Carry Trade

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).

Spain's broad equity index suffered its second largest single-day drop in almost 4 years and Italy also tumbled almost 5% as everything European was sold hard. EuroStoxx (the broad Dow equivalent) is down almost 3% as EURUSD dropped to two year lows, EURJPY to 12 year lows. AAA safe havens were massively bid with Germany, Denmark, and Switzerland all to new low (negative) rate closes. Core equity markets did suffer though with Germany down 2% but it was the periphery that saw the damage in credit-land with Spain 10Y closing at 7.27%, 610bps over Bunds (and 5Y CDS over 605bps). Spanish spreads are +130bps from post-Summit (and pre-Summit) and Italy +78bps, but it is the front-end of the curve that is most worrisome - Spain's 2Y is 132bps wider in the last week. Europe's VIX exploded by over 4 vols to 24% today and once again looks decidedly high relative to US VIX.

Governments Don’t Manipulate the Price of Gold … Do They?

ECB is running out of options. Germany can't afford any more bailouts.  Euro is overvalued compared to the dollar.

With so much economic doom and gloom out there, it’s easy to forget that there are actually some bright spots in the world. I’ve spent the last few days in one of them– Georgia. Perhaps most famous for being continually stomped on by Russia, this place has suffered severe hardship practically since independence from the Soviet Union in the early 1990s. In 2005, Georgia was shut out of the Russian market, it’s largest trading partner. It happened again in 2006. Then, of course, you may remember the Russian military invading Georgia (do you see the theme here?) in August 2008 in support of the breakaway republic of Abkhazia in northwest Georgia. Russian forces rolled across the border, occupied several key areas in the country, and bombed the hell out of Tbilisi just for good measure. The damage is still visible to this day. Yet despite so many challenges, Georgia has finally turned the corner and become one seriously exciting economy with some seriously compelling opportunities.

Equity, credit, and sovereigns all ugly. Merkel's unequivocal comment on her nation's unwillingness to 'share' burdens and slap the proverbial cheek of Monsieur Hollande, Italy's banking union looking for more 'aid', Spain actually asking for their bailout, Greece 'avoiding' reality, and Cyprus pulling the 'China rescue plan' last ditch retort to market angst; but apart from that, things are dismal in Europe. Italy down over 4% and Spain almost as bad on the day as every major equity index is well into the red. Italian banks monkey-hammered down 6/7.5% and halted a number of times. Investment grade credit outperformed (though was notably wider) as financials (subs and seniors), XOver, and stocks are plummeted to 11-day lows. After breaking below the pre-Spanish bailout levels on Friday, Spain and Italy 10Y are now 20-40bps wider with Italy and Spain 5Y CDS notably wider and well over 500bps. Notably the short-end of the Italian and Spanish curves underperformed significantly (curves flattened): 2Y BTPs +57bps vs 10Y +21bps; 2Y SPG +37bps vs 10Y +17bps. Europe's VIX snapped back above 27% (and we note that our EU-US Vol compression trade is moving well in our favor). EURUSD has been smacked lower by over 80pips ending under 1.25 once again.

In a meaningless "test" of investor appetite for Spain's Thursday issuance of 2, 3 and 5 years bonds, Spain today sold €3.04 billion in 12 and 18 month bills, well inside the LTRO maturity, and completely meaningless from a risk perspective - after all even Greece is issuing Bills. Yet for some reason the market which continues to be dumber by the day, somehow took the "successful" auction as an indication that there is actual demand for standalone Spanish subordinated debt. And what a 'success' it was: €2.4 billion in 12 month Bills were sold at 5.074%, the highest since at least 2003 and possibly on record. This is more than 2% greater than the same such auction at the end of May. In other words, Spain just locked in absolutely unsustainable 1 year rates. It also sold €639 million of 18 month paper at 5.107% compared to 3.302% less than a month ago. The good news: bids to cover for the two maturities, from 1.8 and 3.2, to 2.2 and 4.4 respectively. And of course they would: Spanish banks found what little LTRO cash they had lying around and in act of total desperation tried to do a carry trade whereby 3 year paper priced at 1% is used to buy 1 year paper yielding 5%.

We will get a test once again as to the effectiveness of the central bank/MoT confidence game.

Europe was a sea of red (apart from Bund prices) today. With yesterday's window-dressing done and overnight dismissal of Spain's hopeful ECB-workaround, European equity and credit markets were dismal, EURUSD ended under 1.2400, and 2Y Bunds at 0.00% yield. Financials underperformed in stocks and credit with senior bank spreads back up to 300bps and LTRO Stigma jumping 12bps to 177.5bps (near record wides). Spain and Italy dominated both single-name banking and non-banking credit and equity moves as well as sovereigns with Spanish 10Y now +45bps on the week and Italy +37bps (with Belgium, France, and Austria all around 9bps wider). All European equity indices are down for the week with Spain down almost 8%. EUR-USD 3Y basis swaps turned back lower (worse) back to -70bps - not a good sign for funding (especially in light of the drop in LTRO we noted yesterday). On a final note of despair, Spanish 2s10s is now flatter than at any time since LTRO1 - implying that any LTRO debt used to fund a real carry trade is now a loser.

A rare moment of optimism from David Rosenberg: "I've said it once and I'll say it again. And believe me, this is no intent to wrap myself up in stars and stripes. But there is a strong possibility that I see a flicker of light come November. The U.S. has great demographics with over 80 million millennials that will power the next bull market in housing, likely three years from now. After an unprecedented two straight years of a decline in the stock of vehicles on the road, we do have pent-up demand for autos. I coined the term "manufacturing renaissance" back when I toiled for Mother Merrill and this is happening on the back of sharply improved cost competitiveness. Oil production and mining services are booming. Cheap natural gas is a boon to many industries. A boom in Chinese travel to the U.S. has triggered a secular growth phase in the tourism and leisure industry. The trend towards frugality has opened up doors for do-it-yourselfers, private labels and discounting stores.... Few folks saw it at the time. But it's worth remembering, especially now as we face this latest round of economic weakness and market turbulence. It is exactly in periods of distress that the best buying opportunities are borne...and believe it or not, when new disruptive technologies are formed to power the next sustainable bull market and economic expansion. Something tells me that we are just one recession and one last leg down in the market away from crossing over the other side of the mountain. And believe me, nobody is in a bigger hurry to get there, than yours truly. At the risk of perhaps getting too far ahead of myself, but you may end up calling me a perma-bull (at that stage, I must warn you, folks like Jim Paulsen will have thrown in the towel)."

Digging into the details of the Fed's balance sheet can sometimes be a thankless task but  Charles Biderman and Jim Bianco have some fascinating insights into where the real money is being hidden. The stability of the Fed's balance sheet post-QE2, given we are borrowing-and-spending over $100bn per month is all down to Operation Twist and the Fed's creation of demand at the short-end (via telling banks that rates will be low forever and 'guaranteeing' positive carry returns on rolling overnight repo) and using this 'cash' to almost entirely fund longer-term borrowing. In a simple primer of the Fed's implicit risk-free carry trade, the two chaps note that the only downside is too much growth or inflation which would cause a massive unwind of these positions (leading only to further bailouts). Critically though, they explain the fact that Operation Twist (and its implicit off-balance-sheet funding of this risk-free carry trade) is nothing more than the Fed's version of the ECB's LTRO - as the banks are 'encouraged' to buy short-term government debt with risk-free-carry expectations - implying the Fed's balance sheet could in fact be considerably larger than it appears. Yet more ponzinomics explained in a simple way - that surely eventually will trickle down to the masses who will question the emperor's clothing.

"One of my favourite comedians, Eddie Izzard, has a rebuttal that I find most compelling. He points out that “Guns don’t kill people; people kill people, but so do monkeys if you give them guns.” This is akin to my view of financial models. Give a monkey a value at risk (VaR) model or the capital asset pricing model (CAPM) and you’ve got a potential financial disaster on your hands." - James Montier, May 6

Spain's banking system bailout is quickly becoming farcical. According to the WSJ this evening, Spain is to require its banks to set aside more provisions (between EUR20 billion and EUR40 billion) in an effort to overhaul the country's financial sector. This additional need for reserves (or provisioning) puts yet more pressure on the banks' balance sheets as it comes on top of the already EUR54 billion that has been set aside from February. Interestingly the EUR20-40 billion still falls dramatically short of Goldman Sachs' estimate of an additional EUR58 billion that is needed to cover reasonable loss assumptions. We can only assume that the game is to create as large a hole as is possible without tipping the world over the brink and then fill it with the state funds a la TARP (as Rajoy has indicated will be the case).

There was a time in late 2011 and early 2012 when people kept track of cash deposited with the ECB with great interest as it showed just where the latent money in the Eurosystem is going, or rather wasn't (and receiving 0.25% from the ECB in exchange for the 1.00% funding cost to borrow LTRO repos from the ECB, an inverse carry trade if you will). Subsequently it was shown that there is at least one liquidity rotation before the money reenters the ECB, as Spanish and Italian banks were busy buying up sovereign paper (now at a P&L loss since the onset of LTRO 1, never mind 2, and as noted earlier, with haircuts on Spanish paper about to go up by another 5%, the toxic liquidity spiral is about to resume), and that the bulk of the cash actually came in from "Northern" Europe where maturing risk paper was not rolled and instead was dumped with Mario Draghi. One thing is certain: this money was not re-entering the broader economy, but who cares about the people any longer. Well, it may be time to start caring about the ECB daily deposit update, because as of Friday, €793.6 billion was deposited with the ECB - an increase of €2.2 billion overnight, €18 billion compared to a week ago, and the highest since the €816 billion deposited on March 13.

As traders walk in this morning, there are only two numbers they care about: 522 bps and 6.15% - these are the Spanish 5 year CDS and 10 Year yields, respectively, the first of which is at a record, while the second is rapidly approaching all time wides from last November. Needless to say Europe is no longer fixed. And yet despite a selloff across Asia, Europe is so far hanging in, as are the futures courtesy of a persistent BIS bid in the EURUSD just above 1.30 to keep the risk bottom from falling off. It remains to be seen if they will be successful as wrong-way positioned US traders walk in this morning.