Bond

Tomorrow's LTRO is now the latest deus ex out of Europe soon to become a bust ex machina. With consensus for Europe's TLGP operation, which the wildly optimistic ones equate with a Risk On facilitating carry trade expansion facility, at roughly €250, some banks have indicated just how desperate they are and outlier estimates such as those from Citi and RBS see allottment hitting as much as €550 billion. As explained previously so many times, a carry on trade presumes incremental leverage and loading up on even more sovereign debt, something even bank CEOs have said they can no longer afford to do, and furthermore as Exane explained "analysts question whether banks will heed Sarkozy’s suggestion they use the LTRO to finance euro-area governments; it is no substitute for QE." Ironically, by letting the ECB off the hook, for the time being, the LTRO being misperceived as a QE equivalent is making Europe's reality even more difficult as it has greatly weakened the case for Draghi printing. And that is the only thing that can help Europe, if only in the short- to medium-term. But for now, with one day left until the latest Christmas illusion is shattered, we had some great news out of Spain which managed to place 3 and 6 month bill at plunging rates.

Following last week's stellar auctions, this week's issuance trio has started off with a whimper. While Tim Geithner managed to sell $35 billion in 2 year notes today at a near record low rate of 0.24%, the details were very unimpressive. Because not only did the Bid To Cover decline from last month's record 4.07 to a modest 3.45, in line with the last 12 auction average, it was the precipitous drop in Indirect Bidding, aka foreign interest, that was most notable: at just 21.65% this was the lowest Indirect Take Down since February of 2008. Which means Dealers had to take on a majority of the auction. Which they did at 63.66% of the total. Naturally, this will not be a surprise to many: after all according to the latest TIC data, Chinese bond holdings tumbled in October to the lowest in a year, Russian holdings collapsed, and courtesy of the Fed's weekly custodial account updates, we know that foreigners have been selling tens of billions in US paper in the past several weeks. Slowly, the US is becoming the same ponzi scheme that it accuses Europe of being whereby Dealers buy up paper, and immediately repo it back to the Fed and other conduits. In other words, once the European repo market freeze crosses the Atlantic, then it will get very interesting very fast.

Last week, in the aftermath of the global coordinated liquidity swap facility expansion (OIS+100 to OIS+50) from November 30, with the added benefit of the contemporaneous Chinese RRR cut, bond yields plunged on short-term hope that the Fed's action would be a long-term solution for the Eurozone. It wasn't. But not before the ECB received a brief respite from manipulating bond markets. As a result of the November 30 action, the ECB proceeded to buy just €635 million of Peripheral (read Italian) bonds as the BTP yield plunged. Days later, following the realization that this is nothing but yet another band aid mechanism, yields once again soared, and depending on the benchmark used, pushed beyond 7% once again. In the meantime, the story of the ECB's 3 year LTRO rescue, lost in the aftermath of the Fed action, was resurrected, and is now attributed by some as being some pseudo bazooka that will rescue the ECB. It won't as was explained yesterday. And sure enough, one week after the knee jerk reaction from the liquidity intervention, the ECB was once again out in full force picking up pennies in front of the steamroller, buying up €3.361 billion in bonds in the week ended December 16, which brings the total purchases at €211 billion (net of maturities).

As we said last week, when the S&P, in desperate hope that the Euro summit would achieve something, anything, to avoid an eventual downgrade of Europe, called Europe's bluff... and Europe was found to hold 2-7 offsuit. Now, when it has no choice but to downgrade the EuropeAAAn-club, S&P is practically apologizing for its action, and is today saying that since nothing happened to change its opinion, it will have no choice but to proceed with pervasive downgrades, only this time not only sovereigns (which it is expected to conclude on shortly) but also corporates of all shapes and sizes. Unless of course it doesn't, at which point the rating agency can just tell the last guy to turn the lights out on their way out.

Following the auction of the latest $32 billion in 3 year bonds, the market is expected to relax as based on the optic the auction was a stunning success, with a High Yield of 0.352%, higher than just the 0.334% hit in September when the market was collapsing. Yet the Bid To Cover of 3.624 was the highest ever in the series of the bond. Now the bad news: Primary Dealers once again accounted for well over 53.9% of the auction: or about $17 billion, which will be promptly repo'ed back to the Fed with the proceeds used for various other purposes. In other words, the clear demand for $15 billion came in the form of Indirects taking down 39.1% and Directs with 7.0%. Nonetheless, with the When Issued trading at 0.36%, there is no doubt that the auction was a smashing success, under the parameters of the US bond issuance regime. In the meantime, we await to see what happens to German Bund auctions in the next few days if the yield once again collapses, and there is just not enough demand at auction.

Update 2: Draghi just killed IMF lending proposal - "lending money to IMF to buy Euro bonds is not compatible with the treaty" - EURUSD now in free fall.

Update: two additional comments, i) that the ECB is not the IMF, and that lending to the IMF would be very complex legally, and ii) that the liquidity situation is comparable to post Lehman have sent everything plunging to overnight lows. Lastly, Draghi just kicked the ball in Europe's court. This is about to get very ugly fast.

It was all going so well until Draghi dropped the coded 'less' bond purchases 'no bazooka' bomb-shell at which EURUSD, BTPs, European bank stocks, and ES all stalled instantly and started to revert to pre-Dragozel levels. BTPs are holding up the best for now, though almost entirely retraced, but a 1% up and down roundtrip in ES was enough for many to see the schizophrenic market at its best.

Japan will reward investors who buy reconstruction bonds with half an ounce of gold, an added incentive that could boost the return by nearly six times according to Japanese Finance Minister Jun Azumi. Individual investors who purchase more than 10 million yen ($129,000) in the debt with a 0.05 percent return and keep it for three years will receive a gold commemorative coin weighing 15.6 grams (0.55 ounces), the Finance Ministry said in Tokyo today, worth about $948 based on current prices for the precious metal. The offer suggests the return could be boosted to 89,000 yen should gold prices remain at current levels, more than the approximate 15,000 yen one would receive from the bond. The coupon on conventional three-year retail government debt to be sold on Jan. 16 is 0.18 percent. 10 year debt remains near multi record lows of 1%. Silver coins weighing 31.1 grams issued as 1,000 yen currency will be distributed to those who own more than 1 million yen of the bonds, the government said. The coins will be offered for debt going on sale in March. All investors receive a thank-you note from the minister, who showed his to reporters in Tokyo today as proof of his purchase.  Chief Cabinet Secretary Osamu Fujimura also bought the bonds, Azumi said, without saying how much.  This is a sign that the Japanese government like governments internationally is very concerned that they will not be able to sell their government debt.

Following yesterday's announcement that the ECB had purchased a new record total of €207 billion in peripheral bonds, many were focused on today's ECB sterilization announcement to see if, like last week, there would be a failure in the repo market, and less than the full amount of bonds to be sterilized, would be bid. As it happens today the ECB lucked out, after 113 bidders submitted bids for €236 billion in bonds, at a rate of 0.65%, with the threshold €207 billion amount being covered comfortable at 1.19x. Yet one wonders what is it that caused the €50 billion swing in available capital for European banks (last week the tendered for amount was €194 billion). What is ironic is that earlier today, the ECB provided €252 billion in a liquidity providing operation (MRO) to 197 banks at a fixed rate of 1.00%. In other words, banks borrowed €252 billion at 1% from the ECB to lend €207 billion back at 0.65% to the ECB. And that is called a "successful" sterilization.

Those wondering what caused the accelerated reacquaintance of the EURUSD with gravity on its way to what UBS has just dubbed the "beginning of the end" (report to be published shortly), need look no further than the ECB where the ECB had its first failed sterilization since the expansion to monetize Italian and Spanish bonds was launched in August. As noted yesterday, the ECB had to sterilize €203.5 billion in cumulative bond purchases. Instead, it only got bids for €194.2 billion from a paltry 85 bidders. This means that for the first time, as shown on the chart below, the ratio of Bids to Bonds for Sterilization fell under 1. What is much worse, is that this happened on the day of the weekly 7-day MRO, during which a total of 192 banks took a combined €265.5 billion from the ECB's weekly 1.25% handout. The amount tops the 247 billion that 178 banks took last week and is the second week running that demand hit a new two-year high. In other words, despite demanding the most amount of money in 2 years, the banks were unable to flip all that cash and "sterilize" monetized paper. This is very bad news as it confirms that the SMP program is coming to a forceful close as banks withdraw in their shells and any further PIIGS bonds purchases will be no longer sterilized above some threshold level, somewhere in the high €100's, low €200 Bns. Whether this is the final straw that pushes the ECB to print outright remains to be seen: it is surely providing the needed dead cat bounce to the EURUSD as hopes that Draghi will finally do as the banks demand have once again resurfaced.

As usual, the bond market has already an idea on how this will pan out. Looking at various yield curves we get the following picture:

- Greece is “off the chart” (in the “toast” zone)
- Portugal will not make it as debt and interest is not sustainable and the EFSF struggles to raise bailout funds.
- The “soft Euro-zone” could survive by aggressive monetarization of debt by the ECB – once the German hardliners quit. Inflation would probably follow in a few years, but that is another question.
- The “hard Euro-zone” would consist of Germany and the Netherlands. They unilaterally quit the Euro-zone and introduce a pegged currency pair.
- France is really the only unsolved question in this puzzle. Bond yields have peeled away from Germany a bit too far. Historically, France was a “soft” currency country with frequent realignments of exchange rate under the European ERM (Exchange Rate Mechanism). Given the strong political ties France will probably be forced to stay married to Germany, but it will be an unhappy marriage, with an eventual break-up at a later date.
- I have included Hungary just out of curiosity, since their love-hate relationship with the IMF is slightly entertaining.

Ever the contrarian, we were somewhat taken aback by the overwhelming majority of respondents to JPMorgan's fixed income manager survey who expect LSAPs in 2012. With 80% expecting QE3, a majority expecting to add to Agency MBS (and high yield and investment grade credit), it seems the Fed's bang for buck from actually enacting the balance sheet expansion will be significantly lower than it hopes. Maybe third time is the charm but it seems evident from discussions that traders have become numb to this manipulation - even if it does have short-term portfolio rotation impacts - but the difference between managers who expect to reduce EUR assets and those that expect to increase USD assets suggests everyone and their cat is waiting to jump in. The diversification/currency trade seems popular as local denominated EM assets are among the classes managers expect to add the most to but duration risk seems very evenly split as the great majority expect 10Y to hold the 1.5% to 2.5% range. Given the survey results, it seems the lack of belief in any significant fiscal stimulus is being discounted by the strong belief that the Fed will ride to the rescue once again.

Italy, Spain, France and Belgium will each go to market this week to auction bonds worth billions of euros...GASP!  

And so the one thing that was supposed to be set (if only briefly) in stone, the terms of the Greek creditor haircut, has now fallen apart. From Reuters: "The Greeks are demanding that the new bonds' Net Present Value, -- a measure of the current worth of their future cash flows -- be cut to 25 percent, a second person said, a far harsher measure than a number in the high 40s the banks have in mind. Banks represented by the IIF agreed to write off the notional value of their Greek bondholdings by 50 percent last month, in a deal to reduce Greece's debt ratio to 120 percent of its Gross Domestic Product by 2020." And confirming that the IIF has now lost control of the situation, "the country has now started talking to its creditor banks directly, the sources said." And because the NPV is only one component in determining what the final haircut really is, this means that the haircut just got higher or the actual coupon due to creditors will be slashed, a move which will see Sarkozy balking at this overture in which Greece once again sense weakness out of Europe. We can't wait to hear what France says to this latest escalation by Greece, which once again has destroyed the precarious European balance.

Italy held an auction for EUR8 billion 6 month Bills today. Unlike Wednesday's German 10 Year Bund issuance, the auction was not a failure (at least not yet), and for good reason - the yield paid for the Bill was 6.504%, the highest since August 1997, and is nearly double the October 26 auction when it priced at a now nostalgic 3.535%. But... the maximum target of EUR 8 billion was met without anybody's central bank have to retain anything. The bid-to-cover was 1.47 compared to a bid-to-cover of 1.57 one month ago and average yield of the last six 6-month auctions of 2.443% and average bid-to-cover 1.636. All sarcasm aside, this is an unprecedented collapse and a total catastrophe as Italian Bills now yield more than Greek ones - the market has basically said Rome needs a debt haircut and pari passu treatment with Athens. In the aftermath of the auction everything has come unglued: 2s10s is inverted at unseen levels, the 5 Year has hit 7.847% , and Euro liquidity is gone...it's all gone.. as the 3 month basis swap hits -157.5 bps below Euribor, the lowest since October 2008.

Our good friend Doug B., a financial advisor based in Boulder, CO, has done well for his clients by keeping them heavily weighted in bonds. In the essay below, he explains why he intends to stick with this strategy even though many of his peers expect a rebounding stock market to outperform fixed-incomes in the years ahead.  For Baby Boomers in particular, the deflationary trend that buttresses Doug’s strategy holds stark implications.