Credit - Froth on the Daydream

"Do you think when two representatives holding diametrically opposing views get together and shake hands, the contradictions between our systems will simply melt away? What kind of a daydream is that?" - Nikita Khrushchev

Definition of froth:
noun - A mass of bubbles in or on a liquid; foam 
verb - to produce or cause to produce froth
source - Collins English dictionary.

Our reference in this week title is of two-fold. A froth being a mass of bubbles in a liquid form, looking at the quantity of liquidities injected in the system courtesy of central banks (see our post "QE - To infinity...and beyond"), and given the incredible rally in the credit space with more and more players looking at "stealing third base" (to use a baseball analogy), one can argue that many investors are really getting outside their "comfort" zone and investing once again in the riskiest part of the capital structure (Leveraged loans, High Yield, PIKs bonds, etc.), hence our froth reference. Yes, arguably once more, central banks are indeed "frothing".

But, our title is as well a reference to 1947 novel by French author Boris Vian, one of our favorite books of all time. It tells the story of a man who marries a woman, who develops an illness that can only be treated by surrounding her with flowers. We think the current global economic situation tells a similar story, namely that economies developed an illness (credit bubbles) that can only be treated by surrounding them with liquidities.

Credit Booms and Financial - Crisis - IMF

"The majority of the largest financial crises over the past three decades followed significant private credit expansion. While credit booms need not be followed by a period of bust (the IMF calculates that one third of booms sampled were followed by a banking crisis) it notes that many more were followed by sub-trend growth for the subsequent six years." - source Bloomberg

In Boris Vian's great poetic novel, the hero Colin marries Chloé, but Chloé falls ill upon her honeymoon with a water lily in the lung, a painful and rare condition that can only be treated by surrounding her with flowers. One can as well argue that a BSR (Balance Sheet Recession) is a rare condition that can only be treated by surrounding it with liquidities but if credit is not flowing to the real economy which is definitely the case in the Eurozone; a similar fate looms for the European economy as for Chloé in the novel. In the novel at some point, the flower expenses become prohibitive and Colin soon exhausts his funds. 

"The CHART OF THE DAY shows that the ECB’s assets have climbed to 33 percent of the gross domestic product of the nations that use the euro, exceeding levels for the U.S. and Japan. It also shows Draghi’s proposal could drive the central bank’s holdings to exceed 43 percent if policy makers bought all 1.01 trillion euros ($1.27 trillion) of Italian and Spanish bonds due by end-2015 and failed to sterilize purchases. Draghi will propose unlimited buying of government debt, while refraining from a public cap on yields, according to two central bank officials briefed on the plan before the ECB meets today. Sterilization involves draining money from other parts of the financial system to offset the new funds being added." - source Bloomberg.

We are very fond of Boris Vian's novel, and we can find many more analogies in this week credit rambling's title with his masterpiece. 

For instance, as Chloé becomes even sicker, the house they live in starts to shrink and becomes darker and gloomier on a daily basis although the little grey mouse that lives in the house does all its best to clean the windows in order to let the light in. When one looks at the future for Greece, it looks increasingly likely that Greece will become the euro's poorest nation in two years as indicated by Bloomberg:

"The CHART OF THE DAY shows Greek output per person adjusted for relative price levels is set to fall to 71.3 percent of the European Union average in 2014 from 79.8 percent last year, according to the commission’s Ameco database. Slovakia, the second-poorest euro nation, will surpass Greece as early as this year, while Estonia, the zone’s most impoverished state, will top Greece at the end of 2014. Greece is struggling to meet debt-reduction targets imposed by international lenders more than two years after receiving its first bailout. The need for more austerity measures is pushing the economy deeper into recession and more than one-fifth of output will have been erased by 2014, when growth is set to resume after six years of recession." - source Bloomberg

In Boris Vian's book, Colin struggles to provide flowers (credit) for Chloé to no avail and his grief at her ultimate death is so strong his pet mouse commits suicide to escape the gloom. Looking at how the ECB (Colin) is struggling at providing real flowers (credit) to the Spanish real economy (we have long argued that the LTROs provided by Mario Draghi amounted to "Money for Nothing"), we can only wonder about the accuracy of our reference when looking at the deflationary bust unfolding in Spain before our very own eyes - graph source Bloomberg:

"The CHART OF THE DAY shows that the 30 percent expansion of the ECB’s balance sheet since Draghi’s first meeting as President in November 2011 has reduced the Euribor-OIS spread, a measure of European banks’ reluctance to make unsecured loans to one another, to a five-year low. In that time, Spain’s 10-year borrowing cost has risen, even after Draghi channelled 1 trillion euros ($1.3 trillion) to banks via two rounds of Longer-Term Refinancing Operations in December and February. Draghi has also cut interest rates to 0.75 percent in three 25 basis-point reductions, and reinforced his July 26 pledge to do “whatever it takes” to defend the euro by announcing an unlimited bond-purchase program. Spain is yet to request aid, a precondition of central bank bond purchases. The ECB left interest rates unchanged on thursday's meeting." - source Bloomberg

"Maintaining lending and credit flows is paramount to avoid a credit crunch which would essentially impair GDP growth in the process." - Macronomics, Modicum of relief - March 2012

Euro Area Bank Lending Survey - source Thomson Reuters Datastream / Fathom Consulting:

When ones looks at the amount of consumer gearing in Europe versus the USA, no wonder that the amount of "frothing" or flowers from the ECB has been staggering. As indicated by Bloomberg in the below graph, the Credit Penetration has been falling from the 2009 highs, courtesy of the BSR and the deleveraging needed but the gearing of private households as fallen in the US whereas it has risen in Portugal for instance!

"Globally, domestic credit to GDP has fallen seven percentage points from 2009's all-time high, as banks deleverage and consumers pay down debt. While Portugal and the U.S. have the same 193% ratio, the Portuguese credit boom drove consumer gearing to 193% from 135% in 2005-09, unlike the U.S., where the ratio has dropped over the same period." - source Bloomberg

Looking at the recent surge of the Bloomberg US Consumer confidence Index from -34.7 to -34.4 in the period ending November 4, the best reading since April, we remain more positive on the US economy than the European economy. As we indicated last week in our conversation "The year of the empty hand", the divergence of growth between the US economy and the European economy is still reflected in credit prices such as the US leveraged loan cash price index versus its European peer - source Bloomberg:

When causation implies correlation...

In our previous conversation "The link between consumer spending, housing, credit and shipping", we indicated that Shipping is an important credit and growth indicator:

"The relationship between container shipping and consumer spending, traffic is indeed driven by consumer spending".

The below Bloomberg graph displays such a link between economic growth and shipping as well as housing:

"The Baltic Dry Index is a barometer of the health of the shipping industry and broader global economic activity. The daily index aggregates the costs of moving freight via 23 seaborne shipping routes. It covers the movement of dry-bulk commodities, such as iron ore, coal, grain, bauxite and alumina. It also gauges dry-bulk supply-and-demand dynamics." - source Bloomberg

Consumer Confidence is as well a barometer of economic conditions. When one looks at the Consumer Confidence evolution in the Eurozone, one can see the growing headwind for growth to resume which would alleviate the concerns in regards to solvency issues for some European countries:

Source Thomson Reuters Datastream / Fathom Consulting.

In similar fashion, we already touched at the link between European Consumer Confidence and Consumption in our June conversation "Yogurts, European Consumer Confidence and Consumption" where we argued: 

"Yogurts matter as an indicator? One has to wonder...As austerity bites consumer spending and with Italy and Spain in recession, companies have been forced to lower cost to protect earnings so far. End of May the ECB also indicated that loans to households and companies in the euro zone grew at the slowest pace in two years as the on-going crisis curbed demand for credit."

Yogurt giant Danone share price versus European Consumer Confidence since 2006 - source Bloomberg:

"Mind the Gap..."

Economic Sentiment is a well a leading indicator we think, when it comes to predicting GDP growth as in the below Bloomberg Graph plotting the evolution of both in Europe since 1998:

Another, "Mind the Gap".

No wonder GDP growth in Europe is indeed turning South for all:

Source Thomson Reuters Datastream / Fathom Consulting.

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").

As far as our new barometer of Euro Risk is concerned, all is not well. The 3% deficit target in 2013 is highly unlikely to be reached when one looks at a very simple economic indicator, namely France's industrial production and GDP growth since 2001 - graph, source Bloomberg:

French recession will happen. Industrial production slumped to -2.5% the lowest level since 2009 and the biggest drop since January 2009. More than the 1% decline forecast by economists in a Bloomberg news survey. Not only industrial production is cratering but sentiment among manufacturers executives was unchanged at 92 in October.

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").

What was that Standard and Poor's April note indicating with which we completely disagreed with in our April conversation relating to France - "France's Grand Illusion"? As a reminder:

"Apr 04 - Although the current recession in Europe will probably extend into the third quarter, we believe the economy may pick up modestly late this year and in 2013, said Standard and Poor's today in announcing the publication of its report "No Fast Lane Out Of Europe's Recession."

We did not share the same beliefs as Standard and Poors and we still do not share them.

France Fiscal Position - source Thomson Reuters Datastream / Fathom Consulting:

As far as France sovereign CDS is concerned, it trades at the same level as Belgium with Belgium being in a better fiscal position - source Bloomberg:

Back in our conversation "Spanish Denial", we indicated:

"When it comes to Net Financial Wealth of Households as a percentage of GDP, 2000 and 2007, as indicated by Eurostat, Italy is indeed a much richer country than expected, even compared to France and Spain. We could even go further in our analysis and compare Belgium to Italy, given their similar high debt to GDP levels (98.5% for Belgium, 119.6% for Italy), but very low household debt (around 53% for Belgium), very high savings rate (around 17% in 2011 in Belgium) as well as very high level of savings and a mostly domestically held government debt. Both countries enjoy massive private sector wealth, therefore foreign debt is negligible"

The current CDS level reflects our position that Belgium is a better risk than France having not only a much better Fiscal position but a much lower household debt and a very high saving rate:

"A wealthy private sector is significant when it comes to debt dynamics given that by broadening the tax base and introducing bigger transfers from the private sector to the public sector means the demand for government bonds in the primary market can provide a stable base as indicated by last year's report published by Danske Bank - Euro area: Why Italy is not Greece:

"The deficit in the peripherals, apart from Italy, increased sharply in 2008 and 2009. In Italy, however, it never exceeded 6% of GDP, and in 2010 the deficit of 4.6% was half that of Spain and Portugal and much better than Greece and Ireland."

On a final note in relation to France, BNP Paribas latest quarterly earnings has revealed the extent of credit contractions in France as indicated by Bloomberg:

"The appetite for loans in France is diminishing on stagnant growth. BNP said decelerating demand in its domestic retail network had edged loans down in 3Q, with consensus calling for GDP growth of just 0.1% in 2012. Net interest income at French lenders could be under pressure from waning demand and persistent low rates. French business lending contracted 0.5% yoy in September (ECB)." - source Bloomberg

"high expectations + strong consensus = danger."

"Both expectations and memories are more than mere images founded on previous experience."  - Samuel Alexander, Australian philosopher.

Stay tuned!

Markets update - Credit - Anterograde and Retrograde amnesia.

"Anterograde amnesia refers to the inability to remember recent events in the aftermath of a trauma, but recollection of events in the distant past is unaltered.
Retrograde amnesia is the inability to remember events preceding a trauma, but recall of events afterwards is possible."

Another day in the trenches in the credit space, and given the acceleration in the deterioration of the market context, yet another long post starting with a quick review of the price action.
The Itraxx credit indices overview:

The Itraxx SOVx 5 year CDS Western Europe index (15 countries) broke a new record to around 362 bps.
The Itraxx Crossover 5 year CDS index (High Yield) soared to 846.5 bps, highest level since April 2009, a 59 bps increase on the day. Intraday it was almost up by 70 bps.
The Itraxx Main Europe 5 year index (Investment Grade) passed the 200 bps level.
And Itraxx Financial Senior 5 year CDS index as well as Itraxx Financial Subordinate 5 year index widened significantly as well. 318 bps at some point before receding a bit to 302 for the Senior index and 555 bps for the subordinate index, receding in the end to around 540 bps level. Truly nasty price action.

The significant moves today were on the Sovereign CDS space with Germany breaking through 100 bps to 109 bps (39 bps in July) and France breaking the 200 bps level to 205 bps.

Spain 5 year Sovereign CDS versus Italy 5 year Sovereign CDS - we know the story by now. Spain is decoupling:

Another session marked by flight to quality with the 10 German Government bond reaching a new low in terms of yield::

Source Bloomberg - morning snap.
The Bund reached a record low yield of 1.67% and even 30 years reached a record low to 2.47%.

10 year Sweden government bonds versus 10 year German bund, still a correlation of 1:

The liquidity picture, still on the weak side:

But the interesting development we have seen today has been coming from the accelerated deterioration of emerging markets, which so far up had been spared to a certain point.
The SOVX western europe 5 year CDS index versus the SOVx CEEMA (Central Europe and Middle-East and Africa) tells the story:

From divergence back to convergence for both credit indices.

The trigger has been the clear slowdown in Chinese manufacturing, meaning China will not be strong enough to counterweight the US and European slowdown we are seeing.
So, we get a sell-off in emerging equities (down by 4%, a 15 months low), a sell-off in credit, a sell-off in currencies (currencies backed by commodities taking a serious beating in the process), and a sell-off in commodities.

A sell-off in Emerging debt - JP Morgan EMBI Global Diversified:
The J.P.Morgan Emerging Markets Bond Index Global ("EMBI Global") tracks total returns for traded external debt instruments in the emerging markets:

A sell-off in equities - HAIER Electronics Group Co, one of the world's leading white goods home appliance manufacturers. We know it is relevant from the previous post - "Markets - Credit - Controlled demolition" and it follows the decision from the Chinese government to pul its subsidy program it had in place in four Chinese regions:

A sell-off in commodities - pop goes the bubble in copper artificially inflated prices, with China having pulled on the 31st of August another artificial stimulus, namely letters of credit which funded the cash-for-copper collateral game (used as financing instrument...). And copper is closely linked to economic activity as well as fluctuations in Chinese demand, so with a PMI at 49.4 that is what you get:

A sell-off in currencies:
Russian Ruble in trouble:

Indian rupee:

As a reminder from previous post:
"But it isn't only Russia trying to sustain its local currency by buying rubles, it is also happening in India with the regulators also starting to buy local currency and selling dollars and Argentina as well."

Brazilian real - BRL:

Here is the reason:
From Bloomberg - Ye Xie and Josue Leonel.
"The real’s biggest five-day plunge since 2008 is fueling speculation Brazil will sell dollars to shore up the currency, reversing a 28-month-old strategy aimed at stemming gains.
Brazil’s currency has lost 8.6 percent against the dollar since Sept. 14, the most since the global financial crisis drove it down 10.9 percent in the five days through Dec. 3, 2008, according to data compiled by Bloomberg. The slump handed investors in real-denominated bonds a loss of 13.5 percent in dollar terms this month, the worst performance in emerging markets, according to data compiled by JPMorgan Chase & Co.
Speculation is mounting that the real’s slide may deepen, pushing up import prices and adding to the highest inflation rate in six years, if the central bank fails to deploy some of its $352 billion in reserves to defend the currency. Concern policy makers’ surprise rate cut last month signals they are giving up on their goal of slowing inflation is compounding the real’s decline as Europe’s debt crisis erodes demand for emerging-market assets."

From the same Bloomberg article we learn the following:
"The central bank hasn’t bought dollars in the spot market since Sept. 13, breaking a practice it adopted since May 2009. It bought $47.6 billion in the first eight months of this year, surpassing the $41.4 billion it purchased in 2010. It last sold dollars on Feb. 3, 2009, when the real closed at 2.3052 per dollar. It closed yesterday at 1.8756."

Also from Bloomberg:
"Brazil’s central bank yesterday decided not to roll over reverse-currency swap contracts expiring in October, which will lead to the unwinding of $2 billion worth of bets against the dollar. It’s the first time policy makers refrained fromrenewing the contracts since January."

Which led to a surge in Brasil Sovereign CDS of 23 bps to 196 bps on the 5 year. At the same time, Argentina's reserves, following the same path, is seeing its dollar reserves depleted:
"Policy makers on Sept. 20 sold around $700 million in futures contracts due through October to show investors they are maintaining a policy of sustaining the peso and to discourage speculation in the currency, said a central bank official who asked not to be named because of the institution’s policy. The bank buys and sells dollars in futures markets on a regular basis, he said." - source Bloomberg - Camila Russo and Katia Porzecanski - 22nd of September.
Argentina's bonds are now yielding 972 bps more than US treasuries with the 5 year CDS trading at 983 bps according to CMA.

And contagion we have now in emerging markets.


Sovereign CDS 5 year wideners on the 22nd of September - source CMA:

In relation to the credit funding issues story in the European space with have been discussing in various credit related posts, the consequences of the deterioration in liquidity are reaching alarming levels. While we know from the post "Macro and Markets update - It's the liquidity stupid...and why it matters again...", that European banks are on average issued 90% of their term funding needs for 2011, with significant liquidity pools and ECB support, the impossibility for banks to issue term funding and in particularly issue unsecured funding is a big concern given funding needs for 2012.
As Bloomberg points out in an article published by John Glover and Ben Martin:
"It’s been 2 1/2 months since a bank managed to sell a conventional bond in Europe’s public markets, the longest period without a deal ever and another example of the sovereign crisis choking off funding.
UniCredit SpA was the last non state-owned bank to issue senior, unsecured benchmark notes in Europe with a 1 billion-euro ($1.4 billion) sale on July 13, according to data compiled by Bloomberg. That compares with deals worth 41.9 billion euros in the third quarter of last year."

And Bloomberg to add:
"The extra yield investors demand to hold banks’ senior bonds instead of benchmark government debt has soared to 320 basis points, from 202 at the end of July, according to Barclays Capital’s Euro Aggregate Banking Senior Index. The gauge reached an all-time high 325 basis points on Dec. 30, 2008."

From "Markets update - Credit - Crossing An Event Horizon", we know that banks have only managed to issue recently covered bonds, backed by pools of prime loans:
"Lenders, by using prime assets are willing to do whatever is necessary to get funding, as other sources, such as unsecured issuance have dried up, clearly reflected by the very high level reached by the Itraxx Financial Subordinate 5 year index."

Covered bonds - Bloomberg:
"Pioneered in 18th century Prussia, covered bonds give holders first call on a pool of assets that’s managed by the borrower, with the debt given preferential treatment in a default to senior, unsecured notes.
Covered bond issuance rose to 287 billion euros this year, up from 268 billion euros in the same period of 2010, Bloomberg data show."

And we know:
"The recent significant increase in credit spreads for many financials have been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates."

Given ongoing market concerns on potential losses on sovereign bonds, banks prefer to deposit their cash at the ECB (135 billion euros in the last 10 days). So access to term funding for banks in Europe being very weak is a clear and present danger.

And on a final note, last chart of the day, following the downgrade of US banks by Moody's, this is the picture between Bank of America 5 year CDS and Citi 5 year CDS:

“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works” - John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867

Stay tuned!

The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!

"Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss. The risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time."

The recent volatility experienced in August and the continued sell-off in risky assets, suggest something more radical has happened, and what would some people call a game changer. I certainly think it is the case. In this long post we will review the reason behind and more on the subject of the disappearance of risk-free interest rate and its implications.

Safe havens no longer exist. The game was based on confidence, on risk-free interest rates and fiat-money based on the trust we had in our governments.

I am often asked, what monthly letter do I enjoy reading, one particular letter immediately comes to my mind, namely the credit newsletter written by Dr Jochen Felsenheimer from asset management company "assénagon". It is for me, one of the most insightful and best written letter available dealing with credit and credit dynamics.
It is available at the following link, free of charge and a must read:
assénagon Credit Newsletter

"Once a month Dr. Jochen Felsenheimer comments on his analyses of the market for corporate bonds in the Credit Newsletter. In doing so, he not only succeeds to describe current market developments, but also to present the underlying economic theories in an interesting and understandable way."
Dr Jochen Felsenheimer, prior to set up "assénagon", was previously head of the Credit Strategy and Structured Credit Research team at Unicredit and co-author of the book "Active Credit Portfolio Management".

In his latest letter published in August, Dr Felsenheimer comments in the opening of his monthly letter:

"As if the debt situations in Europe and the US were not already bad enough on their own, the attempts to find a way out - which have been in some cases amateurish (Europe) or dominated by power politics (USA) - have had a long-lasting impact on investors across the globe. It is not just a temporary loss of confidence, but actually more about the recognition that the dire search for a safe haven in the capital markets is something of an oddysey."

And Dr Felsenheimer to add:

"In the end, all investors face the same problem - the whole world is a credit investment. And it is difficult to negotiate this problem with the classical theory of economics. Short selling bans, Eurobonds and ratings agency bashing will not provide a remedy here either."

Confidence is the name of the game and the perception of the risk-free interest rates, namely a solvency issue is at the heart of the ongoing issues.

In recent weeks, I have touched on liquidity issues - "Macro and Markets update - It's the liquidity stupid...and why it matters again...".

The liquidity issue discussed in the previous post are key in understanding the implications of recent weeks market activity and change of perception. No matter how you look at it, risk-free, as designated by the coveted AAA from rating agencies are endangered species as I commented in June 2010:
"AAA, the most endangered rating, regulating the rating agencies and Basel III"

The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg.
I wrote in relation to the disappearance of AAA ratings in June 2010 in the post "AAA, the most endangered rating, regulating the rating agencies and Basel III" :
"The decline in triple-A-rated companies is one of the most obvious -- though hardly the most worrisome -- sign of a widespread decline in credit quality."

So, yes, I have to agree with Dr Felsenheimer comment that the world is indeed a "credit investment".

The damages of the debt ceiling debate in the US and the ongoing jitters in the European space surrounding the sovereign debt crisis were both a game changer, in the sense that, it has lead to a global repricing of risk based on a false assumption, namely the existence of risk-free interest rates which the Modern Portfolio Theory is based on.

Couple of interesting points surrounding repricing in credit risk:
Spread between 10 year German bonds and French 10 year government debt:

Spread between Italian 10 year bonds and German 10 year bonds:

Repriced... In 2005, the spread was around 22 bps and before the introduction of the Euro, in 1999, the spread was around 120-130 bps. And it will keep rising, as Prime Minister Silvio Berlusconi keeps testing the ECB's resolve in backing Italian debt by conceding in the revamping of austerity measures decided on the 12th of August. Tax surcharges on high earners have been dropped, cuts in regional spending reduced and measure to lower pension costs reversed, leading to a 7 billion euros hole in the package aiming to balance the budget in 2013.

The consequences of the change of heart of the Italian government lead to a fall in demand in Spanish and Italian bonds in latest auctions: August 30, Investors bid for 1.27 times the amount of Italian 10-year bonds down from 1.38 times. Demand for Spanish five-year debt dropped to 1.76 times from 2.85 times at the previous auction.

Italy has 46 billion euros of maturing bonds in September, rising yields don't help funding costs and they will have to raise 18 billion euros of bonds in September. So far the ECB has sustained Spanish and Italian bonds by 43 billion euros of purchases, more than half of its purchase of Greek, Portuguese and Irish debt since the start of its buying spree a year ago.

Following up on the disappearance of the notion of risk-free interest rates, in the credit space, everything has been repriced, throughout the rating spectrum.
Arcelor Mittal 4 5/8% 11/17 bond (swap related value)- repriced:

Lafarge SA 7 5/8% 11/16 bond, one of Europe's largest cement makers - repriced:

Lafarge's rating is Ba1 according to Moody's, High Yield.

BMW Finance 5% 08/06/18 bond - Repriced:

A2 Moody's credit rating, upgraded on the 24th of July.

and AAA, GE 4 3/8% 09/21/15 bond - repriced as well:

We live in competing systems, where not only does sovereign countries compete against one another to raise capital, but companies as well, and capital is scarce. Access to capital is depending on growth outlooks, consequences are great on debt dynamics.

As put it simply by Dr Felsenheimer in his August note:

"Competing systems between countries in a world of globalisation and fully integrated capital markets restrict a country's room for manoeuvre in that mobile factors of production seek out the state infrastructure which give them the best possible reward. The state can only counter the migration of workers and relocation of whole production sites with economic measures, for example the creation of an effective infrastructure (e.g. education) or tax incentives. Accordingly, a government's outgoings - and also its income - are not just determined by domestic economic developments, but also by other countries' economic strategies. Countries are in competition with each other - just like companies. And this is particularly true within a currency union, which is fully reflected in the different tax policies of the individual member states."

And the race for capital is truly on, hence the liquidity issues building up, as I discussed in a previous post:
"The recent significant increase in credit spreads for many financials have been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates."

There is a point of major importance, as well pointed out by Dr Felsenheimer in his last note:

 "in the current system, capital market performance takes on immense importance in a system of fiat money, i.e. effecient allocation of said money. The great danger of a flippant approach to the provision of fiat money is that the financial markets are able to decouple from the real economy. And that is just what happened in the past few years. Following the crises of the past ten years, excessive liquidity was pumped into the system in order to cushion the real economic consequences. Only a fraction of this made it to the real economy, as a large part seeped away in the banking system and thus in the capital market. This is why the financial market is growing so quickly while the real economy is only showing moderate growth."

Consequences? Dr Felsenheimer sums it up nicely:

 "Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy."

A fiat money based system is based on one single item, confidence, and confidence can only be guaranteed by extreme fiscal discipline by governments. The lower the confidence, the higher the rates issuers will have to pay to raise capital. Solvency of the issuer will ultimately determine the allocation of the capital which means that the impact on Modern Portfolio Theory is as follows, given it postulates that risk-free investment exists and that all investors hold the same risky market portfolio to achieve optimum portfolio, it can only mean more demand for government bonds according to Dr Felsenheimer's August letter.

And confidence is gone.
Confidence is gone in the US with the tragic debate surrounding the US debt ceiling this summer. I recently wrote: "The US downgrade was not a downgrade of America's economy but a dowgrade of its leadership.".
Confidence is gone in Europe, because Europeans cannot even agree on a proper solution for a small problem like Greece, in effect putting the entire European system at risk.
Confidence in the Euro is waning fast with a supposedly independent ECB, now used as a political tool, to bail out cash strapped countries, on fiat-money.

The name of the current game is maintaining, at all cost, rates as low as possible, to avoid government bankruptcies. I do expect rates to stay low, even in the US, and the 10 year bond to reach 1.50% in yield.
Should you have invested in PIMCO 25+ zero coupon US ETF in August, you would be sitting on a 32% monthly performance:

I expect it will go higher and the yield will go lower. No suprise there, but back to our analysis of the disturbing disappearance of risk-free interest rate.

The difference between the current situation of the US and Japan, is that Japan started an an isolated event, we are ending up with truly global phenonemon of over-indebtness.

Consequences:
I started the post indicating, no more safe havens, one could posit, no more safe investments.
Dr Felsenheimer commented in is letter:

 "In terms of global competing systems, we can view countries like companies. The difference is that they only refinance through debt. Even if this refinancing option does not appear unattractive in view of the low interest rate, even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely."

But we are not the only ones with Dr Felsenheimer, in reaching this disturbing conclusion. Arnaud Marès, from Morgan Stanley in his publication of the 31st of August - Sovereign Subjects - The Economic Consequences of Greece, arrives to the same conclusion.

"'Private sector involvement' in the restructuring of Greek debt was in our view a major policy error, which has changed in a quasi-irreversible way the perception of sovereign debt in advanced economies as risk-free and therefore as safe haven assets. This has broadened the channels of contagion across Europe.
Does it matter that sovereign debt is risk-free? It very much does. If sovereign debt is no longer a safe haven, then the ability of governments to implement counter-cyclical policies is impaired. Fiscal policy is becoming at best neutral, at worst pro-cyclical. At a time when growth is rapidly slowing, the economic cost may be high.

Weakening the quality of government credit means weakening the fiscal backstop from which banks benefit. This risks resulting in an accelerated de-leveraging of bank balance sheets, with equally costly economic consequences.

Pandora’s Box has been opened. Only fiscal integration accompanied by centralised financing of governments can bring about full stabilisation of the market in Europe, in our view. The alternative could eventually be a resumption of the run on governments and a wave of public and private defaults.
The ECB can provide protection against a run, temporarily. While the ECB has the capacity to act as a lender of last resort, doing so exacerbates political tensions and is not a lasting solution, we think."

This what I had in mind when I wrote "Credit Terminal Velocity?"

So what are the implications of the disappearance of the risk-free interest rate notion?
Arnaud Marès commented:
"Does it matter whether government debt is risk-free? This, in essence, is the question being raised by the downgrade of the US government by S&P and, much more importantly, by the decision of European governments to effect sovereign debt restructuring in Greece in the form of ‘private sector involvement’.
The answer is yes. It matters considerably, we think. The risk-free nature of sovereign debt and its resulting safe haven status are in our view instrumental to the ability of governments to use fiscal policy counter-cyclically as a macroeconomic stabilisation tool. If government debt is deprived of its safe haven status, then this pushes us back towards a ‘pre-Keynesian’ state of the world where fiscal policy is neutral at best (US), and more likely pro-cyclical (Europe). Against a backdrop of slowing growth in advanced economies, the consequences are likely to be serious."

To put nicely, we are indeed facing contagion on a very large scale, given sovereign debt is officially no longer risk-free and we have not yet reached a satisfying European political solution to European debt woes.

Arnaud Marès in his note also added:
"Government solvency is a blurred concept. For governments with high levels of debt, the concept of solvency is very sensitive to the government’s cost of funding, and therefore to swings in market confidence. What makes a government solvent is its ability to stabilise its debt (as opposed to the level of debt in itself). This, in turn, depends on the ability of the government to generate a sufficient primary balance, which can be expressed as follows:

Where i is the average interest rate paid on the debt and g is the nominal rate of growth of the economy.
What this relationship emphasises is the importance of the interest rate paid on the debt. All other things being equal, a higher cost of funding raises the ‘fiscal hurdle’, i.e., the required primary balance, in proportion to the initial level of debt. The higher the interest rate, the higher the likelihood that the fiscal hurdle becomes politically insurmountable, which in turns justifies a higher risk premium in what becomes a vicious spiral. Conversely, a government with even a very large level of debt can appear entirely solvent if funded cheaply enough,"

And Mr Marès to comment:
"It is possible to be solvent yet illiquid. The second issue with the heads of states’ position is that to guarantee that sovereign debt outside Greece remains risk-free, governments have to have unconstrained access to liquidity. Following the precedents set by Greece, Ireland and Portugal, this can no longer be taken for granted in the absence of sufficient contingency liquidity support by core governments and/or the ECB. The size of Europe’s main inter-government liquidity support scheme (EFSF) has been calibrated in line with the requirements of Greece, Ireland and Portugal. It could be sufficient to absorb in addition the funding needs of Cyprus but not those of Spain and Italy in the event of a ‘run’ on governments, such as that which was effectively starting to unfold until the ECB intervened. In its current state, therefore, it does not constitute an entirely credible liquidity backstop, especially given political opposition in several countries to an increase of its capacity. Meanwhile, the ECB provides indirect liquidity support to Spain and Italy through its bond purchases, but it appeared to take on this role reluctantly and under the assumption that it would only be temporary (until such point at which EFSF may take over). This does not provide much reassurance that solvent government will always be kept liquid."

and contagion we have:

This Bloomberg Chart of the day indicates that the net amount of CDS on France surged to 25.7 billion USD from 12 billion USD in the past year when Italy remained constant according to the DTCC (Depository Trust and Clearing Corp.).

Arnaud Marès added the following in his note on the important of risk-free and its implications:
"This leads us to the central question we raised earlier: why does it matter? What matters is not so much that government debt is risk-free as that it is seen as a safe haven. In our view, this is a precondition for governments to be able to use fiscal policy as a macroeconomic stabilisation tool. Indeed, what allows governments to deploy their balance sheet defensively at a time of recession is two properties of public debt, both of which derive from this safe haven status:
The first is practically unlimited access to finance. This is the property that allowed, for instance, governments to support their banking systems in the winter of 2008/09 by guaranteeing bank deposits and bank debt. In essence, what governments were doing in that instance was to lend their superior access to funding to the banks.
The second property, perhaps even more important, is that in a recession or crisis, flight-to-quality flows towards the safe haven lower the relative cost of funding of the governments. As long as this holds true, governments can cost-effectively deploy their balance sheet, borrowing more to supplement a fall in private sector consumption and investment.

The consequences of disabling fiscal policy. Should public credit start behaving like private credit, then the ability of governments to run counter-cyclical fiscal policies (even merely by letting automatic stabilisers run their course) would in our view be impaired. At best, fiscal policy would become neutral. At worst, it would become pro-cyclical in a slowdown. It is in that sense that we see one of the consequences of the Greek precedent to be to push us towards a ‘pre-Keynesian’ state, where fiscal policy is largely disabled."

So yes, liquidity, matters, because the major implication of the disappearance of risk-free interest rates is that it weakens in the process the quality of the "fiscal backstop" enjoyed by banks which explains the significant rise in bank credit spreads during the summer and particularly in August:
Itraxx Financial Senior 5 year CDS index:

Itraxx Financial Subordinate 5 year CDS index:

The iTraxx SovX Western Europe Index of credit-default swaps insuring the debt of 15 governments rose 12 basis points to 311 at 3 p.m. in London, surpassing an all-time high closing price of 308 on August 26.

And Arnaud Marès from Morgan Stanley to add on the very subject of banks, sovereign and liquidity in his note:
"There is a direct relationship between the credit quality of the government and the cost and availability of bank funding, as illustrated by the correlation between their CDS prices, or by the relationship of causality from sovereign credit rating to bank credit rating. We therefore regard the renewed tensions in the bank funding market in Europe as at least in part the consequence of the decision to use private sector involvement in the restructuring of Greece’s sovereign debt.

The risk, if funding tensions continue, is that banks de-lever their balance sheets more rapidly from the bottom end of the balance sheet (debt reduction and therefore credit contraction) as opposed to more slowly from the top end of the balance sheet (recapitalisation over time through retained earnings). Tougher term funding markets is another of the factors identified by Elga Bartsch as responsible for a deterioration of the European growth outlook."

The detioration of credit as reflected by the diminishing universe pond of AAA securities and the current situation can only lead to the following:
An age of financial repression, so, yields will go down further in core countries, which mean nominal prices will go up, at least that's what the zero coupon 30 year US ETF is showing.

German 10 year Bond, intraday yield movement:

Itraxx Crossover (High Yield) 5 yeard CDS index going wider again:

"My dear brothers, never forget, when you hear the progress of enlightenment vaunted, that the devil's best trick is to persuade you that he doesn't exist!"

Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

So far the devil's best trick has been to persuade us that risk-free interest rates did exist. It ain't working anymore and that is a big cause of concern.

Stay tuned!

Markets update - Credit - Rates - Equities - The Fast and the Furious...and unintended consequences of the US downgrade.

The Fast and the Furious...

Markets update:

In the equity space, it has been volatile to say the least and given sometimes pictures are worth more than words, we'll go through some of the action today.

CAC40 intraday movement, welcome to Disneyland Magic Mountain!

Around 6.5% intraday movement.

But the German Dax index was even more volatile:

EUR/CHF - the trend is your friend and the Swiss National Bank might start printing soon, and join the debasing currency club because it must be starting to hurt exports:

In this "Risk Off" mode, Gold is continuing its uninterrupted rise, from new record to new record:

VIX index - Houston we've got a problem...

Some other risk indicators
Our friend Ted Spread is cooling off a bit:

But it isn't the case for OIS Libor spreads in Euro:

European Government Bonds update:
Shock and awe doctrine in full force on 10 year Italian and Government bonds!
Italian BTP 10 year bonds

But most of the action was on the Spanish 10 year bond!

Is it going to restore confidence in the markets? We still need long term solutions which have yet to be addressed by European politicians. The EFSF will have to be increased or spell the demise of the Euro.
Greece 2 year Government bonds - Zombie Zorba is staying put:

Since the ECB started buying Greek bonds, the 5 year Sovereign CDS for Greece went from 617 bps to 1690 bps according to Bloomberg.

In the credit is getting crushed and liquidity is extremely poor in the cash market.
CDS spreads continue to widen significantly, making everyone feeling extremely nervous. That Lehman feeling all over again...Not good.
Itraxx Crossover 5 year index, drifting wider and wider:

In the sovereign 5 year CDS space, France is widening still:

Australian Banks have also started widening in this sell-off:


Unintend consequences of the US dowgrade = global repricing of risk.

Since the downgrade, U.S. government bonds rallied, with
the yield on the benchmark 10-year note tumbling to an 18-month
low of 2.28 percent. Flight to what is still seen as a safe haven in this brutal environment.
S&P followed up with the downgrade of Fannie Mae and Freddie Mac, DTCC and others, and municipals bonds.
Fannie Mae’s current-coupon 30-year fixed-rate mortgage-backed securities rose 0.14% point to 1.22% points more than 10-year U.S. government debt, according to Bloomberg. A gap of 0.87%, highest gap since April 2009.
Fannie and Freddie have so far received 170 billion USD in federal aid since being placed in conservatorship in September 2008.
AA+ has been assigned by S&P to municipal bonds, a market of 2.8 trillion USD.
The premium paid by European banks to borrow in dollars through the swap market has increased the most since January this year according to Bloomberg. The cost of converting euro-based payments into dollars as measured by the one year cross-currency basis swap fell to 43.6 bps below the euro interbank offered rate (EURIBOR) yesterday according to Bloomberg.

Banks are therefore affected the most by the US downgrade because of the implied support of the US government since 2008. Also given the economic slowdown, they are indeed more affected.

The Markit ABX index tied to subprime-mortgage bonds rated AAA when issued in 2006 fell 2.8 point to an equivalent cash price of 47. The biggest fall since May 2010 according to Markit.

Leveraged Loans, the S&P/LSTA US leveraged Loan index 100, declined by 1.77 cents to 90.66 cents on the dollar, the 11th consecutive fall and lowest level since October. The highest point was 96.48 cents to the dollar on February 14 according to Bloomberg.

Emerging Markets: The JP Morgan EMBI Global Index, mostly used benchmark for Emerging Markets bond funds jumped 34 bps to 354 bps, highest level since 2010.

Basel III is raising capital standards for banks, so quite a few banks need to raise capital. But, with the current market sell-off, the new issue market is essentially shut down, meaning down the line, it is going to be very crowded at some point when the markets cool-off and opens up again. Given countries, banks and others will be coming hard to the market to raise capital, it is going to cost more. Simple as that.

Companies are still hoarding cash and sitting on a hefty pile of 963.8 billion USD in the US according to S&P data. Companies are in great shape to weather the storm. They have paid down debt and are to some extent quite lean with healthy balance sheets.

Finally, unintended consequences on China - Bloomberg:
The Yuan and the Dollar index

Charts of the day - Bloomberg:
Portuguese citizens like Irish citizens, are leaving their countries for a new life, leaving behind their battered and bruised economy:

Migration might fall in negative territory in Portugal unless the government can end the exodus of workers seeking employment abroad. But it isn't only happening in Portugal, it is also happening in Greece and in Ireland.

And as a conclusion, Bank of America's market cap as of yesterday's close was 73 billion dollars, Apple has enough cash to buy it outright in cash with 76 billion USD in the bank account...
Bad news keep piling up for Bank of America since the very ill-fated acquisition of Countrywide...