Macro and Credit - The Lady, or the Tiger?

"In waking a tiger, use a long stick." -  Mao Zedong

Watching with interest the collapse of the China trade deal with the US triggering the return of much muted volatility, as the fear of the "sell in May" motto settles in, given the rising tensions between the two powers, when it came to selecting our title analogy, we decided to go for a literary analogy,  "The Lady, or the Tiger?". It is a much-anthologized short story written by Frank R. Stockton for publication in the magazine The Century in 1882. 

The short story takes place in a land ruled by a semi-barbaric king. Some of the king's ideas are progressive, but others cause people to suffer. One of the king's innovations is the use of a public trial by ordeal as an agent of poetic justice, with guilt or innocence decided by the result of chance. A person accused of a crime is brought into a public arena and must choose one of two doors. Behind one door is a lady whom the king has deemed an appropriate match for the accused; behind the other is a fierce, hungry tiger. Both doors are heavily soundproofed to prevent the accused from hearing what is behind each one. If he chooses the door with the lady behind it, he is innocent and must immediately marry her, but if he chooses the door with the tiger behind it, he is deemed guilty and is immediately devoured by it.

The king learns that his daughter has a lover, a handsome and brave youth who is of lower status than the princess, and has him imprisoned to await trial. By the time that day comes, the princess has used her influence to learn the positions of the lady and the tiger behind the two doors. She has also discovered that the lady is someone whom she hates, thinking her to be a rival for the affections of the accused. When he looks to the princess for help, she discreetly indicates the door on his right, which he opens.

The outcome of this choice is not revealed. Instead, the narrator departs from the story to summarize the princess's state of mind and her thoughts about directing the accused to one fate or the other, as she will lose him to either death or marriage. She contemplates the pros and cons of each option, though notably considering the lady more. "And so I leave it with all of you: Which came out of the opened door – the lady, or the tiger?"

Obviously for those who remember our June 2018 conversation "Prometheus Unbound", we argued the following:

"It seems more and more probable that the United States and China cannot escape the Thucydides Trap being the theory proposed by Graham Allison former director of the Harvard Kennedy School’s Belfer Center for Science and International Affairs and a former U.S. assistant secretary of defense for policy and plans in 2015 who postulates that war between a rising power and an established power is inevitable:

"It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable." Thucydides from "The History of the Peloponnesian War"  

- source Macronomics June 2016

Also, in our September 2018 conversation "White Tiger" we indicated that maverick hedge fund manager Ray Dalio came to a similar prognosis in his musing entitled "A Path to War" on the 19th of September. With our chosen title, we reminded ourselves that "The Lady, or the Tiger?" has entered the English language as an allegorical expression, a shorthand indication or signifier, for a problem that is unsolvable and we are not even talking again about BREXIT here...

In this week's conversation, we would like to look at Financials Conditions, given we recently took a look at the latest quarterly Fed Senior Loan Officer Opinion Survey.

Synopsis:

• Macro and Credit - Financial Conditions? It's a "Slow grind"
• Final charts - The credit market cycle is very well correlated to the macro cycle.

• Macro and Credit - Financial Conditions? It's a "Slow grind"

Back in February, in our conversation "Cryoseism" we indicated the following in relation to the SLOOs:

"We think we will probably have to wait until April/May for the next SLOOS to confirm (or not) the clear tightening of financial conditions. If confirmed, that would not bode well for the 2020 U.S. economic outlook so think about reducing high beta cyclicals. Also, the deterioration of financial conditions are indicative of a future rise in the default rate and will therefore weight on significantly on high beta and evidently US High Yield." - source Macronomics, February 2019

The latest publication of the SLOOs point towards a slowly but surely turning credit cycle. Yet, with the most recent easing stance of the stance, there are indeed clear signs of slow deterioration. With around 8.1% of credit-card balances held by people aged 18 to 29 being delinquent by 90 days or more in the first quarter of the year, the highest share since the first quarter of 2011, we believe it is essential to monitor going forward any weakness coming from the Fed's SLOOs.

On the subject of SLOOs we read with interest Bank of America Merrill Lynch's take from their Credit Strategist Note from the 12th of May entitled "BBBonvexity in IG":

"April Senior Loan Officer Survey: Back to easing 

Not surprisingly, given the sharp decline in uncertainties this year, as the Fed abandoned the rate hiking cycle/QT and the US economy not going into recession any time soon, banks are now back to easing lending standards for large and medium sized firms (neutral for small firms). The Fed’s fresh April senior loan officer survey released today also showed continued weak demand across the board for C&I, CRE, residential mortgage, auto and credit card loans. In addition, the April survey added special questions on foreign exposure with a moderate fraction of banks expecting deteriorating loan quality from current levels over the remainder of 2019. C&I and CRE loans

A net 4.2% of banks reported easing lending standards for large/medium C&I loans in April, a reversal from a net 2.8% reporting tightening standards in January, while lending standards for small C&I loans were unchanged in the April survey after a net 4.3% of banks reported tighter lending standards in January (Figure 20).

At the same time, the net share of banks reporting tighter standards on CRE loans declined to 10.8% in April from 12.3% in January. Please note that the CRE value reported here is the average for the three separate questions on loans for construction and land development, loans secured by nonfarm nonresidential structures, and loans secured by multifamily residential structures. 

Loan demand continued to weaken as the net shares of banks reporting weaker large/medium, small C&I and CRE loan demand increased to 16.9%, 10.3% and 16.9% in April, respectively, from 8.3%, 10.1% and 11.0% in January (Figure 21).

Mortgages 

Net 3.2% and 4.6% of banks returned to easing lending standards for GSE-eligible and QM-jumbo mortgage loans in the April survey, respectively, following net unchanged standards for GSE-eligible mortgages and 1.6% of banks reporting tighter standards for QM-Jumbo loans in the January (Figure 22).

At the same time, the net share reporting weaker demand for GSE-eligible and QM-Jumbo mortgages declined to 17.5% and 12.3% in April, respectively, from net 41.0% and 31.7% in January (Figure 23). 

Consumer loans 

Net 15.2% and 1.8% of banks reported tightening lending standards for credit card and auto loans according to the fresh April survey. This compares to net 6.4% and 1.9% of banks tightening lending standards on credit card loans and auto loans in the prior January survey (Figure 24).

Meanwhile, the net shares of banks reporting weaker demand for auto and credit card loans declined to 6.8% and 1.8% in April, respectively, from 17.4% and 18.2% in January (Figure 25). 

- source Bank of America Merrill Lynch

Overall, there is tepid loan growth on the back of rising delinquencies, not only from the younger generation but, as well for older generations. Delinquency rates are trending up again, and not just for younger consumers. The report found that seriously delinquent credit card balances have also risen for consumers aged 50–69. For borrowers aged 50–59 and 60–69, the 90-day delinquency rate increased by nearly 100 basis points each. It is indeed a "slow grinding" process when it comes to financial conditions. 

Tracking financial conditions is paramount when it comes to assessing "credit availability. The very strong rally seen in credit in general and high yield in particular, even in Europe where macro data has been very disappointing in the first part of the year. Clearly the rally in European High Yield has been based not on fundamentals but mostly due to strong "technicals" such as issuance levels overall. 

We would like to reiterate what we discussed earlier in 2018 in our conversation "Buckling" in when it comes to our views for credit markets at the time:

"As long as growth and inflation doesn't run not too hot, the goldilocks environment could continue to hold for some months provided, as we mentioned above there is no exogenous factor from a geopolitical point of view coming into play which would trigger an acceleration in oil prices. " - source Macronomics, February 2018.

Unfortunately, as of late, we have seen plenty of deterioration from a geopolitical point of view such as the unresolved trade war between the United States and China, or rising tensions with Iran hence the heightened volatility seen so far, in some way validating somewhat the "sell in may" narrative.

While the rally in high beta has been significant, in our most recent musings we have been advocating favoring a rotation into quality (Investment Grade) over quantity (High Yield). Since the beginning of the year the feeble retail crowd has been rotating at least in the high beta space from leveraged loans to US High Yield.

From the same Bank of America Merrill Lynch's Credit Strategist Note from the 12th of May entitled "BBBonvexity in IG" the "defensive" rotation has been confirmed:

"Outflows from risk 

US mutual fund and ETF investors sold stocks and high yield and bought high grade and munis following the recent pickup in volatility. Hence over the past week ending on March 8th investors redeemed $13.71bn from stocks – the biggest outflow since the week of March 20th. A week earlier stocks instead saw a small $0.36bn inflow. On the other hand buying of bonds increased to $3.85bn from $2.12bn (Figure 26), as stronger inflows to high grade, government bonds and munis more than offset outflows from high yield and leveraged loans.

 

Inflows to high grade accelerated to $3.10bn from $2.47bn. The increase was entirely driven by inflows to short-term high grade rising to $0.92bn from $0.30bn. Flows ex. short-term remained unchanged at $2.17bn. Inflows to high grade funds declined to $1.98bn from $2.97bn, while ETF flows turned positive with a $1.12bn inflow this past week after a $0.50bn outflow in the prior week (Figure 27).

Flows also improved for munis (to +$1.31bn from +$0.92bn) and government bonds (to +$0.04bn from -$1.54bn). On the other hand high yield reported a $0.28bn outflow after a flat reading a week earlier, while outflows from loans accelerated to $0.21bn from $0.17bn. For global EM bonds inflows declined to $1.03bn from $2.36bn. Finally money markets had a $16.32bn inflow this past week and a $13.83bn inflow in the prior week." - source Bank of America Merrill Lynch

The most recent heightened volatility, at least in credit markets, is more due to exogenous factors than solely fundamentals such as financial conditions, given that what we are seeing so far is much more akin to a "slow grind" than a complete change in the narrative and the turn in the credit cycle. 

From a "flow" perspective, we continue to monitor the appetite in particular of Japanese investors, which remain very supportive in particular of US credit markets. As we commented in numerous conversations, they have decided to add on more credit risk on a unhedged basis. We therefore think that FX volatility should be monitor closely and in particular any move in the US dollar against the Japanese yen for instance.

On the subject of Japanese flows we read with interest Nomura's Matsuzawa Morning Report from the 16th of May entitled "Banks hold off on foreign bond investment, while lifers continue to shift to credit":

"While the stock market remains unstable, the credit market was solid globally. In this respect, there were no signs that the market is looking to price in an economic downturn, and in fact it seems to be looking for the right time and catalyst to return to a risk-on flow. We expect Japanese investors to continue shifting out of government bonds to credit both in Japan and overseas. The April International Transactions in Securities data showed that lifers bought foreign bonds in line with levels in typical years, but we see this as a surprise given the drop in foreign yields and flattening along the curve. We believe this is reflected in the gradual, ongoing widening in USD/JPY and EUR/JPY basis since the start of the fiscal year (Figure 1).

By taking credit risk, they are trying to cover currency hedging costs, in our view. 

The International Transactions in Securities data for the week of 6 May, released this morning, showed that Japanese investors were net buyers of foreign bonds at only JPY20.8bn (Figure 2).

Given that they were net sellers in the previous two weeks, they remain cautious. In the week of 6 May, foreign yields fell sharply in response to President Trump’s tweets, but Japanese investors do not yet seem to be trading on the issue of the US-China trade conflict. However, we believe that banks’ short-term trading, not the aforementioned lifers, are primarily responsible for this trend. Banks were net sellers throughout April, and seem to be seeking to lock in profits in the near term. Foreign investors’ net buying of yen bonds remains high, at JPY553.5bn. In addition to the drop in foreign yields (currently, 10yr Bund yields are materially below 10yr JGB yields), widening currency basis also seems to support this trend." - source Nomura

"Bondzilla" the NIRP monster is still very much supportive of global allocation into fixed income and particularly in credit markets given the current levels of Japanese JGB yields and the German Bund 10 year yield.

This is what we recommended in our April conversation "Easy Come, Easy Go":

"As we indicated on numerous occasions, the cycle is slowly but surely turning and rising dispersion among issuers is a sign that you need to be not only more discerning in your issuer selection process but also more defensive in your allocation process. This also means paring back equities in favor of bonds and you will get support from your Japanese friends rest assured." - source Macronomics, April 2019

As we stated in our most recent conversation, Investment Grade is as well a far less volatile proposal and as indicated by Nomura, the stock market remains unstable whereas the credit market continues to be solid globally. Sure the trend in the SLOOs is not very positive with rising delinquencies and interest rates levels on credit cards for the US consumer, but, we do not think the credit cycle has finally turned as per our final chart below.

• Final charts - The credit market cycle is very well correlated to the macro cycle.

After all our blog has been dealing with "Macro" and "Credit" since 2009, and there is a reason for this which can be resumed in the title of our final chapter in this conversation. The credit market cycle follows very closely the macro cycle. Our final chart comes from Bank of America Merrill Lynch's Credit Derivatives Strategist note from the 15th of May entitled "Keep calm and carry (on)" and displays the relationship between the credit cycle and the macro cycle:

"The cycle of risk assets 

The credit market cycle is very well correlated to the macro cycle. As the chart below illustrates, a weakening economic backdrop is typically associated with wider spreads and a weakening market trend. To the contrary, when the economic cycle recovers spreads tend to tighten and market trends to improve.

The cycle of “ratings” beta 

The macro cycle is not only a great tool to assess credit spread trends, but also a tool to track the cycle of “ratings” beta (chart 6). We define “ratings” beta as the slope between the monthly total return observed in high-yield vs. that in high-grade credit market (rolling twelve months). We then present in the chart below the trend of that beta (slope of returns) via a z-score analysis (12m z-score). When the macroeconomic backdrop improves and bounces from the lows, investors can realise higher (than average) betas in the high-yield market.

The cycle of “subordination” beta 

Last but not least, the macroeconomic data cycle is also valuable to assess the trends seen in subs vs. senior bonds space. Using the typical pair of IG corporate hybrids vs. senior non-financial senior bonds, to capture subordination premium trends, one can observe similar patterns between the macro cycle and the “subordination” beta cycle. When the macro cycle rebounds from the lows, subs can realise higher betas (than average). Subsequently, betas tend to normalise as the cycle becomes more mature.

- source Bank of America Merrill Lynch 

Financial conditions overall remain fairly accommodative, the issues we are seeing rising again as of late are from an exogenous nature such as "The Lady, or the Tiger?". Can China and the United States resolved their trade issues? Which door investors should choose? We wonder, but, in a volatile environment such as this one, quality credit markets offers more stability we think at this very moment given the Chinese "tiger" is yet to be tamed.

"An infallible method of conciliating a tiger is to allow oneself to be devoured." -  Konrad Adenauer

Stay tuned !  

Credit - Fears for Tears

"A person's fears are lighter when the danger is at hand." - Lucius Annaeus Seneca

In continuation to our musical title analogies and given we have been revisiting old classic "New Wave" music from the 80's while enjoying the quiet daily commute, looking at the continuation of the build in risk (US equities making new highs using margin debt, the great return of covenant-light loans, etc.), we thought this week, we would use a somewhat veiled reference to UK group Tears for Fears for our chosen title, given this year was the 30 year anniversary since the release of their first debut album "The Hurting" (released on the 7th of March 1983). Looking at the increasing risks of a Fed "Tapering" and the poor liquidity experienced in the secondary space during the previous bout of bond volatility, we thought using "Fears for Tears" as a title would conveniently illustrate our growing "fears" concerns that could no doubt led to "tears" and to large inflicted "hurting" in risky assets.

Of course, some will describe us as being outright "bearish" given everyone is vaunting the much improved economic data in the US as well as in Europe. As we pointed out last week, there are indeed a few clouds gathering on the horizon thanks to rising "forced correlations" which could lead to some  additional repricing, and not only in the equities space.

In this week's conversation, we will focus on these risks as well as what capital shortfalls entails in the credit space for subordinated bond holders, which have become again quite complacent on the matter.

We have been tracking with interest not only the rise of the S&P index (blue) versus NYSE Margin debt (red) but we also added S&P EBITDA growth (yellow) as well as the S&P buyback  index (green) since 2009 - graph source Bloomberg:

Of course this only telling half the liquidity induced rally courtesy of our "omnipotent" central bankers and their wealth effect strategy, leading to the use of leverage of any kind, which, leading to some "risk parity" strategic users to rediscover with much "hurting" the inherent risk in too much leveraged risk piled into interest rate sensitive asset which our friends at Rcube Global Macro Research have been discussing as of late. We will touch more on liquidity further in our conversation.

Some argue that concerns on the record amount of borrowing for US stocks are misplaced because, lower interest rates have made the borrowing much less expensive, as illustrated by Bloomberg in a recent Chart of the Day (15th of August):

"Concern that a record amount of borrowing to buy U.S. stocks foreshadows an end to the current bull market is misplaced, according to Michael Shaoul, chairman and chief executive officer at Marketfield Asset Management.

The CHART OF THE DAY illustrates why the issue has emerged in the top panel, which compares total margin debt at New York Stock Exchange member firms with the value of the Standard & Poor’s 500 Index. April’s debt was a record $384.4 billion, according to the exchange.

Lower interest rates have made the borrowing much less expensive -- and less significant -- than it was when the last two bull markets concluded in 2000 and 2007, Shaoul wrote in an e-mailed note yesterday.

Investors are paying about 72 percent less interest than they were at the 2007 peak, as displayed in the chart’s bottom panel. This estimate was calculated by multiplying margin debt by the broker call rate, charged by banks on similar loans to securities firms, as Shaoul did in his note.

Companies’ rising earnings also suggest borrowing is far from excessive, the e-mail said, because they have made stocks more valuable. By this yardstick, the amount of margin debt has to climb 40 percent to reach an equivalent to the two previous market peaks, even if S&P 500 company profit stays unchanged.

“Margin debt expansion will remain in place until corporate earnings falter” or the Federal Reserve raises its target interest rate significantly, the New York-based investor wrote. “We do not expect to see either of these take place for a number of quarters.”" - source Bloomberg.

But corporate earnings are, we think exposed, and the rally has been as well sustained by multiple expansions and very significant stock buy-backs.

Reading through CLSA's weekly Greed & Fear note from the 15th of August, written by Christopher Woods, we could not agree more with his comments, where he indicated that risks on the S&P 500 are rising:

"What does all this mean for the American stock market? Well in one paradoxical sense if growth in the US is not as robust as hoped for, that means quanto easing continues which should support the equity market. Still at some point common sense takes over and a lack of growth is plain bearish for equities, most particularly in the context of an American stock market which in recent months has been driven far more by multiple expansion rather than earnings growth. Thus, the S&P500 trailing PE has risen from 15.6x in late December to 18.4x" - source CLSA - Greed & Fear, 15th of August 2013.

For illustrative purposes, we have been plotting the growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:

On top of that multiple expansion and the induced rally by central banks liquidity injections have been boosted as well by a reduction in denominator via stock buy-backs. The complacency in the equity space is starting to raise our "fears" for "tears" as displayed by Deutsche Bank's US equity strategist at Deutsche Bank graph indicating the price-earnings ratio for the Standard & Poor's 500 with the VIX:

"Investors are becoming overly content about the prospects for stocks after more than four years of gains, according to David Bianco, chief U.S. equity strategist at Deutsche Bank AG.

The CHART OF THE DAY shows how Bianco reached his conclusion: by comparing the price-earnings ratio for the Standard & Poor’s 500 Index with this quarter’s average close for the Chicago Board Options Exchange Volatility Index. The latter gauge, known as the VIX, is based on S&P 500 options.

Bianco’s P/E-VIX ratio closed yesterday at 1.20. At that level, a lack of concern that share prices may fall starts to supplant “realistic and disciplined” investing, he wrote in an Aug. 9 report.

“This complacency signal may pertain more to the derivatives market than the equity market,” he wrote. This quarter’s closing VIX average as of yesterday was 13.59, just above the first-quarter figure of 13.53. The latter reading was the lowest since 2007, when a five-year bull market came to an end, according to data compiled by Bloomberg.

While stocks have room to extend their advance since March 2009, increased volatility is likely to accompany any further gains, he wrote. This would allow stocks to rise relative to earnings without sending another warning sign, the New York-based strategist wrote.

Bianco expects the index to end next year at 1,850, which is 9.2 percent higher than yesterday’s close. His projection for the end of this year is 1,675, in line with the average among 17 strategists in a Bloomberg survey." - source Bloomberg.

Whereas the volatility in the fixed income space has remained elevated as displayed by the recent evolution of the Merrill Lynch's MOVE index falling from early May from 48 bps  towards the 87 bps level, the VIX, the measure of volatility for equities has remained fairly muted - graph source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

Of course when ones look at European government yields and in particular peripheral yields, both Italy and Spain are trading towards the lowest level since 2011 relative to German government yields - graph source Bloomberg:

While the German 10 year government bond has moved in sympathy with the 10 year US treasuries breaking its 1.60% - 1.70% range towards 1.90%, Spanish and Italian yields have so far remained fairly muted. 

In relation to our "Fears" for "Tears", we share the same views as Morgan Stanley, from their Credit Strategy note from the 16th of August entitled "Working Through Our Worries", namely that Europe remains on our top concern list:

"Why Europe is the risk we’d stay focused on

We’re relatively relaxed about higher rates and the EM slowdown, but it’s the risk of renewed volatility in the eurozone that causes us the most discomfort. This may sound odd, given that Spanish sovereign spreads are at their year-to-date tights, but is based on a couple of factors unique to this risk.

First, it enjoys especially high uncertainty: One can look to Fed speeches and US data to inform a view of ‘tapering’. One can follow EM currencies or commodity prices to get a sense of regional stress. No similar metric exists for measuring the cohesion of the Italian government or the likelihood of a rating agency downgrade.

Second, it can strike with high intensity: The large rate move since May has so far been weathered well. No more than a handful of European corporates are experiencing serious credit trouble from a sharper China slowdown.

Sovereign weakness, in contrast, has repeatedly shown the ability to drive severe, broad-based weakness in our market.

Third, while it is not our base case, there are plausible reasons why a eurozone crisis could re-emerge: Improving economic data in Europe are encouraging. Yet the ratings of nearly all eurozone sovereigns remain on negative outlook. Debt/GDP will likely rise and unemployment should stay high well into 2014, even if growth ‘improves’ to ~1%. The eurozone’s ability to backstop a crisis remains hamstrung by the continued lack of a banking union, an OMT programme that our economists believe will be difficult to activate, and a continued reluctance by the ECB to use QE." - source Morgan Stanley

Yes, we all know that Mario Draghi's OMT "nuclear deterrent" has yet to be tested. But what we are concerned about is, as we indicated in our conversation "Cloud Nine", is the lack of credit growth in peripheral countries which are most likely to be exacerbated by the upcoming AQR 

As a reminder: AQR = Asset Quality Review, planned for 1st Quarter 2014 as a prelude to the ECB becoming the Single Supervisor for large euro area banks in 2H 2014. The AQR's intent is to review banks challenged loan portfolios and the need for capital increase.

"Until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending." 

One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector.

"Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments"

It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record as displayed in the below table by Bloomberg:

"Euro zone financial institutions' sovereign holdings totaled 1.78 trillion euros in June, up from 1.4 trillion euros in December 2011. In efforts to maintain asset values and lower auction costs, banks have increasingly supported their sovereigns by purchasing sovereign debt, which may stop their own associated CDSs and funding costs from rising aggressively. Over-exposure to sovereign debt (and loans) can threaten solvency should conditions deteriorate enough." - source Bloomberg.

In that sense the European Banking Union is more akin to a Government/Bank Union when it comes to sovereign bonds holdings.

As we indicated back in our conversation "Cloud Nine", indeed the government is the preferred borrower when it comes to lending as displayed in Bloomberg Chart of The Day from the 13th of August:

"Italian banks are increasingly using liquidity to buy more profitable sovereign debt, reducing loans to companies and households, as Italy’s longest recession in 20 years makes lending more risky.

The CHART OF THE DAY compares the banks’ purchase of Italian government bonds and loans made to the private sector.

Italian banks increased their holdings of the country’s debt by almost 100 billion euros ($133 billion) in the 12 months ended June 30 to a record 402 billion euros. In the same period, loans decreased by 55 billion euros, or 3.3 percent, to 1.63 trillion euros.

“There’s a crowding-out effect,” said Carlo Alberto Carnevale Maffe, professor of business strategy at Milan’s Bocconi University. “The public debt is soaking up resources from the private sector, offering higher yields on capital and a lower investment risk, at a time in which companies and families are struggling to repay their debt.”

Italian banks, which have borrowed more than 255 billion euros from the European Central Bank’s longer-term refinancing program, are investing part of the liquidity obtained at lower interest rates in short-term government bonds that offer higher yields. That’s favored by Italy’s government, which is seeking domestic buyers to replace lower purchases from foreign investors so it can cover a monthly average issuance of 40 billion euros in securities to finance its $2.7 trillion debt. At the same time, banks are more reluctant to lend as a recession saddles them with mounting bad loans." - source Bloomberg

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

Oh well...

So when it comes to our "Fears for Tears", liquidity has always been our top concern, credit wise.

As we posited in "The Unbearable Lightness of Credit":
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“

The recent surge in the fixed income space of May and June have indeed been very stark reminder of the importance of liquidity. On that subject we came across a Risk.net article entitled "The great unwind: Buy-side fears impact of market-making constraints" which struck as a perfect illustration of Roger Lowenstein's quote:

"At the start of May, as prices for US agency bonds reached what would later prove to be a peak, one New York-based hedge fund decided to sell its portfolio of roughly $100 million in AAA-rated mortgage-backed securities. The fund’s senior trader expected to be out of the position in a day, or even less. If it had gone to plan, it would have been beautifully timed, but it didn’t go to plan.

“You’re talking about AAA agencies – OK, with some callable features – and you don’t expect there would be no liquidity for that kind of instrument. The only reason I allowed us to carry that position is that, in my mind, you should be able to blow out of it in basically a day, or even an hour for that kind of size. But the reality was it took us a month,” he says.

The fund initially turned to a single dealer, which bought less than $10 million of the bonds upfront, promising to take the rest as and when it could find bids from other clients. Over the course of the next four weeks, the position shrank slowly, and the price of the bonds steadily slipped. The trader declines to say how much value was given up, but he admits the fund’s hedges did not work perfectly, and says it lost money on the portfolio during the month. Eventually, losing patience, the fund brought in a second bank to speed up the process.

“Effectively, there was no liquidity for that stuff. The discrepancy between the expectation and the actual liquidity was one of the largest I’ve ever experienced,” he says.

This fund was one of the lucky ones, selling the bulk of its portfolio before bond market jitters turned into a full-scale rout in the last week of May. The sell-off was triggered by the fairly innocuous statement from Federal Reserve chairman, Ben Bernanke, that the central bank might rein in its programme of quantitative easing. As fixed-income investors sought to pare back the huge positions they have built up in recent years, prices moved dramatically, triggering further waves of selling – yields on 10-year US Treasury bonds leapt 80 basis points in six weeks to close at 2.73% on July 5, but everything from emerging market sovereign debt to corporate bond exchange-traded funds (ETFs) was hit.

“I’ve never seen markets move so far on so little news,” says one senior, London-based trader – a sentiment shared by many other market participants.

Some banks, plus buy-side firms including BlackRock, Deutsche Asset & Wealth Management and Fortress Investment Group, now explain this episode in the same way: the problem was illiquidity, and the cause was bank regulation.

New capital, liquidity and leverage rules are making it more expensive to carry inventory, they say, meaning banks have less capacity to take principal risk. The consequence is that market-makers were not initially willing to absorb the supply of securities: orders were broken into smaller clips, bid-offer spreads exploded, in some cases even enquiries had the power to move markets. Once prices had collapsed, demand strengthened, enabling bank trading desks to match up buyer and seller more rapidly, and stabilising the market.

Or so the argument goes, and there is a lively debate, particularly among dealers, about how important these factors were. But the bigger question is what happens next. As interest rates normalise, investors that have gorged on fixed-income securities will all be trying to cut their exposure – a prospect the chief risk officer at one US bank’s asset management arm calls “the great unwind”. With market-makers unable to provide the kind of liquidity many investors are used to, he predicts a period of sustained, savage volatility, and the head of rates distribution at one UK bank agrees: “We’ve just had a 30-second trailer for the full movie.”

For now, there is little science to back up these scary predictions, but there are anecdotes, intuition, a lot of first-hand experience – and some numbers.

“There’s never been a wider gap between the amount of overall product out in the market versus dealer balance sheets. When you start looking at the size of the institutional market and daily turnover as a function of the dealer balance sheet, you get some pretty horrific stats,” says Richard Prager, head of trading and liquidity strategies at BlackRock in New York.

Others see it the same way. “There is a pent-up mismatch that has been built as real-money asset managers have swelled in size while dealers have reduced their inventories, and there is a real risk that some investors may not understand the effect this structural imbalance has on the underlying liquidity of some of those portfolios,” says Randy Brown, co-chief investment officer at Deutsche Asset & Wealth Management in London.

According to data compiled by the Federal Reserve Bank of New York, the inventory of corporate bonds held by primary dealers plunged from a high of $235 billion on October 17, 2007 to just $55.9 billion as of March 27 this year. An even bigger drop has been seen in holdings of agency debt, which fell from a high of $69 billion in May 2008 to $6.8 billion by March 27 – a decline of 90%.

The same trend has been seen in corporate bonds, according to Peter Duenas-Brckovich, global co-head of credit flow trading at Nomura in London. “If, 10 years ago, the Street was willing to hold 4.5 to 5% of the outstanding debt, that number is now only 0.5%,” he says.

Constraint

The major constraint has been the introduction of the Basel Committee on Banking Supervision’s new trading book capital rules – known as Basel 2.5 – which has forced dealers to hold more capital against trading book assets through the use of a general market risk charge measured using a 10-day value at risk at a 99% confidence interval, a stressed VAR charge and, for banks that model specific risk, an incremental risk charge (IRC) (see box, The roots of the problem). But banks also face a new leverage ratio and structural restrictions on their ability to take proprietary trading positions – however those are defined.

“Post-crisis, the proportion of inventory held by dealers has diminished dramatically; collectively, dealers’ inventory is a tenth of what it once was,” says Chris Murphy, global head of rates and credit at UBS, and a member of the bank’s investment bank executive committee. “Banks were complacent about housing inventory in the pre-crisis years, and balance sheets were out of whack with the industry’s real risk-bearing capacity. That has been corrected by the Basel capital overlay, where warehousing credit products in the lower-rated space – like high-yield or emerging markets – is extremely punitive. And banks also have to comply with leverage ratios, which act as a major constraint on balance sheet size.”

Large asset managers agree on both the cause and the effect. “Holding securities longer term has always been challenging for dealers. Today, constraints on funding cash inventory are even more pronounced because of new regulations, lower credit ratings for most dealers, and mark-to-market concerns if credit spreads widen. Dealers will assume positions temporarily while trying to place bonds elsewhere, but I would not expect them to offer significant additional longer-term capacity,” says Hilmar Schaumann, chief risk officer of Fortress Investment Group in New York.

What this means, simply put, is that markets are likely to move further and faster when clients are selling – and traders say the reaction to Bernanke’s comments is the perfect example.

“He basically said, ‘At some point in the future, there is a possibility we might think about maybe – maybe – not doing quite as much bond buying’. And we still had a complete meltdown. That’s a lot of movement for not a lot of news. Imagine if they’d actually changed rates,” says the London-based head of European fixed-income trading at one large European bank.

Another example is the reaction to the July 1 resignation of the Portuguese finance minister. By July 3, the country’s 10-year bonds had jumped from 6.38% to 7.46%. The price of the bonds fell around five points – or 5% of par.

“It’s a peripheral credit that is expected to have problems, but a five-point drop? I’ve been doing this for 20 years – the news does not justify the move. This is not a corporate where the head of accounting quit because of accounting fraud. This is highly suggestive of poor liquidity in the market,” says Nomura’s Duenas-Brckovich." - source Risk.net

Moving on to the subject of complacency in the subordinated bond space, we eagerly await the results of the AQR tests which will be conducted by the ECB and we agree with CITI's take from their credit note from the 13th of August:

"European Union finance ministers recently reached an agreement on several topics which should form the backbone of the European bail-in legislation (expected to be implemented from 2015): e.g. the priority of payments in the event of a bail-in and the creation of national based resolution funds. Essentially, the agreement specifies a list of liabilities which will not be bailed-in (e.g. guaranteed deposits); this list excludes equity, sub and senior debt, i.e. they are “bail-inable”.

According to our interpretation of the draft directive, national authorities will only have the ability to inject “public” money into a bailed-in bank once losses of 8% of total assets have already been absorbed. In other words, for sub or senior debt not to be bailed-in, other (presumably more junior obligations like equity) securities would have to have already absorbed (i.e. bailed-in) 8% of the total liabilities of the bank. What does this mean (to us at least)?

-If the equity to total liabilities ratio in a bank were more than 8%, there would be a chance that sub debt may not be bailed-in. However, the average equity to total liabilities ratio in European banks is 5% and very rarely exceeds 8%, which means that sub bail-ins appear very likely.

-The ratio of equity plus subordinated debt to total liabilities for the average European bank is around 7%, which means that national authorities would pretty much be forced to “fully” bail-in equity and subordinated bondholders. Figure 4 shows the distribution of the ratio of equity plus subordinated debt to total liabilities across European banks.

In many cases, the ratio is below 8%. Even if the ratio is above 8%, sub debt would likely be bailedin if losses are above that level and/or national authorities want the post “bailined” bank to have a meaningful capital base

-What about senior debt? In the average European bank, equity plus subordinated debt will make up around 7-8% of total liabilities, which means that national authorities will likely have discretion not to bail-in senior debt.

National authorities will, in our view, make use of bail-in legislations when dealing with distressed banks going forward. We expect that bail-ins will trigger restructuring credit events in current CDS contracts, as was the case in SNS and Bankia, and “bail-in” credit events in the new CDS contract."  - source CITI

Of course we have long voice our "Fears for Tears" for the subordinated bond holders and it has been a recurring subject in our numerous credit conversations. It support our long standing views expressed in our post "Peripheral Banks, Kneecap Recap, Kneecap Recap":

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

Back in our conversation "The Week That Changed The CDS World", we indicated that the recent SNS case has derailed the auction process and the validity of the current CDS subordinated contract. In the case of SNS, because the auction used senior bonds, the recovery was around 95.5 for the bucket at 2.5 years and 85.5 for other maturities segment. Given the payout equates to par minus recovery, a CDS subordinated bondholder only received 14.5 (100-85.5)....so much for taking a CDS in the first place...

1. 
   The issue was that the auction could not operate due to lack of deliverable, it reminds us of a similar case with Delphi Automotive when a market maker had squeezed the market and cornered the bonds which had led to a higher recovery rate and smaller payout to the CDS holders. The markets then moved towards cash settlement to avoid some players to rig on purpose the auction process.
   
   In the case of the SNS expropriation, the CDS mechanism has derailed somewhat the auction process, hence the need to ensure with the new contracts a smoother payout mechanism. Obviously going forward Sub CDS protection should trade wider. 
   
   
   One of our prime candidate for "Fears for Tears" and for failing the upcoming AQR tests in relating to the subordinated bond holders risks, is troubled Italian bank MPS (Montei Dei Paschi). We agree with Bank of America Merrill Lynch's recent note on MPS from the 14th of August entitled "Defusing the capital problem" about the increasing probability of a debt-to-equity swap for the Italian lender:
   "A sub-debt-to-equity swap could help MPS’s capital position

   In our view, an effective solution to the capital issue could be a subordinated debt to equity swap. This is not without recent precedents (Commerzbank, Portuguese banks). Some issues may arise in connection with the Italian rules on dedicated capital increases and pre-emptive rights, but we do not think that these are insurmountable. Incidentally, Banco Popolare has a convertible outstanding which allows the bank to trigger anticipated conversion effectively at a discount to market value (bondholders will receive the face value plus 10%)". Besides, according to new EC rules “state aid must not be granted before equity, hybrid capital and subordinated debt have fully contributed to offset any losses”. If our interpretation is correct, this may imply that ahead of conversion of the state aid into equity, current shareholders and sub-bond holders might have to bear the losses. In our view, this should be a good enough reason for bondholders to accept trading out of (relatively illiquid) bonds into shares. In July 2012, MPS launched a senior-to-sub swap, which was a wasted opportunity as MPS realised just a modest capital gain. A sub-debt-to-equity swap would have the advantage of moving the full sub-debt balance exchanged for equity (rather than just the delta between market price and tender in a cash-to-debt deal).

   MPS has relatively limited options with respect to using its subordinated debt to recapitalise the bank because of the relatively high cash prices that many of the bonds trade at. In some other examples, banks have been able to take advantage of the discount at which their bonds trade to par and monetise this – this seems less clearly an option here given that many bonds trade in the 90s or even higher. We do not exclude that cash prices could fall in the coming months of course but our assessment is that MPS sub bond prices have been surprisingly resilient in the face of the bad news emanating from the bank on the one side and a clearly underperforming sub CDS which is currently indicated at well over +1,000bps on the other side. This is a level that we’d generally associate with very high default risk. There is a big disconnect between MPS cash bonds and its CDS. The latter is implying that there is a high likelihood of a Credit Event. 

   We think this is most likely to be a Restructuring Credit Event rather than a Failure to Pay. We estimate that MPS has subordinated debt with a face value of about €5.3bn, not including the FRESH, all of which essentially could be made available to recapitalise the bank if there was a debt-for-equity swap. In our view, the bank could offer to buy back its subordinated bonds for shares, albeit that this would be very dilutive given that MPS’s current market value is around €2.5bn. Even if the bank decided to focus on the more subordinated parts of its capital structure (T1 and UT2), there would still be potentially €3bn that could be raised in this way. Part of the capital raised would be the gain from taking out any liabilities below par but most of the capital would come from a straight swap of the liabilities for equity. "- source BAML

   
   

   But there is a catch for the holders of the current CDS subordinated contract as pointed out by CITI:
   "Under the current CDS contract, if sub debt is converted into equity before the auction date there will be no subordinated deliverables for the auction, as was the case in Bankia." - source CITI

"Fears for Tears"...

On a final note, German exporters should start to have as well their "Fears for Tears" given the Chinese slowdown will continue to weigh on German output as indicated by Bloomberg Chart of The Day:

"China’s credit squeeze is signaling a downturn in German manufacturing, according to ING Groep NV.

The CHART OF THE DAY shows that Germany’s factory output as gauged by a manufacturing purchasing-managers’ index has mirrored Chinese bank-lending growth since a credit boom that began in 2008. As China’s Communist Party seeks to rein in lending on concern that wasteful investment will threaten

longer-term growth, Germany’s export-oriented manufacturers are poised to suffer.

“China’s economy is shifting from domestic investment to more of a domestic consumption model,” said Martin van Vliet, senior euro-zone economist at ING in Amsterdam. “If you’re a German exporter selling machinery, that’s bad news.” China will start a nationwide audit of public-sector debt this week as the government pressures banks to better manage their balance sheets after the record surge in credit. The nation’s economic growth slowed for a second quarter to 7.5 percent in the three months ended June and the government has set a target of 7 percent a year for the five years through 2015. China hasn’t expanded at a slower than 7.6 percent pace

since 1990.

A reduction in debt-fueled Chinese investment spending may hurt German machinery orders in particular. Machinery sales to China last year were valued at 16.9 billion euros ($22.5 billion), accounting for more than a quarter of total shipments to the country, according to the Federal Statistics Office in Wiesbaden.

German exports to China have increased at an average rate of 15.8 percent a year since 1995, more than twice as fast as the total gain. That’s helped Germany weather the effects of the euro-area’s sovereign debt crisis, now in its fourth year." - source Bloomberg.

"Prosperity is not without many fears and distastes; adversity not without many comforts and hopes." -Francis Bacon 

Stay tuned!

Chart of the Day - 10 year German bund versus 10 year Swedish government bond

"Two roads diverged in a wood and I - I took the one less traveled by, and that has made all the difference." - Robert Frost, American poet.

One of the indicator we have been following in various credit conversations has been the spread between 10 year Swedish government yields and German 10 year government yields. It looks like this relationship is breaking again this time with Swedish yields rising. Back in November 2011 in our credit conversation "The song of Roland", this relation looked like it was breaking due to a German "failed" auction which saw German yields rising above Swedish 10 year government yields. From March 2011 and during most part of 2012, German Bund yields have been moving in lockstep with 10 year Swedish government yields - source Bloomberg:

Although it might be a little bit premature to confirm a clear break in this relationship, it nevertheless warrants close monitoring.

While the Swedish Krona is projected to extend gains in 2013 against the euro for a fifth year in a row (up 4% in 2012), Sweden looks most likely to avoid the euro area's recession woes this year. As reported by Niklas Magnusson from Bloomberg on the 3rd of January: "The country’s central bank, which has lowered rates four times since December 2011 to support growth, has signaled it’s now done with easing policy, which may weigh on a three-year rally in Swedish bonds. “The strong performance of the krona reflects a correction from very undervalued levels following the financial crisis of 2008, but also the relative strength of the Swedish economy and its healthy public and external balances," Kasper Kirkegaard, senior foreign-exchange strategist at Danske Bank A/S in Copenhagen, said last month in an e-mailed reply to questions."

Sweden is one of the 7 only remaining nations boasting a AAA rating with stable outlook along with Australia, Canada, Denmark, Norway, Singapore and Switzerland with a debt to GDP level at 38%.

Although the Swedish rate futures market as indicated by the same Bloomberg article is pricing a 25 bps rate cut in the June contract, given Riksbank cut on the 18th of December its benchmark rate by 25 bps to 1%, traders could be poised to some disappointment should the Swedish Central Bank decides to hold the line in 2013.

Stay tuned!

Credit - When causation implies correlation

"All human actions have one or more of these seven causes: chance, nature, compulsions, habit, reason, passion, desire." - Aristotle 

Looking at the dismal economic figures coming out of Europe as of late (PMI, consumer confidence, unemployment in Spain, IFO, etc.), we could not resist using in our title a veil reference to the phrase used in science and statistics "Correlation does not imply causation". Admittedly, a correlation between two variables does not necessary imply that one causes the other, but when it comes to European woes, not only did the ECB's LTROs amounted to "Money for Nothing" given the lack of transmission to the real economy as we posited in February this year, but looking back at the overzealous deficit targets set up by the European Commission which we discussed in our conversation "A Deficit Target Too Far", we are not surprised to see that the economic causation does indeed implies correlation to current European economic woes unsurprisingly due to poor loan growth as displayed by the below Bloomberg graph displaying loan growth in in the Euro Zone with the Euro Zone Money Multiplier at multi-year low:

"Third quarter bank results will shed further light on the outlook and appetite for euro zone bank lending. The money multiplier remains at multi-year lows and recent regulatory steps to soften or defer the implementation of new liquidity and capital rules underscore the pressing need for banks' loan supply to improve, release cash to the economy and support growth" - source Bloomberg.

Yes, some will counter us, by saying that the opposite assumption which we used in our title, that correlation proves causation is a questionable cause of logical fallacy also called "cum hoc ergo propter hoc" ("with this, therefore because of this"). Well, truth is, the economic contraction in Europe is a consequence of the first event sometimes describe in latin as "post hoc ergo propter hoc" (after this, therefore because of this) namely rapid credit contraction due to accelerated bank deleveraging courtesy of the EBA (European Banking Association) objective for most European banks to reach a Core Tier 1 capital of 9% by June 2012.
So dear readers, no, we do not think it is a logical fallacy, "post hoc" supposedly being a "tempting error" because the temporal sequence in Europe appears to be integral to causality namely credit contraction:
A occurred, then B occurred
Therefore, A caused B

Of course as of late, our "Generous Gambler" aka Mario Draghi, ECB's president, has defended is latest OMT (Outright Monetary Transactions) bond buying plan on the 24th of October in front of the German parliament with a warning about deflation risks:
"In our assessment, the greater risk to price stability is currently falling prices in some euro-area countries"
and added:
"In this sense, OMTs are not in contradiction to our mandate: in fact, they are essential for ensuring we can continue to achieve it."

Arguably our dexterous "Generous Gambler" has indeed been highly successful in propelling Spanish bonds gains above Germany as indicated by Bloomberg:

"Investors who held onto Spanish bonds this year as the price of the securities whipsawed amid the euro-area debt crisis stand to earn more than those who sought refuge in German bunds. The CHART OF THE DAY shows Spanish debt has handed investors a 4.2 percent return since Jan. 3, rebounding from an 8.7 percent loss in the period through July, according to data compiled by Bloomberg and the European Federation of Financial Analysts Societies. German bunds, perceived as Europe’s safest sovereign debt, have earned 2.7 percent this year. The Iberian nation’s securities have surged since the European Central Bank said it will buy bonds." - source Bloomberg

Making us reminding ourselves part of the great poem from Charles Baudelaire which we have used in numerous conversations:
"If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!"
Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

The most recent table of monthly purchases of sovereign debt is a clear indicator of the faith many investors have put in our "Generous Gambler" - source Bloomberg:

"Euro zone banks purchased an aggregate 33.3 billion euros of sovereign debt in September, following sales of 24.9 billion euros in the preceding two months as yields fell and gains were taken. The ECB commitment to do "whatever it takes" drove the Spanish 10-year yield down to 5.5% from August highs above 7%, and recent bank purchases reflect this new-found confidence." - source Bloomberg

"The greatest trick the devil ever pulled was to convince the world he didn't exist"
Roger "Verbal" Kint- The Usual Suspects

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

Our generous gambler also argued the following: 
"OMTs will not lead to disguised financing of governments. All this is fully consistent with the Treaty’s prohibition on monetary financing. Moreover, they will focus on shorter maturities and leave room for market discipline."

But he also said the following:
"The ECB intervenes only in countries where the economy and public finances are on a sustainable path."

Our "Generous Gambler" is indeed kept on a tight leash for now, a German one that is, courtesy of the Banker's Algorithm.

Our "Banker's Algorithm" comes into play when you think about on-going Spanish deflationary vicious spiral given our computational reference which we touched again last week:

"The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state."
So of course, our Banker's algorithm has avoided the deadlock in Europe because of Spain. Clearly by denying or postponing the request, it has determined the Spanish request could put the European system in a clear unsafe state!
For Spain, it is "request denied" courtesy of the Bankers' algorithm."

Question being now, can Europe survive in the current form (number of countries) without making material sacrifices? One has to wonder...

By managing to keep Germany’s liabilities unchanged German Chancellor Angela Merkel has been in fact the clear "winner" of the last European summit in June (number 19...) we argued in our conversation "Europe - The Game of the Century". On the 18th of October, Chancellor Merkel in her address to the German lower-house has indeed craftily defended again Germany's liabilities by declaring:
"Financial aid without conditions attached has in some cases frustrated the drive to streamline economies, and therefore joint liability is the wrong answer"

Given the IMF has cut its euro-region growth forecast for 2013 from 0.7% to 0.2% with the European economy potentially shrinking by 0.4% in 2012 instead of the "projected" 0.1% by the ECB, in this week's conversation we will look at correlations and causation on our European ship given the increasing risks of "Mutiny on the Euro Bounty" in 2013 which we have been highlighting since April this year:
"As well as Fletcher Christian and part of the crew, our European "sailors" (politicians) were attracted to the "idyllic" initial cheap funding environment provided by a single currency umbrella. The recent austerity "harsh treatments" measures imposed by the captain of the ship (European Commission) which we reviewed in our recent conversation ("The Charge of the Light Euro Brigade") seems to be clearly pushing some of the members of the crew towards mutiny. This explains somewhat, why the European ship is attempting to change tack, moving towards growth."

"Prosperity makes friends, adversity tries them." - Publilius Syrus

Unemployment figures in Germany which will be published next week and will be key. So will be economic data from Germany. In September 2011, in our conversation "Much ado about nothing" we argued:
"And given Merkel's big u-turn relating to the Japanese nuclear disaster in 2011, and that next general election in Germany are to be held in September 2013, and we know that Merkel is already committed to a third term, we would really follow closely the German economy in general and the German labour market in particular. "

There is indeed a growing rift between France and Germany in relation to the course that needs to be taken in relation to Europe due to a growing divergence in the political agenda for both France and Germany. We agree with the latest report from Nicolas Doisy - Politoscope number 10  from Cheuvreux which validates our recent analysis Merkel and our Banker's algorithm:
"Delaying the euro federal Big Bang again: the Franco-German “phoney war” (redux):
-While it should be starting, Europe's federal Big Bang is stalling again due to diverging political agendas in Germany and France with regard to the euro institutions. The disagreement is partly real (i.e. of substance) and partly fake (i.e. purely motivated by domestic politics) and likely to drag on for months… if not years.
 -Merkel has timed her agenda in 2013 with a view to the full monty (re-election and a euro to her liking) and thus intends to frame the debate to her advantage. To keep her options open, Merkel wants to have the final say on any decision regarding Spain and the euro: this is why she uses the federal agenda as a red herring.
-To secure her chances for re-election, Merkel needs to keep the Eurozone quiet during the coming year: this is why she has agreed to the ECB's OMT for Spain. For as long as she is leading the electoral polls, she is sure to keep both France and the SPD in check: this is why she is skilfully nurturing German anti-euro feelings.
-Hollande's options are limited, as he can only bank on the SPD or market pressure to break the deadlock: he thus also uses this debate to keep his own left in check. His only potential ace is to use next year's recession in the Eurozone to table his "growth" agenda again, so as to get a more lenient fiscal treatment by Germany. 
-All in all, this Franco-German divide over institutional options looks very likely to lead to a two-speed Eurozone as the periphery will continue entering its debt-deflation." - source Cheuvreux.

Moving on to France and the subject of when causation implies correlation, we noted from the same interesting note from Cheuvreux the following interesting correlation. Namely that Hollande's popularity is 100% correlated with the rise in unemployment since he has taken office: 5,000 more unemployed = 1% less popularity for Hollande, so that (theoretically), according to Cheuvreux's analysis, he should be ousted when unemployment reaches 3.2 million:

"Hollande's first option out of this diplomatic deadlock could be for the social democrats to win next year's election or the leadership of another Grand Coalition. However, after supporting France's stance very vocally on several occasions in the winter of 2011, the SPD has gone mute on the issue of Eurobonds in particular. This clearly is a sign that Merkel has so far won the battle of public opinion on the euro issue." - source Nicolas Doisy - Cheuvreux.

Following up on François Hollande's political strategy of hoping for the social democrats to win next year's election, we could not resist, (given our post title) but refer to "Mierscheid law"!
The Mierscheid law was a satirical forecast published in German magazine Vorwärts on 14 July 1983 which forecasted that the Social Democratic Party of Germany (SPD)'s share of popular based on the size of steel production in Western Germany: "The Vote share of the SPD equals the Index of the crude steel production in the western federal states - measured in millions of tonnes - in the year of the federal election".

"The last corroboration of the law was in the 2002 election, where the West German crude steel production was 38.6 million tonnes, and the vote share of the SPD 38.5%. For the early election in 2005 the vote share was 38.4%, with a mean crude steel value of 40.0 million tonnes. Over the last ten elections, the two values were within two units nine times, and within one unit seven times." - source Wikipedia

- source - the full Wiki.

With German confidence falling to the lowest level in more than two and half years and Europe's composite PMI falling to 45.8 from 46.1 in September, the IFO institute's business climate index unexpectedly dropped to 100.0 from 101.4 in September, indeed accelerated deleveraging and generalized austerity is increasing the causation of economic woes and the correlation with worsening economic outlook. We feel comfortable with our recent call of growing divergence between the growth differential between USA and Europe as indicated by the recent PMI.

We also believe that as economic woes weight on both Germany and France in 2013, so will increasing political rifts arise in the process. We do agree with Nicolas Doisy's take from Cheuvreux, namely that there is indeed a new "phoney war" evolving between both countries:
"This (peaceful) remake of the Franco-German phoney war obeys a purely political logic and forces the Eurozone to continue walking along the abyss for another year. Unfortunately, it can only add to the uncertainty surrounding the fate of the Eurozone by leaving deflationary Spain very much on the hook: there is no clear prospect of Eurobonds any time soon, be it to recapitalise Spanish banks or help Spain's government. Beyond, this phoney war could well turn into another "battle of Stalingrad" when the actual size of the Spanish problem is fully revealed, right after the German election (if not before). It is thus to be hoped that another Grand Coalition wins in Germany, as seems to be the preference of the German electorate. Such an outcome would have the advantage of creating the conditions of a de facto national unity government in Germany. In any event, this Franco-German great divide over institutional options looks very much apt at leading to a two-speed Eurozone of sorts in the not-so-distant future. Indeed, it appears clearly from this debate that the core issue is what to make of the periphery. This amounts to raising the question: (where and how) does the periphery belong in the Eurozone? While still implicit, this theme will surely rise to the front in near future." - source Cheuvreux - Nicolas Doisy

Indeed, what to make of the periphery in general and Spain in particular given the recent Spanish banks earnings which clearly indicate that Oliver Wyman's nightmare scenario could as well play out which therefore clearly justify the retention in the allocation process of our European Banker's algorithm?
Caixabank, the third biggest bank saw its profit fall 42% as it accelerated loss recognition tied up to real estate with 4.41 billion euros of provisions in the first nine months to fully cover the required 2.44 billion euros from the first RDL (Royal Decree Law) and 600 million of the 2.1 billion euros in charges needed from RDL2 passed in May. Bad loans jumped to 8.42% in September from 5.58% in June and 4.9% in December 2011.
It was a similar story for Spanish giant Santander, with third quarter profit felling 94% due to the necessary purge in real estate exposure needed with net income falling to 100 millions euros from 1.8 billion euro a year earlier. Bad loans as a proportion of total lending rose to 4.33% from 4.11% in June. The bad-loan ratio across the Spanish business climbed to 6.38% from 5.98% in June and 5.15% a year earlier.

The rise in bad loans are all a reflection of the rise from bad loans in the construction sector as reported by Bloomberg:

"September's Spanish stress test projected aggregate losses of 270 billion euros for the banks under its adverse scenario, with a 43% loss on real estate developers, identical to Santander's 3Q real estate non-performing loan ratio. Spain's construction and real estate bad debt topped 100 billion euros at 1H and may rise faster and further than stress estimates." - source Bloomberg

No wonder the Banker's algorithm is reluctant in allocating "resources". In that context, the bad bank SAREB which need to be in place by December, will have as much as 90 billion euros of asset based on their transfer price, initially comprising land, developer loans and residential units that went bad according to Bloomberg article "Spain Bad Bank Seen Too Big to Work With $117 Billion: Mortgages" by Sharon Smyth from the 25th of October.
"The Bank of Spain has yet to fix transfer valuations for the assets based on the stress tests of Spanish lenders carried out by management consultants Oliver Wyman and published on Sept. 28. The 90 billion euro number is based on transfer prices, so the original value of the assets is likely to be higher.
In comparison, Ireland’s National Asset Management Agency, set up in 2009, spent 32 billion euros on mortgages with a face value of 74 billion euros to cleanse its banking system.
Lenders that take state aid will have to transfer to the bad bank foreclosed property of more than 100,000 euros, real estate and builder loans of more than 250,000 euros and controlling stakes in property firms, according to the Economy Ministry official. A decree to regulate the entity should be passed on Nov. 16. It may be amplified in the future to include loans to consumers, small and medium enterprises and retail mortgages." - source Bloomberg.

In relation to Bankia, we argued in May 2012 in our conversation "The Tempest the following" with our good credit friend:
"A better solution would be to force a conversion of debt to equity (In a debt-for-equity swap, a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company). Doing so will not require 7 to 10 billion funds, but would of course dilute shareholders and destroy bond holders (haircut)."

The ECB is now pushing for inflicting losses on junior debtholders as reported by Emma Ross-Thomas, Esteban Duarte and Ben Sills from Bloomberg on October 25 - ECB is Said to Push Bankia Losses as Spain Purges Assets:
"The European Central Bank and European Commission want investors including preference shareholders to swap their securities for new shares to reduce the cost to the taxpayer, according to two people who asked not to be named because the discussions are private. Profit at Banco Santander SA, Spain’s biggest lender, slumped in the first nine months as it took a 14.5 billion-euro charge on real estate losses.
Confronting the toxic legacy of Spain’s 10-year building boom is imposing political costs on Prime Minister Mariano Rajoy as he faces a separatist challenge in Catalonia, protests on the streets of Madrid and a battle to avoid a full bailout." - source Bloomberg.

Back in our May conversation we indicated:
"Transparency in asset valuations would finally help in discovering the extent of the problems plaguing the Spanish Financial sector. The set-up of a "Bad Bank" in similar fashion to Ireland's NAMA, would indeed force price discovery and true valuations provided a third party assessor is drafted."

and we added:
"Without credit growth resuming, the ambitious target deficits will not be met in Spain. The conditions for growth needs credit growth to resume, as shown by the recent credit growth in the US (see our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid..."). Spain has to go through resolving the Spanish banking encumbered balance sheets."

When causation implies correlation...

Credit wise, for Spanish banks, the rise in the issuance for "Puttable bonds" is a cause for concern we think. Puttable bonds are fixed-income securities which investors are able to redeem before maturity. It is a very dangerous option given the funding shock it could create should investors decide in concert to exercise their option. As reported by Bloomberg by Esteban Duarte and John Glover on the 25th of October in their article "Santander Seeks Salvation in Puttable Bonds":
"Banco Santander SA, Spain’s biggest lender, is placing its trust in bondholders by issuing 4.4 billion euros ($5.7 billion) of fixed-income securities that investors are able to redeem before maturity.
Bonds with put options make up 36 percent of Santander’s debt funding this year, compared with 9 percent in 2011, according to data compiled by Bloomberg. While the bonds have lower interest rates, they leave the bank vulnerable to a potential 7 percent increase in the 33.4 billion euros it must repay next year. Investors have already demanded early repayment on 1 billion euros of the notes." - source Bloomberg

Puttable bonds are indeed a typical instrument used by financial institutions under stress. For us, a big red flag.

Another red flag we think for Santander, comes from its dwindling capacity in absorbing potential losses at the parent bank by its increasing policy of partial IPOs such as the one done in Mexico as indicated by CreditSights in their report Spanish Banks - The Value of Empires from the 22nd of October:
"In Santander's case especially, the capacity of equity in its foreign subsidiaries to absorb potential losses at the parent bank is being reduced by its policy of partial IPOs (the goal being to list all the most significant subsidiaries within five years – see Santander: Partial IPO in Mexico). The erosion of loss absorbing capacity that this implies at parent or group level is reflected in the Basel 3 reform that will ultimately prevent banks from including in consolidated CET1 capital any surplus equity contributed by minorities in excess of the subsidiaries' minimum regulatory requirements." - source CreditSights

On a final note, looking at the our "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield), falling again towards 1.55% versus 5 year Germany Sovereign CDS which has cratered below 25 bps, by avoiding increasing so far Germany's liabilities, Chancellor Merkel has in effect alleviated concerns on Germany's exposure to European woes we think - source Bloomberg:

It's deflation (デフレ) in Europe.

"Correlation is not causation but it is sure a hint" - Edward Tufte - professor emeritus of political science, statistics and computer science at Yale University.

 Stay tuned!