Surging Libor-OIS And Cross Currency Basis Swaps Indicate Europe's Response Is Too Little Too Late
Even as the immediate factor for the 1000 point drop in the Dow is investigated for the next several months by the SEC, a process which will likely not come to any reasonable market structure regulatory recommendation before the SEC is forced to analyze the next subsequent (and even greater) crash, the one primary fundamental cause for the sell off in stocks this week was the ever deteriorating situation in Europe. As the euro tumbled on Thursday afternoon, which we noted 20 minutes before the stock market crash began in earnest, as implied correlation algos went berserk, and as viewers were witnessing the near-warfare in Athens live, things just got too real for speculators (investors is so 20th century). Various computerized trading platforms merely kicked on (or rather, off) after the initial panic had already set in, and liquidity evaporated, leading to the implosion in the market. And the primary reason for the initial market pessimism early on Thursday was the fact that even as the whole world was listening to Jean-Claude Trichet to say soothing words after the ECB's rate decision, the central bank president once again did not realize the gravity of the situation. And to speculators, long habituated to Bernanke's endorsement of infinite moral hazard and speculative mania, the fact that someone refused to play "ball" and leave open the possibility that failure is still permitted in our day and age was the last straw. Now, 48 hours later, we learn that the rumors, which we reported about the ECB preparing a bailout fund, were indeed true. Our sense is that at this point the ECB's action is "too little, too late" as contagion fear has already crept deep within the fabric of various overt and shadow funding/liquidity mechanisms. Additionally, the world is now convinced that Europe can only deal with problems retroactively, and who knows how big and unfixable the next problem will be: the ECB, which has lost most of its credibility after "inviting" the IMF to do a heavy part of the bailout, is about to become the laughing stock of global central banks. Trichet is seen merely as a powerless bureaucrat, caught between Merkel's electoral struggles and Bernanke's demands for contagion interception and implicit Fed supremacy over Europe. The contagion from the "isolated" Greek fiasco is rapidly spreading. Here are some of the ways in which markets are about to be affected.
First, we present Evidence A of how the market reacted on Thursday to the critical (lack of) announcement by Jean-Claude Trichet. The chronological sequence of events culminates with Accenture trading at $0.01 and begins with rolling disappointment that Trichet had not received the "Global Moral Hazard" memo:
To be sure, those conspiratorially minded could say that a primary reason for the Thursday sell-off was to prove to Europe, whose various parliaments were voting on Friday on the Greek bail out package, that the end of the world would surely come if they did not do as the French and German banks demanded... Because as we have repeatedly demonstrated those standing to lose the most from a Greek collapse are merely Europe's incarnation of Wall Street. And as the ECB and the IMF had wasted all of their credibility and "doomsday talk" ammo, a practical demonstration would have served the best purpose.
The biggest worry that the ECB has let matters go too far, is that what was considered purely an exercise in sovereign risk, has now spread to financials as well. And will likely not stop there. This makes sense, as the banks are at the nexus between the public (bail out) vertical and the private (shareholder) space. As an aside, if Obama continues on his warpath with Wall Street, banks will very soon become regulated utilities: equity upside will be capped based on what side of the bed the president wakes up on. Until then, increased risk within the financial space will merely bring up PTSD flashbacks to the last quarter of 2008. As BofA shows in the chart below, sovereign risk has become a proxy for financial risk (and vice versa). In this sense what is happening with Greece (and the next much bigger country to be bailed out), is identical to the Bear-> Lehman catastrophic progression, as Zero Hedge has indicated repeatedly.
So now that financials (away from America) and European sovereign risk are congruent, this brings up the question of who is supposed to resolve the escalating crisis in Europe. And unfortunately, the two parties in control are the ECB and the IMF, the two most bureaucratic and ineffectual organizations in our day. It is no surprise that pundits hope that the Fed steps in and takes charge of the European bail out. Yet even the Fed's arms may be tied - unlike in the US, debt monetization will be difficult to pass in a traditionally hawkish ECB, not to mention the political complexity of dealing with one currency union but 20 different bond markets. Whose debt will the ECB monetize? Who will benefit the most? These are all questions that the Fed did not have to worry about. Which means that the Fed could be limited to providing merely FX swap bailout lines (more on this in a second).
And that Europe will need vast amount of liquidity imminently is beyond a shadow of a doubt. With Spain forced to pay a recent record 3.5%+ on its auction Thursday, a surge of almost 100 bps in a little over a month, it is only a matter of time before Spain follows Greece and Portugal into the penalty box of public capital markets exclusion. To demonstrate just how massive the check will be if the Greek contagion remains solely within the PIIGS, below we once again present the redemption calendar for 2010 and 2011 in Bills and Bonds for the peripheral countries. In a nutshell, there is over E700 billion in contractual bond redemptions in just the next two years. And this excludes any short-term funding needs by the banks of the PIIGS.
The critical observation here is that merely meeting Europe's funding needs, now that the ECB is increasingly relegated to second-tier status, the IMF's recently expanded to $500 billion New Arrangements to Borrow facility will be insufficient by nearly half to meet liquidity demands for the next 18 months. Let alone any discussion that by the time it becomes clear how unsalvageable the euro and Europe are, the US will be underrated by $100 billion as the one single biggest contributor to the NAB.
Yet all this would be irrelevant if, as some permabulls claim, America could simply decouple itself out of the Europe-shaken world and continue pretending that a +34k clear NFP print is really +290k, thus claiming all is well. However, as the very much globalized credit markets have demonstrated over the past week, decoupling is and has always remained a myth. And for those keeping a close finger on the pulse of the credit markets, one needs look no further than Libor, as well as the slightly more arcane cross-currency basis swap.
As can be seen below, the TED spread (spread between LIBOR and the 3 month UST), has been aggressively moving wider as LIBOR surges.
If you notice a similarity between the last week's LIBOR widening and the panicked blow up in the interbank lending rate in August 2007, September 2008 and March 2009, you are not alone. As Bank of America points out:
Libor [has begun] to set higher, widening out the spread between Libor and the central bank rate policy (OIS). This has a similar feel to August 2007 when the first signs of banking credit risk surfaced due to underperformance in subprime. The issue this time is not necessarily about the quality of the underlying assets, but rather the counterparty – a European peripheral country. The concerns are ultimately due to European banks holding the largest amount of peripheral sovereign debt. The effect on Libor and other metrics has therefore been a function of the exposure of different country banks to the debt of the peripherals. In contrast, Japan, Australia and Canada have very little exposure to this sovereign debt, and thus have had the lowest movement in Libor-OIS.
Yet the biggest concern aside from the actual asset value of underlying sovereigns, is the amount of dollar-notional held by European banks, and the currency funding mismatch, manifesting itself in an even more aggressive move in the EURUSD cross currency basis than in LIBOR (for now at least).
What this means in plain English is as follows, again from BofA:
One might be tempted to conclude that the situation in Europe should not matter much for the US. We do not believe this is the case since the financial markets would create the “contagion”, and Libor can be the conduit. USD Libor spiked over the past few weeks due to higher Libor submissions by non-US banks in the USD Libor setting panel. The higher USD Libor submission is ultimately a function of demand for dollars in Europe, which arises from large holdings of dollar assets by European banks. According to the BIS, as of December 2009, European banks held $3.59 7tn of US debt (this US debt is both private and public dollar-denominated debt). Note that total dollar-denominated debt held by foreign banks is $5.393tn, implying that European banks hold two-thirds of the US debt held by banks worldwide. This demand for USD financing overseas is also reflected in the significantly negative cross currency basis swap (see above), with the one-year EUR/USD swap at -50bp (versus -37bp at the end of March).
Further, the forward Libor-OIS have widened more than spot. We believe the market is essentially pricing in that the sovereign credit risk is not going away soon. This is also consistent with other measures such as the Libor 3s-1s basis, which also prices in continued stress. Until there is some significant plan put in place that can be scaled up to support any country, contagion risk should put upward pressure on Libor. As Chart 10 shows, even though longer maturity Libor-FF have increased, it is still moderate compared with 2007-08. Thus, we believe there is more room to go in the Libor-FF widening.
And herein lies the rub: it is always these excessive dollar asset holdings by European banks that force the Fed to come out and bail European institutions which get clobbered with margin calls once the euro plummets. Recall that at the peak of the post-Lehman crisis, in December 2008, the Fed disbursed over $580 billion in liquidity swaps to prevent just the kind of liquidity crunch that LIBOR is indicating could be in store for Europe all over again. And rumors are rife that the Fed is about to launch just these swaps again, if it hasn't already. Surely, Bernanke can not take the risk that left to its own devices, Trichet will only make an even bigger mess out of things. And due to the interconnectedness of credit markets, a liquidity crisis in Europe would promptly take the S&P back to 666, killing the Chairman's incipient debt inflation experiment in its tracks. Which is why we expect that the Fed will likely announce the reintroduction of currency swaps imminently, as the Fed is all too aware of how critical it is to be prepared in advance for another liquidity "risk flaring" episode.
Curiously, Bank Of America disagrees that the Fed will go ahead with currency swaps for the following very valid reasons:
- Even though Libor-OIS has widened out significantly recently, current levels are still fairly moderate compared with 2007.
- The Fed has been discussing ways to drain excess reserves from the banking system via term reverses/deposits etc. Currency swaps would increase the size of the reserves. Note that the Fed can drain reserves via increasing the SFP program, increasing the scale of reverse repos and term deposits. But the Fed will need to be very careful about communication to prevent being viewed as a precursor to tightening.
- A political issue is around the “exigent circumstances” clause in the Fed’s charter that has to be invoked in order to allow currency swaps with nonbanks. In the Finance Reform Bill currently being debated in Congress, there is some discussion about removing the exigent language from the Fed’s charter. We imagine the Fed would not want to bring unnecessary attention to the exigent clause just yet.
Good points, although we have no problem seeing Bernanke override the market any time on threats of Mutual Assured Destruction for bullets 1 and 2, and seeing the facility with which he has invoked 3 in the past it probably would not be an issue either, although we would love to see Alan Grayson's response, who will likely crucify the Chairman if that is the pretext used to bail out Europe... again.
The bottom line is that Europe is caught in a corner, in which every subsequent action is now seen as a reactive response to the most recent calamitous incident, and thus not even last night's announcement of a bail out facility will do much for the EURUSD rate. And should the EUR crash to the 1.20 support level, then the Fed will have no option but to institute currency swap lines, which in turn will activate a whole new set of liquidity parameters. Not the least of which will be that the realization that the recovery leg of the fabled V-shaped economic expansion has been a mirage. The only other option for Europe, is outright monetization. We think this will not happen, as that action would be the death knell of the Euro, which would then tumble close to parity, once again forcing the Fed to get involved. If anyone will monetize anything, it will be the Fed, which is so far saving the worst for last. It is likely that the mid-term elections are seen by Bernanke as the Maginot line past which it will still have sufficient time to deflate enough of the dollar to catch the massive CRE refi wave in advance of the 2012 cliff. Yet the clock is ticking - each day that the DXY rises, is another day that makes the trillions in worthless maturities increasingly more difficult to roll, and thus will force all the mark to myth on bank balance sheets to come out in the open on the maturity date. While the clock has now run out for Greece, and most of the euro periphery, its ticking has just gotten that much louder for the United States itself. But not before Europe is forced to make the difficult choice of submitting to Fed authority or face the future on its own, and without its own consolidated currency.
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