Macro and Credit - The Ghost of Christmas Past

"These are the shadows of things that have been. That they are what they are, do not blame me!" - The Ghost of Christmas Past, A Christmas Carol by English novelist Charles Dickens, 19th December 1843

While discovering with great pleasure that we had won the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September conversation and with the additional points made in our recent "Cinderella's golden carriage", we reminded ourselves for this week's title analogy of the sayings of the Ghost of Christmas Past that came to haunt Ebenezer Scrooge in Dicken's 1843 masterpiece "A Christmas Carol". This angelic spirit showed Scrooge scenes from his past that occurred on or around Christmas, in order to demonstrate to him the necessity of "changing his ways", as well as to show the reader how Scrooge came to be a bitter, cold-hearted miser. Looking at where some High Yield Energy spreads are close to ending the year with the continuous downward pressure on oil prices and most of the commodity sector, is indeed, an illustration of the Ghost's philosophy. Credit spreads are what they are and do not blame us for having commented over the last few years over the deterioration of the credit cycle. If the Ebenezer Scrooges of the credit world have been hurt in the latest sell-off in the High Yield space, they had it coming. Low spreads of yesterday are indeed the shadows of things that have been to paraphrase Charles Dickens.

While typing this very note, we watched with great interest Central Bank of Azerbaijan (CBAz) decision to devalue the AZN by another 35% to AZN1.55/$ and deciding to shift to a fully floating exchange rate starting from December 21. We pointed out in our recent conversation "Cinderella's golden carriage" that in similar fashion to AAA ratings, currency pegs are as well a dying breed:

"In similar fashion AAA ratings are a "dying breed" and "golden carriages" often return to "pumpkin" state, currency pegs are not eternal as we reminder ourselves in our long September 2015 conversation "Availability heuristic - Part 2":

"There is indeed a clear trend in "de-pegging" currencies in the Emerging Market world, but in Developed Markets (DM) as well, the CHF event of this year has shown that pegging a currency in the current monetary system is bound to fail at some point. The sovereign crisis in Europe has also shown the inadequacy of the Euro for various European countries with different economic and fiscal policies as well as different composition (hence our negative stance on the whole European project...).

When it comes to our recent "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop" - Macronomics

 - source of the table - Société Générale 

Interesting thing happens during currency wars, currency pegs like cartels do not last eternally. These are indeed the "shadows of things that have been", hence our recent HKD peg break case that earned us some praise from Saxo Bank.

Before we move on towards our usual ramblings, it is that time of the year where we would like to take the time to wish you dear reader and your family a wonderful Christmas and a happy and prosperous New Year. On that special occasion, we would like to extend our thanks for the support we received on our blogging journey and to our growing number of our readers (thanks for your praise in 2015). We would also like to thanks our good friends from Rcube Global Macro Asset Management for their numerous qualitative and quantitative contributions throughout 2015. We also would like to extend our thanks to our good cross-asset friend "Sormiou" for providing us with his great insights on the subject of volatility and his regular comments, and interesting exchanges we had during the course of 2015. We are looking forward to hearing more of him in 2016 given the clear potential for more volatility to come in that respect. We also hope we will hear more from you dear reader in 2016. Don't hesitate to reach out and comment!

As we move towards the last few days of yet another eventful year full of "sucker punches" such as the CHF move thanks to yet another peg blowing out courtesy of the SNB and the Yuan "surprise" of the summer thanks to the PBOC, we would like this week in our closing conversation for 2015 to continue looking forward towards 2016, as we think, the rising instability will generate interesting proposals for the "contrarian" punters. Also we do think that our "outrageous" prediction prominently featured in Saxo Bank's recent publication is by no mean "outrageous", more on this later in the conversation. Similar  "convex" trades abound, as central banks' magic spells are losing their strength, and these "macro" trades will go hand in hand with "volatility" in 2016. To reiterate ourselves, there lies the crux of central banks interventions, there is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis.

Synopsis:

• 2016, will be all about "risk-reversal" trades
• The EM 2016 outlook - its weaker than you think
• Final chart - Short Hong-Kong? Go long Japan "tourism"

• 2016, will be all about "risk-reversal" trades

It seems to us that many investors today are "living in the shadows of things that have been", namely that they live under the "pretence" that the "central bank put" is still in play. This "pretence", we think is particularly entrenched within the "equities" crowd who suffers from "overoptimism", whereas us, in the "credit" crowd, we suffer from "overpessimism". Overall, investors, suffer from deep bipolar disorder but, that is another subject.

Furthermore, as we have shown in our last conversation "Charles' law", rising positive correlations due to the intervention of our "generous gamblers" aka "omnipotent" central bankers have led to significant rising "instability" à la Minsky, and they also have induced a reach for yield, pushing many "players" outside of their "comfort zone" leading to "yield compression" on a "grand scale" as displayed in the below chart from Bank of America Merrill Lynch's Global Equity Derivatives Outlook for 2016 published on the 9th of December:

"Reaching for yield in Europe given QEWith almost €3trn of negative yielding govt debt (~45% of the total outstanding), the hunt for yield in Europe is as strong as ever. With such low (negative) returns on safe haven assets, central banks have pushed income-seeking investors further out on the risk curve, resulting in a policy-induced contraction in yields across asset classes (Chart 26). 

With Mario Draghi unleashing QE in 2015 and leaving room to further expand it in 2016, the hunt for yield will likely gather steam, in our view. Indeed, the higher yields on offer in both EU equities and HY credit relative to safe haven assets are among the key investment reasons cited by our equity & credit strategists in their 2016 outlooks.

Yield is only half the story: need to weigh vs. asset riskYield vs risk framework: With a lack of assets offering reasonable yields, investors often focus excessively on (just) the yield on offer with less attention to the associated investment risk." - source Bank of America Merrill Lynch

Indeed, "yield hogs" are still on the "yield trail" and have been enticed by our generous gamblers to play on the "beta" game a little further up the risk scale.

What is once again "striking" to us, as me move towards 2016 is the "consensus" in many positions, which we think that from a "positioning" perspective and contrarian approach could be enticing. Could it be that when everyone is thinking the same, that no one is really thinking? We wonder.

In terms of "risk-reversal" punts, we read with interest Bank of America Merrill Lynch's Futures and HF positioning report from the 20th of December entitled "Leveraged Funds bought record S&P 500 –tugging a war with Asset Manager":

"Futures positioning across asset classes (CFTC data) 

Equities (disaggregated data)
S&P 500 (consolidated) – Leveraged Funds (LF) decrease short by $34.6bn over four week to -$16.6bn – a record buy since the consolidated TFF data started in June 2010. Asset Manager/Institutional (AI) decrease long by $6.1bn last week to $40.5bn. AI net position is near 3-year low (3.2%tile); LF near 3-year high (98%tile).
NASDAQ 100 (consolidated before June 2013) - Asset Manager/Institutional increase long by $0.2bn to $10.1bn. Leveraged Funds increase long by $1.5bn to $4.0bn.
Russell 2000 - Asset Manager/Institutional increase short by $0.7bn to -$6.4bn. Leveraged Funds decrease short by $0.6bn to -$0.9bn. One-year z-score is above two for LF (i.e. contrarian bearish). Total Open Interest is near a 3-year high (95.5%tile). 

Interest Rates (disaggregated data)
CBT US Treasury - Asset Manager/Institutional decrease long by $1.3bn to $19.3bn. Leveraged Funds decrease short by $3.0bn to -$1.4bn. Other reportables (sovereign) net
position is near a 3-year low (1.9%tile), with one year z-score below two.
10-yr T-notes - Asset Manager/Institutional decrease long by $2.6bn to $28.1bn. Leveraged Funds increase short by $0.7bn to -$28.8bn.
2-yr T-notes - Asset Manager/Institutional bought $4.1bn and flipped to a long for the first time since Nov. 3rd, with one-year z-score above two (abnormally bullish sentiments among AI). Leveraged Funds decrease long by $0.9bn to $11.2bn, with one year z-score below two (i.e. abnormally bearish sentiments among LF). 

FX (disaggregated data)
EURO - Asset Manager/Institutional increase short by -$1.4bn to -$2.2bn. Leveraged Funds decrease short by $1.7bn to -$17.3bn.
JPY - Asset Manager/Institutional (AI) decrease short by $0.9bn to -$3.7bn. Net position stays near 3-year low for AI (5.7%tile) and sentiment is on a buy signal (one-year z-score rallying from the Nov. 3rd low). Leveraged Funds decrease short by $2.7bn to -$5.7bn.
AUD – Asset Manager/Institutional decrease short by $0.2bn to -$1.9bn. Leveraged Funds bought $1.2bn and flipped to a net long for the first time since Oct. 2014; z-score is above two (contrarian bearish). Meanwhile, net positon for Other Reportables -(sovereign) remains near 3-year low (6.4%tile)." - source Bank of America Merrill Lynch

Whereas Asset Managers and Leveraged Funds agree on the Russell 2000 short position, which is of no surprise given its correlation with High Yield, what seems to us very interesting is the significant positioning of the Leverage community in being short 10 year T-Notes to the tune of -$28.8bn as per the chart below from Bank of America Merrill Lynch's report:

 - source Bank of America Merrill Lynch

Given the recent US Q3 GDP print at 2% (well below 3.9% growth in Q2) and given the current high level of inventories we highlighted recently in our conversation "Cinderella's golden carriage", it seems to us that US GDP is weaker than expected and is going to be "weaker for longer". On a side note, we have increased our US long duration exposure for this very reason. As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:

"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you."

From a "risk-reversal" perspective, we think, the current sizable "short positioning" from the "Leveraged crowd", offers a good contrarian punt, given the "weaker" outlook as of late of the US economy. 

In similar fashion, the "consensus" trade of being "short" the Euro versus the USD, appears to us overly "crowded". In that sense, Steen Jakobsen's CIO of Saxo Bank's call of EURUSD flying towards 1.23 in the latest Outrageous Predictions for 2016  is not that "outrageous" we think, particularly if you factor in that for the 12 months to October, the cumulated current account surplus represented 2.9% of eurozone gross domestic product, compared with 2.4% for the 12 months to October 2014. The latest October figure for the current account surplus came at €19.8bn, which is €9bn more than at the same period in October 2014 (€10.8bn).

Here is below the significant positioning of the Leverage community in being short EUR/USD to the tune of -$17.3bn as per the chart below from Bank of America Merrill Lynch's report:

 - source Bank of America Merrill Lynch

It certainly looks crowded to us, and are the shadows of things that have been, given that as of late,  Le Chiffre aka Mario Draghi, hasn't been on his best "bluffing/betting" behavior.

When it comes to Emerging Markets woes which have been well commented by all the usual suspects, when it comes to our prognosis for 2016, we think that there is indeed more pain to come rather than to expect a "relief rally" from an "outrageous prediction" perspective. Our "reverse osmosis" macro theory we touched on again recently is still playing out. This brings us to our second point.

• The EM 2016 outlook - its weaker than you think

While the "commodity rout" is well documented, we think that in 2016, we will the materialization of defaults and restructuring in the EM world given the exposure of the banking sector in these countries to the sector. In relation to this exposure, we would like to point out to a Bank of America Merrill Lynch report published on the 16th of October and entitled "China spillovers and the leverage channel":

"The commodity channelCommodity exporters – Malaysia, Thailand and Indonesia (see Chart 2) – have been disproportionately impacted, largely as commodity prices slump on weaker demand, as China rebalances away from investment-driven growth. 

Casualties include coal, base metals (iron and copper) and palm oil. Coal prices, for instance, have fallen some 62% since January 2011. Falling commodity exports hurt the current account balance, fiscal revenue and also the wages of lower income, rural households.
Lower export revenues and the declining terms of trade have weighed on the growth of commodity exporters. Indonesia’s GDP growth is at its weakest since the Global Financial Crisis, at +4.7%. Infrastructure spending is failing to offset slumping commodity exports so far, given the slow progress. Malaysia's GDP growth will likely slow markedly in the second half of the year, as slowing exports spill over to weaker consumer and investment spending.
The IMF highlighted in its latest October WEO report that the weaker outlook for commodity prices implies that the annual growth in output for net commodity exporters will decline further, by almost 1% point, in 2015–17 compared with 2012–14. The reduction in growth for energy exporters is projected to be larger, at about 2.25ppt over the same period.

 

The leverage channelConcerns over financial system vulnerabilities have risen, given the commodity downcycle and the sharp depreciation of currencies in emerging economies, particularly commodity exporters. The latter has implications for foreign-denominated debt. Economies with high foreign currency borrowings and high exposure to commodities are particularly at risk of loan defaults and banking system losses.

We identify loan exposures to the commodity sector, defined as loans extended to the agriculture, forestry & fishing, and mining & quarrying segments. Singapore (9.2% of GDP), India (7.2%), Malaysia (3.7%) and Indonesia (3.4%) have the largest share of bank loans to the commodity sector, as a proportion of nominal GDP (see Chart 3).

As a share of total corporate debt, Thailand and Indonesia rank highest, with about 31% and 30% of corporate debt borrowed by commodity producers. China (26% of total), India (26%) and Malaysia (18%) also have relatively sizeable amounts of debt borrowed by energy and metals & mining companies (see Chart 4). This is worrying and may have profound implications on financial stability, as commodity demand and prices remain under pressure. Based on IMF data, ASEAN countries Indonesia (52% of total corporate debt), the Philippines (28%), Malaysia (18%) and Thailand (16.5%) have the largest share of foreign-currency non-financial corporate debt out of total company borrowings in Emerging Asia.

Our Asia Pacific financials team recently highlighted that Hong Kong banks would be the most directly impacted by a China hard-landing. Many Chinese firms borrow funds offshore in Hong Kong and firms in Hong Kong are also reliant on cross-border businesses (tourism, trade, shipping, etc.). Among banks in the rest of Asia, Singapore banks DBS and OCBC have the largest loan book exposure to HK/China, accounting for 36% and 26% of total loans, respectively. The exposure of UOB, Taiwanese financials, Public Bank in Malaysia, and Australian banks are generally much smaller, in the 4% to13% range. Banks in other markets have insignificant exposure, but could be indirectly impacted by any slowdown in their domestic economies. 

Defaults and restructuring of commodity-related firms may be early indicators of potential financial stress for banks. High gearing and foreign currency-denominated debt appear to be a characteristic of commodity producers and trading companies. Commodities are priced in US dollars and are, therefore, hedged, goes one argument. Exploration and mining often require heavy capital investment and, hence, large-financing requirements. Commodity trading companies are also highly geared by their very nature. The China contagion may be far from being over, as the financial stress on commodity and debt-laden firms starts testing banks." - source Bank of America Merrill Lynch.

The path of normalization of the Fed has continued to exert additional pressure on already strained EMs thanks to Global Tightening Financial Conditions triggered by the US Dollar "margin call" thanks to the tapering of the Fed and now with the latest small increase in rates.

When it comes to the Fed's hiking cycle, the Fed is not only hiking in an environment of slowing earnings in the US, it is also hiking in an environment where Asian growth is slowing as displayed by Deutsche Bank in the below chart from their report from the 17th of December entitled "Asia Macro in a non-zero world":

"Business cycles in the region are in much weaker shape, with growth slowing – not accelerating – into this Fed hike (Chart above). Export growth has been printing in negative territory across Asia, a far cry from the double-digit growth seen when the Fed last raised rates (2004). Asian central banks will not be able to keep up with even a gradual Fed this time, and front-end rate differentials will narrow. The only central bank we think could hike rates is the Philippines. Elsewhere, rates in China, Taiwan, Korea, and Thailand could be very close to, or even below, US rates by end-2016. The market appears underpriced for this divergence." - source Deutsche Bank

Furthermore, when it comes to EMs' growth, this time it's different as their growth have been much tepid as of late. On the subject of the outlook for EMs, we read with interest LCM's take from their Cross Asset Weekly Report from the 15th of December entitled "Themes for 2016":

"EM: How Will It End?This is a good transition for our second point: the EM situation. We wonder how it could end because we do not see any positive outcome for them. In the developed world, the most flexible economies that have enjoyed the highest accommodative financial conditions of history have needed several years to recover after the US centric financial crisis. How long will need an EM country under
financial repression to recover from an EM centric financial and economic crisis? We do not know precisely but we suspect much longer than the US.
The chart below gives an indication of the negative pressure on the whole EM universe. If we exclude the global crisis of 2009, never before so many EM countries have failed to generate an economic growth rate above 3-4%. 

High economic growth is becoming scarce for these countries so clearly, we can talk about a new paradigm for them. On the right, the chart shows that a consequence of that lower growth is a higher accumulation of the public debt, leading to a rise of the Debt/GDP ratio towards its 90’s level. The current crisis seems deeper than the 97/98 crisis which was initiated by a financial crisis. 

This time, it is not a financial crisis that triggers the economic crisis but an endogenous economic crisis that arises following excess investment in assets that turned unproductive (real estate and manufacturing for China and commodity-related sectors for LatAm, the Middle East and Russia). This is a big difference. This economic crisis is not the result of a fundamental financial vulnerability that would have been exploited by investors. There has been no US$ interest rates shock, no speculative attacks on countries. The weakness comes from the real economy and the depreciation of the currency is the consequence of that weakness, not the cause. 

We show with the following chart the Budget balance for 2015 of selected EM countries and their short term cost of funding (5-year sovereign bond yield). There is a clear discrimination: Brazil suffers unaffordable rates whilst Chile and Peru, its neighbours that are also affected by weaker growth, maintain access to global markets. 

On the right, we see that the Government bond yields of Brazil and Russia have reached very high levels. Contrary to Turkey, these countries are already in recession making the situation desperate. The financial system is under great pressure, NPLs are on the rise, the risk for them of running out of a US$ financing is a reality. Equity valuation is therefore intriguing as Brazilian banks trade at 0.7 times their book value and Russian banks at 1.0 times their book value. In other words, this does not look to be a capitulation phase. The situation is critical but investors have not thrown in the towel and this is why in our opinion the downside for the most fragile EM equities is intact.

The underweight position on EM assets is supposedly consensual but as we discussed in our weekly note #115 “Story Positioning”, we do not believe this lie. PMs are not underweight EM assets because they cannot short an oversold asset; it is inconceivable for them.
This negative trend is therefore intact because the investor participation rate is very low. The EM currencies are depreciating because of two events: 1) the US dollar rise with the expectations of higher real rates and 2) because of financial outflows resulting from a deterioration of the EM external position and a loss of investor confidence. 

 - source LCM, Bloomberg

The new story among EM countries is the weakness of the rich Middle East countries. Their economic disarray looks like 1998 as they return to deficit in terms of budget balance and current account position. It is clear that they can afford it after having benefited for several years from the oil rent but as is often the case, the deterioration is faster and stronger than the improvement. The currency peg of these countries may be tested. We should therefore keep an eye on this region because being anchored to the winner when you are a loser is of limited interest. 

The consequences of the reduced amount of petrodollars flooding to developed and emerging markets are unknown but in the EM case it helps to further reinforce the vicious circle they suffer. The later, slower and weaker recovery scenario that we mention is obvious and this is why on financial markets investors should not expect too much from EM assets.

The accumulation of debt adds another challenge to EM countries that could act as an accelerating factor for the economic crisis. Within the EM world we continue to distinguish three groups: 1) commodity exporting countries 2) China and 3) the rest (mainly EM Asia ex-China). This EM crisis started with the first group as the decline of commodity prices quickly revealed their intrinsic weaknesses. Now it is moving to Asia and because there remain many unanswered questions, it should be a recurring topic for 2016.
For markets, this change of focus from LatAM/Russia to China does not mean that the situation is fixed but that it is extending. This is the problem and this is why 2016 could be another bad year for EM assets. The corporate bond defaults remain limited, the help of the IMF has not been required, so we have not as yet seen the classic indicators of capitulation that increases the reward/risk ratio of being contrarian." - source LCM, Cross Asset Weekly Report, 15th of December 2015.

While these are the shadows of things that have been in 2015, we have to agree, with LCM. We do not think we have yet reach the "capitulation" point that would make the asset class an "enticing" investment proposal.

In terms of "enticing" proposal, we would like to end up on a more "positive" note in our final point of our conversation, with the "attractiveness of the Japanese tourism sector.

• Final chart - Short Hong-Kong? Go long Japan "tourism"

We think that the Hong-Kong woes which we have again highlighted in our conversation "Cinderella's golden carriage" have greatly benefited Japan and will continue to do so in 2016. This has been furthemore highlighted by the WSJ in their article from the 17th of December entitled "Hong Kong Retailers Lost in Currency Translation":

"Retail goods in Tokyo are on average 34% cheaper than in Hong-Kong. Hong Kong retailers lost in currency translation as Chinese shoppers turn to Japan amid cheaper prices and yen." - source The Wall Street Journal

Given Japan has been the big beneficiary as highlighted in our previous conversations when looking at air travel surge towards Japan from China mainland, it makes sense we think, to continue to play this theme in 2016. On that note we read with interest Société Générale's Best Trade Ideas for December and January and would like to point out to additional points made in their research note on the subject of Japanese tourism:

"Japanese tourism is a long-term theme and its development is a pillar of Abe’s growth strategy. The government objective of reaching 20m visitors by 2020 is within reach. 

Consumer demand, a tailwind for Asian equities. Tourism expansion in Japan results from a combination of factors, including a weaker yen and government policy encouraging foreign visitors flows (for instance through easing visa deliveries). Rising wages and robust Asian consumer demand is another key element. In the past three years, the bulk of Japan’s tourism growth is attributable to Asian visitors. 

Exposure to tourism through SG Japan Tourist Basket. The basket, launched in March 2015, has been constructed along liquidity and diversification constraints. Sectors represented in the basket include transportation, appliances (30%) and retail trade (25%). Given the liquidity constraints, the basket consists of a combination or “pure” and “less pure” players, with a significant overall flavour of outbound travel.

- source Société Générale

When it comes to Honk-Kong's retail woes thanks to its US dollar peg, Japan is indeed the prime beneficiary, particularly when one notices that luxury watches exports from Switzerland to Hong-Kong have fallen by 28% according to Bloomberg.

In relation to Hong-Kong's currency peg, we are left wondering if indeed the fall in "luxury watches" is not indicating that "time" is running out? Is our prediction for 2016 so "outrageous"? We will soon find out...

"Every adversity, every failure, every heartache carries with it the seed of an equal or greater benefit." - Napoleon Hill, American writer

Stay tuned!

Credit - The European iterated prisoners' dilemma

"The only possible Nash equilibrium is to always defect. The proof is inductive: one might as well defect on the last turn, since the opponent will not have a chance to punish the player. Therefore, both will defect on the last turn. Thus, the player might as well defect on the second-to-last turn, since the opponent will defect on the last no matter what is done, and so on. The same applies if the game length is unknown but has a known upper limit." - source Wikipedia

In continuation to game theory references, given we recently touched on the subject in our conversation "Agree to Disagree", we thought this time around we would make a reference to the prisoners' dilemna. After all, in Europe, it is all about game theory, given than many pundits are arguing whether Germany will cooperate or not in resolving the on-going European woes, pledging its balance sheet in the process.

In game theory and in relation to our European iterated prisoner's dilemma we have :

"If it is supposed here that each player is only concerned with lessening his time in jail, the game becomes a non-zero sum game where the two players may either assist or betray the other. In the game, the sole worry of the prisoners seems to be increasing his own reward. The interesting symmetry of this problem is that the logical decision leads each to betray the other, even though their individual ‘prize’ would be greater if they cooperated. In the regular version of this game, collaboration is dominated by betrayal, and as a result, the only possible outcome of the game is for both prisoners to betray the other. Regardless of what the other prisoner chooses, one will always gain a greater payoff by betraying the other. Because betrayal is always more beneficial than cooperation, all objective prisoners would seemingly betray the other.

In the extended form game, the game is played over and over, and consequently, both prisoners continuously have an opportunity to penalize the other for the previous decision. If the number of times the game will be played is known, the finite aspect of the game means that by backward induction, the two prisoners will betray each other repeatedly.

In casual usage, the label "prisoner's dilemma" may be applied to situations not strictly matching the formal criteria of the classic or iterative games, for instance, those in which two entities could gain important benefits from cooperating or suffer from the failure to do so, but find it merely difficult or expensive, not necessarily impossible, to coordinate their activities to achieve cooperation." - source Wikipedia.

For now every European politicians in Europe seem to "Agree to Disagree", it looks to us increasingly probable that the outcome could be different to what is expected from Germany. The outcome for the European project is going to be rather binary. It is either "Federalism" or break-up. In fact it is Germany who has always pushed for more integration, more "Federalism". In September 1994 both Karls Lamers and Wolfgang Schauble from the CDU presented their project of accelerated integration to France. It entailed a faster integration within the European Union for Germany, France, Belgium, Luxembourg and Holland. France at the time was under "Cohabitation", Socialist French President Mitterrand had as Prime Minister Edouard Balladur from the opposing party, having lost ruling majority in the parliamentary elections leading to a political stand-off which lasted for two years. The European game is therefore in the political French camp. President François Hollande having garnered a strong political support in the recent parliamentary elections, it will be interesting to watch if French politicians will indeed accept to lose their powers for the collective good, or, if they decide to cling on their individual mandates and powers and a "Federal Europe" will not happen. Will the French surrender again? We dare to ask, staying politically correct in our conversation ("Cheese-eating surrender monkeys", being a derogatory description of French people that was coined in 1995 by Ken Keeler, then-writer for the television series The Simpsons).

Looking at the "social-clientelism" mentality which has prevailed in French politics in the last 30 years, and given the trauma stemming from the European 2005 referendum, one has to posit the French willingness in moving towards a full lasting Federal European Union.

While many are comparing the need for Europe to evolve in a comparable way to the evolution of the United States towards a full Federal Union. We do not have to go that far to find a more relevant example to the current European plight. In fact as our good credit friend mentioned in one of our most recent conversation, he pointed rightfully towards...Switzerland! The Federal Constitution adopted in 1848 is the legal foundation of the modern Swiss federal state. It is among the oldest constitutions in the world.

There are three main governing bodies on the Swiss federal level: the bicameral parliament (legislative), the Federal Council (executive) and the Federal Court (judicial).

Europe already has all three.

"The Swiss Parliament consists of two houses: the Council of States which has 46 representatives (two from each canton and one from each half-canton) who are elected under a system determined by each canton, and the National Council, which consists of 200 members who are elected under a system of proportional representation, depending on the population of each canton. Members of both houses serve for 4 years. When both houses are in joint session, they are known collectively as the Federal Assembly. Through referendums, citizens may challenge any law passed by parliament and through initiatives, introduce amendments to the federal constitution, thus making Switzerland a direct democracy.

The Federal Council constitutes the federal government, directs the federal administration and serves as collective Head of State. It is a collegial body of seven members, elected for a four-year mandate by the Federal Assembly which also exercises oversight over the Council. The President of the Confederation is elected by the Assembly from among the seven members, traditionally in rotation and for a one-year term; the President chairs the government and assumes representative functions. However, the president is a primus inter pares with no additional powers, and remains the head of a department within the administration." - source Wikipedia.

The Swiss cantons also have a permanent constitutional status and, in comparison with the situation in other countries, a high degree of independence. Under the Federal Constitution, all 26 cantons are equal in status (pari-passu...). Each canton has its own constitution, and its own parliament, government and courts. Switzerland also boasts, in similar fashion to the US, a Federal Supreme Court.

So could it be France derailing the whole European project in the end rather than Germany? We wonder.
But we ramble again, erring on the political side. Time for our credit overview, revisiting our pet subject of bond tenders and the ongoing issues in the peripherals, particularly in Spain, given we recently received the results for the Spanish Bank Recapitalisation independent estimate and 62 billion is the number.

"The Gap is closed" we indicated on the 16th of June in relation to the European space. Now both the Eurostoxx and German 10 year Government yields seems to be moving in synch, lower that is while credit spreads for financials as indicated by Itraxx Financial Senior 5 year CDS index is moving wider following rating agencies multiple downgrades and on-going concerns on peripheral sovereign yield levels - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

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

Last week Spanish risk premium reached a new historical high breaching easily the 7% level, with renewed concerns on Spanish banks given the rise in Spanish bad loans. (reaching 8.72% in April from 8.37% in March).

As Societe Generale clearly indicated in their recent global research alert, the markets have indeed lost confidence in Spain:

The challenge European leaders face at the 28-29th June summit is to come out with a big plan as indicated in their recent note by Societe Generale: "Comprehensive restructuring of the economy/the banking sector is  required to restore market confidence....due to a rise in national and regional public debt...".

Indeed, Government debt to GDP could reach 90% of GDP in 2012:

"Spain’s budget deficit is expected to end 2012 at 5.3%, vs 8.9% in 2011, so government debt could reach 90% of GDP this year. On top of that, Spain holds a rising amount of regional debt (which has doubled since December 2008) and contingent liabilities, such as the FROB (Fund for Orderly Bank Restructuring). Taking into account these two elements and the current recession in Spain, debt could rapidly reach unsustainable levels." - source Societe Generale.

Unfortunately, Spanish property market and bank restructuring go hand in hand and as many pundits have indicated, Spanish property bubble and deleveraging has yet to start effectively as indicated by the below graph from Societe Generale:

"House prices could decline by a further 20-25% in an adverse scenario (see last week’s results of the independent evaluation of the Spanish banking sector)." - source Societe Generale.

The Spanish Test Assumptions:

The Stress Test Property Assumptions may not be aggressive enough - source Bloomberg:

"A 19.9% yoy drop in Spanish house prices for the adverse scenario could easily be exceeded if confidence is not restored by the recently announced bailout. At 1Q, yoy declines ranged between 7% and 12% depending on the source, while from 1Q08 highs, house price declines total 21%. Should this rate of deterioration continue, the 4.5% 2013 forecast decline may prove conservative." - source Bloomberg.

The results from the independent audit, the Spanish Assumptions at least looks credible for retail, for corporate less so, according to Bloomberg:

"A 6.8% contraction of lending supply for 2012 and 2013 looks reasonable for retail lending when compared with experience through the crisis. A 6.4% and 5.3% decline for corporate loan supply looks far less cautious when considering that January 2012 data showed a 6% yoy drop, before sovereign fears heightened." - source Bloomberg.

Another issue with the results from the Spanish Test Assumptions comes from the GDP worst case scenario retained no lower than 2009 experience as shown by Bloomberg:

"A decline of 4.1% in Spanish GDP for 2012, the adverse scenario used in the stress test, is less severe than the 4.4% yoy drop of 1H09. While this scenario is calculated from a lower absolute GDP base, it is key for bad-debt experience, unemployment and credit supply. Coordinated EU action is needed to drive long-term interest rate assumptions lower." - source Bloomberg.

We do not want to be seen as party spoilers, but as we posited in relation to the numerous EBA (European Banking Association) test for financial institutions, no test, no stress, no stress, no test...

No wonder Spanish Financial CDS has been on widening trend - source CMA:

Unless significant steps are taken in the next European summit, and we mean "shock and awe", given Spain and Italy have significant funding needs until 2014, the game might be coming to an end leading to the defect of some players in the process of our "European iterated prisoners":

- source Societe Generale.

From this similar Societe Generale note, higher loan delinquencies and low industrial production are the main risks:
"Risk 1: Spanish loan delinquencies, back to the 90s
-Spanish bank delinquent loans increased again to 8.72% in April, from 8.37% in March, thereby reaching an 18-year high. This trend is likely to
persist as unemployment and bankruptcies continue to rise.
-Acceleration in number of delinquent loans means Spanish banks are likely to suffer from increasingly larger losses in the future
-Report carried out by two consulting firms estimates Spanish banks' capital shortfall at up to 62bn euros.
Risk 2: European industry deteriorates
-Eurozone industrial production fell 2.3% compared to the same month last year, driven down by the southern Europe countries.
-If the Eurozone fails to undertake the necessary structural reforms, the northern European countries could get drawn into southern Europe’s downward spiral.
-In contrast, US industry has remained quite resilient since the beginning of the year, with total industrial production in May up 4.7 percent yoy."

We will not delve again into the difference between "Stocks and Flows" central to our thought process namely the United States and Europe growth differentiation as we already touched on this subject in our conversation "Growth divergence between US and Europe? It's the credit conditions stupid...".

Moving on to our pet subject of subordinated bond tenders, as at some point, as we argued recently (Peripheral Banks, Kneecap Recap), losses will have to be taken, it is all going Dutch, Dutch auction that is. While ailing Portuguese bank BCP (Banco Comercial Português) announced on the 20th of June a bond tender relating to mortgage backed securities, BBVA bought back some asset-backed bonds too on 26 senior and 25 mezzanine portions of bonds backed by consumer loans, mortgages and business loans, with prices ranging from 46 to 95%. All part of "liability" management exercises to raise some capital and strengthen the capital base, meaning more pain for bondholders in the process.
While the 62 billion being the estimated amount earmarked by independent consultants Oliver Wyman and Roland Berger, burden sharing is currently being considered with the European Union in respect to a 100 billion euro rescue package for the Spanish financial system.

"The government in Madrid is also considering giving more power to the national regulator to restrict sales of loss-absorbing securities such as preferred stock to individuals, said the person. De Guindos has said that preference shares shouldn’t have been sold to retail investors.

Supervisors “failed” over the sale of preference shares to retail investors, said De Guindos June 5 in the Senate.

Spanish lenders sold 22.4 billion euros ($28.2 billion) of preferred stock to individual investors through retail branches. Banks have offered clients holding most of that amount to swap the securities into common stock or other subordinated instruments, according to data compiled by CNMV, the financial markets supervisor." - source Bloomberg

We correctly foresaw this process for weaker peripheral banks.

"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.

We wrote in October 2011 relating to bond tenders and the move towards debt to equity swap:
"We expected others to follow suit and given the difficulty for the weaker players in the peripheral space to access capital at a reasonable rate, as well as needing to boost their core Tier 1 capital base, it was of no surprise to see Portuguese bank Banco Espirito Santo following French bank BPCE in tendering some of its subordinated debt on the 18th of October, but this time around, we have a debt to equity swap."

It is still a game of survival of the fittest, even for some Italian banks, given Monte dei Paschi di Siena (MPS), Italy’s third-biggest bank, according to December 2011 EBA exercise, had a capital shortfall of Euro 3.3 billion. The bank, which must also repay 1.9 billion euros of state aid provided in 2009... Monte Paschi may use the government’s aid program, the so-called Tremonti bond, as part of its plan to boost capital by end of June 2012 (9% Core Tier 1 Capital), Il Sole 24 Ore reported. Also, S and P put MPS’s ratings on Watch Negative citing pressure on the bank’s financial position from a combination of deteriorating asset quality metrics, weakened earnings, and low financial flexibility. Separately, the main shareholder of MPS, the Monte Paschi Foundation has reportedly reached an agreement with its creditor banks to restructure its debt. S and P placed its 'BBB/A-2' L-T and S-T counterparty credit ratings on Italy-based Banca Monte dei Paschi di Siena SpA (MPS) on CreditWatch with negative implications. Agency also put all of its ratings on MPS' subordinated, junior subordinated, and hybrid debt issues on CreditWatch negative. The rating action reflects S and P’s view as the convergence of various negative pressures on MPS' financial profile. Monte Paschi First-Quarter profit fell 61% on higher write downs and has a market value of around 2.8 billion euros. MPS is considering selling its 2.5% stake in the Bank of Italy to the central bank to reach the June 2012 threshold.

As indicated by Bloomberg, Italian corporate and household bad debt totaled 109 billion euros ($138 billion) in April, an increase of 15 percent from a year earlier, according to Bank of Italy data.

Non-performing loans rose to 5.4% in March, up from 3% in June 2008, according to Italian Banking Association data. Impairments, excluding writedowns, rose to 58 billion euros from 50 billion euros. CDS on UniCredit, (Italy's largest bank) rose to 532 basis points on June 19 from 292 on March 19, according to data compiled by Bloomberg.

With unemployment rate at 10.2% in April the highest in most than 12 years, Italian banks as well as their Spanish peers are facing economic deterioration facing but are not plagued by housing related issues and high household private debt levels.

If it could be of any solace to European Banking woes, the new capital regime for US Banks will as well trigger at some point some "liability" management exercises namely bond tenders as indicated by CreditSights in their note - US Banks - The New Capital Regime - Bonjour Basel - 24th of June 2012:

"US banking regulators released proposals for new capital rules for banks aimed at complying with Dodd-Frank Basel III. The new guidelines apply to all US banks with some variations/differences for banks over 50 billion USD in assets and were mostly in-line with expectations.

The new guideline call for higher levels of capital, which could make the financial system safer but also reduce returns and cause banks to reassess their balance sheets. They believe that new requirements fortify the banks’ ability to absorb losses and withstand a potential systemic shock, which is a positive for fixed income investors and both positive and negative for equity.

US banks will now have a new set of minimum capital requirements, incorporate additional capital buffers and limitations outlined in Basel III and phase-out trust preferred securities in accordance with the Dodd-Frank Act. When the new limits are fully phased-in, banks are required to maintain a common equity Tier 1 ratio of 7% and Tier 1 ratio of 8.5%, including a capital conservation buffer of 250 bps. The limitations and changes to risk weights could influence business decisions including lending and mortgage servicing.

Trust preferred securities are phased-out reflecting the requirements of the Dodd-Frank Act.

Non cumulative preferreds continue to receive Tier 1 capital treatment and could make up the majority of non-common equity Tier 1 capital. As a result, they expect issuers and investors to focus primarily on preferreds to address their non-common equity Tier 1 Capital and yield needs, respectively."

On a final note Money Markets wager ECB will cut deposit rate as indicated by a recent Bloomberg Chart of the day:

"The CHART OF THE DAY shows that the Eonia-OIS measure, which estimates interbank borrowing costs over the next three months, fell below the 25 basis points the ECB pays for deposits. The last two times this happened the central bank cut the rate within two weeks." - source Bloomberg

"There are few ironclad rules of diplomacy but to one there is no exception. When an official reports that talks were useful, it can safely be concluded that nothing was accomplished."

John Kenneth Galbraith

Stay Tuned!