the major story for us right now is that the broad concept incorporated in “Exter’s Pyramid” is in operation. This something we mentioned in Autumn last year and it’s occurring across currency and credit markets and, to some extent, in equities. To recap, John Exter (a former Fed official, ironically) thought of the post-Bretton Woods financial system as an inverted pyramid resting on its apex, emphasizing its inherent instability compared with a pyramid resting on its base. Within the pyramid are layers representing different asset classes, from the most risky at the top down to the least risky at the bottom. He foresaw a situation where capital would progressively flow from the top layers of the pyramid towards the bottom layers. “…creditors in the debt pyramid will move down the pyramid out of the most illiquid debtors at the top of the pyramid…Creditors will try to get out of those weak debtors & go down the debt pyramid, to the very bottom."
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.
The full blown curve inversion that is taking the PIIGS by storm is slowly coming to a TBTF near you. As the chart below shows, the 5s/10s in CDS curves for the most prominent banks are now inverted, while the bulk of them are flat at best. Should the ongoing pounding in GS stock continue, look for flatness to slowly creep to the 4, 3, 2 and 1 Year marks.