Markets - Credit - A Deficit Target Too Far

"I think we may be going a bridge too far."
British Lieutenant-General Frederick Browning, deputy commander of the First Allied Airborne Army to Field Marshal Bernard Montgomery

Our title follows up on our previous conversation "All Quiet on the Western Front", where we discussed our BIG reservations relating to the unachievable Spanish deficit target of 3% in 2013. This week's analogy refers to the overly ambitious Operation Market Garden of September 1944 in relation to the overly ambitious deficit targets set up by European leaders for Spain. It wasn't really a surprise to see Italy today following the footsteps of Spain and revising its budget deficit target for 2013 from 0.1% to 0.5%. They have as well revised their 2012 GDP contraction from 0.5% to 1.2% with a GDP growth target of 0.5% for 2013. Oh well...Initially, Operation Market Garden was marginally successful and several bridges between Eindhoven and Nijmegen were captured. However, General Horrocks' XXX Corps ground force's advance was delayed by the demolition of a bridge over the Wilhelmina Canal, as well as an extremely overstretched supply line (ESM and EFSF firepower are overstretched as far as Spain and Italy are concerned)...a bridge too far, and certainly a deficit target too for Spain, but here we go, we ramble again. Before we revisit the overly ambitious plan for Spain, and review France as the new barometer of Euro Risk with the upcoming first round of the presidential elections, it is time for our usual credit market overview.

The Credit Indices Itraxx overview - Source Bloomberg:

Since last the last rebalancing of credit indices on the 20th of March, Itraxx Credit indices have been overall wider, with SOVx Western Europe 5 year CDS index (representing CDS of 15 European countries, with Cyprus replacing Greece since its "selective default") wider by 26%.  Itraxx Crossover 5 year CDS index (High Yield risk gauge - 50 European companies) was wider by 12.5 bps in the early afternoon, 125 bps wider since the roll date of the 20th of March.

Itraxx Crossover has been rising and Eurostoxx Volatility is rising to 23.45 - source Bloomberg:

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield) is still pointing towards the lowest level reached in 2011, around 1.73% - source Bloomberg:

A game of capital preservation rather than a search for yield for European investors.

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

As indicated by CreditSights in their recent note - Eurozone - Recycling ECB Reserves in Italy and Spain on the 17th of April, LTRO 1 and LTRO 2 have enabled Spanish and Italian banks to soak up domestic bonds:

"The ECB’s provisions of liquidity to Italian and Spanish banks have partly been used by those banks to increase their holdings of domestic government bonds.

Spanish and Italian banks have increased their holdings by 41 billion euro and 19 billion euro between the end of November and the end of January following the first three year LTRO. That increase in holdings by domestic banks has coincided with a dramatic decline in foreign holdings of those two countries’ government bonds. The result is an increase in concentration of government bond holdings within those two countries banks."

Given recent developments in revised deficit target objectives for both Italy and Spain, as well as the significant widening in credit spreads (Itraxx Financial Senior index indicating a rise in financial risk) and tightening of "safe haven" German bund, we would advise caution. In fact we have seen this movie before, so clearly "Mind the Gap" - source Bloomberg:

In fact Europe's volatility index V2X is well above VIX index and the divergence between both has been rising - source Bloomberg:

The liquidity picture, as per our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

While liquidity conditions have seriously improved since the end of 2011, thanks to the ECB's two rounds of LTRO, the LTRO "alkaloid" effect is somewhat fading hence the renewed tensions seen on the Itraxx Financial Senior Index indicating a deterioration in one of these indicators. According to Nomura in their report "Wilting growth and sovereign and bank pressures" from the 10th of April:

"Other areas of the funding markets are increasingly showing signs of stress, including the EUR-USD cross currency basis swap. This has been compressing across the tenors, primarily due to the Fed swap line, which was put in place in November 2011, but also due to lower volumes going through these markets given the unwind in USD operations by some banks leading to reduced USD funding through these sources. We could see a continuation of this renewed widening as tensions increase in the euro area."

Moving back to the subject of the overly ambitious deficit reduction plan for Spain in true Market Garden style, a recent report published by Exane BNP Paribas strikes a blow to the plan in a less courteous manner than British Lieutenant-General Frederick Browning : "Are deficit targets credible? In short no"

Exane BNP Paribas believes the GDP Growth for Spain will only amount to -1.1% versus an official estimated growth of 2.4% in 2013, leading to a budget deficit of -5.6%  in 2013 versus the overly optimistic objective of -3% discussed in the conclusion of our previous conversation. Clearly "A Deficit Target Too Far".

Exane BNP Paribas in their note convey several reasons for their estimate:
"Collapse in tax receipts puts additional pressure on spending cuts" - Source Exane BNP Paribas - Eurostat:

Regions account for 50% of spending in Spain - Source Exane BNP Paribas - OECD:

"-45% of Regions' spending goes to health and education - tough to cut.
-Regional governments missed targets significantly in 2011; targets for 2012 are too ambitious".
- Exane BNP Paribas

In their note Exane BNP Paribas is going further, public confidence in the government is waning, as indicated by recent polls from Spanish newspaper El Pais:

When austerity bites with high youth unemployment, risks of social stability are mounting, which could potentially lead to a European Autumn in similar fashion to the Arab Spring?

As far as credit flows to the real economy are concerned, the potential problematic loans currently sitting on Spanish banks balance sheet will undoubtedly weight heavily on economic growth in the near term as indicated by the latest rise in Non-performing loans to 8.16 percent in February according to the Bank of Spain, its highest level since 1994.

"Current consensus for 2012 Spanish GDP is for a contraction of 1.2%. As the government attempts to realize 37 billion euros of austerity savings, this figure may well increase unemployment and drive consumer spending lower. Santander's FY11 Spanish NPL ratio was 5.5%, with real estate loans at 28.6%. Lower GDP could drive these figures higher." - source Bloomberg

In fact according to Bloomberg Chart of the Day from the 17th of April, Spanish Mortgage Defaults may double on joblessness:

"The CHART OF THE DAY shows that unemployment was 24.5 percent when the mortgage default rate peaked at 5.5 percent in 1994. Even as the jobless rate rose to 23.6 percent this month, defaults are half as high at 2.7 percent." - source Bloomberg

European Subprime in the making? (we wondered in our last conversation), US Mortgage delinquencies peaked at 11.2% according to Bloomberg, Spain has yet to rise to these levels:

"Banesto, Santander's domestic subsidiary, revealed the percentage of problematic property loans had risen above 50% by 1Q, from 32% 12 months earlier. In February, the Bank of Spain announced 35 billion euros of provisions and 15 billion of capital to clean banks' balance sheets. These measures may be revisited should deterioration continue." - source Bloomberg

On a final note, we previously discussed at length France's "Grand Illusion", and France is clearly moving to center stage.
As indicated by Cheuvreux in their recent Cross Asset Research from the 16th of April:
"Spain is the 2012 epicenter of EZ financial stress. The return of pressures upon the vulnerable compartments of the EZ equity universe has been remarkably rapid even by the standards of the recent past because so many have been waiting for this accident to happen. The French election acts as a further accelerator."

We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections. French CDS were driven wider today with apparently some heavy buying of CDS protection from real money accounts and Hedge Funds according to market makers in the French CDS space - source CMA

Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").

"Everybody is ambitious. The question is whether he is ambitious to be or ambitious to do."
Jean Monnet - French political economist and diplomat, regarded by many as a chief architect of European Unity.

Stay Tuned!

Markets update - Credit - Bayesian thoughts

"In the Bayesian (or epistemological) interpretation, probability measures a degree of belief. Bayes' theorem then links the degree of belief in a proposition before and after accounting for evidence. For example, suppose somebody proposes that a biased coin is twice as likely to land heads than tails. Degree of belief in this might initially be 50%. The coin is then flipped a number of times to collect evidence. Belief may rise to 70% if the evidence supports the proposition." - source Wikipedia

Today's analogy refers to our rising degree of belief courtesy of Bayesian statistics but also to the well-studied "optimism bias" which most of us are affected by:
"The ability to anticipate is a hallmark of cognition. Inferences about what will occur in the future are critical to decision making, enabling us to prepare our actions so as to avoid harm and gain reward. Given the importance of these future projections, one might expect the brain to possess accurate, unbiased foresight. Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, we underrate our chances of getting divorced, being in a car accident, or suffering from cancer. We also expect to live longer than objective measures would warrant, overestimate our success in the job market, and believe that our children will be especially talented. This phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics."
Tali Sharot - The optimism bias - Current Biology, Volume 21, issues 23, R941-R945, 6th of December 2011.

But, here we go again, lost in our thought process once more. It is time for a credit market overview, the improved tone in the credit space and following up on our previous Hungarian story with an interesting goodwill write down, courtesy of BayernLB, what a surprise...

The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

While banks are still so far hoarding cash at the ECB's overnight facility earning 0.25% in the process (new reserve period starts on the 18th of January), liquidity picture is improving at least on the Libor OIS spread level, indicating clearly the 30th of November Central banks operation has had its effect on dollar funding issues.

The Credit Indices Itraxx overview, overall a better tone - Source Bloomberg:

Itraxx Financial Subordinate 5 year CDS index falling below the 500 bps level and closing around 480 bps, overall a better tone in the Credit space with a flurry of corporate bonds issuance, Spanish bond auctions, ECB keeping rates at 1% and more. Since the beginning of the year we have seen quite a few issues of Senior Financial Unsecured bonds issuance from core European banks:
Nordea Bank 2.24% 2014 (1 billion euros, quarterly floating) on the 4th of January,
Abn Amro Bank 4.75% 2019 (1 billion euros) on the 4th of January
ING 4.25% 2017 (1 billion euros) on the 6th of January,
UBS 3.125% 2019 (1.5 billion euros) on the 11th of January,
Rabobank 4% 2022 (1.75 billion euros) on the 11th of January,
Standard Chartered 4.125% 2019 (1 billion euros) on the 11th of January.

Itraxx Crossover 5 year index (High Yield gauge) evolution - Source Bloomberg:

The Itraxx Crossover represents 50 companies with mostly high-yield credit ratings. The index decreased by around 21 basis points today to 713 bps.

The most important news reported was by Handelsblatt about the European Banking Authority being likely to postpone the annual stress test for banks initially set up for June and published in 2012. Could it be in order to avoid spoiling the celebration of the London Olympics? It might be more realistically to do with the recent concerns of raising much needed capital in 2012 following the dreadful right issues results of Unicredit which we discussed previously and avoid a dreadful credit crunch for 2012 in the process. Deleveraging bank balance sheets in conjunction with reaching a core tier one capital level of 9% was indeed a recipe for disaster looking at 2012 wall of refinancing (somewhat alleviated by the 36 months LTRO operation conducted on the 21st of December by the ECB).

There is again an interesting disconnect between the move in the 10 year German Bund and the Eurostoxx, a point we touched in our post "Mind the Gap..." - source Bloomberg:

Volatility falling still in the process as shown in the bottom level of the graph displaying 6 month implied volatility and V2X index.

Could the disconnect be different this time?

Flight to quality mode is so far is still on, with Germany 10 year Government bond trending back towards record lows - Source Bloomberg:

One of the indicators we have been following in our 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 coming back following the scary German auction of the 23rd of November (see our post "The song of Roland") - source Bloomberg:

The current European bond picture with some respite for Italy and Spain - source Bloomberg:

Even our CPDO/EFSF is looking healthier in yields term back to the 3% levels - source Bloomberg:

But what made our credit friend and us really chuckle today, following up on our "Hungarian dances" post, was the news regarding BayernLB (Bayerische Landesbank, the second-
biggest German state-owned lender) which as reported today by Stefan Wagstyl in his column "beyondbrics" in the Financial Times has effectively been "bloodied in Budapest":

"Germany’s BayernLB said it would report a net loss for 2011 because it was writing down the value of its Hungarian subsidiary, MKB Bank."

Reminding us exactly of what discussed last time around:

"Tracking goodwill impairments will indeed be a necessary exercise in 2012 as they can take a real chunk out of bank earnings in the process."


BayernLB anticipates net loss for 2011 under German accounting standards (HGB) due to Hungarian government actions - press release:
"12 January 2012
Munich - Due to the need to write down the book value of its holding in its Hungarian subsidiary MKB Bank, BayernLB currently anticipates that it will report a net loss for 2011 in its separate accounts under German accounting standards (HGB).

BayernLB is compelled to take this measure because actions by the Hungarian government, to include the extremely high bank levy and recently passed Foreign Currency Conversion Act, have substantially impaired MKB Bank's earnings prospects.
The writedown on the book value of its holding in MKB Bank will have a significant impact on BayernLB's net income under German accounting standards and thus overshadows the positive performance of its operating business with customers.

As a result of the expected loss in the HGB financial statements, BayernLB does not expect to service its equity capital instruments (profit participation certificates, silent partner contributions and BayernLB Capital Trust 1 securities) for financial year 2011.
As things currently stand, it will not be possible for the profit participation certificates and silent partner contributions to avoid sharing the loss. A definitive statement on the amount of the loss participation is not expected to be possible until the financial accounts have been approved at the end of April 2012."

Consequence: Bayern LB Capital Trust (Tier 1 ) Perp call 2017 – 6.2032% - $ 850 million – Isin XS0290135358. Price: 32/34 Down 7 points...
Ouch!

We have to say it again, like we did in our previous conversation and as well in November in our Goodwill conversation:

"Tip for “banks’ friends”: First came dividends cuts, then bonds haircuts. Next, we will see some massive write-off (Goodwill ?). UniCredit started, others will follow. The path will be very painful for both shareholders and bondholders."

So effectively, BayernLB equity capital instruments holders can kiss their coupon goodbye...

And my good credit friend to comment:

"And this kind of event will affect much more banks than expected by the market. I expect Austrian banks to make similar announcements very soon, with potential worse consequences considering their position in Central Europe."


EUR/HUF currency levels - source Bloomberg:

We were in agreement with Deutsche Bank in our last conversation:

"As a conclusion, we expect events to unfold rather quickly in Hungary. It may come down to a choice between a partial loss of sovereignty in economic management or of a debt restructuring, to be made at the highest political level."

In fact according to Bloomberg, the likely choice seems so far towards partial loss of sovereignty, indeed we argued last time around, we have seen this movie before...

According to Bloomberg:

"London, January 12 (MTI) - There is a "good probability" that the Hungarian government will sign a Stand-by Arrangement with the IMF as early as the first quarter of this year, London-based emerging markets economists said on Thursday.
In its comprehensive 2012 outlook for the CEEMEA region released to investors in London, Morgan Stanley said a two-year programme of 15-20 billion euros would be sufficient to reassure markets about Hungary's funding needs."

But given our current "Bayesian thoughts", and as indicated by Morgan Stanley in the same article:

"We think that the next few months should see Hungary's refinancing risks
fall significantly thanks to assistance provided by the IMF/EU". That said, "we think that even though there are good chances of a deal in the near term, the relationship with the IMF is likely to be rocky to say the least, as long as the current administration is in place... Therefore, the risk of some rift between Hungary and the EU/IMF a few months down the line remains intact", Morgan Stanley said."

So, all in all, we would have to agree with Dr. Constantin Gurdgiev, from his latest post entitle "Great Moderation or Great Delusion":

"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

And to use a baseball analogy from our Americans friends, don't try stealing third base in this market environment!

"Information: the negative reciprocal value of probability."
Claude Shannon

Stay tuned!

A tale of two markets - Credit versus Equities

At the start of the Financial crisis, with the subprime debacle of the summer of 2007, there was a big disconnect between the credit markets and the equities markets. Volatility was falling on the equities market meanwhile credit spreads were simply exploding, sometimes with gigantic intraday movements. I remember seeing 100 bps intraday move on the 5 year Itraxx Crossover index.

Credit markets, were early indicators of trouble in 2000 and 2007.

Tracking the implied volatility skew from equity options can be a good indicator of market movements in the equity world. Skew indicates the difference in demand for put options and call options. Following the standard measure of three-month volatility skew can be very useful.

In theory Credit can be assimilated to a long OTM (Out of the Money) equity option. A Credit Default Swap (CDS) is a proxy for a Put Option on the Assets of a Firm. This means that by going long on bonds the bondholders are long the face value of the bond and short a put option on the assets of the firm with the strike price being the face value (principal) of the bonds.

In recent years, according to a research published by Morgan Stanley in March 2009 by Sivan Mahadevan, correlations between changes in credit spreads and changes in various implied volatility metrics, have been very similar to short-dated ATM (At The Money)equity options. Liquidity being an important factor and short-dated ATM being the most liquid in equities, whereas the 5 year point being the most liquid CDS point (Credit Default Swap). Given there is an extremely low probability of an entire equity index going bankrupt, Morgan Stanley's research team further comment that ATM volatility can be used to make comparisons between equity and credit. The cash equity/credit relationship is apparently less stable than the volatility/credit relationship according to Morgan Stanley's study.

The recent significant increase in credit spreads for many financials have been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates. In a recent post, we touched on the subject in relation to the wall of maturities facing financial institutions up until December 2012 competing at the same time with Sovereigns in the need as well and the risk of crowding out.

Both credit and equity markets (as well as equity volatility) are driven by macroeconomic news.

There is a belief that fixed income markets are "smarter" than equity markets. It was certainly the case in 2007.

Today we have again an interesting disconnect:

In the graph you have:
Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year government bond, GDBR10), and at the bottom Eurostoxx 6 months Implied volatility.

At the same time, European High Yield debt is tighter than Bank Sub debt.

Europe's Junk Proves Safer Than Risky Bank Debt:

"The extra yield buyers demand to own high-yield non- financial notes instead of government securities fell below that on bank subordinated debt on Jan. 6, and is now 29 basis points lower, according to Bank of America Merrill Lynch index data. Before November, speculative-grade bond spreads had never been within 100 basis points of those on bank notes, which on average are rated eight steps higher."

"Relative yields on speculative-grade European company debt shrank 51 basis points to a three-year low of 437 since Oct. 31, a month before Ireland asked for an 85 billion-euro bailout, according to Bank of America Merrill Lynch’s Euro Non-Financial High-Yield Constrained Index. Subordinated bank bond spreads widened 125 basis points in the same period to 466, approaching the highest since July, the EMU Financial Corporate Index, Sub- Type shows."

"Financial credit has “significantly decoupled” from the rest of the corporate bond market since November because of higher expected losses and increased volatility amid the sovereign crisis, Morgan Stanley strategists led by Andrew Sheets said in a Jan. 14 report."

This leads us to discuss Capital Structure Arbitrage.

Capital Structure Arbitrage is according to the definition: any of a number of trading strategies designed to arbitrage the relationship between assets issued at different parts of a company's capital structure. Examples include convertible arbitrage (trading convertibles against equity options, for example), trading secured loans versus unsecured bonds of the same issuer and trading senior debt against subordinated debt of the same issuer.

It will be a big theme in 2011 according to UK Special Situations manager Alex Breese:

He said: "The capital structure arbitrage currently presented by corporate bonds yielding less than the free cash flow yield on equity will encourage the quoted sector to buy equity, either through share buybacks or merger and acquisition activity."

"This will be one of the key drivers for the UK market in 2011."

And probably a key driver in the credit space in general.

There is blood...Europe Government Bond Market getting whacked this morning

Linderhof Castle, Atlas statue, Upper Bavaria, Bavaria.

Looks more and more that Germany is the European Atlas supporting all of Europe...

Just four days earlier I wrote there will be blood. I was expecting additional pressure in the Government bond market. We have it. The bond vigilantes are clearly not satisfied with the politicians answer to the crisis. The Irish solution is clearly not enough to calm the market. The EFSF is a weak structure as well, please look at the previous post "The European Vortex" for more details.

Spreads of European Government debt versus Germany:

Versus the 10 Year German Bund:
France: 49 +7 bps wider
Belgium: 117 +20 bps wider
Spain: 273 +29
Italy: 190 +27
Portugal: 432 +14
Ireland: 653 +13
Greece: 891 no change

Versus the 5 Year German BOBL:
France: 34 +4 bps wider
Belgium: 114 +23 bps wider
Spain: 288 +32 bps wider
Italy: 190 +30 bps wider
Portugal: 420 +14 bps wider
Ireland: 673 +15 bps wider
Greece: 1046 -1 bps tighter

Versus the 2 Year German Schatz:
France: 21 +3 bps wider
Belgium: 80 +19 bps wider
Spain: 290 +32 bps wider
Italy: 193 +38 bps wider
Portugal: 398 +14 bps wider
Ireland: 564 -13 bps tighter
Greece: 1140 -4 bps tighter

New records at wider levels for:
2 year Spanish at 290 bps ,
2 year Belgium at 80 bps
2 year Italien at 193 bps
5 year Spanish at 288 bps ,
5 year Irish at 673 bps
5 year Italian at 190 bps (as I was typing this post, 200 bps was reached)
10 year Spanish at 273 bps
10 year Belgium at 117 bps
10 year Irish at 653 bps
10 year Italian at 190 bps

Only sellers apparently this morning...

Bid by appointment only please...

Good news for Germany, German unemployment level is at its lowest level since December 1992 at 7.5%.
German IFO (business confidence index) reached a record level in November .
Bad news for Germany their high spending neighbors are falling apart.
Euro/USD went below 1.30.

Anterograde Amnesia or Retrograde Amnesia? Or both?

Definitions:

Anterograde amnesia refers to the inability to remember recent events in the aftermath of a trauma, but recollection of events in the distant past in unaltered.

Retrograde amnesia is the inability to remember events preceding a trauma, but recall of events afterwards is possible.

"To slightly modify Alexis de Tocqueville: Events can move from the impossible to the inevitable without ever stopping at the probable."

David Einhorn, President of Greenlight Capital, in John Mauldin' "Outside the box" on the 26th of October 2009

The market moved dramatically tighter following the announcement of the 750 billion euros package and bank share rallied massively in double digits on the Monday.

"Monday, in fact, saw the biggest one-day change in the history of the Markit iTraxx Europe index – tightening from 142bp to 102bp."

http://ftalphaville.ft.com/blog/2010/05/14/232156/cds-report-volte-face/

Well, the euphoria did not last very long...

Itraxx Main CDS 5 year has move again at around 110 bps. Corporate default risk as measured by the Itraxx index is on the rise again after a strong respite:

"The Markit iTraxx Financial Index of swaps on the senior debt of 25 banks and insurers jumped 15 basis points to 147 and the subordinated index rose 19 to 215, JPMorgan prices show."

http://www.businessweek.com/news/2010-05-14/greece-leads-surge-in-credit-risk-as-ackermann-doubts-debt-plan.html

It is very interesting to see that the Itraxx Financial index senior is trading wider than the Itraxx Main Europe as historically, it should trade tighter. Corparate debt is seen safer than bank debt for the time being.

You just can't get rid of a problem by throwing money at it and Deutsche Bank chief Josef Ackermann did not help our politicians by raising doubt on Greek debts currently being snapped up on the secondary markets by European Central banks in a concerted effort.
As a result the Euro currency took another massive beating Rocky Balboa style and broke through a very important support at 1.2450 against USD from March 09 lows:



Euro did fell to lowest level since Lehman Brothers collapse as finally people envisage the probability of a Euro break up:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aqquuYOAN_sE&pos=2

Sounds familiar does it? Be nice, please rewind...

I discussed this exact subject on the 9th of December last year in my post The importance of being earnest, about the Eurozone in general and the Euro in particular.

http://macronomy.blogspot.com/2009/12/importance-of-being-earnest-about.html

I stated at the time:

"The virtues of joining a single currency doesn't coincide with the vices of some European governments, who issued more debt and ran larger and larger budget deficits. It is a game you cannot play forever unless you can devalue and make your own citizens poorer in the process, which used to be a regular tool used by Italy before joining the Euro."

Looks like Volcker shares my views...

http://www.bloomberg.com/apps/news?pid=20601010&sid=a8CjGqGASv9E

“You have the great problem of a potential disintegration of the euro,” former Federal Reserve Chairman Paul Volcker, 82, said yesterday in London. “The essential element of discipline in economic policy and in fiscal policy that was hoped for” has “so far not been rewarded in some countries.”

Quizz time:
In the above quote, Paul Volcker was thinking about which country?
A. Greece
B. France
C. Spain
D. Portugal
E. Italy
F. All of the above


In this previous post as well I indicated the possibility of a Euro break up. You will find the links to the analysis which had already been made by Nouriel Roubini and Macro Research house Gavekal.

But back to this week price action.

By tearing up the sacred rule book and resorting to the Nuclear Option of Quantitative Easing (the politically correct definition for what really means "screwing your currency"), the Euro could only go down from there. There was the same result for the GBP when the Bank of England resorted to "Quantitative Easing" (I hate these two words).

VIX is now much higher than in my previous post on the 10th of April:



And Gold? New record high as well. The only way is up now that the US, UK and now Europe are all equal in the "Debasing Currency Club".



On the employment front in the US you have the following:

Source Creditsights.com:

https://www.creditsights.com

"There are a total of 10 million claimants receiving some type of unemployment benefits. Furthermore, there are a growing number of individuals (referred to as ‘99ers” in some circles) who have exhausted all 99 weeks of benefits and are waiting for tier 5."

290,000 increase in NFP (Non Farm Payrolls) for April.

But unemployment is still rising and you have, as Creditsights mentioned a growing number of 99ers.



Clearly deleveraging is still in full play which means further headwinds for employment levels in the near future in the US

So much for the "anticipated" V recovery...

Update on the bond vigilantes: FLIGHT TO QUALITY (at least perceived quality...)

http://www.bloomberg.com/apps/news?pid=20601087&sid=a3uJ_8cLNk.A&pos=3

"U.S. two-year notes had their first three-week winning streak since January as demand for the safest assets rose on speculation Europe’s sovereign-debt crisis will damp growth and lead to disintegration of the euro."

BONDS PRICE YIELD (Bloomberg)
10-Year UK 108.13 3.75 yield
10-Year German 101.20 2.86 yield
10-Year French 103.23 3.12 yield
10-Year Italian 101.12 3.90 yield

Bund is the safe haven in Europe.

Spreads of German 10 year Bund versus other European countries 10 years government bonds is on the rise:

Spread BUND VS French OAT 10 year (Bloomberg):



Spread BUND VS Italian BTP 10 year (Bloomberg):



Spread BUND VS Spain 10 year (Bloomberg):



Spread BUND VS Greek 10 year (Bloomberg):



And good old TED spread is moving up as well:

http://en.wikipedia.org/wiki/TED_spread

"The TED spread is the difference between the interest rates on interbank loans and short-term U.S. government debt. The TED spread is an indicator of perceived credit risk in the general economy."
"
When the TED spread increases, it is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. Interbank lenders therefore demand a higher rate of interest, or accept lower returns on safe investments such as T-bills."



No need to panic yet given long term average of TED is around 30 bps but definitely something to watch.

The theme is still the same deflation then inflation down the road as we are still ongoing the painful deleveraging process which goes with the reduction of public spending and tackling the debt burden. GDP growth will be slow, and slightly positive to negative in some European countries.