Chart of the Day - Volatility of Euro Zone peripheral yields

"Anyone who attempts to generate random numbers by deterministic means is, of course, living in a state of sin."- John von Neumann 

As pointed out by our good cross-asset friend, now that realized volatility of the US 10 year bond is superior to the ones of Italian BTPs and Spanish Bonos, although there is a significant yield difference (+150 bps), risk models/allocation models using historical VaR are going to soon love peripheral bonds relative to US Treasuries.

From CITI & FT:

Bloomberg recent Chart of the Day from the 9th of October display a similar pattern but emphasizes on the rise of the Euro:

"The CHART OF THE DAY shows the euro has strengthened to an eight-month high against the U.S. currency as a measure of Spanish and Italian bond yield swings dropped below that of Treasuries last month for the first time in at least a year. At the same time, Treasury volatility has risen as U.S. lawmakers remain deadlocked over the budget and investors debate when the Federal Reserve will trim its dollar-debasing stimulus program...The volatility of Spanish 10-year yields as measured by the 65-day standard deviation, a study of how much the rate has moved each day compared with the average change, was 4.96 basis points on Oct. 3, versus 6.01 basis points for the benchmark Treasury. As recently as May, the measure for Spanish bonds was more than double its U.S. equivalent. The volatility of Italy’s 10-year yield was 5.24 basis points. " - source Bloomberg

"I don't write a great song every day. I don't write a great song every couple weeks. It comes in such random times." - Macklemore 

Stay tuned!

Credit - The Fabian Strategy

"Who looks outside, dreams; who looks inside, awakes." - Carl Jung

"The Fabian strategy is a military strategy where pitched battles and frontal assaults are avoided in favor of wearing down an opponent through a war of attrition and indirection. While avoiding decisive battles, the side employing this strategy harasses its enemy through skirmishes to cause attrition, disrupt supply and affect morale. Employment of this strategy implies that the side adopting this strategy believes time is on its side, but it may also be adopted when no feasible alternative strategy can be devised." - source Wikipedia

While enjoying our break, catching up on some reading in the sun, but keeping abreast of the news surrounding the "fiscal cliff" and the evolution leading to the resolution of the "Mexican standoff" in the US Congress, as well as a lack of positive growth outlooks for Europe in general and France in particular for 2013, we could not resist using yet another military historical reference to the on-going situation. Hence, the choice of our title, which appeared to us, once more, appropriate, given the market context.

In similar fashion to the strategy named after the dictator of the Roman Republic Quintus Fabius Maximus Verrucosus employed against the mighty Hannibal during the Second Punic War (218-202 BC), Fabius strategy though a military success, was a political failure. We found it rather entertaining that in respect to the "Fiscal Cliff" saga, the great George Washington was sometimes called the "American Fabius" for his use of the Fabian Strategy during the first year of the American Revolutionary War, leading to John Adams declaring about the continuous use of the strategy at the time to declare:  "I am sick of Fabian systems in all quarters!" We too, are sick of the use of Fabian systems in the United States in general and in Europe in particular.

When it comes to Europe, will not change our stance in 2013, as we pointed in a "Tale of Two Central banks", we would like to repeat Martin Sibileau's view we indicated back in October 2011 when discussing circularity issues:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

- source JP Morgan Asset Management - Guide to the Markets - 1Q 2013 slide 48.

As far as Europe is concerned when it comes to using the Fabian Strategy, baby steps are being taken in Europe to evolve towards a full European Banking Union and more in trying to break the link between sovereigns and financial institutions, the recent one being the approval on the 13th of December of yet another acronym, the SSM (Single Supervisory Mechanism), which is assigning the supervision of European Banks by the ECB. The SSM will only be fully operational in March 2014. A SRM (Single Resolution Mechanism) dealing with ailing financial institutions is yet to be approved. 

In "A Tale of Two Central Banks" in December 2011, we correctly argued:
"You cannot ask the ECB to suddenly morph into a Fed. This process will undoubtedly take time and a due process, but a larger involvement of the ECB is so far conditional to stricter fiscal discipline."

In relation to Europe, we will even push our reference further to Fabius Maximus Verrucosus (Mario Draghi) strategy against the mighty Hannibal (Bond vigilantes). Hannibal had two particular weaknesses. First, he was commander of an invading army on Italian soil and as long as the Italians remained loyal to Rome (Brussels), then there was no hope that Hannibal (Bond vigilantes) could win. But should the Romans (European politicians) keep on losing battles, in similar fashion, the faith of the European populations in Brussels could weaken or wane. Fabius (Mario Draghi) calculated that the way to defeat Hannibal (Bond vigilantes) was to avoid engaging with him in pitched battles, so as to deprive him of victories. He determined that Hannibal's extended supply lines, and the cost of maintaining the Carthaginian army made of mercenaries (Hedge Funds) in the field, meant that Rome (Brussels) had time on its side (source Wikipedia).

This is exactly what Fabius aka Mario Draghi has been doing with his OMT promises! Avoiding in effect pitched battles and frontal assaults so far with the Bond vigilantes (Hannibal). So, rather than fight, in similar fashion to Fabius, Mario Draghi has been shadowing Hannibal's army instead (aka the Bond vigilantes), sending out loud and clear messages against the Bond vigilantes to nullify Hannibal's superiority. Mario Draghi's strategy is similar to Fabius, given he has been wearing down the Bond vigilantes' endurance and so far discourage a break-up of the European Union, without having to challenge the "Carthaginians" to a decisive "monetization" battle.
"Hannibal's second weakness was that much of his army was made up of mercenaries from Gaul and Spain, who had no great loyalty to Hannibal, although they disliked Rome. Being mercenaries, they were unequipped for siege-type battles; having neither the equipment nor the patience for such a campaign. The mercenaries desired quick, overwhelming battles and raids of villages for plunder, much like land-based pirates. As such, Hannibal's army was virtually no threat to Rome, a walled city which would have required a long siege to reduce, which is why Hannibal never attempted it. Hannibal's only option was to beat Roman armies in the field quickly before plunder ran out and the Gauls and Spaniards deserted for plunder elsewhere. Fabius's strategy of delaying battle and attacking supply chains thus hit right at the heart of Hannibal's weakness; time, not energy, would cripple Hannibal's advances. The Fabian strategy, though effective in some ways, was perceived as cowardly and unbecoming of the Fabian name, established by his ancestors' victories in pitched battles." - source Wikipedia

In similar fashion to the mercenaries of Hannibal, Hedge Funds have no great loyalty, the equipment or patience (of their investors) for such a long European campaign, given they also desire quick overwhelming battles and raids for plunder hence the significant bond rally in 2012, following Mario Draghi's use of the Fabian Strategy but we ramble again...

The Fabian Strategy at play - European bond picture, the fall was dramatic for peripheral bonds in the second half of 2012 thanks to Mario Draghi's intervention with Spanish 10 year yields falling towards 5.00%, whereas Italian 10 year yields are now well below 5% around 4.25% and German government yields rising towards 1.60% levels with other core European bonds yields rising as well in the process - source Bloomberg:

So, what is our prognosis (literally fore-knowing, foreseeing the likely outcome of an illness) in relation to the European outlook for 2013 in general and credit in particular you might rightly ask? In our first conversation of the year we will share our views.

EUR/USD and Gold views for 1st quarter of 2013:

Last year, on the 25th of January 2012 we made the following forecast in relation to the European recession and the EUR/USD following the FOMC decision to maintain US rates in our conversation - The law of unintended consequences:
"Unintended Consequences according to Martin Sibileau:
"With the Fed swaps, as we pointed out on September 12th, the Euro is still artificially stronger than without the swaps, which makes the EU less competitive. Finally, the institutional uncertainty of the EU zone remains unaddressed. All these factors only contribute to prolong the recession and a high unemployment rate."Given today's decision of the FOMC to maintain US rates low until late 2014, it seems to us that the European recession can only be prolonged as indicated by Rcube Global Macro research in our previous conversation, increasing the likelihood of a Euro Breakup.
Again, like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content.
Does the FOMC's latest decision put a floor to the drop of the euro versus the dollar? Are the FED's swap lines and latest FOMC decision delaying a painful adjustment in Europe? We wonder."

The on-going "Risk-On" scenario is maintaining the Euro at an elevated level versus the dollar. While touching again on our recent subject of asset correlation (see our post "Risk-Off Correlations - When Opposites attract"), in "Risk Off" periods we have noticed that the 120 days correlation has been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, such as now, the correlation is falling to lower levels. The correlation between both the German Bund and US 10 year note is currently falling albeit at very smaller pace than in early 2012 - source Bloomberg:

Until there is another "Risk-Off" phase, the EUR/USD should remain in the region of 1.30 versus the US dollar.
Nota Bene: ("Risk On" refers to a period of time in which investors are putting money into risky assets such as stocks, commodities, etc. "Risk Off" meaning the exact opposite with investors putting money into safe haven assets such as cash and treasuries or German Bund).

The current "Risk-On" phase will continue to put as well some downward pressure in the short term on Gold prices and commodities. Dollar index versus Gold - source Bloomberg:

This short term bearish pattern on Gold has been reflected in the Gold Options market - source Bloomberg:

"The CHART OF THE DAY tracks options for the SPDR Gold Trust, the biggest exchange-traded fund backed by bullion. The ratio of puts, which grant the holder the right to sell the security at a specified price by a certain date, to calls, which confer the right to buy, advanced to 0.57 last week, the highest since Jan. 4. Open interest in puts has jumped 30 percent since October. Gold has dropped 8.5 percent since reaching this year’s high of $1,798.10 an ounce on Oct. 5 as signs of improvement for the U.S. economy reduced demand for haven assets. Prices are still on pace for a 12th straight annual gain, a streak that Goldman Sachs Group Inc. forecasts will end next year as the growth continues to accelerate." - source Bloomberg

Gold could recede towards 1550-1600 levels during this quarter before bouncing back when "Risk-Off" will materialise again.

Economic outlook in Europe in 2013 is depending on "genuine" credit growth:
As we posited in numerous conversations, "genuine credit growth" to the real economy (not LTROs which amount to "Money for Nothing") is key in order to generate sufficient economic growth to counter solvency risks. Given corporate loans supply is still falling in Europe, we do not think the deflationary forces in Europe in 2013 will be countered, far from it - source Bloomberg:

"Corporate loans outstanding to the euro zone, down 240 billion euros from January 2009's all-time high, fell for the twelfth time in fourteen months, as financing to the troubled region's businesses remains scarce. With the application of Basel III capital and liquidity rules potentially deferred, policymakers will be keen to encourage increased lending in this key segment." - source Bloomberg

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits:
"So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans."- "Subordinated debt - Love me tender?" - Macronomics, October 2011

Spanish Real GDP growth and Loan Growth since 2006 - source Bloomberg:

As displayed by the latest Spanish misery index making new highs, the deflationary spiral is still playing out - source Bloomberg:

We expect Spanish unemployment to come close to 28% in 2013 with continued rising NPLs in the process.

Back in October we argued that Spain surpassed 90's perfect storm:
"Generally rogues waves require longer time to form, as their growth rate has a power law rather than an exponential one. They also need special conditions to be created such as powerful hurricanes or in the case of Spain, tremendous deflationary forces at play when it comes to the very significant surge in nonperforming loans."

In percentage term, it is true that the latest figure of 11.23% is significantly above the 1994 record of 8.99% but, in absolute term, Spain is not facing a perfect storm but the mother of perfect storms when it comes to the absolute size of the non-performing loans in billions of euros - source Thomson Reuters Datastream / Fathom Consulting:

We therefore share Nomura's view on the growth outlook for the Eurozone in 2013:
"The key challenge for the eurozone in 2013 is the prospect of continued weak growth. On balance, the fiscal stance for the region will continue to be a drag on growth, and monetary policy is unable to provide an offset because of ongoing deleveraging dynamics in key banking systems, and tightening credit conditions in peripheral countries. The currency channel has for now not worked either. Meanwhile, consumption and investment remain weak as the deleveraging process continues its course. In that context, the only meaningful source of growth in the region will be externally driven, in our view. Our baseline scenario for the euro area is one of contraction on average for the region (of -0.8% in 2013) with deep recessions in peripheral countries and shallow recessions in the core." - source Nomura, 14th of December, Euro Area - The 2013 Challenge.

Since 2008, European policy makers approved more than 5 trillion euros of state aid to banks with Ireland and Denmark leading recipients according to Bloomberg:

"The CHART OF THE DAY shows how much the European Commission allowed each country to use to prop up lenders from 2008 to the end of September 2012. The amount is expressed as a percentage of 2011 economic output. The payments comprise recapitalizations, funding guarantees and treatment of toxic assets. More than 1.6 trillion euros was actually used by the end of last year. Ireland needed to pump more than 60 billion euros into its banks after a housing bubble burst following the 2008 collapse of Lehman Brothers Holdings Inc. Denmark used 145 billion euros in guarantees and put 10.8 billion euros into lenders as capital. “Guaranteeing a financial system after a crisis is one thing; if banks have to actually take losses it’s another entirely,” said Christian Schulz, an economist at Berenberg Bank in London. “If bank losses migrate onto the public balance sheet, then they’ll have an impact.” The Commission approved aid of 571 billion euros, or 365 percent of 2011 output, to banks in Ireland, and agreed to 613 billion euros of state aid to Denmark, the equivalent of 256 percent of GDP. While Denmark actually used 158 billion euros of the sum approved, Ireland used 350 billion euros, according to the Commission." - source Bloomberg

We expect to see a much larger bailout figure for Spain in percentage terms of GDP in 2013.

The big beneficiaries of the "Fabian Strategy" in 2012 have been European Banks - source Bloomberg:

"Following Mario Draghi's late-July promise of ECB action to protect the euro, the Bloomberg Industries Emerging European Banks Index rallied 29% to year-end 2012. With the fiscal cliff averted for the time being, the keys to share price performance in 2013 include attaining a "grand bargain" on the U.S. budget and a lasting solution to Europe's debt crisis, including the proposed banking union." - source Bloomberg

Given the unconditional support provided by the ECB, you can expect Core European Banks to continue to rally during the 1st quarter in 2013. Senior Financial bonds from peripheral banks should as well continue to perform. The recent 5 year  Spanish bank BBVA  new 1.5 billion euro senior financial issue has been easily absorbed by investors (5 billion euros worth of orders in the book from more than 400 investors), and performed significantly at the launch last Thursday. Initial guidance was mid-swaps +310 bps and launched at +295 bps. Last September BBVA issued a similar bond offering at +380 bps.

In fact CDS wise the Itraxx Financial Senior 5 year index is at the tightest level versus the Itraxx Main Europe index representing Investment Grade credit risk since April 2011 at around 20 bps apart. - source Bloomberg:

Europe in 2013 will still be a story of broken monetary policy transmission channel to the real economy.
So we still expect the US to outperform significantly Europe when it comes to economic growth!

The divergence which we explained in our conversation "Growth divergence between the USA and Europe" should persist in 2013. US PMI versus Europe PMI - source Bloomberg

Short term, we do expect a minor reduction in the divergence as reflected in credit prices such as the US leveraged loan cash price index versus its European peer. You can clearly notice the uncanning similarity with the above graph from Bloomberg indicating the evolution of the PMI index:

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, 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 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")."

France's industrial production and GDP growth since 2001 - graph, source Bloomberg:

December figure came at -3.6% and next week data print for France industrial production is expected at -3.9% confirming our recession call for 2013, yet the French government is sticking to its 0.8% growth target which the budget is based on to reach the 3% deficit target. Not only will France fail to reach the 3% target but the budget shortfall will be significant.

As far as France's sovereign CDS is concerned, it now trades 9 bps above Belgium's sovereign CDS, Belgium being in a better fiscal position (not because of the recent arrival of Gérard Depardieu, there is more to it!) - source Bloomberg:

Is the OMT a game changer courtesy of our "Generous Gambler" and Fabius aka Mario Draghi? We do not think so:
On that subject we agree with Nomura's take from their 10th of December paper - Italian political uncertainty highlights the insufficiencies of the EU firewall:
"The insufficiency of the eurozone’s “firewall” Many investors validate long positions in peripheral debt markets based on the presumption of a "Draghi put", or that the ECB will indeed do all that is necessary to remove the risk premium from markets and preserve the EUR. However, the ECB has actually backtracked on many of the commitments made in July and August to the point where the forthcoming OMT programme appears to even less effective than the unlamented SMP it has replaced:
-Seniority. The ECB originally said it would ensure that the OMT would be pari passu to private investors, but Draghi stated in October that rules against direct monetary financing of sovereigns preclude the ECB taking a hair-cut on its bond holdings or even an NPV loss. As such, the subordination problem of the SMP seems likely to recur in the OMT.
-Predictability. One problem with the SMP was that investors were unable to embed their bond purchases in their asset allocation strategies. It would buy into weakness, but not necessarily follow through into strength, and would be out of the market for long periods. The OMT looks even less predictable than the SMP as the ECB has said it will buy for 1-2 months before pausing to see if a country passes its conditionality test. This would impose on countries such as Spain and Italy the quarterly event risk that originally helped undermine liquidity in GGBs. In this respect, while some investors may have purchased 4-5 yr SPGBs or BTPs in expectation of sliding down to the ECB‘s 1-3 year intervention zone, the current parameter actually stresses that the timeframe for investors looking to "co-invest" with the ECB might need to be 1-2 months rather than 1-2 years. 
-Market access. An additional problem of the OMT is that it can buy only as long as a country has full market access. This precludes the OMT supporting countries such as Portugal, and increases the risk of the ECB actually being able to buy SPGBs or BTPs: technically, the OMT will not be able to operate if Spain or Italy lose market access during the 3-4 week gap that will exist between a country asking for ESM support and requisite approvals allowing the ECB to buy bonds. 
Because of these factors, the OMT appears less flexible and effective than the SMP was, especially when one considers that the OMT will only be focused on the 1-3 year part of curves. Moreover, the aspect of the firewall designed to support sovereigns beyond 3yrs – the ESM – appears even weaker than the OMT. We have already noted how we are concerned that the OMT might not be able to fund itself at a pace and price sufficient to finance the degree of primary market bond buying that may be needed in Spain and eventually Italy. Moreover, the ESM‘s "Plan B" of transforming itself in part into an entity that issues first-loss certificates is fundamentally flawed as the ESM cannot legally take a first loss." - source Nomura.

In our late 2012 conversation "Synchronicity" we approached the subordination issue coming from the introduction of Collective Action Clauses in the European government bond market in 2013:

"Although the introduction of CACs reduces restructuring costs and facilitate the process, it should nevertheless increase risk premiums attached to the new issues. Welcome to subordination in the European government bond market!

But as we stated, "caveat creditor" given that even non-CACs bondholders can face the music with the introduction of retroactive CACs."

In addition to the above points made by Nomura, we also agree with the views of Protesilaos Stavrou, from his blog posted in September 2012:

"-Assuming that the governments of Spain and Italy sign a deal with the EFSF/ESM and that the ECB will then stick to its promise of buying "unlimited" amounts of bonds on the secondary markets; it seems that the sterilization process will effectively set in motion a gradual but steady diminution of available credit for other borrowers. Put simply, if the ECB bails out Spain and Italy it will effectively have to sterilize its operations by cutting off credit from more credible borrowers, meaning that Spain and Italy will crowd out the rest. Those who will suffer the most out of this, are of course small and medium sized enterprises that will be bereft of any affordable credit for years to come. 

Spain's broken transmission mechanism - source Nomura - No solidarity without conditionality:

-"With the collateral requirements being reduced into insignificance, it is clear that bankers will have an incentive to use whatever funds they have at their disposal to cling on to sovereign bonds of any kind, so that they may put them up as collateral for near-zero ECB liquidity in a circular process of speculation where cheap ECB-funding is channeled into the bonds markets and repeats the cycle leaving the banker with the profits from the margin between the primary interest rate and the yield of the bonds. If that is so, the distortion of the capital structure is exacerbated as credit will continue to flow into state coffers and the vaults of financiers to sustain the toxic debts and malpractices of the past. Once again the chilling effects will be felt by the lower and middle parts of the income distribution, while a selective elite will enjoy their speculative bonanza." - Outright Monetary Transactions: Reasons not to be cheerful - Protesilaos Stavrou, September 2012

Credit views for 2013:
We share similar views with Citi when it comes to the perspective for credit in 2013 after a stellar performance in 2012:
"In forming our views for 2013, first we'll make the case that corporate credit quality is deteriorating by more than what seems to be consensus. Leverage, measured as net debt / EBITDA, has risen notably from the low of two years ago. Moreover, we'll argue that the systemic risk has now been priced out of the market even though it could very well return under similar or different guises later in the year. 

However, it is getting harder and harder to find anyone prepared to put such fundamental arguments above all-powerful "technicals". Like Pavlov's dogs, it feels like the credit market has been conditioned by central banks to assume that any selloff is self-defeating as it will be met with yet more liquidity, with yet more inflows pushing asset prices up again. 

Examining the link between central bank interventions and asset prices, what strikes us is that although the central banks clearly have huge leverage over markets, their influence is not constant. The last three years demonstrate that. When asset prices are elevated their incentive to stimulate further wanes – and indeed central banks may want a certain amount of market pressure from time to time to keep politicians committed to painful reforms. 

The interaction between these two opposing fundamental and technical influences will probably determine much of your fund performance in 2013. Ask us about our "forecasts" and we don't end up very far from our peers: We expect € cash spreads to tighten 10-15% generically and total returns of 2.5% in IG and 5% in HY. 

However, we are not on board with the emerging consensus that systemic risk has been all but eliminated for now, and that volatility will be much lower from now on. That view feels complacent to us. Central bank technicals probably have the upper hand longer-term, but we think it is very unlikely that the year will pass without one or more of the risk-off periods as seen in recent years. But when? 

Chances are the selloff will occur exactly when the last skeptic has capitulated and lots of crowded longs have accumulated. And the trigger will be an event that is either impossible to predict or insignificant relative to the size of the market movement it causes. We didn't say it would be easy!". -source Citi - Credit Outlook 2013.

We don't believe the hype in credit and as we argued in our conversation "Hooke's law" previously the "credit mouse-trap" has been set by Central Banks:
"So, in relation to our title, in true Hooke's law fashion, 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)."

Back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

Citi's final thoughts from their 2013 Credit Outlook:
"In our opinion, the biggest decision investors face this year is whether the OMT really is an effective backstop against perceptions of systemic risk, allowing credit markets to trade on an idiosyncratic basis. If it is, then the next decision is whether the liquidity rush will be strong enough throughout the year for spreads to go on ignoring the deterioration in most credit metrics. 

The consensus that appears to be emerging is that the answer to both is 'yes'. On that basis, it is no wonder that markets have been performing so well. 

However, we'd answer those questions a little differently. To us, systemic risk is dormant, but not eliminated. It could crop up from any number of angles. We expect that the ECB backstop and others like it will be tested during the year in what remains an exceptionally challenging economic environment for Europe. Moreover, we struggle to see markets disregarding the weakening credit metrics and rating downgrades indefinitely. 

We do concur with the consensus position that these challenges will ultimately be circumvented, but just not without a certain amount of kicking and screaming in markets. 

Quite likely it will be from spread levels that are significantly tighter than currently – and indeed tighter than our full-year forecasts imply. But it is exactly in a significant overshoot that credit becomes vulnerable: central banks are likely to do less, money is likely to flow elsewhere, issuers will take advantage of tight spreads and investors will have extended themselves. 

The market we operate in today is just inherently more prone to volatility than previously. Consider that in 2007, a 5% reduction in exposure by US mutual funds in credit sold to the dealers would have increased their positions by just 10%. Today, a 5% outflow from mutual funds would double dealers’ exposure! 

As such, when it comes to 2013, much more than is reflected in the modal forecasts, the devil really is in how spreads are distributed through the year."

“It may feel antisocial to switch to the orange juice when the party’s still in full swing, but the last few drinks are always the ones you end up regretting later.” – Matt King - CITI

and particularly when your drink has been spiked by Central Banks' Rohypnol (Rohypnol rose to prominence as the date rape drug because it was colourless, odourless, tasteless and easily dissolved)...

We would like to use again a reference to Bastiat in relation to liquidity and Credit Markets (from our conversation "The Unbearable Lightness of Credit"): "That Which is Seen, and That Which is Not Seen"

The "Fabius Strategy" followed by Mario Draghi and the liquidity injected have effectively done "Rohypnol" wonders to Swap pressures - source Bloomberg:

"Movements in the currency derivative market over the past 12 months confirm European Central Bank President Mario Draghi’s success in vanquishing the funding pressures in the region’s banking sector. Demand by European banks for short-term dollar-based financing via swaps has dimmed after the ECB provided emergency long-term funding and cut interest rates. The CHART OF THE DAY shows the cost to covert euro-based funding into dollar loans through the currency market has collapsed after reaching almost three-year highs in November 2011, cross-currency basis swap rates indicate. The agreements to borrow in one currency and lend in another, usually last one to 30 years." - source Bloomberg.

As we argued in "The Omnipotence Paradox", the Zero Rate policies induced by our "omnipotent" Central Banks are destroying capitalism in the sense that capital because of lack of return cannot be deployed efficiently and is once again "mis-allocated. It is as well, to some extent, neutering volatility: VIX shows Economic-Policy Risk are overlooked - source Bloomberg:

"Investors are showing too little concern about the possibility that U.S. stocks will fall victim to an economic-policy debacle, according to Myles Zyblock, chief institutional strategist at RBC Capital Markets. The CHART OF THE DAY compares the Chicago Board Options Exchange Volatility Index, also known as the VIX, with a policy- uncertainty index developed by professors at Stanford University and the University of Chicago. The VIX appears to be “a coiled spring,” Zyblock wrote two days ago in a note to clients. The performance gap between the index and the policy gauge shows investors are too focused on rising home and auto sales, falling unemployment and other favorable signs, the Toronto-based strategist wrote." - source Bloomberg.

In 2013 it is still deflation in Europe:
"When it is hard to get money because banks will not lend, or for any other reason, there is less power to bid for goods. Prices then fall, because people lack money with which to pay." - Irving Fisher - The Money Illusion, 1928.

Stay tuned!

EFSF - If you are in trouble - double

"What investors should never forget about credit risk is that it is an event risk!"
Credit Crises: From Tainted Loans to a Global Economic Meltdown by Jochen Felsenheimer and Philip Gisdakis

For a change, it is going to be a shorter post than usual. In this post we will review the extension of the EFSF and the risk it entails.

I have already touched on the EFSF and its similarity with CPDO products which were the craze during the halcyon days of structured credit in the post - "Much ado about nothing": "in our levereraged EFSF play, the lower volatility in interest rates, the lower likelihood of default. But in a CPDO/Leveraged EFSF, there is a risk of failure of repayment of full principal at maturity."

I discussed this very subject with my good credit friend today, and here is what he had to say about the EFSF following our conversation:
"To summarize, European states only guarantee each bond issued by the EFSF in accordance to the percentage of their contribution. Each time a country needs the funding of the EFSF, that country cannot guarantee anymore the future bonds to be issued … so the remaining countries have to share the cost of guaranteeing the future bonds. Initially, Portugal was a guarantor for the bond issued to help Ireland. Once Portugal asked for help, the EFSF lent money and Portugal could not guarantee any new bonds issued by the fund, while still guaranteeing the one issued before to help Greece and Ireland. So each time a country suffer a rating downgrade, the pressure increase on the other contributors.
That explains the subordination of the EFSF bonds to the sovereign bonds of its contributors … and why leveraging the fund is not the right solution !
Here below is a chart where you can see the correlation of the EFSF bonds with the French 10 years OAT bonds … versus the German 10 years Bund. The correlation between the EFSF 10 years and the French OAT 10 years is 1.
As French spreads keep on widening, so does the EFSF spreads. This is frightening and explain why a France downgrade will jeopardize the whole scheme."

And to illustrate our conversation we came up with the nice illustration below:
In white… EFSF 10 years bond
In yellow … French 10 years OAT
In orange … German 10 years Bund

What's wrong with this picture? You probably know by now.

EFSF existing bonds:

EFSF 10 year bond versus German Bund

And my good credit friend to add:
"Main talks were about E.U. combining the EFSF and the ESM by mid 2012 to create 1 Fund with 940 billion euro (1.3 trillion US $) firepower.
Well, obviously there is a number of issues about such a conclusion….

The 500 billion Euro ‘permanent” bailout fund (ESM) was slated to replace the 440 billion "Temporary" European Financial Stability Facility (EFSF) fund. Well, the latest proposal that has the stock markets excited is to merge the two funds …. But there is a bias, it double counting the money."

Bloomberg:
“European governments may unleash as much as 940 billion euros ($1.3 trillion) to fight the debt crisis by combining the temporary and planned permanent rescue funds, two people familiar with the discussions said.
Negotiations over pairing the two funds as of mid-2012 accelerated this week after efforts to leverage the temporary fund ran into European Central Bank opposition and provoked a clash between Germany and France, said the people, who declined to be identified because a decision rests with political leaders.
Disclosure of the dual-use option helped reverse declines in U.S. stocks and the euro on speculation it could help break the deadlock among European leaders. Their wrangling led to the scheduling of a summit three days after an Oct. 23 gathering.
The 440 billion-euro European Financial Stability Facility has already spent or committed about 160 billion euros, including loans to Greece that will run for up to 30 years. It is slated to be replaced by the European Stability Mechanism, which will hold 500 billion euros, in mid-2013.
A consensus is emerging to start the permanent fund in mid-2012, the people said. During the transition between the two funds, euro-area governments originally agreed to cap overall lending at 500 billion euros, a figure deemed sufficient when Greece, Ireland and Portugal were the primary victims of the debt crisis.”

On this very subject my good credit friend commented:
"Now …. Have a look:
The total overall cap is 500 billion euros, of which 160 billion have already been committed or spend to help Greece. Therefore there is only 340 billion left! So how can you get 940 billion euros? This would raise the permanent fund above the agreed upon amount…. And the German Supreme Court has stated this cannot be done without a popular vote (referendum) !!! Also bear in mind that the German Supreme Court has ruled there should not be a permanent bailout fund at all…. Which add to the already constitutional issue.
I do not see a popular vote in Germany having a positive outcome!"

Please find here after the link to the ESM term sheet as of March 21st 2011:
http://www.vm.fi/vm/fi/04_julkaisut_ja_asiakirjat/03_muut_asiakirjat/20110322Laajen/ESM_Term_Sheet_21.3.2011.pdf

Page 10 of the term sheet :“As originally foreseen, the EFSF will remain in place after June 2013 so as to administer the outstanding bonds. It will remain operational until it has received full payment of the financing granted to the Member States and has repaid its liabilities under the financial instruments issued and any obligations to reimburse guarantors. Undisbursed and unfunded portions of existing loan facilities should be transferred to the ESM (e.g. payment and financing of installments that would become due only after the entry into force of ESM). The consolidated EFSF and ESM lending shall not exceed € 500 bn.”

So, please fasten your seat belt as the weeks ahead might be quite volatile indeed.

"When written in Chinese, the word "crisis" is composed of two characters. One represents danger and the other represents opportunity."
John F. Kennedy

Stay tuned!

The Good, the Bad and the Ugly - Update on some Macro situations

First of all, apologies for not having posted more frequently. I have been quite busy recently on other matters.

In the current market environment, differences between countries are more marked than ever.

While in the Euro area clear divergences are showing, between the German power house and the weak peripheral countries, Greek, Ireland and Portugal sinking further, some countries are clearly doing better than some others.

Not everything is all Doom and Gloom.

It is become more paramount to carefully study in details the full macro pictures in this difficult investment environment, plagued by low yields, rising inflation and high unemployment. Are we moving towards stagflation? Not yet, but signals are getting stronger.

In this post we will review the Good, the Bad and the Ugly, highlighting the differences and reviewing the current market context and significances.

The Good:

We will start by Sweden:

"The Gross Domestic Product (GDP) in Sweden expanded 7.3 percent in the fourth quarter of 2010 over the same quarter, previous year. Unlike the commonly used quarterly GDP growth rate the annual GDP growth rate takes into account a full year of economic activity, thus avoiding the need to make any type of seasonal adjustment. From 1994 until 2010, Sweden's average annual GDP Growth was 2.68 percent reaching an historical high of 6.90 percent in September of 2010 and a record low of -6.70 percent in March of 2009."
Source - Trading Economics.

Furthermore, Sweden predicts a budget surplus and plans to tax cuts are economy beats Europe according to Bloomberg article from Johan Carlstrom.

"The largest Nordic economy will expand 4.6 percent this year, compared with the 4.8 percent predicted last month, the government said in its spring fiscal policy bill released today in Stockholm. The government raised its forecast for growth in 2012 and 2013 and predicted a widening surplus over the next four years as unemployment falls."

"The Swedish economy grew 5.5 percent in 2010, the most since 1970, as exports recovered from the global financial crisis."

Sweden is doing the right thing:
"Reinfeldt’s four-party government alliance had already revealed it will invest more money in the country’s railway infrastructure and that it wants to ease benefit rules for long- term sick leave. It’s also considering next year cutting income taxes for foreign nationals with “expert knowledge,” dividend taxes for some small businesses and allowing bigger write-offs for investments in research and development."

Applying recipes for expansion:
"The government has cut income taxes by 70 billion kronor ($11.1 billion), or about 2.1 percent of the economy, since coming to power in 2006. It has also reduced corporate and payroll taxes and abolished a levy on wealth."

The results, a booming economy and a fall in unemployment:

A History of Balanced budgets:

Leading to a rising GDP per Capita:

Finance Minister Anders Borg wants Sweden to introduce tougher rules on capital buffers than other countries.
The government is closely monitoring housing to avoid a bubble and already has introduced measures to contain rising household debt such as introducing a loan-to value cap of 85% for mortgage borrowing.

Sweden definitely sits in "The Good" camp, macro wise.

Canada.

I posted before on Canada as a leading example:

Canada, a great example of successful structural reforms and efficient banking regulation

Here is an update on the macro picture for Canada.

GDP Growth for Canada, January 2007 until January 2011:

Canada's budget was either balanced or in surplus, ensuring a reduction of Canada's debt to GDP and enabling them to face the financial turmoil in a much better shape than many other countries.

According to the IMF, Canada’s economy will grow by 2.8 per cent this year, up from an earlier forecast of 2.3 per cent.
The Canadian economy grew 3.1 per cent in 2010.

For the OECD, the forecast is that Canada’s GDP will grow by 5.2 per cent in the first quarter, and 3.8 per cent in the second. In comparison, the OECD has the U.S. economy growing at 3.1 per cent in the first quarter and 3.4 in the second.

http://www.thestar.com/business/markets/article/969530--oecd-bullish-on-canada

"Canada’s economy will grow faster than any other country in the G7 in the first two quarters of 2011."
“That’s full-steam ahead. 5.2 per cent would rank as the second-best quarter of the past 10 years,” said BMO deputy chief economist Doug Porter of the OECD’s Canadian outlook.

Unemployment is falling thanks to solid growth prospects:

Canada is clearly part of "The Good" section of our current macro review.

Another strong member of the group, Germany, the clear power house of Europe.

GDP growth is way above its European peers:

Consequences, unemployment is falling faster than in other EU countries:

What is very interesting is that, 10 years ago, France and Germany were at the same economic levels, both were the leading European power economic houses. Now France is clearly lagging behind. In a future post I endeavour to go into more details about this evolution which we witnessed in the last 10 years and the consequences for France in the not so distant future. Unless some major structural reforms are implemented, like they were in Germany, France will not move in the right direction.

The German discipline:

"The Good, the Bad and the Ugly" in the Eurozone per GDP Growth in 2010:

"The Good, the Bad and the Ugly" in the Eurozone per Government Budget Country Ranking in 2010:

"The Good, the Bad and the Ugly" in Scandinavia per Government Budget Country Ranking in 2010:

"The Good, the Bad and the Ugly" in Latin America per Government Budget Country Ranking in 2010:

"The Good, the Bad and the Ugly" in Major Economies per Government Budget Country Ranking in 2010:

Governmnent Yields 10 Year Notes - Source Trading Economics:

The Bad:

United Kingdom struggling to surge from the ashes of the financial crisis:

Inflation lower this month to 4% thanks to price war between major UK retailers:

I posted extensively on the effect QE in the UK would have on inflation on this blog. Previously, I commented that the Bank of England is facing a difficult situation, with the rise of inflation and its mandate of keeping it around 2%. At some point the Bank of England will have to raise rates, but, given the fact two thirds of UK mortgages are depending on short term rates and UK households are already massively leveraged (debt to income at a record level in the G7 countries club), the risk of a double-dip is massive and Mervyn King is fully aware of the difficulties that lie ahead. Mervyn King is trying to delay as much as possible the inevitable rise in interest rates and the March inflation figure at 4% clearly gave him some small room to breath.

UK budget deeply stretched:

UK unemployment levels not falling fast enough at the moment:

UK unemployment rate for the three months to February 2011 was 7.8 per cent of the economically active population, down 0.1 on the quarter. The total number of unemployed people fell by 17,000 over the quarter to reach 2.48 millions.

France is yet again, delivering below par performance which is clearly not helping its already strained budget.

A slow GDP growth below potential for France:

A sticky unemployment level due lack of structural reforms and flexibility in the labor market:

A decaying trade balance, January 2000 - April 2011:

As a comparison, France's closest and biggest trading partner, Germany has seen its trade balance soar, leading to a faster and more solid GDP growth.

Could France lose its coveted AAA rating? One thing for sure, the decoupling of the French and German economy has increased dramatically in the last ten years. I will post more on the subject in a future post.

Another member of "The Bad" group in the Eurozone is Italy.

"The Gross Domestic Product (GDP) in Italy expanded 1.5 percent in the fourth quarter of 2010 over the same quarter, previous year. Unlike the commonly used quarterly GDP growth rate the annual GDP growth rate takes into account a full year of economic activity, thus avoiding the need to make any type of seasonal adjustment. From 1982 until 2010, Italy's average annual GDP Growth was 1.45 percent reaching an historical high of 4.70 percent in December of 1988 and a record low of -6.50 percent in March of 2009. This page includes: Italy GDP Annual Growth Rate chart, historical data and news."

Italy GDP growth from January 2000 to April 2011:

While benefiting from a GDP boost following the introduction of the Euro after 1999, since then, Italy's GDP growth has been overall muted.

As The Economist posted in early April, Italy can be seen as the Achilles heel of Europe.

"ITALY’S public debt is the sleeping dog of the euro zone’s crisis. So far the markets have mostly let it lie. Although in 2010 it rose by three points, to 119% of GDP, Silvio Berlusconi’s finance minister, Giulio Tremonti, held the budget deficit to an impressive 4.6%, well below his target of 5%."

The article goes on:

"In fact the euro crisis has again laid bare the structural weaknesses in Italy’s economy. When euro-zone GDP falls, Italy’s falls by more; when it rises, Italy’s rises by less (see chart). The country has too few big firms. It is not generating jobs for the young: more than a fifth of the country’s 15- to 29-year-olds neither work nor study. Too few women have jobs (in the euro zone only Malta has a lower female-participation rate). The south remains a huge drag: in broad terms, GDP in the north may grow by as much as 3% a year, but in the south it shrinks by 2%, pulling the average down. Youth unemployment in parts of the south is 40%. And, as the Bank of Italy’s governor, Mario Draghi, has noted, Italian entrepreneurs have to cope with an unusually high level of organised crime. Police operations show that the ’Ndrangheta from Calabria has burrowed deep into the economic fabric of the north."

For the excellent The Economist interactive guide on the Eurozone spreading infection please use the below link:

Europe's economies - Spreading infection

Unemployment for Italy is still too high: January 2000 - April 2011.

But Italy's public finances were held tight thanks to its finance minister.
Italy Budget Deficit from January 2000 until April 2011:

Much tighter than France for instance.

The issue for Italy is that to meet the European rules on public debt, Italy will need annual economic growth of about 2 percent and a balanced budget. I do not see it happening in the near future.

ECB’s Draghi Says Italy Needs GDP Growth Near 2% for Debt Rule - Bloomberg

"The European Union last month reached an agreement on tougher economic oversight rules for member countries, including fines for governments that don’t cut overall debt fast enough. The accord came after Italy, with debt of 118.9 percent of gross domestic product last year, pushed for a broader definition of government borrowing that may offer a better chance of avoiding future sanctions for violators of the debt rules.

While countries with debt over 60 percent of GDP will be required to make annual cuts equal to 1/20th of the excess, progress will be judged against a range of “relevant factors,” the ministers agreed. Italy has pushed for private debt levels, which are low in Italy compared with the EU average, to be included in the gauge."

Analysis: Marchionne offers reform model to stagnant Italy - Reuters

"There is no doubt Italy is in dire need of reform."

According to this article from Reuters by Gavin Jones and Lisa Jucca

"Its economic growth consistently lags its euro zone partners and, according to International Monetary Fund data, it was the world's fourth most sluggish economy between 2000 and 2010, ahead of Zimbabwe, Eritrea and Haiti. Real disposable income has been stagnant since 1990 and the average hourly wage, adjusted for the cost of living, is 30-40 percent below that of its three main European peers, Germany, France and Britain. It is the only euro zone country where per capita output is lower now than it was in 2000.

Of course there are many reasons for this state of affairs, but analysts agree that one factor is the rigid and centralised system of industrial relations and an inability to increase productivity in line with its competitors."

But it is not too late for reforms. Germany remain's Italy’s largest trading partner. Germany is purchasing 12.7 per cent of Italian exports.

What is currently plaguing Italy's economy remain its ongoing North-South divide. Italy is a two zones economy and it is hindering its growth dramatically:

It is not too late for France either.

Both Italy and France, need to become probably more like Germany. In order to do so, they have to go through much needed structural reforms: Productivity and competitiveness were key to Germany's recent success.

The Ugly - Peripheral Europe:

Ireland has been the subject of quite a few posts on this blog.

Ireland debt status is now closer to junk following another round of downgrades from the rating agencies:
Moody's downgraded Ireland to Baa3 status with a negative outlook.

The Irish economy contracted for the third year running in 2010. GDP growth of 0.9% and 2.2% is forecast for 2011 and 2012.

As I posted previously, the Irish financial sector sunk the country.
Allied Irish Banks latest financial results is a good indication on how the country's public finances were deeply put into the red. AIB used to be Ireland's largest lender. AIB revealed additional losses recently: 10 billion Euros in 2010 from 2.3 billion Euros in losses a year earlier.

Now AIB, which is almost totally owned by the Irish government.

So far AIB has received 7.2 billion Euros in government aid to date and we know now it needs an additional 13.3 billion Euros in capital, following the latest Irish banks Stress Tests. On its own, AIB's capital injections so far represents an incredible 12.5% of GDP. And this is just for AIB, I am not including, Anglo Irish or Bank of Ireland.

There is only one explaination for the high losses in the Irish financial sector: High concentration of risk in property lending. Anglo Irish's loan book was on 10 promoters only as indicated previously.

Since Ireland embarked on its fiscal austerity programme two years ago, the Irish economy has contracted by at least 11%, and, 16% in three years in total. Consumer spending is down 14 percent since 2008.

"Commercial property prices have plunged 60 percent since peaking in 2007, while rents have fallen an average 50 percent, according to real-estate agent CB Richard Ellis Group Inc. (CBG)"

Source Bloomberg: Irish Retailers Fight Investors Over Rents After Economy Sinks

For the IMF, Irish growth will be "Ugly" in 2011, a miserable 0.5% according to there latest forecast.

In comparison:

"Growth for the Euro Area is estimated to be 1.6%. In advanced economies worldwide, growth is estimated at 2.5%, with developing world growth put at 6.5%."

The employment in Ireland is as well, a truly "ugly" picture:

Ireland Unemployment: January 2000 - April 2011

The blame for financial crisis is not all our own
We need to draw attention to punitive stance on financing of bank resolution, writes Colm McCarthy

"Holders of Irish bank bonds should take losses instead of the Irish Government footing the bill for their bailout," European Central Bank governing council member Axel Weber said.

Mr Weber added:
"To save a country's banking system, it is not necessary to write a blank cheque for the total balance sheet of the banking system."

"'In Ireland, the question is whether the banking sector has to be saved as a whole,' he added. 'Would it not be a better route to isolate deposits, to minimise losses to Irish taxpayers and to find a complete solution . . . with private sector participation instead of buying them out.'"

"Mr Weber echoes the consistent editorial position of the Financial Times, the Wall Street Journal and the Economist magazine among others."

This is the difficult dilemna, Ireland is facing, haircuts or more austerity for its taxpayers.

As for Portugal, last time it received an IMF package in 1983, the result was higher productivity and exports. Is it going to be different this time?
The key element for Portugal, as well as Spain to some extent, lies in a major structural reform of its labor market. Portugal needs to become more competitive again. Competitiveness is a key factor of success as highlighted by the German economic situation.

Portugal benefited as Italy in a short boost to its GDP growth after 1999, but since then, its GDP growth has not been stellar to say the least:

Portugal GDP Growth: January 2000 - April 2011

"The Gross Domestic Product (GDP) in Portugal expanded 1.20 percent in the fourth quarter of 2010 over the same quarter, previous year. Unlike the commonly used quarterly GDP growth rate the annual GDP growth rate takes into account a full year of economic activity, thus avoiding the need to make any type of seasonal adjustment. From 1989 until 2010, Portugal's average annual GDP Growth was 2.16 percent reaching an historical high of 6.50 percent in March of 1995 and a record low of -3.70 percent in March of 2009."
Source Trading Economics.

Austerity is biting even more Portugal's employment levels:
Portugal Unemployment Rate Jan 2000 - April 2011

As a reminder, CDS for financials are deeply correlated to Sovereign CDS levels as of the 7th of April 2011.

In regards to Greece, the writing is on the wall and a restructuring seems to be the most likely outcome:

Greek Government bonds run on the 14th of April 2011:
Price Yield

GGB 4.6 05/20/13 78.4410 17.8539
GGB 5 1/2 08/20/14 68.2760 19.1830
GGB 6.1 08/20/15 67.1960 17.3838
GGB 3.6 07/20/16 58.9710 15.5923
GGB 4.3 07/20/17 59.1350 14.7267
GGB 4.6 07/20/18 59.2450 13.8444
GGB 6 07/19/19 61.2950 14.257
GGB 6 1/4 06/19/20 64.1660 13.1971
GGB 5.3 03/20/26 58.6110 11.0967
GGB 4.6 09/20/40 53.6850 9.2031

Greece Sovereign CDS 5 year spreads reached a record on the 14th of April 2011 to 1164 bps, implying a Cumulated Probability of Default of 60% according to CMA.
CDS 5 year levels for Peripheral countries as of the 14th of April 2011:

Conclusion:
A real recovery in productivity is the only way for a sound economic recovery.

An interesting article as a follow up on European Banks financial woes:

Euro vs. Invasion of the Zombie Banks

By Tyler Cowen in the New-York Times

Are we seeing the application of Gresham's law in current market turmoils and hot money pouring into Emerging Markets? I will discuss on this subject in a future post.

Gresham's law as per wikipedia:
"Gresham's law is an economic principle "which states that when government compulsorily overvalues one money and undervalues another, the undervalued money will leave the country or disappear into hoards, while the overvalued money will flood into circulation."

"It is commonly stated as: "Bad money drives out good", but is more accurately stated: "Bad money drives out good if their exchange rate is set by law."

Robert Mundell believes that Gresham's Law could be more accurately rendered, taking care of the reverse, if it were expressed as, "Bad money drives out good if they exchange for the same price."