipitating bankruptcies and
5.A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make
6.A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to
7.pessimism and loss of confidence, which in turn lead to
8.Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause
9.Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest." - (Fisher 1933)

We wrote at the time:
"Therefore a perceived inflation can happen in a deflationary environment, it can co-exist."

In the post "Low rates environment and the risk of evergreening à la Japanese", we described the following:
"Companies "are hoarding and in fact not hiring. The paradox of thrift versus the paradox of debt. Companies hoarding cash and households paying down their debt, typical of a deflationary environment and the fear of uncertainty. Households are busy rebuilding their balance sheets and companies have been busy defending their balance sheet."
We concluded our December 2010 conversation making the following important point:
"It is therefore critical to avoid evergreening à la Japanese, the sooner the restructuring of debt, the better and the faster the economic recovery."

To illustrate the above important point, we think the convergence between Iceland's  5 year CDS and Ireland is a compelling display of the impact an accelerated restructuring can have on economic recovery. We have discussed at length this important point back in our conversation in March entitled "Equities, there's life (and value) after default"): "By preventing default, creative destruction cannot happen in true Schumpeter fashion"- source Bloomberg:

Iceland and Ireland are now only around 68 bps apart when looking at their CDS spreads ("Iceland - The Great Debt Escape" - August 2011). - "He who rejects restructuring is the architect of default." - Macronomics.

We agree with the recent comments from Exane BNP Paribas from their QE3 FAQ from the 21st of September:
"The effective impact of QE3 may be less elevated than suggested by econometric models, for two reasons. First, interest rates and mortgage rates have already reached record lows, without triggering much additional business investment. In other words, investment has been much less sensitive to interest rates than in the past and it is uncertain whether a further decrease in yields can change this situation. Second, the mortgage market remains impaired, as close to 50% of households with a mortgage cannot refinance or get a loan at the record low market rates due to their lack of equity."

"In sum, while QE3 will certainly help the economy in sustaining asset prices and financial conditions, this support should remain modest in the short term due to the excessive leverage that remains in the household sector. If financial conditions stay at their current level, we would expect a positive impact of around 0.25 points over the next year. Of course, this is a static estimate. Financial conditions may continue to improve as the Fed continues to buy long-term assets, or they could deteriorate if another shock hits markets. In any event, monetary policy would not be able to offset a sizeable fiscal shock that might occur in the coming quarters. Our base scenario is that fiscal policy would wipe out 1.2% of 2013 GDP, much more than monetary policy can currently add to growth." - source Exane BNP Paribas.

We think Dr Bernanke is indeed going "all in", expecting the "bluff" will be enough to raise expectations and therefore boost the economy and changing expectations.

There would be an easier way to boost the prospect for a return of economic growth and it would mean improving service for struggling homeowners given US banks have been failing to adhere to at least two sets of servicing guidelines since 2010. The Home Affordable Modification Program, that required speedy response from banks has repeatedly been ignored. As indicated by Bloomberg in their article - "Banks That Flunked Servicing Tests Face Watchdog" by Hugh Son from the 25th of September:
"One in five U.S. residential units are underwater, or tied to loans that are bigger than the value of the home, according to CoreLogic Inc., a Santa Ana, California-based mortgage data firm. Of those 10.8 million properties, 15 percent have fallen behind on payments."

We believe accelerating the restructuring process and the deleveraging of US households would be far greatly effective in helping out the US economy in the on-going deleveraging process otherwise the US risk facing "evergreening" à la Japanese as indicated above and might never move back towards "The World of Yesterday".

From the same Bloomberg article:
"The five biggest servicers have given about $10.6 billion in relief through June, mostly in the form of short sales in which a delinquent borrower’s home is sold for less than the amount owed, Smith said last month in a report. That results in fewer credits because servicers get less than 50 cents on the dollar for short sales. They are expected to ramp up loan modifications in the coming months."

Moving on to credit, we believe credit is becoming incredibly expensive and crowded akin to a potential  "Bull Trap" as indicated by CreditSights in their latest Euro Issuance Performance review from the 26th of September:
"With two days left before the end of September, fixed rate-euro denominated issuance has already easily exceeded all previous September issuance volumes with 52 billion Euro of investment grade and high yield deals brought to market. 
Those deals have broadly performed well, especially those from the stressed-eurozone countries. 
But outperformance remains reliant on improvement in the sovereign situation. And so while stressed-country new issues offers attractive yields and compelling new issue premiums, they could prove a trap for investors when volatility returns and liquidity disappears."

We already discussed at length the risks of dwindling liquidity in credit markets. Back in our July conversation "Hooke's law" we argued:
"Given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894)."

In our last conversation we also indicated the following worrying trend:
"This latest credit market "euphoria" has been marked by the significant return of Covenant lite issuance. Back in May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz..."."
Our concerns have been duly validated by the following information relating to the covenant quality of new deals from the following Bloomberg article - "Bond Sales Approach $1 Trillion in Third Quarter: Credit Markets" - 27th of September:
"Bond investors are also accepting looser terms from speculative-grade companies. A Moody’s measure of weakness in bondholder protections included in U.S. junk-rated debt increased to 3.94 in September, the worst since November. The gauge, known as a covenant-quality score, compares with 3.71 in August and a 2012 average of 3.72 through last week, according to Moody’s. “In environments where there is a lot of demand, investors will have less say in the covenant package,” said Matthew Musicaro, an associate analyst at Moody’s. “Either you invest in the deal or you don’t.” Moody’s reviewed covenants on 41 bonds sold through Sept. 21 and focused on covenants including those that restrict the use of cash, investments in risky assets and leverage. The deals are rated on a scale of one to five, with five representing the weakest covenants."

Mouse trap, or Bull Trap, it is indeed definitely loaded...

"We can't forever be spending our lives paying for political follies that never gave us anything but always took from us, and I am content with the narrowest metes and bounds provided I have peace and quiet for work." - Stefan Zweig

 Stay tuned!

Credit - From Hektemoroi to Seisachtheia laws?

Seisachtheia (Greek: σεισάχθεια, from σείειν seiein, to shake, and ἄχθος achthos, burden, i.e. the relief of burdens) was a set of laws instituted by the Athenian lawmaker Solon (c. 638 BC–558 BC) in order to rectify the widespread serfdom and slaves that had run rampant in Athens by the 6th century BC, by debt relief. - source Wikipedia

"Under the pre-existing legal status, according to the account of the Constitution of the Athenians attributed to Aristotle, debtors unable to repay their creditors would surrender their land to them, then becoming "hektemoroi", i.e. serfs who cultivated what used to be their own land and gave one sixth of produce to their creditors.

Should the debt exceed the perceived value of debtor's total assets, then the debtor and his family would become the creditor's slaves as well. The same would result if a man defaulted on a debt whose collateral was the debtor's personal freedom.

The seisachtheia laws immediately cancelled all outstanding debts, retroactively emancipated all previously enslaved debtors, reinstated all confiscated serf property to the hektemoroi, and forbade the use of personal freedom as collateral in all future debts. The laws instituted a ceiling to maximum property size - regardless of the legality of its acquisition (i.e. by marriage), meant to prevent excessive accumulation of land by powerful families." - source Wikipedia.

As many in Europe are awaiting the much anticipated results in France for the second round of presidential election, we thought, given Greece is as well having important elections on the very same day which could well decide its European fate, we would like this time around refer to the Athenian policy followed by Solon. Debt relief existed in many ancient societies and many religions. More recently Brady Bonds were a way of tackling the Latin American debt crisis. We do expect to see more debt to equity swaps for some weak peripheral banks but we ramble again. In this long credit conversation, we will look at an updated Eurozone scenario courtesy of our Rcube Global Macro Research friends. But first a much needed long credit overview with a focus on upcoming downgrades, Basel III regulations indicating clear additional "unintended consequences"...

The Credit Indices Itraxx overview - Source Bloomberg:

The cost of insuring against default in Europe is on the rise again as we towards an increasingly risk-off scenario in 2011 redux fashion. First weekly increase in three weeks and 3 days of consecutive rise in three days. Itraxx Crossover 5 year CDS index of 50 High Yield companies rose to 648 bps whereas Itraxx Main Europe 5 year CDS index (125 investment grade entities in Europe) rose to around 142 bps compared to around 138 bps a week ago.

As far as the financial sector is concerned, since February Moody's has put 114 European banks on downgrade review, meaning "Real Money" is bracing for a "May impact". There is some solace for our European banks as 17of the largest banking names are as well in the "iron sight" of the rating agency: Citigroup, Bank of America, Goldman Sachs, JPMorgan Chase, the Royal Bank of Canada and Morgan Stanley.
At the same time European Union Finance ministers are in a bind. On the 3rd of May they failed to reach an agreement to toughen bank capital rules facing stiff British resistance and aiming for a deal on the 15th May at the next meeting. The Basel Committee on Banking Supervision deadline is 1st of January 2013. Denmark is holding the current EU rotating presidency is offering a compromise with a risk buffer of 5% on banks' domestic and non-EU exposures against the initial 7% core capital requirements of their risk-weighted assets proposed by Michel Barnier, the EU's financial services chief.

But the challenge for the financial sector does not end thanks to cheap term-funding provided by the ECB twice. As Nomura indicated in their note Eurozone and Basel III - Fears for Tiers, from the 4th of May:

"Subordination is a recurring aspect of the eurozone debt crisis. This has taken the form of private sector investors in government debt being junior to not just the IMF into a debt restructuring, but also to the ECB and its SMP. It also takes the form of unsecured bank creditors being effectively subordinated by the growing reliance of banks on secured funding, as assets are pledged as collateral and balance sheets grow increasingly encumbered. The ECB's 3yr LTRO collateralised loan facility has accelerated balance sheet encumbrance and exacerbated a shortage of collateral in Europe. Unsurprisingly, eurozone monetary data confirm that banks are still struggling to raise term-funding.

The challenge that many banks face in raising term-funding is particularly problematic as over the coming years the eurozone banking sector will need to implement the Basel III liquidity framework. This forces institutions to increase the maturity of their funding profile. (The EBA estimate the Basel III funding shortfall at EUR1.9trn, which is around 75% of the size of the European senior debt market, and we use simplifying assumptions to calculate the demand for term-funding from the eurozone banks at around EUR4.9trn.) Early adopters of Basel III (most notably banks in Australia and New Zealand) have shown that this process leads to sharply rising bank funding costs, wider lending rate spreads to the policy rate, and as a consequence a lower "neutral" central bank policy rate. This latter point in turn has notable consequences for the conduct of monetary policy and the behaviour of yield curves, which tend to flatten and shed curvature at lower yield levels.

We already expected Basel III to spur these changes over the coming years, but the impact will be magnified if the unsecured financing markets do not recover. This will increase the extent to which Europe experiences a war for deposits among banks, the extent to which lending rates rise and the extent to which balance sheets shrink."

Basel III proposals - BIS ratios to manage liquidity risk:
"-The Liquidity Coverage Ratio (LCR).
The LCR requires that a bank has sufficient liquidity to survive for 30 days under a stressed scenario when global financial markets are assumed to be in crisis, all wholesale funding has dried up, unsecured lines of credit provided by other financial institutions are withdrawn and banks experience partial deposit flight. To mitigate this risk, the LCR requires that banks hold a liquidity buffer of high quality, liquid, central bank repo eligible, unencumbered assets, which are at least equal to the amount of net cash outflows a bank may face over a 30-day period.
-Liquidity buffer.
The liquidity buffer can comprise a minimum 60% of Level 1 assets (cash, excess reserves with a central bank, government, multilateral and selected agency debt) and a maximum 40% of Level 2 assets, which are highly likely to be spread products with for instance a 20% Basel II risk weighting. However, regulators are still debating what assets can be classed as eligible Level 2 assets (in Europe the EBA is suggesting a broader definition that would include highly liquid RMBS and – potentially – non-repo eligible assets such as listed equities and gold).

-The Net Stable Funding Requirement (NSFR).
This is a longer-term liquidity ratio and is aimed at ensuring that banks have sufficient liquidity to meet their funding needs during a stressed scenario for a period of 12 months. In short, a bank’s "stable funding" over a 12-month timeframe must be greater than the amount of required funding (cash requires less stable funding than unencumbered loans to retail and small business customers, which have a residual maturity of less than one year)." - Source Nomura - Eurozone and Basel III - Fears for Tiers, 4th of May.

We think upcoming downgrades means more collateral posting and more haircuts on collateral that can be pledged for funding at the ECB and dwindling "quality assets" therefore even lower German Bund Yields...

"Unintended consequences" as indicated by Nomura in their note:
"-Increased bank demand for government bonds. Banks will need to structurally increase their exposure to government bonds as they accumulate the liquidity buffer.
-Banks disincentivised from relying on short-term funding. In calculating the LCR and NSFR, banks are penalised for relying on short-term wholesale funding as only a portion of this liquidity can be used in calculating liquidity thresholds. Banks are therefore incentivized to issue longer-term debt or take in longer-term deposits.
-Increased demand for fixed deposits. Banks are incentivised to increase the proportion of their deposit funding, which is fixed for a long period of time, and are disincentivised from relying on financial sector deposits, which are ineligible.
-The LTRO is not a long-term solution. Only normal central bank liquidity provisions focused on open market operations can provide liquidity that is Basel III compliant. Non-standard liquidity measures such as the ECB's LTRO operations cannot be included in the calculations.
-Bank funding requirements increase as less liquid assets are held on bank balance sheets. This directly conflicts with the desire of regulators in selected European countries such as the UK to increase bank lending to SMEs and the consumer sector. These loans are less liquid than investment in government bonds or credit products and hence will incur a higher Basel III funding requirement.
-First mover advantage. The bulk of the Basel III liquidity framework needs to be implemented over the next five years and in its entirety by 2019. However, there is a distinct first mover advantage.  In the eurozone alone, the scale of long-term funding needed is larger than the market can realistically provide at yields that are economically viable. Hence, the sooner a bank can increase its long-term debt issuance, raise its term deposit funding, or unwind its balance sheet before its competitors do the same, the cheaper its funding costs will be and the less pressure it will face to reduce its balance sheet. In this respect, the current effective subordination of unsecured creditors of eurozone banks due to the balance sheet encumbrance issue allied to a general aversion of creditors to increase exposure to banks is particularly worrisome as this impedes the ability of banks to obtain term-funding."

We keep repeating this, but it is still very much a game of survival of the fittest....Cash is clearly king in the Basel III framework and, as Nomura put it, will therefore could lead to a war for deposits in Europe...The British stiff resistance to the latest regulatory proposals come from the fact that banks are very large in the UK relative to their GDP:

"The upward pressure on deposit rates is likely to be unequal between countries. In particular, countries with banking systems that are large relative to the domestic deposit base may face particular upward pressure on deposit funding costs and/ or pressure to pare back balance sheet. Clearly, this is an issue in the UK, where the banking sector is extremely large relative to GDP and the pool of domestic savings. Excluding the Bank of England, the combined balance sheet of UK MFIs measured GBP8.3trn in March, more than five times the value of GDP, and deposits only consisted of 37.5% total liabilities." - Nomura

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield) are falling below the lowest level reached in 2011, dipping below 1.60%. It's deflation (デフレ). - source Bloomberg:

Another fresh record low for the German Bund helped by the miserable recent PMI surveys in Europe and the rise in joblessness in Europe reaching 10.9% in the process with European politicians making a dash for a "Growth Pact". Wishful thinking definition: "the erroneous belief that one's wishes are in accordance with reality" - Collins English Dictionary.

As stated above in relation to Basel III, increased demand for government bonds from banks (60% of the liquidity buffer) means more German bund buying...
Prior to the LTROs, banks had been scaling back their exposure to European sovereign debt as well as Sovereign funds as indicated by Josian Kremer in Bloomberg on the 4th of May - Norway Dumps Ireland, Portugal Bonds on Euro Crisis Concern:

"Norway’s sovereign wealth fund sold all its Irish and Portuguese government bonds after rejecting the Greek debt swap and warned that Europe faces considerable challenges.

The $610 billion Government Pension Fund Global returned 7.1 percent, or 234 billion kroner ($41 billion), as measured by a basket of currencies, in the first quarter, the Oslo-based investor said today. Its equity holdings gained 11 percent while its fixed-income investments rose 1.6 percent.

The fund, which voted against Greece’s debt swap this year because it disagreed with being subordinated to the European Central Bank, also said it reduced debt holdings in Italy and Spain amid a broader strategy to cut investments in Europe. The fund added government bonds from emerging markets such as Brazil, Mexico and India."

When the trend is your friend...

The current European bond picture with the recent rise in Spanish and Italian yields - source Bloomberg:

We recently commented peripheral banks in both Italy and Spain have been soaking up their domestic bonds courtesy of LTRO 1 and LTRO 2, the dramatic decline in foreign holdings of Italian and Spanish debt increases concentration of risk in these two countries banks.

Following our focus on Basel III unintended consequences, it is time to move on to the Eurozone Scenario update courtesy of our friends at Rcube Global Macro Research.

"As the positive impact of both the LTRO and the ESM on Eurozone sovereign spreads seems to be fading, we think that it is time to revisit our main scenario for the Eurozone. This year, it appears that Spain and/or Italy are going to be the culprits of a third summer of Eurozone distress."

As stated by Rcube in our note "The European Overdiagnosis" (20/01/2012):

"We believe in a muddle through scenario for the Euro, at least for the next few years. The Euro’s existence solely depends on the willingness of European authorities to pursue the experiment. In the short and medium‐term, there’s just too much political capital invested in the Euro project. Consequently, the path of least resistance will most likely consist in resuming last summer’s emergency summits, probably featuring Merkollande instead of Merkozy.

As Spain’s or Italy’s yields approach levels that triggered previous EFSF intervention, it is becoming clear that the size of the current firewall (€700Bn = €200Bn from the EFSF ‐ some of which is already being used, and €500Bn from the ESM) is largely insufficient. If Italy and Spain were to lose access to the bond market, the current setup would barely cover the PIIGS’ refinancing needs until the end of 2013."

Spain and Italy dwarf other PIIGS’ bond payments:

"In a way, Europe was fortunate that the first endangered countries (Greece, Ireland and Portugal) collectively amounted to only 7% of the Eurozone GDP. Now that Spain (10.6% of the Eurozone GDP) and maybe Italy (16.8%) are also reaching the point where they need assistance from the rest of Europe, the only solution will have to come from the ECB, maybe in a more direct manner than through LTROs. The taboo of large direct ECB interventions will probably fall at some point during the next quarters. The uncertainty surrounding the timing and modalities of these interventions will probably provide interesting trading opportunities.

That said, we have to keep in mind that, in the long‐term, these interventions will do nothing to restore a balance between Eurozone countries’ competitivity." (see Rcube's related comments in "The European Flutter" – The Eurozone’s Other Problem: Unit Labor Cost Divergence).

"Therefore, we believe that some countries will eventually choose to exit the Euro, not because they are forced to do so by the markets, but because it will be the only way to exit the negative spiral of austerity-driven recessions." - source Rcube Global Macro Research.

Rcube's Eurozone breakup model (where recovery values are based on relative Unit Labor Costs), currently gives us the following implied exit probabilities:

We can see that 5 year implied exit probabilities remain very elevated (and at all time highs for Spain).

"However, unlike many, we do not consider a Euro breakup as a doom and gloom scenario. The path leading to the breakup will indubitably be painful, but the end result could offer interesting buying opportunities." - Rcube Global Macro Research

We agree with our friends and clearly indicated it in our post "Equities, there's life (and value) after default!". Hence our "provocative" title "From Hektemoroi to Seisachtheia laws?".

"Indeed, when we look at historical examples of countries that broke their peg with a currency that was too strong relative to the competitivity of their economy, we can see that their equity market performances were quite juicy after their currencies reached to a new equilibrium level." - source Rcube Global Macro Research.

Argentina's stock market performance post peso - source Rcube:

Russia's stock market performance post ruble devaluation - source Rcube:

 Mexican stock market performance post peso devaluation - source Rcube:

Korean stock market performance post won devaluation - source Rcube:

"Devaluations are never easy." - Jeffrey Sachs

Stay Tuned!