Carry Trade

The only sector of the S&P 500 that was not red today (and for that matter the week) is Tech as AAPL managed another wonderful 1.45% rally today (up 5.6% on the week - it's best performance in 3 weeks and notably AAPL hasn't had a down week since 1/13 -0.6%). As SNL might say, "we need more parabola". Volume was average (for equities and futures) today but bigger blocks came through to sell into the close ahead of the long weekend and tomorrow's early excitement. Financials once again struggled and along with Energy are the worst of the week but it is the majors (in particular Morgan Stanley) that has been hammered this week as MS is -8.2% from Europe's close on Monday with the rest of the TBTFs down around 6% - finally catching up to credit's weakness. Equities closed down marginally but sold off in futures after the close - back below VWAP - having dropped all the way to reconnect with IG and HY credit's less ebullient perspective this week (before credit extended its losses to its widest in three months!). Treasuries managed to entirely recover their post-FOMC spike closing near the low yields of the day/week with the 7Y belly outperforming on the week down around 5bps (with 30Y -1bps on the week). Commodities halted their descent (much to the chagrin of media commentators it seems) as Oil outperformed on the day (and into the green for the week) over $103. Gold and Silver are still underperforming the USD's gains on the week (up 1.4%) led by EUR and CHF weakness. FX chatter was dominated by the spike-save in EURCHF (taking out Goldman's stops) and the mirror CAD strength JPY weakness relative to the USD. It seems EURUSD has become relevant again as it heads back towards 1.30 the figure (3 months lows). VIX went briefly red around the European close and broke 17% before closing marginally higher on the day as the term structure steepened a little more once again.

European equity prices fell for the third day in a row and pulled back near six week lows, breaking below the 50DMA for the first time since it crossed above on 1/16. Today's drop was the largest in three weeks as Italian banks were halted, plunging their most in over three months and back at levels not seen since mid January. Most Italian banks are down 9-11% in March but BMPS is down over 24% as Italian sovereign yields start to come unhinged again (ironically a day after Monti announced the crisis was over). 10Y BTPs broke back below last Friday's lows (the moment the ECB stepped in last time to save the day) up over 5.2% yield - catching up to CDS levels (and ITA spreads are +23bps on the week). Spain is also weak (+15bps on the week) and heading for 3 month highs in its yields. Since the CDS roll (March 20th), the sell-off has accelerated with equity and credit markets tracking lower together (as opposed to the last few months where credit underperforms and then snaps back higher). We discussed the LTRO Stigma trade earlier and that has continued sliding notably wider today as LTRO-encumbered banks hugely underperform. We suspect hedges (sovereign credit, financial credit, and equity) placed early in the year for the 3/20 Greece event (among other things) have run off and now managers are reducing risk in real terms (selling) as opposed to replacing hedges which is why the uber-supported markets of Italy and Spain are losing the battle now. Lastly, Europe's VIX is its richest relative to US VIX since the rally began, jumping dramatically today.

All you need to read.

Welcome to the global village.

Seemingly hidden from the mainstream media's attention, we note that the last six weeks has seen the second largest devaluation in the JPY since Sakakibara's days in the mid-90s. As Sean Corrigan (of Diapason Commodities) notes, this has to be putting pressure on Japan's Asian neighbors - not least the engine of the world China. Furthermore, JPY on a trade-weighted basis has cracked through all the major moving averages and sits critically at its post-crisis up-trendline. As we noted last night, perhaps Japan really is toppling over the Keynesian endpoint event horizon. JPY weakness and the carry trade may not be quite as hand in hand if rates start to reflect any behavioral biases, inflation (or more critically hyperinflation) concerns any time soon.

And how can it not be? As Banco de Espana just released earlier today, Spanish banks have borrowed a record €152 billion in February, a €19 billion increase from January. At least we now know what the capital shortfall was in Spain since pre-LTRO days, when total borrowings were €98 billion: "LTRO is for carry trade purposes"... right. So thank you European tax payers, and the 'bad bank' hedge fund formerly known as the ECB - you just bought Spain a few more months, however with your actions you guaranteed that nobody will change any part of their destructive behavior, and merely enable even more solvency crises in the future, which will be band-aided with even more trillions in free money, and so on, until the global central banks need to show their expansion not on a weekly but millisecond basis. And oh yes, this explains why Blackrock is tripping over itself this morning recommending Spanish bonds, which "may offer opportunities for long-term investors" - perhaps the same profit opportunity that the ECB had on its Greek bond holdings purchased at 80 cents of par and collapsed at about 20.

The continual restatement by endless talking heads of the compression in Italian bond spreads/yields as some indicator of success and recovery in Europe is becoming nonsensical. Short-end rates have become anchored, and as UBS notes today, the huge liquidity injections have caused structural breaks between curve slop and spread levels (curve now at its steepest since EUR inception). However, what makes the nonsense-speak greatest is the disappointment in terms of market reaction post LTRO2. After the previous two major liquidity injections (LTRO1 and the Reserve Requirement shift) we saw a considerable spread compression very soon after. However, in the two weeks since LTRO2, Italian spreads have gone nowhere (and have in fact seen notably larger volatility and intraday decompression in the last few days post-Greece). With theeconomics of the carry trade diminished, and the market fully priced in LTRO's impact, expectations of further improvement in Italy's bond curve seem entirely dependent on more surprise liquidity (unlikely short-term) as the carry-trade engine appears to have run out of fuel (or collateral maybe?)

While LTRO may have slowed the need for immediate asset sales and larger deleveraging in European banks, the two most significantly worrying trend concerns remain front-and-center - those of deposit flight and lending cuts. The latter remains a concern for the BIS, who note in their recent report, that lending curtailment by European banks focused primarily on risky (non-sovereign) and USD-denominated (EM mostly) debt as banks sought to reduce risk-weighted assets (RWA) to meet Basel III capital rules. It would appear though that banks remain in deleveraging (asset sale) mode, in anticipation of the end of ECB facilities down the road, which will become increasingly troublesome given the encumbrance of so many of their assets already by the ECB itself. What is most concerning though is the dramatic and accelerating deposit outflows from not just Greece but Italy and Spain (which just happen to be by far the largest 'takers' of LTRO loans). In other words, as more and more deposits outflow from these two major sovereign nations' banking systems (notably to Finland, Germany, and Luxembourg apparently), the only way to fund bank liabilities (as long as the interbank market remains dead - which is likely given everyone's self- and projected-knowledge) will be the ECB.

Even With Back Dated Deals Featuring Only One Party, One Can't Escape Greece's Problem Shared By Much Of The EU. Let's look at some nasty consequences...

Does the ECB stop printing? No, because it can't.

We know how AIG and MF ended, as of yet we don't know how LTRO will end. Lots of "carry" trades have worked out well, but when they don't, the result is pretty ugly. Now we are seeing margin calls from the ECB starting to occur and we noted yesterday that MtM losses will start to evolve in some of the carry trades as risk is unwound very recently - perhaps we are getting a sneak peek at the cause of the next vicious cycle crisis.

Not many websites, analysts or authors have both the balls/temerity & the analytical honesty to take Goldman on. Well, I say.... Let's dance! This isn't a collection of soundbites from the MSM. This is truly meaty, hard hitting analysis for the big boys and girls. If you're easily offended or need the 6 second preview I suggest you move on.

For those who are in a hurry today, the bottom line is that Japan is in serious trouble right now and is a top candidate to be the next black swan. Here are the elements of difficulty that concern me the most, each one serving to reduce Japan's economic and financial stability:

• The total shutdown of all 54 nuclear plants, leading to an energy insufficiency
• Japan's trade deficit in negative territory for the first time in decades, driven largely by energy imports
• A budget deficit that is now 56% larger than revenues (!!)
• Total debt standing at a whopping 235% of GDP
• A recession shrinking Japan's economy at an annual rate of 2.3%
• Renewed efforts underway to debase the yen

As I wrote a shortly after the earthquake in March 2011, Japan is facing an economic meltdown. If it is not careful, it may well face a currency meltdown, too. These things take time to play out, but now almost exactly a year after the devastating earthquake of 2011, the difficulties for Japan are mounting -- as expected.

Okay, we don’t know if that is a good translation of Dead Bank Walking into Portuguese, but we didn’t think zombie banks was sufficient. As Portugal's sovereign spreads have risen by 200bps in the last 3 weeks and now trade at a wholly unsustainable 1200bps over Bunds, we thought it worth looking at how large (and under-capitalized) the Portuguese banking system was. Perhaps more critically just how zombified they were with regards to their Central Bank liquidity needs - the picture is not encouraging. As tensions continue to mount internally, it seems the LTRO's lull should be used to wipe out the weak banks or recap the less-than-dismal banks as that is the only real firewall. With the Greek PSI/restructuring dangling in the dust, it seems increasingly likely (as the IIF just noted) that Portugal is next and imminent given market pricing, despite the 'uniqueness' of their Hellenic neighbors.

That red color on your screen this morning is not a failure in the green pixel channel but an indication of three main things. First, European composite PMIs came in at 49.3, down from 50.4 in January, and below the preliminary print 49.7 released on February 22. The main reason was the slide in the Eurozone Service PMI which printed at 48.8 on expected 49.4. This included a deterioration not only in the peripheral countries but in the core stalwarts France and Germany too. Elsewhere, China reduced its growth target to 7.5% this year, the lowest goal since 2004. The government will also aim for inflation of about 4 percent this year, unchanged from its goal in 2011. China also announced that it will target a deficit of 800bn CNY for 2012, a rather surprising change from its previous stance. Rounding out the dour note is a Moody's announcement that Ireland is likely to need a second bailout when its current aid program ends, rating agency Moody’s warned today, and that it too may need a PSI just like Greece. Then again, scratch may and replace with will. From the Irish Times: "In its weekly credit outlook report, Moody’s also warned a No vote in the upcoming fiscal treaty referendum would bar Ireland from receiving further funds from the European Stability Mechanism (ESM). The agency predicted the Government would have to rely on the ESM for additional funding after the existing bailout program expires in 2014. "We expect Ireland to face challenges regaining market access in 2013 and it will likely need to rely on the ESM, at least partially, when the current support  programme expires,” it said." As a reminder, if Ireland proceeds with a referendum on the Fiscal compact, and the referendum fails, it will have no ESM support, and thus no second bailout potential. Finally, the ECB deposit facility usage soared to an all time record of €821 billion overnight, confirming that the LTRO 2, contrary to some wrong analysis, is not being used for Carry trades at all.