Another day, another LCH margin hike on Spanish and Italian bonds. Spanish SPGBs which will have to post more margin beginning tomorrow are all bonds with a maturity between 0.75 and 3.25 years, as well as bonds between 10 and 15 years, as well as all short-term Italian bonds between 3.25 and 7 year, in effect offsetting Draghi's "reverse Twist" house of cards. Expect to see more flattening in the Spanish and Italian 2s10s curve, followed by more promises of imminent action by the ECB, which however, may finally be realizing that for Spain to actually demand a bailout, its 10 years will have to be closer to 10% than to 5%. Finally, if this ratcheting up in asset encumbrance in Europe doesn't send the VIX to single digits nothing will.
Two years in and they are only starting now? What took them so long. Also, absolutely nothing new here, but merely the latest attempt to shift public opinion and EUR viability perceptions ever so slightly by one of Germany's most respect magazines. Those whose agenda it is to spook Germany with images of fire, brimstone, and 3-page mutual assured destruction termsheets if the Euro implodes, are now free to take the podium. One wonders: if it wasn't for the inevitable collapse of the EUR.... the inevitable collapse of the EUR.... the inevitable collapse of the EUR.... the inevitable collapse of the EUR, and of course Paul Ryan, would there be absolutely no news today?
It's not unheard of for stocks to rally when economic conditions are weak, particularly when corporate profits are doing well; Q2 marked a new all-time high run rate of S&P profits. As a result, the 13% gain in the S&P this year is not a complete anomaly. But, as Michael Cembalest of JPMorgan notes, in prior cycles, 'weak economy' stock market rallies were predicated more on the view that a private sector recovery was just around the corner, rather than the current view that more Central Bank stimulus is just around the corner. The other notable aspect of the rally is that it took place as earnings forecasts for 2012 and 2013 have been falling, and as Q2 revenue growth slowed. To paraphrase what’s going on, Cembalest believes "Bronze is the new Gold" as expectations are so low, that anything better than recessionary data can be well-received by markets. Of course, the other factor behind the recent rally is the prospect of unlimited bond purchases by the ECB to which the JPM CIO science-fictionally analogizes: "Swallowing an alien is one sure-fire way to get rid of it, but then you have to wonder what happens once it gets digested. Color me nervous how this all turns out."
Think the attempted fake suicide by Bayou Capital's Sam Israel which dominated the headlines for a few days in 2008 was strange? You ain't seen nothing yet: as the following excerpt of Octopus, The Secret Market And The World’s Wildest Con by Guy Lawson via the Daily Mail explains, that was merely the anticlimatic culmination of an amazing tale of bogus London traders, 'secret' Bond markets, frontrunning the Fed, fake CIA and MI6 spies, ponzi schemes and staged murders.
While many argue that corporate profitability in the US knows no bounds as cost-cutting amid 'slow' growth will fill the gap, we offer this quite compellingly nerve-jangling chart of the increasing dependence of S&P non-financial operating profits and the weakness of the US Dollar. The negative correlation between macro-level EPS and the U.S. dollar is both theoretically and empirically clear. As Citi points out, profits earned abroad are reported in depreciating or appreciating terms, boosting or reducing profits; and as the negative correlation between the USD and global growth can result in 'double counting' of earnings influences - this leads to too much hope at 'turning points'. What is more critical is the trend higher in the USD - whether due to EUR break-up fears and safe-haven flows OR courtesy of Draghi's EUR weakening QE/LTRO promises - is tending to push Bernanke's hand to act to weaken the USD (do NEW QE) to 'strengthen' corporate profits and the economy. However, with inflation-expectations now high and macro data stabilizing, his justification is far from clear - no matter how high the hopes and dreams have become.
Just as we were complaining about lack of newsflow, here comes Germany, coincidentally just as Merkel comes back from vacation, with an update from Karlsruhe that the Constitutional court, which may reject the ESM as is in its September 12th decision, will likely be delayed even more following the filing of a brand new lawsuit challenging the constitutionality of the ESM.
With newsflow today non-existent, and the market acting somewhat bizarrely (i.e., not soaring on endless revenue misses and GDP forecast cuts, and in fact, selling off) we take this opportunity to share some philosophical "deep thoughts", although not from Jack Handey, but from the latest issue of the Edelweiss Journal.
Yes, there are call constraints. Yes, there are 'beta' differences. But, given the strong technicals (fund flows) and empirically high correlations between the much-more-like-stocks-than-bonds high-yield credit market and the equity market, the current divergence between equity ebullience and credit curmudgeon-ness is all-too-reminiscent of the post-LTRO2 sanity check that credit 'imposed' on equities. Not only are high-yield bonds underperforming stocks (as we warned last week), but the HYG ETF is now trading at a significant discount to intrinsic value which (back in March) was the start of a more pronounced downturn as cash bonds were force-sold into an illiquid market backdrop.
Last week we presented the aftermath of the very much unannounced "Conference of Beijing" as a result of which Africa has been slowly but surely converting to a continent controlled almost exclusively by China. However, there was one thing missing: even as China has been virtually the sole source of infrastructure funding in Africa, the continent has long been a legacy dollar preserve, which obviously means renminbi penetration and replacement would be problematic to say the least. As it turns out, this too is rapidly changing: as the WSJ reports, Africa is increasingly just saying "nein" to the USD. "African countries are trying to shoo the U.S. dollar away, even if it means threatening to throw people who use greenbacks in jail. Starting next year, Angola will require oil and gas companies to pay tax revenue and local contracts in kwanza, its currency, rather than dollars. Mozambique wants companies to exchange half of their export earnings for meticais, hoping to pull more of the wealth in vast coal and natural-gas deposits into the domestic economy. And Ghana is seeking similar ways to reinforce "the primacy of the domestic currency," after the cedi plummeted more than 17% against the dollar in the first six months of this year. The sternest steps come from Zambia, a copper-rich country in southern Africa where the central bank has banned dollar-denominated transactions. Offenders who are "quoting, paying or demanding to be paid or receiving foreign currency" can face a maximum 10 years in prison, the central bank said in a two-page directive in May." Is it time to dump the EUR in hopes of a short covering rally that continues to be elusive (just as Germany wants) and buy Zambian Kwachas instead? We will wait for Tom Stolper to advise Goldman clients to sell the Zambian currency first, but at this rate the USDZMK may well be the most profitable currency pair of the next 3-6 months.
Short-term expectations of volatility, as measured by VIX, traded down close to a 13% handle this morning as the so-called 'fear' index dropped to practically its lowest level since July 2007. As we mentioned last week, complacency is back in more ways than just the level of VIX. Realized volatility, especially after last week's small range and low volume markets, has fallen but implied volatility is now at its most 'complacent' relative to realized vol since the end of LTRO - as it appears anticipation of the fully-expected printing-press euphoria is priced into both asset and vol markets. Furthermore, the term-structure of volatility, which measures short-term concerns relative to medium-term, has fallen at its fastest pace in 5 months (again confirming short-term complacency) and has only been this steep (short-term volatility dramatically low relative to medium-term volatility) once since the March 2009 rally began - right near the post-LTRO2 highs in the S&P.
Since hope re-blossomed at the start of June and was reignited by Mario's musings, the equity markets of the US and Europe have surged in an outpouring of faith in central bank excess and policy-maker's abilities to 'fix' everything (despite decades of truth that points in the exact opposite direction). But while the market levitates on ever-increasing multiples (as earnings current and forward are dragged lower by the economic reality of a debt-deleveraging world), the true picture of what is driving stocks become clear. For the first time since the BTFD rally began in March of 2009, cyclical stocks (or economically-sensitive firms) are underperforming notably - implying notably lower expectations for a levered recovery by the consumer. As Bloomberg's Chart of the day notes, either the economy will hockey-stick back to a significant rebound or broad equity market indices will fall back to a more defensive reality - given the non-economy-helping nature of LTRO/QE, we suspect the latter. Do you believe in miracles?
It is important to note that markets were also unusually calm during the two weeks of the Chinese Olympics in 2008. The 2008 Summer Olympic Games took place slightly later in August than the London Olympics – starting August 8 and ending August 24. Only days after the ending of the Chinese Olympics came massive market volatility in September and then seven months of market turmoil. Similarly to this Olympic year, in Olympic year 2008, gold traded sideways to down in a period of consolidation prior to further gains. Gold bottomed in September 2008 in euro and sterling terms. Another brief bout of dollar strength saw gold bottom in November 2008 in dollar terms. Besides the eurozone crisis (and the significant risk of the German Constitutional Court deciding on September 12th to reject the recently cobbled together alphabet soup response to the crisis (ESM etc etc) and significant instability in the Middle East, there is also the not inconsequential risk from the US Presidential campaign and the upcoming ‘fiscal cliff’.
Italy just announced its all-time record high general government debt load at EUR 1.973 trillion. What is perhaps most stunning, given all the talk of austerity, cutting back, reforms, and change is that the size of this debt is growing at an ever-increasing pace that is simply stunning. Pre-Euro (1999), Italy's debt was growing at a rate of just less than EUR 2 billion per month; in the eight years from then until the crisis in 2008, Italy's pace of debt growth (fostered we are sure by the convergent cheapness of funding and their immutable belief in invincibility) almost perfectly doubled to EUR 3.8bn per month. Since 2008, and the onset of excess Keynesian ridicule we assume, Italy's debt load has grown at a stunning pace of EUR 6.4 billion per month and perhaps most incredible; however, the last nine-months (since the peak 'peak' of the crisis in September of last year) has seen the pace of debt-load growth surge to EUR 9.5 billion per month. Sustainable levels of exponential debt growth - sure!
We think as a matter of political reality, given the German polls, that Berlin will refuse to adequately fund Greece and that they will be forced back to the Drachma as a matter of Ms. Merkel’s desire for re-election. The honest truth is that the Greek debts have become so large and so impossible to pay that unless there is absolute debt forgiveness, which we think is politically impossible in Germany and a number of other European countries; the country must roll over as a matter of fiscal reality. In March, the last figures that are available, the Spanish banks lost $66 billion of capital as the citizens of Spain moved their money to safer havens. What the LTRO gave, the populace took away and the situation is unsustainable. Spain will soon be forced into a full-fledged bailout in my opinion which will require money for the regions and for the banks. What amazes us the most is that so many people have the honest opinion that Sir Draghi is going to come charging out from the round table, from the gilded gates of the ECB and save Europe. That White Knight is subject to the whims of Germany and the rest and all of the talk of independence and the separation of Church and State is just that; talk.