According to the WSJ, the “ECB is willing to forego profits on their Greek bonds”. That statement strikes me as one of the scariest things that a central banker could say (and there is some tough competition for that one). Forego profits? Here is the chart of a typical Greek bond over the past 2 years. The ECB started buying Greek bonds in May 2010, and stopped sometime in 2011. How do they possibly have “profits” to give up? They have “profits” because they live in an accrual accounting world. They buy bonds, don’t mark them, and accrue the interest. The accrued interest counts as “profit”. That is the carry trade. That is what everyone is so excited about for the banks. Banks can buy bonds, not mark them, and book the interest accrual (and payments) as profit. The problem with accrual accounting is when a sale is forced. Whatever the reason for the sale (in this case, a restructuring/default by Greece), the accrual accounting game is over and you have real profit or loss. The “profit” is the total proceeds received for the sale, versus total purchase price, plus any coupon payments received, minus costs of carrying the position. Some entity is taking the real world loss.
Credit Suisse believes LTRO 2.0 will see a gross uptake of EUR500-650bn, notably above current consensus around EUR325bn. The math is straightforward and does not exaggerate too much for the speculative demand which they (like UBS) do not expect to be as significant as many happy-talkers. Between existing LTROs rolling off, rotation from the MRO, Emergency Liquidity Assistance financing, deposit flight, and reserve requirement reduction they arrive at around EUR300bn and believe a further EUR200-350bn in covering private debt refinancings (and perhaps some speculative activity though as we already noted the economics are nothing like as attractive anymore), their estimate is around twice the initial LTRO net increase which could take the ECB balance sheet to over 35% of GDP, dramatically above the US and UK, and the following scenario analysis sets out the short- and long-term implications of varying gross uptakes for LTRO 2.0.
While it is hard to call that any 3 year paper issuance, which prices at 0.347%, or the second lowest in history, and just wide of the When Issued, a weak auction, this is precisely what happened, as today's $32 billion 3 Year Notes saw a big drop in the Bid To Cover to 3.302 from 3.729 previously, but more importantly saw Direct Bidders account for nearly two thirds of the total takedown, responsible for 63.8% of the entire allotment. This was the highest Primary Dealer allocation in three years, since January 2009, when the PDs were parking cash in the short end in droves as the equity market was imploding. Troubling was that Indirects took down just 27.7%, or tied with the lowest since 2006. And as a reminder, the PDs will take any and all paper they receive, and promptly flip it in the back hole of the shadow market's repo engine for something close to 100 cents on the dollar. Which means the real interest from end buyers for ZIRP-covered paper is getting less and less. Just as Bill Gross predicted. In other news, the US liquidity trap is alive and well.
The Fed is doing everything it can to push people out the risk curve, and in particular is encouraging the hunt for yield in credit products. A lot of people are arguing that “credit” is cheap. That spreads are high and offer a lot of value. That may even be true, but the problem is that most retail investors don’t own bonds on a spread basis, they own them on a yield basis. The ETFs are all yield based. The mutual funds are all yield based. The argument might be that “corporate credit spreads” are cheap, but people aren’t investing in corporate credit spreads, they are investing in corporate credit yields, and that strikes me as very dangerous. The yields are being held down by operation twist. The treasury has anchored the short end and continues to shift money to the long end, keeping those yields low, for now. What happens when that ends? And keep in mind that credit almost always grinds tighter and gaps wider with little to no warning. When the shift from concern about not getting enough yield to concern about how much notional I can lose always seems to catch the market by surprise.
Since the start of the year, global markets have been apparently buoyed by the understanding that Draghi's shift of the ECB to lender-of-last-and-first-resort via the LTRO has removed a significant tail on the risk spectrum with regard to Euro-banks and slowed the potential for contagious transmission of any further sovereign stress. In fact the rally started earlier on the backs of improved perceptions of US growth (decoupling), better tone in global PMIs, and potential for easing in China and the EMs but it does seem that for now the ECB's liquidity spigot rules markets as even in the face of Greek uncertainty, as George Magnus of UBS notes, 'financial markets are most likely to defer to the ECB's monetary policy largesse' as a solution. Both Magnus and his firm's banking team, however, are unequivocal in their view that the next LTRO will unlikely be the last (how many temporary exceptions are still in place around the world?) and as we noted earlier this morning, banks' managements may indeed not be so quick to gorge on the pipe of freshly collateralized loans this time (as markets will eventually reprice a bank that holds huge size carry trades at an inappropriate risk-weighting) leaving the stigma of LTRO borrowing (for carry trades, substitution for private-sector funding, or buying liquidity insurance) as a mark of differentiable concern as opposed to a rising tide lifts all boats as valuations reach extremes relative to 'broken' business models, falling deposits, and declining earnings power.
They expect a EUR300bn take up of the next LTRO, somewhat larger than the previous EUR200bn add-on - but not hugely so - as the banks face a far different picture (in terms of carry profitability) and yet-to-be-proven transmission to real-economy credit-creation that will make any efforts at a fiscal compact harder and harder to implement as its self-defeating austerity leave debtor countries out in the cold. The critical point is that unless the market believes there will be an endless number of future LTROs, covering the very forward-looking private funding markets for banks, then macro- and event-risk will reappear and volatility will flare.
Hardly a week passes without some washed out, discredited legacy media outfit bringing up the "China will bail out Europe" rumor from the dead if only for a few minutes, just so the robots which have now shifted from stocks to the EURUSD, ramp the currency higher and stop out the weak housewife hands. So while we know what the wishful thinking within the status quo (and those who wish to receive its advertising dollars) is, here is the reality. From Reuters which translates China's Financial News: "Chinese banks and companies in the northern port city of Tianjin have cut their exposure to Europe as the euro zone debt crisis festers. In a recent survey of 53 banks and 15 firms done by the local foreign exchange regulator, 11 banks said they had cut or stopped trade finance for European countries with high debt risk, suspended derivatives business with European banks, cut or stopped lending to foreign peers, particularly those from Europe, the newspaper said." Isn't this a little contrary to an atmosphere of mutual goodwill if not mutual bail outs? "They also reduced the issuance of euro-denominated wealth management products as a weakening euro resulted in negative earnings last year. The pullback by Chinese companies comes as European leaders have appealed to the Chinese government to support debt bailout funds. Although Chinese leaders have expressed confidence in European nations, they have also refrained from making firm financial commitments, urging Europe first to take further steps on its own." But why is Tianjin important: "Europe is Tianjin's second-largest exporting destination only after the United States. But local exporters are trying to sell more domestically or venture into emerging markets to cut their reliance on the euro zone, the newspaper said." Great work Europe: by slowly going broke, you are implicitly promoting the development of the Chinese middle class. And for that general act of goodness for humanity, well Chinese humanity, we salute you.
- Please - we beg you, help us - IMF Urges Beijing to Prepare Stimulus (WSJ)
- Stalemate in talks on Greek austerity measures (Telegraph)
- U.S. Sets Money-Market Plan (WSJ)
- Forty States Sign On to Foreclosure ‘Robo’ Settlement (Diana Olick)
- Greece bail-out funds could be split (FT)
- Japan Adopts Stealth Intervention as Yen Gains Hurts Growth (Bloomberg)
- Papademos to Meet Greek Party Chiefs as ‘Great Sacrifices’ Loom (Bloomberg)
- Glencore-Xstrata deal meets shareholder opposition (Reuters)
- Romney campaign takes aim at rival Santorum (Reuters)
While the EURUSD's recovery post Europe's close seemed to modestly support stocks, the USD is still up from Friday's close as ES (the e-mini S&P 500 futures contract) closes marginally in the green against the direction of FX carry, Treasuries, commodities broadly, and credit. The volumeless (and gravitationally unchallenged) push from post-Europe dip lows this afternoon were generally ignored by VIX, investment grade, and high-yield credit markets, after the morning was a relatively significant amount of selling pressure in HYG (the increasingly significant high-yield bond ETF) to pre-NFP levels only be bough all the way back and some more into the close. Average trade size and deltas had a decidedly negative feel on every algo-driven push higher from VWAP to unchanged but the divergence between Brent and WTI dragged the Energy sector over 1% higher (as every other sector lost ground with Financials and Materials underperforming. Treasuries rallied well from the Europe close and closed just off low yields of the day as commodities all ended lower from Friday's close with Copper and WTI underperforming and Silver just edging Gold as they hovered around USD's beta for the day. VIX dropped modestly after the cash close but ended higher on the day with a notably low volatility of vol from mid-morning onwards (and the late-day vol compression seemed index-driven as implied correlation also fell commensurately). A quiet day in European sovereign and financials along with the disastrously low volume day in ES and on the NYSE really don't feel like signs of broad participation as Greek events slowly but surely unfold along the path of known resistance.
Mind versus technicals.
If you think the EU Crisis is over, think again. True we’ve got until March 20th for the Greek deal to be reached, but things have already gotten to the point that Germany has essentially issued its ultimatum. Either Greece hands over fiscal sovereignty, or it defaults in a BIG way.
Bernanke's recognition of his penalizing savers with low rates as an 'issue for people' sparked an interesting note from the WSJ on how sensible and stoic savers are being herded (unsafely) into risky investments. Bernanke's insistence that "our savers collectively have to hold all the assets of the economy and a strong economy produces much better returns in general" must be juxtaposed with comments from a money manager that "I don't think that's a fair-trade" for money intended to be invested safely. By removing the last shred of hope for a rise in savings rates anytime soon, the Fed is once again creating the potential for major unintended consequences as the 30% drop in interest income for US savers from the 2008 peak forces them to extend duration (TSYs), lower quality (corporate bonds), and/or increase leverage/risk (equities). One only has to look at Treasury yields, Muni yields, investment-grade bond yields, and now high-yield bond yields for how tempted investors (retail and professional 'insurance/pension' assets) have become to take their safest net worth asset (low risk liquidity) and expose it to the business/credit cycle and all its myriad event risks. While reducing the rate of savings might seem sensible for the short-term from the Fed perspective, it leaves a wholly unsustainable recovery (or bubble in who knows which asset class next) and as Nordea notes this week, based on their models, a considerably higher savings rate will be needed going forward (for any sustainability) even as 'saved money' is rotated into risk or spent on quality-of-life maintenance. Perhaps it is time for many to listen to the sensibilities of the WSJ's last (75 year-old) interviewee who notes "At my age, I can't be a risk-taker anymore" as maybe it is time to consider the reality of the recent good US data in relation to coinciding elements such as inventory build-up, plummeting household savings, and lower gas prices when adding to that risky investment.
With the impending March 20th maturity GGBs trading at 1400% yield (or 36% of par), EURUSD trading at 1.31, and European financials (and Greek financials explicitly) all up considerably, one could be forgiven for confusion as to what is priced in and what is not. As Bank of America (BAML) noted earlier in the year, believe it or not, Greece remains a blind spot and that risks from Greece are not fully priced in. Summarizing the deep cuts that Greece is expected to make - the Troika is demanding fiscal measures of 2% of GDP in 2012 - BAML points out that while they believe a common ground can be found, the asymmetric risks of a disorderly default could weaken the EUR well below their projection of 1.25 in the first half of the year. Certainly, while Greek sovereign bond markets seem priced for inevitable default (as real cashflows still count in the credit markets), FX and equity markets seem to be jumping-the-shark of the crisis - Europe will be stronger without Greece and Fed will backstop inevitable crisis - and missing the interim crisis conditions (Lehman-moments) that will occur as tail-risk scenarios and social unrest (that LTRO seems to have assuaged for now in people's minds) could return rapidly across the entire region. With frustration growing between an impatient Troika (that faces total humiliation, moral hazard, and ugly precedents for others) and a stubborn April-election-facing political class in Greece (along with the inability of the PSI to get done for all the reasons we have discussed in the past - foreign law bonds, basis traders, hedged positions, hedge fund sovereign litigation arbs) it seems the Troika has the most to lose for now seemingly holding a gun to their own head (as once again a massive ECB intervention might be needed with all its knock-on effects on the Fed's balance sheet expansion).
On Friday, Zero Hedge presented an extensive refresh on the one latent hotbed of troubles that everyone has conveniently forgotten about, yet which is getting worse by the day: the Mediterranean region, in "What Lies In Store For The "Cradle That Rocks The World" - A History Lesson In Crisis" and specifically Egypt -that most populous Arab nation, which last time we checked, is still Israel's neighbor (and which still controls the Suez canal). Still, for some of our more attention troubled readers who may have passed on the Friday piece, here is a much shorter version from Art Cashin which focuses on just one of numerous variables in play - the relationship between the controlling military and the resurgent Muslim Brotherhood. In other words, in deposing of Mubarak, the US has once again done its bull in a china shop approach to foreign relations and replaced one quite predictable dictator with a bevy of far more dangerous unknowns. Cashin's conclusion is traditionally cryptic and ominous: "The most populous Arab nation on the Earth and Israel’s closest neighbor is on the verge of something dramatic and potentially very, very dangerous. Watch carefully and constantly."
Three weeks ago, Zero Hedge was the first to bring the world's attention to the legal (and explicit trading/risk) ramifications of European sovereign bonds. We noted the ECB/IMF's subordinating impact on unsuspecting sovereign bond holders but much more explicitly showed the huge gap in market perception between domestic- and foreign-law bonds (and the fact that they have very different ramifications given the rising tendency for retroactive CACs or simply local-law changes to accommodate restructurings). The arbitrage of "dumping all weak protection bonds and jumping to the 'strong' ones" which we preached is indeed occurring and now three weeks later, JP Morgan is suggesting its clients take advantage of this same arbitrage strategy (citing the very same thesis and legal justifications as we did) as domestic law bonds offer significant advantages to the sovereign (and therefore implicit disadvantages to the lender or bond holder just as we said) relative to foreign law bonds. While we are flattered that our analysis is deemed worthy of mainstream sell-side research regurgitation, we caveat the celebration with the concern that perhaps JP Morgan already took advantage of the information a 'fringe blog' provided to the world (as we know many funds did given the requests for more explicit bond details) and is now looking to unwind the profitable (though modestly illiquid) positions it has been accumulating for the past three weeks.