Chart of the Day - France in Limbo

"In the theology of the Catholic Church, Limbo (Latin limbus, edge or boundary, referring to the "edge" of Hell) is a speculative idea about the afterlife condition of those who die in Original Sin without being assigned to the Hell of the Damned" - source Wikipedia

Looking at France's gradual economic decline, from the core, towards the periphery, we thought the term "Limbo" would be appropriate if one looks simply at the Taylor rule, as indicated by the below graph  from Thomson Reuters Datastream / Fathom Consulting:

"Our Taylor rule analysis suggests that the German economy might actually benefit from tighter money. But the French economy needs a monetary loosening. Higher interest rates stemming from tapering could be profoundly damaging for the French corporate sector." - source Fathom Consulting

On top of that, French corporate margins are at a 25 years low, making them acutely vulnerable should the Fed proceed with its "tapering", also indicated in the below graph from Thomson Reuters Datastream / Fathom Consulting:

"The nexus between French banks and unprofitable NFCs represents the vulnerable underbelly of the Euro Area. The impact of Fed tapering could expose that. Should that risk materialise, we envisage significant implications for French assets." - source Fathom Consulting

While the CAC 40 is highly diversified and more and more loosely correlated to the activity within France, the latest willingness of the government to raise corporate tax to around 38% makes us see France as the new barometer for Euro Risk as a whole. Serious structural reforms have yet to be implemented.

"It is the end. But of what? The end of France? No. The end of kings? Yes."
Victor Hugo

Stay tuned!

Credit - The Awful Truth

Lucy: It's enough to destroy one's faith, isn't it?
Jerry: Oh, I haven't any faith left in anyone.
The Awful Truth (1937)

Following up on last week conversation in relation to the deflationary forces at play and in continuation to last week's analogy to one of our favorite movies of all time, we thought this week we would as well use one in our title, this time 1937 classic starring Cary Grant, namely "The Awful Truth", which catapulted is career. 

In the movie, Lucy and Jerry Warriner having filed for divorce have to settle in court for the custody of their dog Mr Smith. Abandoning the law books, the judge leaves the "final decision" of custody up to the dog:  "The custody of the dog will depend upon his own desire". 

In similar fashion, to last week's argument about inflation and deflation and the gold sell-off, in the movie, the dog, Mr Smith, swiveled his head back and forth between his two owners (inflation or deflation) unable to choose until Lucy lured him by cheating, surreptitiously with a glimpse of its favorite squeeze toy. 

All that glitters is not gold, and while some central bankers managed to trigger inflationary expectations with various QE programs, the recent sell-off in gold might indeed be the boogeyman in this deflationary environment. In similar fashion to QE2, QE3 triggered a significant rise in Inflation Expectations, but since the beginning of the year, 5 year forward breakeven rates have been falling, indicative of the strength of the deflationary forces at play - source Bloomberg:

The Fed’s five-year, five-year forward break-even rate, fell to 2.69% last week, the lowest since before the central bank said in December it would buy $45 billion of Treasuries a month on top of the $40 billion of mortgages it was already purchasing.

Yes, QE is supposed to create inflation and should be supportive of gold, but looking at this chart from a recent Bank of America Merrill Lynch report from the 16th of April entitled "The Curious Case of Stocks and Credit", as indicated above the recent fall in break-even inflation rates is a not a good sign:

In this week's conversation we will therefore look at various deflationary signs that signal caution in this very complacent environment, as displayed by the on-going disconnect between equities and bond yields.

As indicated by Bank of America Merrill Lynch's recent note, stocks should normally be reacting to an ease in inflation expectations:

"Everybody is getting worse but stocks and credit are getting better. US economic data is deteriorating, there are global growth concerns in Europe and most recently in China reflected in sharply dropping commodities, and inflation expectations are coming down hard. Yet stocks and credit are moving back toward their peaks. Every time over the past several years when inflation expectations have eased significantly stocks have declined and credit spreads widened meaningfully. But not this time. We continue to side with the weakening macro backdrop and retain our tactical (short-term) short positioning in investment grade credit. Perhaps stocks and credit are holding up on the perception that US and Japanese QE will push investors into US risk assets regardless of fundamental weakness – in other words, that strong technicals will overcome weak fundamentals. That appears uncharted territory, as what we have seen in the past is that QE can work to push investors into risk assets when perceived to boost economic activity and thus create inflation (Figure 3). We have little evidence that QE alone can do the job, without being perceived to improve fundamentals. Thus, again, we expect the weakening macro backdrop to prevail. However, in the meantime the technicals are undeniably strong despite the lack of retail inflows to long and intermediate high grade bond funds. Clearly we are seeing foreign institutional investors – especially from Asia – moving into US corporate bonds. However, this process has been ongoing for at least a year and is unrelated to the expansion of Japanese QE." - source Bank of America Merrill Lynch

For us the 5 most dangerous words have always been:
"It is different this time"

As we clearly indicated last week, in the US, High Yield credit has remained in line with equities since the beginning of the year. The de-correlation between credit and equities is nearly exclusively coming from Investment Grade credit and we indicated the relationship between High Yield and Consumer Staples in our conversation "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option" how defensive the rally in the S&P500 has been so far - source Bloomberg:

While Bank of America Merrill Lynch's short term positioning in investment grade seemed obvious early April,  the recent weakness in both the S and P500 and High Yield, in conjunction to weaker macro data warrants caution we think. 

Maybe we ought to be worried that something not great is unfolding in Asia, probably the reason why the US is so nervous about Abenomics. Is China at risk of social unrest due to labor conditions and weaker inventories signaling a much weaker economic outlook than expected?

With Japan playing "beggar thy neighbor", it is risks stirring trouble in the entire Asian region which is already hurting badly South-Korea with companies like Bridgestone and Sumitomo Rubber being the biggest winner so far of the weaker yen - source Bloomberg:

"The CHART OF THE DAY shows the best and worst performers this year among 46 companies in the MSCI World/Automobiles & Components Index, with Japan’s Sumitomo and Bridgestone, the world’s largest tire maker, surpassed by only Mazda Motor Corp. Their rivals Milan-based Pirelli & C SpA and Michelin & Cie., which is headquartered in France and is Europe’s biggest tire producer, are among the worst performers. The euro-zone economy has contracted for five straight quarters and the jobless rate rose to a record in early 2013, crimping vehicle sales. Bridgestone, which had 77 percent of its sales from abroad last year, said in February profit would climb to a record high in 2013, even under the assumption the yen would average 89 per dollar. Japan’s currency slumped to 99.66 per dollar on April 9, the weakest level since April 2009, after the Bank of Japan took unprecedented stimulus last week to end 15 years of deflation." - source Bloomberg.

On top of that, the European automative market's weakness continued in March and new car registrations were down 10.3% YoY following a 10.2% decline in February and 8.5% decline in January. It marks the 18th consecutive months of YoY decline. European car sales are sliding to a 20 year low. Not even Germany is immune to the deflationary trend given its auto market plunged by 17%. European car sales are a clear indicator of deflation as we indicated in April 2012. Our concerns have unfortunately been confirmed by these latest figures and as indicated by Tommaso Ebhardt in Bloomberg on the 17th of April in his article - "Europe Car Sales Heading for 20-Year Low as Germany Plummets", not even mighty Germany is immune:

"The German car-sales drop was the steepest among Europe’s five biggest auto markets, and compared with an 11 percent fall in February. The U.K., where sales increased 5.9 percent, overtook Germany in deliveries in March, according to the ACEA. Spain, Italy and France all posted declines.

“The western European passenger-car market is on track this year to hit levels last seen in 1993, and Germany seems to be in a free-fall,” Max Warburton, an analyst at Sanford C. Bernstein Ltd. in Singapore, wrote in a report to clients yesterday. “While unit profitability in Germany is not nearly as high as China, it’s still a critical driver of German carmakers’ earnings and the current trend is quite disturbing.” Deliveries at Wolfsburg-based VW, the regional market leader, dropped 9.3 percent, with the namesake brand posting a 15 percent decline. BMW, the world’s biggest luxury-car producer, sold 4.7 percent fewer vehicles in Europe last month." - source Bloomberg.

And if France is in trouble as we currently think it is, Germany will be too, very soon, given motor vehicles are Germany's biggest export to France as indicated by the below graph from Exane BNP Paribas:

As far as motor vehicles and China, should the Chinese economy weakens further, Germany will no doubt have issues:

- source Exane BNP Paribas - 28th of March 2013 report.

German exports and Chinese PMI showing a disconnect - source Exane BNP Paribas:

China accounts by the way 34% of global demand for rubber and inventories have climbed to 117,696 tons according to the Shanghai Futures Exchange, the highest in more than three years. 

Evolution of rubber in the largest exchanges in China and Japan since March 2010 - source Bloomberg:

"The CHART OF THE DAY tracks rubber on the largest exchanges in China and Japan since March 2010, with the gap reaching a 27-month high on Feb. 20 amid a weakening yen and strengthening yuan. The material used in tires and medical gloves traded at an  equivalent of about 404 yen in Shanghai on Feb. 11, the most  since September 2011. The Tokyo price had an 11-month peak of  334 yen per kilogram on Feb. 6, data compiled by Bloomberg show.  The Tokyo price last exceeded the Shanghai price in May 2011, the data show. Japanese Prime Minister Shinzo Abe’s monetary easing, dubbed “Abenomics,” has contributed to the yen’s more than 15 percent decline since mid-November. The yen fetched 93.50 per dollar as of 7 p.m. in Tokyo yesterday. By contrast, the yuan rose to a 19-year high of 6.2073 per dollar. Even as rubber futures in Tokyo fell 2.6 percent yesterday into a bear market, the most active contract in Shanghai lost 3.2 percent. Along with the currency market, China’s efforts to boost stockpiles in the world’s largest rubber market had contributed to the premium. With the inventory program set to decelerate, prices in Shanghai could fall, particularly as Southeast Asian producers have stepped up shipments to China to take advantage of the price differential, Tang said. Inventories in the Shanghai Futures Exchange were the most in about three years as of March 29, at 117,696 tons, according to the bourse. “Buying in Tokyo and selling in Shanghai may be the most profitable trade to get exposure.” Tang said." - source Bloomberg.

As we indicated in our conversation Pareto Efficiency:

"In a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off. Given an initial allocation of goods among a set of individuals, a change to a different allocation that makes at least one individual better off without making any other individual worse off is called a Pareto improvement." - source Bloomberg.

In true Pareto efficient economic allocation, while some pundits wager about simultaneous developments having contributed to the weakness in Emerging Market equities, for us Emerging Markets have been simply the victims of currency wars and "Abenomics", a subject we approached in last month conversation "Have Emerging Equities been the victims of currency wars?" - MSCI EM versus Nikkei - source Bloomberg:

If you look again at the Bloomberg table displaying the worst performers this year among 46 companies in the MSCI World/Automobiles & Components Index, the most affected, in true Pareto efficient allocation process are the Europeans, sinking deeper in a secondary depression.

While the strength of the Euro has been supported by the FOMC's January 2012's decision to maintain US rates low until late 2014, has in effect prolonged the European recession, delaying in effect a painful adjustment in Europe and to make matters worse, Europe is facing prolonged agony, with now Japanese joining the party with "Abenomics".

Like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content, and using another analogy, Europe is now facing pressure from two tectonics plates, initially pressure from the US and now Japan.

We always thought that the on-going crisis had a path similar to a particular type of "rogue waves" called "three sisters" ("three sisters" rogue waves sank SS Edmund Fitzgerald - Big Fitz) which were used as a comparable analogy by Grant Williams in November 2011.

We are witnessing three sisters rogue waves in our European crisis, namely:
Wave number 1 - Financial crisis
Wave number 2 - Sovereign crisis
Wave number 3 - Currency crisis

Another sign of the deflationary forces at play is the Euro-zone Corporate Credit Supply which continues to be elusive - source Bloomberg:

"A lack of corporate loan supply continues to hamper economic recovery across the euro zone. Lending to non-financial corporates (NFCs) fell in 11 of the 17 euro area countries in early 2013, with the Netherlands the sole large economy to show an increase in loans outstanding. Unless there is a pick-up in supply, growth forecasts will likely remain anemic and recovery slow." - source Bloomberg.

In numerous conversations, we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced. The decline in the oil price to a nine-month low may prove to be another sign of deflationary pressure and present itself as a big headwind. Why is so?

Whereas oil demand in the US is independent from oil prices and completely inelastic, it is nevertheless  a very important weight in GDP (imports) for many countries. Monetary inflows and outflows are highly dependent on oil prices. Oil producing countries can either end up a crisis or trigger one.

Since 2000 the relationship between oil prices and the US dollar has strengthened dramatically.  As we highlighted in our conversation in May 2012 - "Risk-Off Correlations - When Opposites attract": Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China's economic expansion and increasing consumption in Emerging Markets.

We believe that the current disconnect between oil prices, the Standard and Poor's index and the US 10 year Treasury yield warrants caution, as it seems to us that the divergence is very significant as displayed in this graph from Bloomberg from the 12th of April:

In a recent note entitled "The asymmetric beta of credit spreads" , Bank of America Merrill Lynch points as well to a weakness of oil prices which might be indicative of weaker growth expectations:

"Is oil re-pricing growth expectations?
A slowing economy could push Brent down below $95/bbl Brent prices have declined by almost $20/bbl on a combination of seasonal and cyclical headwinds. Some of these cyclical pressures are too large to ignore, such as China’s drop in energy demand growth or Europe’s sharp contraction in credit supply. In addition, emerging and developed markets face mounting structural challenges. To name a few, energy importing countries like China, Japan or India are seeing $15/MMBtu nat gas prices at the margin, while others like Brazil are struggling with high labor costs and rising inflation. In Italy or Spain, a high cost of capital poses a major challenge to a recovery. Should the global economic recovery stall further, Brent oil prices could fall below $95/bbl in the near-term.  
Our economists see few downside risks to EM growth…
At any rate, our economists still expect China to post GDP growth of 8.0% in 2013 and 7.7% in 2014. These numbers are consistent with our expectations of 360 and 485 thousand b/d in oil demand growth, respectively. A robust China outlook should translate into strong EM growth and hence oil demand. Having said that, Chinese oil demand in March grew by just 255 thousand b/d, consistent with average GDP growth of around 5 to 6%. Surely, solid EM demand has been a constant in the oil market for decades, so a structural slowdown in economic activity would not bode well for global crude oil prices."
 …so we keep our $112/bbl Brent forecast in 2014 for now

For now, we stick to our 2014 Brent forecast of $112/bbl despite the weaker data, as OECD ex-US inventories remain low. But we are concerned about the structural headwinds facing many economies. Whether it is high energy costs, expensive labor costs, a rising cost of capital, declining profitability, or misdirected investment into unproductive assets, the dislocations created by five years of zero interest rate policy in DMs will likely have some negative consequences in EMs. With oil demand growth exclusively supported by buoyant EM growth for years, lower global GDP trend growth (say from 4% down to 3%) could push Brent firmly out of the recent $100-120/bbl band into a lower $90-100/bbl range." -source Bank of America Merrill Lynch  - 17th of April 2013.

The issue of course is that we believe that "Abenomics" is a game changer from a pareto efficient allocation approach and that Emerging Markets in the vicinity of Japan which are already suffering, will be facing even more suffering in the second quarter hence our negative stance on emerging market equities, and on commodities as well.

On a final note, the latest hedge fund monitor from Bank of America Merrill Lynch from the 19th of April shows that they are positioning for a market correction:
"Based on our exposure analysis, macro hedge funds sold the S&P 500, NASDAQ 100, and commodities to a net short while increasing long exposure to the US Dollar Index. This suggests that macro funds are positioning for a market correction. Macros also sold 10-year T-notes to a net short. Within equities they switched to favor small caps from size neutral but are not at an extreme reading." - source Bank of America Merrill Lynch.

And as we posited before, if it is time for a pullback, get some greenbacks, at least that's what Dr Copper,  the metal with the economics Ph.D, is telling us given that as per a graph from Barclays, CFTC Comex positioning is the shortest on record:

"Copper plunged through $7,000 a metric ton in London for the first time in almost 18 months and

headed for a bear market on concern that demand from China to the U.S. and Europe may falter. Tin was also poised to enter a bear market. Copper for delivery in three months on the London Metal Exchange slumped as much as 4 percent to $6,800 a ton, the lowest level since October 2011, and was at $6,850.50 at 2:56 p.m. Seoul time. A close at the current level would be more than 20 percent below the metal’s last bull market peak in February 2012." - source Bloomberg, 18th of April 2013, Copper Poised to Enter Bear Market as Industrial Metals Slide.

Is Copper finally is telling us something about the real world, which equity markets are not currently focused on in true Zemblanity fashion, Zemblanity being "The inexorable discovery of what we don't want to know"? We wonder...

And, what if the trigger will be in Asia like in 1997 (as suggested by Albert Edwards recently) and not Europe after all? We wonder as well...

"Wonder rather than doubt is the root of all knowledge." - Abraham Joshua Heschel, Polish educator.

Stay tuned!

Credit - The Yield Skeksis

"The ignorant mind, with its infinite afflictions, passions, and evils, is rooted in the three poisons. Greed, anger, and delusion." - Bodhidharma 

While watching the on-going "Yield Famine", with credit investors dipping their toes more and more clearly outside their comfort zone and snapping up CLOs (Collateralized Loan Obligations), providing the necessary fuel for the biggest surge in corporate buyouts since the outset of the financial crisis, we thought our weekly analogy should, no doubt, refer to some of the main antagonists, the Skeksis, from Jim Henson's legendary 1982 fantasy film the Dark Crystal.

In the Dark Crystal, the Skeksis are the corrupt rulers of the planet Thra, having inherited it from their benevolent Urskek predecessors. While they are the embodiment of their knowledgeable predecessors, due to the accelerated decomposition of their bodies, the Skeksis constantly search for ways to prolong their lives at all costs. In similar fashion to the Dark Crystal Skeksis, our Yield Skeksis constantly search for ways to enhance their yield returns.

The primary method of the original Skeksis was to expose themselves to sunlight channeled directly through the Dark Crystal, though the amount of energy replenished to them was greatly dependent on the conjunction of Thra's three suns. In similar fashion, our Yield Skeksis are highly dependent on interest levels set up globally by the Central banks to replenish their level of "energy". 

Another method used by the original Skeksis to prolong their lives at all cost was to drain the lifeforce from other life-forms by exposing them to the reflect beams of the Dark Crystal, with the life-force collected in a liquid form (or coupons for our Yield Skeksis) and drunk only by the Emperor, who regains his youthful appearance. The effect on the drained victims was to turn them into near-mindless husks which the Skeksis use as slaves.

Looking at the incredible surge of Greece ASE equity index since 2012 (up more than 110%), in similar fashion to the end of the Dark Crystal, following the unification of the crystal triggering in effect the merger between the Mystics and the Skeksis, the land is shown rejuvenated and equities rallied:

No doubt, our post from the 4th of March 2012 entitled "Equities, there is life (and value) after default!", indicates the powerful effect of bond restructuring / partial default can have on equities. It looks "crystal clear" to us, but we ramble again...

Of course our reference to the corrupt Skeksis from the Dark Crystal and some European politicians would be purely fortuitous as the saying goes. Although the Skeksis are capable of forming alliances, they are by nature extremely paranoid toward each other. After all the Skeksis were only 10 compared to the 27 members of the European Union:

-The Emperor skekSo (having originally been an energetic ruler who enjoyed lavish festivity and sporting events which he invariably won. As he aged however, he became increasingly paranoid and spiteful).

-The Chamberlain skekSil (skekSil is the most devious, most notably as his intentions are never fully revealed and seemingly contradictory).

-The Scientist skekTek (the other Skeksis fear him out of ignorance of his work. His fascination with anatomy was very great he went as far as amputating his right arm and leg, replacing them with mechanical constructs).

-The Ritual Master (aka High Priest) skekZok (spearheads the various rituals the Skeksis practice such as the "Ceremony of the Sun", and sees their laws as absolute).

-The The Garthim Master (aka General) skekUng (his constant blundering in the capture of the surviving gelflings fails to evoke the desired respect of his subjects).

-The Gourmand skekAyuk

-The Slave Master skekNa

-The Treasurer skekShod (He frequently bribes the other skeksis into temporarily loaning him their personal possessions).

-The Scroll Keeper (aka Historian) skekOk, (also the most dishonest as he constantly rewrites the Skeksis' history to suit his allegiances and propaganda needs).

-The Ornamentalist skekEkt (skekEkt is nonetheless described in The World of the Dark Crystal as an extremely vain and callous character who would gladly cause the death of countless animals for the sake of fabricating one cloak).

but we wander in our thoughts once more.

Similar to the Skeksis from the Dark Crystal, by preventing the ultimate restructuring  in Europe (which will eventually happen), creative destruction cannot happen in true Schumpeter fashion.

Following a quick overview, we would like to focus once again on the broken credit transmission mechanism in Europe in general and in peripheral countries in particular.

The indicator we have been monitoring, has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes. In "Risk Off" periods we have noticed that the 120 days correlation had been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level. Currently the correlation is falling towards 70%, indicative of the on-going "Risk-On" in risk assets. - source Bloomberg:

The divergence between the performance in US equities (S and P500) and the Eurostoxx 50 has been clearly receding recently following the Italian elections scare, the red line in the graph being Italian 10 year yields - source Bloomberg:

In similar fashion, this divergence between US equities and Europe equities can be seen in the evolution of VIX versus its European counterpart V2X - source Bloomberg:

The short volatility spike in both the VIX and V2X has clearly receded, with V2X receding from 24 towards 17.

We have been monitoring as well the relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

The significant tightening witnessed this week in credit indices, has led the European High Yield risk gauge to recede towards the lowest points of 2010 and 2011, closing around 405 bps. The benchmark of 50 companies mostly speculative-grade ratings has fallen 47.5 bps this week, the biggest fall since January 4th and the lowest level since July 2011, supported by the US jobless rate and nonfarm payrolls number on Friday coming at 236 K.

But when it comes to the 7.7% unemployment level touched in the US. As far as we are concerned, unless we start seeing both a rise in velocity M2 and the US labor participation rate, we will remain skeptical about the much vaunted US recovery underway - source Bloomberg:

So, you might have 7.7% unemployment level but the US labor participation rate is still trending down and is now at 63.5%, a 32 year low and velocity remains muted. As we argued in our conversation "Zemblanity":

"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

So can someone please demonstrate to us how "this time it is going to be different" in terms of outcome for the US labor market given the "paradox of thrift" with bank reserves sitting idle at the Fed like we indicated in our previous conversation, with a broken transmission to the US economy, and questions surrounding fiscal stimulus which could potentially alleviate the situation (tax breaks for small companies anyone...)?"

Moving back to our Yield Skeksis analogy and relating to "Pareto Efficiency" in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off, it is that simple, and the losers today being unfortunately the younger generation in "developed" countries, leading to high unemployment in Europe and lower growth.

We have highlighted the deflationary forces at play in Europe in our shipping conversations, the lack of credit and the broken credit transmission channel have led to poor growth prospects in conjunction with a significant rise in bankruptcies in Europe leading to a continuous rise in unemployment levels. The recovery in exports and shipping which could bring some improving growth prospects for Europe is clearly hindered by unemployment levels - source Bloomberg:

"Unemployment within the euro zone is expected to increase to 11.95% in 2013 from 11.7% in 2012, and to improve slightly to 10.8% by 2015. Lower unemployment is crucial for expanding global demand for goods, keeping capacity loose and rates depressed. The recovery in the shipping industry will not be fully realized without improving unemployment trends."  - source Bloomberg.

But if you think that in this game of survival of the fittest, the prolonged impact has only impacted the greed of  "Yield Skeksis" in a true Pareto efficient way, the QE induced rise in Bunker fuel prices has as well killed off the "velocity" of ships forcing them in essence to adjust their supply chain to survive:

"Slow steaming, or moving slower to conserve fuel, has affected 90% of shippers' supply chains and 85% of them had to make changes to their operations, according to a survey by Centrx and St. Joseph's University. Given the longer transit times, shippers are increasing inventory levels and moving to multiple carriers to gain access to additional departure times." - source Bloomberg.

Courtesy of ZIRP, our Yield Skeksis have seen:
-Falling Yields (in the Dark Crystal movie, originally, Gelflings were most ideal in essence extraction until they were exterminated and Podlings were used in their place, their lifeforce having a temporary effect on the drinker)
-Falling labor participation rate
-Falling velocity

In relation to the European government bond picture, this week Spanish 10 year yields closed around 4.85% and Italian 10 year yields around 4.57% whereas German government yields closed around 1.50% levels - source Bloomberg:

But even the excess liquidity which have been provided to financial institutions via LTRO 1 and LTRO cannot prevent the return at some point of sovereign risk - source Bloomberg:

"Excess euro-zone bank liquidity, defined as ECB current and deposit accounts less reserve requirements and marginal lending, drove falling yields and improved bank liquidity from late 2011. Current concerns on Italian political instability and delivery on austerity targets demonstrate that while retained LTRO funds continue to ensure adequate liquidity, bond yields and bank funding costs may rise again. Excess liquidity in the euro-area banking system fell below 400 billion euros for the first time since December 2011, when the first ECB long-term refinancing operation (LTRO) was announced and disbursed. Collectively, 224.7 billion euros of LTRO I and II have been repaid since the end of January. If excess liquidity falls further, scrutiny will likely fall on Euribor, EONIA and other liquidity-cost indicators. - source Bloomberg

Moving on to the subject of the broken credit transmission mechanism in Europe in general and in peripheral countries in particular, we have long argued that LTRO liquidity injections amounted to "Money for Nothing". 

Only 61 billion of Euros came back to the ECB relating to the second tranche of the LTRO, indicative on the  cautious stance of financial institutions in peripheral countries, which had been the biggest beneficiary. This is not really a surprise given that Italian banks for instance are seeing a steady rise in bad loans as the political gridlock is staving growth in the process. This is clearly indicated by Sonia Sirletti and Fabio Benedetti-Valentini in their Bloomberg article from the 7th of March entitled - Italian Banks' Bad Loans Seen Rising as Gridlock Hampers Growth:

"Italian corporate and household non-performing loans rose to a record in December, reaching 125 billion euros, according to data from the Italian Banking Association. Banks’ gross non-performing loans as a proportion of total lending increased to 6.3 percent from 5.4 percent a year earlier. France’s BNP Paribas SA, which owns a retail bank and consumer credit unit in Italy, and Credit Agricole SA reported higher bad-loan provisions from their Italian branch networks in the fourth quarter. 

Italy’s central bank has increased inspections and is urging banks to take more provisions. “In periods of market tension, the intensity of supervision cannot be relaxed,” Governor Ignazio Visco said in a speech on Feb. 9. “The Bank of Italy review of the top 25 banks likely means an increase in non-performing loans coverage” in the fourth quarter, Francesca Tondi, an analyst at Morgan Stanley, wrote in a report March 6. “We think 2013 accounts will also be affected by still-growing NPLs and the need for more coverage. 

Sovereign Debt:

UniCredit shares as much as doubled in Milan trading, and Intesa surged as much as 73 percent, after European Central Bank President Mario Draghi’s July pledge to do “whatever it takes” to defend the euro. Those gains began to erode over the past month as Italian government borrowing costs increased in the run-up to the elections. “Any renewed rise in funding costs would be the equivalent of a tightening in monetary conditions, with the potential to slow the economy,” Credit Suisse Group AG analysts including Yiagos Alexopoulos and Christel Aranda-Hassel said in a note last week. Italian banks tied their fortunes more closely to the financial strength of the state in 2012, increasing holdings of the country’s sovereign debt by 58 percent to 331 billion euros. Italy has 2 trillion euros of debt, more as a share of its economy than any developed nation other than Greece and Japan.” - source Bloomberg

This provision pressure on Italian banks can already be seen in the growing spread difference between German, and Italian Corporate loans with costs widening - source Bloomberg:

"The cost of accessing a corporate loan in Italy is nearly 1.5% higher than the equivalent in Germany. In mid-2011, Italian new loans were priced more cheaply than Germany's and since 3Q12, new corporate lending in Italy has cost more than in Spain. Coupled with lower repayment of LTROs by Italian banks than witnessed in Spain and political turmoil, the outlook for credit costs and supply in Italy is deteriorating." - source Bloomberg.

But it is not only Italy which is stricken by this broken credit mechanism transmission to the real economy. Spain has well is facing similar issues of significant rising corporate loan costs - source Bloomberg:

"The cost of a new corporate loan in Spain of more than 1 million euros for a duration of one to five years reached a four-year high in January, underlining how supply and cost of credit to Spain's corporates remains a source of concern. While IMF analysis suggests significant progress has been made on reform, and anecdotal evidence suggests that the domestic deposit war may soon come to an end, supply of credit remains poor." - source Bloomberg

According to Bloomberg, Rates on consumer credit loans up to one year in duration fell 0.8% in Spain and 0.4% in Italy during December but not enough to offset the pressure coming from rising nonperforming loans.

As we posited in January 2013 in our conversation "Cool Hand", the Bank of Spain has been revisiting the introduction of caps to time deposit rates in order to reduce the deposit war which started in 2012. While there is no doubt, early signs, of some sort of ceasefire, as indicated by Bloomberg. The lower than anticipated refund of the LTRO in conjunctions with rising nonperforming loans, might not be enough to increase credit access to the real economy - source Bloomberg:

"Interest rates on new spanish household deposits, with less than one year maturity, fell more than 50 bps to 2.43% in January, the biggest absolute drop for four years. Following five straight months of growth in deposits with an agreed maturity, this hints at improving liquidity and banking conditions following many months of bank restructuring and reform." - source Bloomberg.

The fall to 2.43% is the biggest monthly decline since Bank of Spain records began in 2003.

Truth is when it comes to the deleveraging process for European financial institutions, much more is needed when one looks at the level of Loans to Deposits as indicated by Morgan Stanley in their note from the 1st of March on European Banks:

Credit wised, the Loan-to-bond refinancing, or disintermediation, is another growth driver in European High Yield markets as European banks tighten lending conditions. According to Bloomberg, analysis shows 50% of funding in Europe from loans vs 40% in U.S. so while banks are in retrenching mode, companies are switching to the bond market rather that asking banks for loans with the stringent covenants normally attached to bank loans:

After all our the greed of our "Yield Skeksis" knows no bound and if ones looks at CLO demand for AAA  rated portions, one could see that the average spread on institutional loans was 377.6 basis points last month, down from 515 at the end of June 2012, as reported by Bloomberg and according to S&P Capital IQ Leveraged Commentary and Data.

Back in 2007 the tightest level was 243.3 basis points. On top of that and according to Bloomberg, borrowers obtained more than $88 billion in loans last month from non-bank lenders, exceeding the pre-crisis peak of $55 billion in April 2007 and more than tripling the $26.7 billion received in January, according to JPMorgan Chase & Co. More than 80 percent of the loans made this year were used to reduce borrowing costs or extend maturities.
On top of that ZIRP engineered by the Fed has managed to raise the level of corporate takeovers to 86.6 billion dollars in the US in February, the busiest month since July 2008 according to data compiled by Bloomberg.

Given the appetite of our Yield Skeksis it remains to be seen how low spread can go in order for them to replenish their level of "energy", but that's another credit bubble story, we think.

"It is greed to do all the talking but not to want to listen at all." - Democritus

Stay tuned!

Credit - Synchronicity

"When coincidences pile up in this way, one cannot help being impressed by them—for the greater the number of terms in such a series, or the more unusual its character, the more improbable it becomes." - Carl Gustav Jung

Dear credit ramblings readers, apologies for the recent lack of posting, but, as of late we have been travelling, to attend a board meeting, windsurfing that is, hence our lack of "availability" in posting our regular  weekly credit feature. Yet, we did manage to take with us the laptop, to keep abreast of the evolution, or should we say lack of resolution of the on-going European debt crisis. We also manage to take with us some handful of books, one being "The Debt-Deflation Theory of Great Depressions" by the great Irving Fisher, which was originally published in Econometrica, Vol. 1, No. 4 in October 1933.

In this 1933 publication, Irving Fisher pointed out some very relevant points in relation to debt and deflation (which has been a regular theme on this blog). For instance, according to Irving Fisher, "the chief secret of most, if not all great depressions: The more the debtors pay, the more they owe. The more the economic boat tips, the most it tends to tip. It is not tending to right itself,  but is capsizing."

Looking at some of our 2012 conversations, we have used in numerous occasions sailing analogies for this very precise reason, and, in particular back in May 2012 in our conversation "The Raft of the European Medusa":
"Following up on the theme of navigation and sailing dear to our heart, given "The Tempest" raging and the unraveling of the "Mutiny on the Euro Bounty" courtesy of the high stakes poker game being played by Greek politicians and their European creditors (reminiscent of "Schedule Chicken" once more...), we have decided to use yet another sailing analogy but this time referring to Géricault's painting masterpiece "The Raft of the Medusa". 
Similar to the fate of the Medusa ship, the story so far has been the European Commission in an effort to make good time in reducing budget deficits, decided to impose unrealistic budget reduction objectives ("A Deficit Target Too Far") while imposing drastic reduction in bank leverage and balance sheets, courtesy of the European Banking Association (EBA) June 2012 deadline of 9% of Core Tier 1 capital. These combined actions led to credit contractions, no surprise there, leading to reduced economic growth in Europe compared to the US ("Growth divergence between US and Europe? It's the credit conditions stupid..."). While utter financial meltdown disaster was narrowly avoided thanks to the ECB's LTRO operations, the lack of experience or ability (or both...) of the captains of our "European Flutter" ship have indeed landed the European project on a sandbank, with of course, a "raft" full of "unintended consequences" such as mutiny, with Greek bond subordination during the recent PSI leading to insubordination (a buyers strike...) in parts of the European bond market."

When it comes to Europe, we have not changed "tack", 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."

So, why our chosen title and what is the link with Irving Fisher you might rightly ask? Well, dear readers we owe you some explainations. Synchronicity is the experience of two or more events that are apparently causally unrelated or unlikely to occur together by chance, yet are experienced as occurring together in a meaningful manner. The concept of synchronicity was first described in this terminology by Carl Gustav Jung, a Swiss psychologist, in the 1920s.

When one look at the event of the 1930s as related by Irving Fisher and the on-going discussions surrounding the "Fiscal Cliff", we could not resist but refer to Carl Jung's principle of Synchronicity:
"In fact under President Hoover, recovery was apparently well started by the Federal Reserve open-market purchases, which revived prices and business from May to September 1932. The efforts were not kept up and the recovery was stopped by various circumstances, including the political "campaign of fear". - source "The Debt-Deflation Theory of Great Depressions" by Irving Fisher, originally published in Econometrica, Vol. 1, No. 4 in October 1933.

Carl Jung believed, like we do, that many experiences that are coincidence due to chance in terms of causality could be an expression of deeper order. Concurrent event that first appear to be coincidental can later turn out to be causally related are termed incoincident. The "collective unconscious" defined by Jung is inherited, which is supportive of the idea of Synchronicity he developped:
"When coincidences pile up in this way, one cannot help being impressed by them - for the greater the number of terms in such a series, or the more the unusual its character, the more improbalbe it becomes." - Carl Jung

Admittedly, Carl Jung's theory of synchronicity is equal to intellectual intuition, but we digress as per our usual rambling habits.

Therefore in this week credit conversation, we would like to point out to the upcoming subordination of European sovereign debt courtesy of the much anticipated broad introduction of CACs (Collective Action Clauses) by January 2013 which implies at some point, debt will be much more easily repudiated. Given our title is namely Synchronicity, we will of course make further references to the great work of legendary Irving Fisher.

While musing through Irving Fisher's nine factors occuring and recurring (together with distress selling), indicative of cross-currents of a depression, we could not resist but focus on point VII from Irving Fisher's table leading us to experience Carl Jung's Synchronicity theory.
VII
- (5) Decrease in Profits
- (5) Increase in Losses
- (7) Increase in Pessimism (fall in Consumer Confidence in Europe is indicative, we think)
- (8) Slower Velocity
-  (1) More Liquidation
- Reduction in Volume of Stock Trading

- source JP Morgan 2013 Derivatives Outlook.

In addition to factor (8) coined "Hoarding" by Irving Fisher, Europe is as well a good example of the application of "Synchronicity" given as described by Irving Fisher, "Banks have been curtailing Loans for Self-Protection" courtesy of the European Banking Association rule of reaching 9% of Core Tier 1 Capital before the end of June 2012 with the economic impact we all have witnessed by now mostly in peripheral countries (see our conversation "Money for Nothing"):
"We mean "Money for Nothing" given our friends at Rcube Global Macro, in their latest study of the ECB quarterly bank lending survey indicate a significant worsening of the credit crunch in Europe, meaning plenty of liquidity impact for banks but confirming our 2011 fears of credit contraction for corporates and households ("Money for nothing and the Casino Chips for free..." - Macronomics)- February 2012

No wonder European Banks CDS spreads receded significantly in 2012, touching an 18 months low - source Bloomberg:

"European bank CDS levels have fallen to lows not held since June 2011, before the sovereign crisis and funding concerns in Spain and Italy flared aggressively and markets fell heavily. Down more than 250 bps since November 2011 highs, the improvement in European bank perceived creditworthiness has far outpaced that of U.S. and Asian peers" - source Bloomberg

In addition to factor number 8 and as indicated in Irving Fisher's work, banks have been busy selling investments.

Looking at rising correlations, in conjunction with the fall in volatilties which we tackled courtesy of our friends at Rcube Global Macro in our conversation "Why have Global Macro Hedge Funds underperformed", the recent rise in these correlations as indicated by this graph from JP Morgan 2013 Derivatives Outlook, it is, we think a cause for concern:

- source JP Morgan 2013 Derivatives Outlook.

As our friend Martin Sibileau puts it in his latest post "The year 2012 in perspective":
"At the end of 2011, when the collapse of the banking system in the Euro zone (courtesy of M. Trichet) was dragging the rest of the world, the Swiss National Bank established a peg on the Franc to the Euro and the Federal Reserve extended and cheapened its currency swaps with the European Central Bank. These two measures –indirectly- coupled the fate of the assets in the balance sheets of the Euro zone banks to the balance sheets of the central banks of Switzerland and the US. As in any other Ponzi scheme, when the weakest link breaks, the chain breaks. The risk of such a break-up, applied to economics, is known as systemic risk or “correlation going to 1”. As the weakest link (i.e. the Euro zone) was coupled to the chain of the Fed, global systemic risk (or correlation) dropped. Apparently, those managing a correlation trade in IG9 (i.e. investment grade credit index series 9) for a well-known global bank did not understand this. But it would be misguided to conclude that the concept has now been understood, because there are too many analysts and fund managers who still interpret this coupling as a success at eliminating or decreasing tail risk. No such thing could be farther from the truth. What they call tail risk, namely the break-up of the Euro zone is not a “tail” risk. It is the logical consequence of the institutional structure of the European Monetary Union, which lacks fiscal union and a common balance sheet. I am not in favour of such, but in its absence, to think that the break-up is a tail risk is to hide one’s head in the sand. And to think that because corporations and banks in the Euro zone now have access to cheap US dollar funding, the recession will not bring defaults, will be a very costly mistake. Those potential defaults are not a tail risk either: If you tax a nation to death, destroy its capital markets, nourish its unemployment, condemn it to an expensive currency and give its corporations liquidity at stupidly low costs you can only expect one outcome: Defaults. The fact that they shall be addressed with even more US dollars coming from the Fed in no way justifies complacency."

In relation to our "Synchronicity" theory and Irving Fisher, let us quote him again:
"When the starter consists of new opportunities to make unusually profitable investments, the bubble of debts tends to be blown bigger and faster than when the starter is great misfortune causing merely non-productive debts. The only notable exception is a great war and even then chiefly because it leads after it is over to productive debts for reconstruction purposes".

Furthermore, if Irving Fisher's debt-deflation is correct and if Synchronicity is correct as well, the "infectiousness of depressions internationally is chiefly due to a common gold (or other) monetary standard and there should be found little tendency for depressions to pass from a deflating to an inflating, or stabilizing country". We can easily conclude that the infectiousness of the European depression is chiefly due to a common monetary standard, namely the Euro. Therefore a break-up of the Euro would not be a "Black-Swan" per se, but the Euro not breaking up would be one.

Moving on to the subject of CACs namely Collective Action Clauses, the European Commission has agreed with the other European countries that as of the 1st of January 2013, all new issues will include CACs. Welcome to subordination in the European government space!

What are CACs?
"CACs are contractual provisions that:
1. Facilitate an issuer approaching bondholders with a proposal to modify ey terms of the relevant bond;
2. Enable a majority of these bondholders to agree to the proposed modifications; and
3. (where the requisite majority has so agreed) provide that the modifications are binding on all bondholders." - source Linklaters

As of the 1st of January, all new debt maturing above 1 year will include these clauses. According to a recent report published by Natixis, the European model for CACs allows for a much easier mobilisation process as well as an easier way of reaching majority and impacting similar securities at the same time. The modification of single series of one bond necessitate 75% of the notional represented in the meeting and 66 2/3 % of the total notional for the written resolution, but as well as for any securities taken individually (66 2/3% and 50% respectively). The objective is to reduce the majority level for a bond taken individually to facilitate the process.

CACs will be integrated to new issues, and the European Commission has imposed a threshold of a minimum of 55% of new issues including CACs, the other 45% will enable the liquidity of non-CAC related stock of government bonds. Going forward, the European Commission ambitions to reach a level of 95% of CAC bearing government bonds by 2023, the additional 5% will remain to maintain the liquidity of the current 10-30 year range. According to the note from Natixis, European issuers will need 5 to 7 years to obtain a stock level equivalent to the existing stock of non-CAC bonds. Since the default of Mexico in 1997, and Argentina in 2001, the use of CACs has risen significantly.

But what are the "unintended consequences"?

According to the same note from Natixis, with the introduction of CACs, one of the very first unintended consequences, will be that government will be tempted by using restructuring via CACs rather than solve their budgetary issues.
This moral hazard come with a cost, namely, rather than lowering the cost of funding, it will raise it given most new issues coming with CACs will be issued under domestic law.

We see another parallel with one of our pet subject, namely "bond tenders" in the capital structure of banks which has been a regular topic. Raising subordinated debt always come at the price because of the risk taken by the investor. For instance the possibility of coupon deferrals for Tier 1 bonds as well as UT2 make these junior subordinated debt instruments ineligible as reference obligations for CDS.

With the arrival of CACs and the already dwindling liquidity in the sovereign CDS space courtesy of the naked ban effective the 1st of November, one can only wonder about the attractiveness or use of the Sovereign CDS market in Europe.

Another important point from the Natixis note from an historical point of view (or maybe from a "Synchronicity" point of view) in relation to CACs, is the ability of these instruments to avoid default. A preemptive restructuring is always preferable to a post restructuring. Caveat creditor (let the lender beware...). The difference between haircuts from a pre-restructuring (CACs) and post-restructuring is close to 55% according to Natixis, in the case of restructuring occurring in Emerging Markets. Greece with its PSI and 53.5% is in the higher range of pre-emptive restructuring.

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.

On a final note, some pundits are indicating that Americans could be soon buying again durable goods - source Bloomberg:

"Americans may soon start buying more cars, appliances and other items because the ones they own are the oldest in almost half a century, according to Neil Dutta, Renaissance Macro Research LLC’s head of U.S. economics. The CHART OF THE DAY displays the average age of so-called consumer durable goods, as compiled by the Commerce Department since 1925. Dutta referred to the annual figures in a note to clients yesterday. Last year, the average climbed to 4.6 years, the highest since 1962. The increase from 4.5 years was the fourth in a row, the longest streak since the Great Depression. “Consumers are increasingly likely to commit to big-ticket purchases” as their finances improve, wrote Dutta, who is based in New York. Household debt fell to 81.5 percent of gross domestic product as of Sept. 30 from 97.5 percent at the end of June 2009, when the most recent recession ended, according to the Federal Reserve. Disposable income rose 12 percent during the same period, based on Commerce Department data. Increased spending on durable goods is one reason why U.S. economic growth is poised to accelerate, the report said. Dutta also cited a rebound in housing and the potential for growth in business investment." - source Bloomberg.

While the above sounds reasonable looking at the historical time frame used, when one thinks about "Synchronicity" and the theories of Irving Fisher and the events from May to September 1932, one might begin to wonder because the definition of Zemblanity is "The inexorable discovery of what we don't want to know":
"MV=PT as per Irving Fisher's equation. Unfortunately, it looks like the increase in M with a falling V, is not leading to a rise in T nor in a rise in the US labor participation rate for "Doc" Bernanke. "

Until we see a significant rise in Velocity M2 (a subject we discussed in Zemblanity), we will remain cautious on the US economic outlook and we would like to conclude this conversation with one graph displaying the US Labor Participation Rate with the Unemployment rate in the US since 2007 - source Bloomberg:

"Everything has been said before, but since nobody listens we have to keep going back and beginning all over again" - André Gide, French writer.

Stay tuned!

Credit - St Elmo's fire

“But now St. Elmo's fire appeared, which they had so longed for, it settled at the bows of a fore stay, the masts and yards all being gone, and gave them hope of calmer airs.” - Ludovico Ariosto's epic poem Orlando furioso (1516).

"St. Elmo's fire is named after St. Erasmus of Formiae (also called St. Elmo, the Italian name for St. Erasmus), the patron saint of sailors. The phenomenon sometimes appeared on ships at sea during thunderstorms and was regarded by sailors with religious awe for its glowing ball of light, accounting for the name. Because it is a sign of electricity in the air and interferes with compass readings, sailors also regarded it as an omen of bad luck and stormy weather." - source Wikipedia

We decided once more to follow on one of our favorite theme of maritime analogies looking at the recent evolution of events. After all, our recent post of the 8th of May "The Tempest" was a reference to Shakespeare's late masterpiece of 1623. Our title "The Tempest" was also a closely affiliated to our chosen post title Saint Elmo's fire, displaying a more negative association than our opening quote, as evidence of the tempest inflicted by Ariel according to the command of Prospero in Shakespeare's play:

PROSPERO
"Hast thou, spirit, Perform'd to point the tempest that I bade thee?"
ARIEL

"To every article. I boarded the king's ship; now on the beak, Now in the waist, the deck, in every cabin, I flamed amazement: sometime I'ld divide, And burn in many places; on the topmast, The yards and bowsprit, would I flame distinctly, Then meet and join."

As we ramble again in the opening of our post, in our usual habits, one of the earliest references to the St Elmo's fire phenomenon appeared apparently in Alcaeus's Fragment 34a (Ancient Greek lyric poet - 6 BC) about the Dioscuri, or Castor and Pollux. Why are we making a reference to the Dioscuri again you might wonder? Because in our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets" in reference to the Dioscuri we argued back in early November 2011 the following:

"So now the ECB has a stark choice, similar to the one Pollux was given by Zeus, to save his dying brother Castor by sharing his immortality with his mortal brother (namely European peripheral countries) or spend his time in Olympus (letting Europe fail, one country after another). The ECB is the only institution that can step in and become the lender of last resort, effectively becoming in essence a FED like entity which should be backed by a central treasury (and we discussed this point in our last conversation), or doing nothing and our Greek swan might take us to another path...

We know that Pollux made the right choice and enabling in the process, the two siblings to become the two brightest stars in the constellation (Gemini).

And the Dioscuri "characteristically intervened at the moment of crisis, aiding those who honored or trusted them." - Source Wikipedia."

St. Elmo's Fire is also a 1985 American coming-of-age film directed by Joel Schumacher, a prominent movie of the Brat Pack genre, revolving around a group of friends that have just graduated from Georgetown University and their adjustment to their post-university lives and the responsibilities of encroaching adulthood. Looking at the attitude of our "European Brat Pack", one has to wonder if our European Politicians will ever adjust to their respective responsibilities and embrace somewhat adulthood which would in effect determine whether our Saint Elmo's fire evolves towards a positive outcome in Ludovico Ariosto's fashion, (leading to the rise of the Dioscuri), or to the negative association of Saint Elmo's fire, namely disaster and tragedy. So for Europe, we think it's graduation time but we clearly divagate..."Misery Loves Company" we wrote in October 2011, and in similar fashion many asset classes have recently experienced similar pain due to the ongoing crisis particularly once again in Emerging Markets. In our long conversation, we will look at the broader impact and consequences following our usual credit overview.

The Itraxx CDS indices picture on Friday - source Bloomberg:

Yet another tale of ongoing volatility and a day of two halves. It started on a positive tone with Itraxx Crossover 5 year CDS index (50 European High Yield entities - High Yield credit risk gauge) tightening significantly in the morning before widening in the afternoon on the back of the negative news flow in the afternoon leading the indices to widened slightly further more than Thursday. The SOVx index representing the CDS gauge risk for 15 Western European countries (Cyprus replaced Greece recently in the index) remains at elevated levels and so does the Itraxx Financial Senior Index, a further indication of the existing correlation between financial and sovereign risk.

As indicated by Senior Strategist Divyang Shah's recent article in IFR, severing the financial/sovereign link is easier said than done:

"In the US this has been made easy by the post-Lehman concerns over money market funds and temporary government insurance on non-interest bearing checking accounts that has helped to see total insured bank deposits rise to US$7.3tn at the end of June last year compared with US$5.9tn in the second quarter of 2008 (Fitch).

In the eurozone the insurance of deposits took the form of state guarantees which is why what had started out as a banking crisis also turned into a sovereign crisis for some eurozone states starting with Ireland.

The ECB’s Peter Praet today points towards the need to disconnect the banks from sovereign debt, but this is proving a little difficult. The focus on Spain currently and Bankia especially is about a more general concern that the sovereign does not have the resources in order to overhaul the Spanish banks/financials and thus external assistance in the form of ESM/EFSF funds will be required."

The risk of course of deposit flights is indeed a very serious cause for concerns as indicated in the same note by Divyang Shah:

"A Greek exit has simply accelerated concerns over the outlook for financials as investors question the viability of the euro. The FT this morning highlights how funds are dumping euro assets (“Big European funds dump euro assets”) but what matters is the trickle of deposits leaving the periphery.

Data shows that on a y/y basis (March 11–March12) corporates reduced their deposits in Spanish banks by €31bn while retail investors have reduced theirs by €11bn. The point at which this trickle turns into a flood is uncertain but it’s a risk that the eurozone does not want to flirt with especially as sovereign and financial risk is still intertwined."

Deposits flows are indeed key factors in determining the stability of any financial system in peripheral countries as indicated by Bloomberg:

"With an 18 billion euro recapitalization of Greece's banks agreed and access to standard ECB facilities set to reopen, May's 700 million euros of announced deposit withdrawals may reverse. In 2006, household deposits were 45% of total liabilities vs. 32% in March, while deposits from banks were 6% vs. 25%. Retail funding remains key for future stability." - source Bloomberg.

In relation to Banks' "viability" and connection to sovereign risk, we have been sounding the alarm for a while in relation to subordinated bondholders about the very real risk of debt-to-equity swaps occurring in the financial bond space, meaning more pain and losses for both bondholders and shareholders alike. Time has come to warn senior unsecured creditors as well, as reported by Jim Brunsden and Ben Moshinsky in Bloomberg on Friday:

"The European Union will seek to give regulators the power to impose writedowns on senior unsecured creditors at failing banks as part of measures to prevent taxpayers from footing the bill for saving crisis-hit lenders.

The writedown powers would apply to senior unsecured debt and derivatives, while some other claims, including secured debt and deposits that are protected by government guarantee programs, would be shielded from the losses, according to draft plans obtained by Bloomberg News."

The plans are scheduled to be published on the 6th of June. The plans will have to be agreed on by finance ministers from the EU’s 27 member states and members of the European Parliament before they become law and the bail-in powers must be in place across the EU by the start of 2018.

So yes, our long standing assumptions are indeed correct, namely that debt-to-equity swaps are coming, it is part of the "liability" exercise needed to recapitalize ailing banks in Europe:

"As well as writing down claims, national regulators would also have the power to convert them into equity, according to the draft rules." - source Bloomberg.

When it comes to financial institutions in distress, it seems that more and more financial institutions are relying on ELA (Emergency Liquidity Assistance), which according to Bloomberg is increasingly being tapped - Frozen Europe Means ECB Must Resort to ELA for Banks:

"The first rule of ELA is you don’t talk about ELA.

Each ELA loan requires the assent of the ECB’s 23-member Governing Council and carries a penalty interest rate, though the terms are never made public. David Owen, chief European economist at Jefferies estimates that euro-area central banks are currently on the hook for about 150 billion euros ($189 billion) of ELA loans.

The program has been deployed in countries including Germany, Belgium, Ireland and now Greece. An ECB spokesman declined to comment on matters relating to ELA for this article.

The ECB buries information about ELA in its weekly financial statement. While it announced on April 24 that it was harmonizing the disclosure of ELA on the euro system’s balance sheet under “other claims on euro-area credit institutions,” this item contains more than just ELA. It stood at 212.5 billion euros this week, up from 184.7 billion euros three weeks ago.

The ECB has declined to divulge how much of the amount is accounted for by ELA."

When it comes to European Banking woes, which have been as well a regular feature in our conversations, Bankia share were suspended on Friday - source Bloomberg:

Bankia restated its 2011 results - saying it made a 2.98 billion euro loss for 2011 rather than the 309 million euros in profit it announced in February - and asked for the aid from Spain's bank bailout fund, FROB requesting 19 billion euro of financial support. Late Friday, rating agency Standard and Poor's downgraded Bankia, along with four other banks, to "junk" status: Bankinter, Banco Popular Espanol, Banca Civica, Banco Financiero y de Ahorros S.A.

Formed in December 2010 from merger of seven troubled banks, Bankia's most toxic assets were moved into holding company BFA.

Listed on the Madrid stock exchange in July 2011. Chairman Rodrigo Rato resigned earlier in the month before Bankia was "part-nationalized". Two weeks ago, the government intervened and awarded Bankia a 4.47 billion euro loan.

In our conversation "The Raft of the European Medusa", we discussed the ill-fate Bankia IPO which occurred in July 2011. Rodrigo Rato was the former Managing Director of the International Monetary Fund (IMF) from 2004 to 2007 and declared in relation to the July 2011 IPO for Bankia that it “has been considered a reference point for the Spanish banking industry” and was completed “in the middle of a true storm in the markets that imposed the toughest financial conditions of the last decade,” in a speech on July 20 2011.
Individual investors bought about 60 percent of the shares on sale in the IPO we indicated previously.

How can one expect Spain's to restore investor confidence when:

-as we indicated in our conversation "The road to hell is paved with good intentions‏", Spanish Economy Minister expected Bankia to only need 7 billion to 7.5 billion euro to meet provisional rule and declared he did not expect Spain Mortgage defaults to rise much. Total bill amounts now to 23.47 billion euro and counting for Bankia so far...

-the former 9th IMF Managing Director Rodrigo Rato led a very questionable July 2011 Bankia IPO based on "irregular" and "insincere" financial accounts leading to significant losses for already rattled Spanish individual investors.

One has to wonder. We do.

Meanwhile the price action in the European Bond Space has been volatile to say the least.

The current European bond picture, a story of ongoing volatility for Italy and Spain, but with France, joining the fray with a significant drop in yield over two days, dropping more than 20 bps - source Bloomberg:

French OAT 10 year Government Bond Yield receding significantly on the 24th of May - source Bloomberg:

French bonds falling towards their lowest level of 2.50%, experiencing a significant "flight to quality" move which so far Germany had benefited mostly.

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield), with 5 years Germany Sovereign CDS above 100 bps - source Bloomberg:

"Demand at almost record highs for German bunds and the insurance to hedge against default on the securities indicates that investors are increasingly betting on the breakup of Europe’s monetary union.

The CHART OF THE DAY shows 10-year German bund yields at all-time lows and the cost to insure the benchmark European debt close to record highs. Yields on the securities fell as low as 1.35 percent today as investors seek a refuge while European leaders seek to keep Greece within the euro and the currency bloc’s debt crisis from worsening.

“The signals are counterintuitive, but the market is pricing in an increasing probability of a euro zone breakup,” said Jürgen Odenius, chief economist at Prudential Financial Inc.’s Prudential Fixed Income unit in Newark, New Jersey. “And betting that even though the German balance sheet will take a big hit, that their new currency, which doesn’t yet exist, would

appreciate tremendously.” Credit-default swaps on 10-year German debt rose to 126.09 on Friday, according to data compiled by Bloomberg." - source Bloomberg

This graph has indeed been a regular feature in our conversations for obvious reasons...

Another interesting graph we have been tracking with much interest displays the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:

We do expect the SPX index to fall further in conjunction with Oil prices. We saw that "Misery loves company" back in 2011. In similar fashion, many various asset classes are experiencing significant correlation on the downside, following a similar pattern.

Oil prices are poised to fall further because drilling-rig use and stockpiles are at their highest levels in decades, according to Michael Shaoul, Oscar Gruss & Son Inc.’s chief executive officer as reported by Bloomberg:

"The CHART OF THE DAY compares weekly data on the number of oil rigs, as compiled by Baker Hughes Inc., with the Department of Energy’s weekly figures on crude inventories. Last week’s rig count of 1,382 was the highest in 30 years, Shaoul wrote yesterday in an e-mailed note. The number increased 45 percent from a year ago. Oil stockpiles totaled 382.5 million barrels, the most since mid-1990.
“Even though demand has remained steady, it has been overwhelmed by supply,” the New York-based analyst wrote. “The clear risk is that this will be resolved by sharply lower prices in the coming months.” Oil has tumbled 14 percent on the New York Mercantile Exchange this month. The loss exceeds an 11 percent decline in Brent crude, another benchmark, and would amount to the biggest monthly loss in two years." - source Bloomberg.

Commodities, like in 2011, experienced as well some significant retracement with Cash silver losing as much as 1.3 percent to $27.9275 an ounce and to around $28.30. The metal is 1.5 percent lower this week for a fifth weekly drop, the longest losing streak since July 2011. Raw materials slid to a five-month low this week and more than $4.3 trillion was erased from the value of global equities this month on concern that Greece will exit the euro as the region’s debt crisis deepens according to Bloomberg.

Emerging-markets stocks as well, have seen the longest string of weekly losses since 1994 according to Bloomberg:

"The MSCI Emerging Markets Index sank 0.4 percent to 898.57 at 12:42 p.m. in Hong Kong. The gauge has fallen 0.9 percent this week, poised for a 10th weekly decline, on concern that Europe’s debt crisis and China’s economic slowdown will curb demand for riskier assets."

So yes, "Misery" does indeed, love company, and in 2012 like it did in 2011:
"Emerging-market equity funds posted outflows of $1.5 billion in the week ended May 23, Markus Rosgen, Hong Kong-based analyst at Citigroup Inc. said in a report today. Overseas investors sold $5 billion of emerging-market stocks in Asia, the biggest weekly outflow this year, according to the report." source Bloomberg.

"Emerging-market dollar bonds may start to match declines for developing-nation stocks as the
Greek debt crisis further weakens the risk appetite of investors, according to Mizuho Securities Co.
The CHART OF THE DAY shows JPMorgan Chase & Co.’s Emerging Market Bond Index has dropped 2.4 percent this month, while the MSCI Emerging Markets Index of stocks plunged 12 percent. During a sell-off that started Sept. 8, the indexes fell in tandem, with dollar debt declining 5.5 percent in two weeks. The lower panel shows emerging-market credit-default swaps have being gaining since March, mirroring a rise in the cost to insure against losses leading up to early September."  - source Bloomberg.
Dollar-denominated fixed-income securities from emerging-market nations have returned 4.2 percent so far in 2012.

"Emerging-market bond funds attracted $633 million in the week to May 16, taking inflows this year above $20 billion, according to U.S. research company EPFR Global. Some $15 billion of that was invested in dollar notes. About $2.3 billion was pulled from equity funds, the second week of withdrawals, paring inflows this year to $20.5 billion, EPFR said." - source Bloomberg
We've seen this movie before...

In relation to European economic data, it is hard to find any comforting news with euro-area unemployment rate climbing to 11 percent in April, the highest in data compiled by Bloomberg back to 1990, and worrisome PMI numbers coming clearly on the weak side.

The divergence between US and European PMI indexes - source Bloomberg:

Widest level reached since 2008, 9.80 between both PMI indexes.

On a final note, our good cross asset friend indicated to us an interesting correlation between the Japan Nikkei index and Japan's sovereign 5 year CDS since the beginning of March. The index has been falling whereas at the same time, Japan's sovereign CDS is rising. The bottom graph indicates so far a fairly muted volatility for the Nikkei index:

If Europe is moving towards a Japanese decade, there might be at least some solace for Spanish Golf players given that according to Bloomberg there has been a high correlation between Golf Membership fees and Tokyo land prices - source Bloomberg:

"The CHART OF THE DAY compares an index of commercial land prices in the Tokyo metropolitan area, compiled by the Japan Real Estate Institute, with the average membership price among Japan’s three most-expensive golf clubs. The average joining fees at Koganei Country Club, Tokyo Yomiuri Country Club and Yomiuri Golf Club this year have fallen about 40 percent compared to the full-year average in 2011, according to prices compiled by Nikkei Golf Corp., a Tokyo-based broker for membership trades.
Tokyo’s office vacancy rates increased to a record high of 9.23 percent in April from 9 percent a month earlier, pushing rents to a record low, according to Miki Shoji Co., a closely held office brokerage company. The vacancy rate was also 9.23 percent in January. The commercial property index peaked in early 1991, about a year after average prices for the country clubs reached a record high of 288 million yen ($3.62 million), the data show. Golf-membership prices soared in Japan during the 1980s bubble economy, then slumped as the country suffered through series of recessions the past two decades. At least 800 golf clubs went bankrupt since 1991, according to Meiji Golf, a Tokyo-based broker. Some of the most expensive clubs in Japan don’t allow memberships for women or foreigners."

"Markets can be as treacherous as the sea". - Macronomics

Stay tuned!