If there is one thing the Fed taught the world's investors it was to front-run them aggressively; and whether by unintended consequence or total and utter lack of belief that despite a 'promise' to do 'whatever it takes' to stoke 2% inflation the BoJ are utterly unable to allow rates to rise since the cost of interest skyrockets and blows out any last hope of recovery, interest rates are collapsing. Japan's benchmark 10Y (that is ten years!!) yield just plunged from 55bps (pre-BoJ yesterday) to 34bps now. That is a yield, not a spread. Nothing to see here, move along. Of course, not to be outdone, Japanese stocks (Nikkei 225) are now up 6.75% from pre-BoJ (3% today) trading at 13,000 - its highest since September 2008 (Lehman). But there is one market that is showing its concerns at Japan's inevitable blow up - Kyle Bass' 1Y Jump risk has more than doubled in the last 4 months.
With Bernanke leaving the door open, but not pre-committing, in a check-raise to Draghi next week, market focus remains almost exclusively on the bond-buying program to support Spain. Credit Suisse expects markets to be mildly disappointed by Draghi's words and deeds as they question how far he can go, and in terms of near-term market moves, how much is said at next week's meeting versus said at later occasions or indicated through actions (e.g. once Spain asks for help). Draghi has already started to manage expectations with his Die Zeit comments (pitched at the German populous) but in order to get a handle on what the various scenarios are - and what the implications could be - here is Credit Suisse's matrix of compromise.
UPDATE: *ITALIAN TWO-YR NOTE YIELD RISES ABOVE 5%, 1ST TIME SINCE JAN 11
While every wannabe bond-trader and macro-strategist can quote 10Y Spanish yields, and maybe even knows what the front-end of the Spanish yield curve is doing (and why), there are three very significant events occurring in the Spanish sovereign credit market. First is the inversion of the 5s10s curve (5Y yields were above 10Y yields at the open today); second is the velocity with which 2s10s and 5s10s have plunged suggesting a total collapse in confidence of short-term sustainability; and perhaps most critically, third is the record wide spread between the bond's spread and the CDS (the so-called 'basis') which suggests market participants have regime-shifted Spain into imminent PSI territory (a la Greece and Portugal) as opposed to 'still rescuable' a la Italy for now. As we pointed out earlier, there is little that can be done (or is willing to be done) in the short-term, and the inevitability of a full-scale TROIKA program request is increasingly priced into credit markets (though its implicatios are not in equities of course).
European sovereigns peaked in spread yield early this morning before the surprisingly positive German confidence data but while France, Belgium, Austria and more significantly Portugal are all improving, Spain and Italy remain far less positive in this small downtrend after two days of significant selling pressure. Both are now around 35bps post the US non-farm-payroll data with Spain cracking back above 6% yield (and remains above 500bps in 5Y CDS). For those wondering what is going on in Portuguese spreads, it appears CDS-Cash basis traders are very active, according to desk chatter, with the spread between extremely 'cheap' bonds and CDS compressing to 7 month narrows here - bonds remain 232bps wide of CDS though as liquidity, ECB subordination, and CDS trigger concerns remain (though this is in from over 700bps difference at its worst in late January 2012).
Belgium is the latest entrant to the fully inverted 5s10s club. Yet what is scary is that even Austria and France have just 14 bps to go before they also invert. And most worryingly, Germany is just 4 bps behind. Keep a close eye on the 5s10s. If it inverts for everyone in Europe, including the UK and German, it is game over.
Dismal data from French manufacturing and industrial production along with growing chatter of a 'core' Europe strategy having been discussed is sending spreads among sovereign bonds notably wider. As a reminder Italy faces a rather large 1Y bill auction later this morning and the front-end of the BTP curve is underperforming as 2s10s inverts for the first time since August 1994.
Goldman's Francesco Garzarelli has just released a follow up to the "next steps" piece from yesterday (which so far has been woefully wrong in predicting a ceiling to Italian spread). So perhaps this time Goldman will be a little more accurate, which for those who may be buying Italian bunds on the dead cat bounce, will not be a good thing. Here's why: " Should Italian BTPs trade above 450bp relative to AAA-rated EMU sovereigns over a period of time, the initial margin would increase by a further 10%. Currently, the initial margin for repo on Italian securities on LCH ranges between around 4% and 20%, increasing along the maturity structure." The take away from the above - another 10% margin hike is coming. As for those who bought Italian bonds from Goldman yesterday on hope that the bottom is in, better luck next time - as Goldman says "In the meantime, the higher priced Italian government bonds will continue to be sold, as commercial banks raise liquidity buffers as higher margin requirements are applied. On our central case, intermediate to long-end bonds should continue to be supported relative to AAA-rated securities by the ECB." Considering the 5s10s is most inverted since 1994, this is not a very controversial call.
UPDATE: and in case you thought it was just Italy, the contagion is truly rotten to the core as OATs crack over 17bps wider to Bunds - the largest single-day widening in history and over 8 standard deviations.
Presented with little comment as we note the record-breaking move in today's spread between BTPs and Bunds is almost unprecedented and at 10 standard deviations is likely to have risk managers tapping trader's shoulders across many trading rooms. 2s10s and 5s10s curve inversion and a CDS-Cash basis that is now widening once again after some early compression just adds to the running-at-the-cliff's-edge feeling.
There are several moving parts in the drama that is Italian credit markets. Unfortunately no matter which measure a trader or PM looks at (unless you are Blackrock's un-MtM-able book or MS's Level 5 assets), it seems increasingly clear that the Italian funding situation is rapidly shifting to a low-confidence/default-equilibrium and jumping the chasm to high-confidence/no-default seems further and further away. Unintended consequences, as we have discussed at length, from the EU Summit (exemption of official-sector holdings from haircuts, non-triggering CDS logistics, and an EFSF unable to cope with a sovereign like Italy) leaves traders/managers with a binary decision on investment. While yields may seem attractive, the size of systemic risk being engaged being long BTPs is huge compared to a GGB 'bet' and unless the ECB steps in with an unlimited bazooka, no amount of yield support will cover the MtM losses managers will face as they 'im'patiently wait for reform.
Financials were the day's worst performers as already-priced-in downgrades from Europe, and absolutely not-priced-in talk of worrying liquidity upsets in RMBS markets, staggered them -3.5% pulling back to very fractionally above unchanged on the week. S&P futures managed a small loss on the second lowest volume day since 9/20 with some 'inhuman-looking' moves especially towards the close where ES ripped 20pts (with no support from risk) only to give it all back even quicker. FX also traded in very gappy mode today with some rips and dips - especially after Europe closed as the USD ended the day higher but down marginally lower on the week. TSYs weakened into the close with 30Y outperforming (and 7Y underperforming) post NFP this morning. Credit remained stubbornly weak into the close even as equities burst higher which is similar to commodities and oils in the last few hours as they dropped from their earlier highs and stabilized.
It has not been Jim Caron's decade. The Morgan Stanley rates strategist, riding on the coattails of the always wrong Morgan Stanley economics team led by David Greenlaw, has been wrong in his annual rates call year after year after year. Which is unfortunate because while unable to see the forest for the trees, Caron does have a better grasp of rates than most other Wall Street penguins. That said, just like everyone else in the status quo, Caron has just come out with another short duration call (i.e. sell bonds), probably the 6th time in a row he has done that in the past 3 years. Perhaps 7th time will be the charm. Amusingly, Caron, terrified to be seen in the same camp as Bill Gross who is short bonds on fears that there will be nobody available to step in an buy the 80% of gross issuance that has been monetized by the Fed to date, make this very loud caveat on his short bond call: "To be sure, our shift toward short from neutral duration has nothing to do with the end of QE2 and related concerns that there will be a lack of demand to buy US Treasuries once the Fed stops buying them. As we have stated many times in the past, the outlook for the economy will be the main driver of yields, not the end of QE2." No, instead Caron believes that the sell off in bonds will be due to the same bullish economic growth call that he has been predicting over... and over... and over... and over... etc. More interesting is how he suggests the trade is implemented: in MS' view the best way to be bearish on rates is with a DV01 neutral 7s-10s flattener: "we continue to recommend being short 5s on the 2s5s10s fly. In line with the butterfly, and in order to express a more robust short duration position, we recommend a curve flattener on the UST 7s10s curve: · Sell $133.7mm OTR 7y Notes; · Buy $100mm OTR 10y Notes." Perhaps those who want to be short bonds, but for the right reason, that predicted by Zero Hedge and then Bill Gross, this may be one of the better ways to put the trade on.
Equities continued their path of convergence to credit's recently weak signals today as we saw the largest compression between debt and equity in two months. Up-in-quality and up-in-capital structure very evident as single-name vol rose notably.
By now it is no secret that the end of QE2, should one actually transpire as the alternative is surging bond yields which as described yesterday means gross interest expense as a percentage of total US revenue would hit a Weimaresque 30%+, the collapse in equities will be dramatic, once the marginal buyer of up to $8 billion in daily risk disappears, and as was further pointed out recently, the only variable that every asset class correlates with with no exception is the Fed's balance sheet. And while the drop in equities is all but guaranteed, a more important question is what happens to not only Treasury rates but to the shape of the curve. Even though the jump in rates seems inevitable (to those whose career does not depend on pursuing the lemming-like call of the sellside groupthink wild), the finer nuances in the curve shift have not seen a broad discussion. Morgan Stanley's Jim Caron, whose predictive track record leaves much to be desired, has released an analysis of what the end of QE2 will look like from a rates perspective. We urge readers to take this analysis with the same dose of skepticism as any FX recommendation from Goldman's Thomas Stolper.
Unlike Morgan Stanley whose calls on the shape of the yield curve have been pretty much wrong all year, and which have changed consistently, Goldman has been rather quiet on what it expects the curve to do. Today Francesco Garzarelli has come up with expectations that, unlike MS, the bulk of the buying will be concentrated at the 5Y locus, even shorter than the MS-preferred 7-10 Y. While this does make sense as there are far more bonds of shorter duration available for purchase, it also means the average holdings of the Fed will soon be cut in duration even more, which will eventually become a sufficiently large political factor that we expect Congress to soon get involved in discussions over the viability of the Fed's balance sheet (think massive asset-liability duration mismatch). Goldman also notes that it expects the 30 Year to be purchased and that the 10-30s will flatten, even as the 5s10s steepens. In other words a 5s10s30s butterfly may be the right way to play the Goldman trade... or to, inversely, fade it as so often is the right way to trade Goldman recos.