Investment Grade

When US equity futures, Treasury futures, and FX markets opened yesterday to a 'risk-on / reality-off' scenario, we made it clear that we suspected things would look very different by the European close. Sure enough, the markets in Europe (and US) have seen a dramatic shift in sentiment as the realization of the end-game here grows louder. It is evident that any strength, any rip, is to be sold. EURUSD rallied 1.2% at its best near the open last night but is ending 0.2% lower from Friday's close. Europe's broad equity market is closing modestly red after being up almost 2% at the open. Europe's financial credits led the equity market once again as senior spreads swung from a 20bps rally to a 10bps sell-off by the close. Italy was crushed after opened up over 4% to close down over 2.75% as Italian banks were halted all the way down. Spanish banks gave back all their gains (SAN was up almost 6% at the open and closed red). Investment grade credit notably underperformed and high-beta XOver swung from a 35bps tightening to close modestly wider. European sovereign bond spreads all opened notably tighter but were crushed by the close with Spain and Italy underperforming (+60bps and +50bps from their intraday low spreads respectively). Quite simply, Europe has swung from Spanish bailout fantasy to Europe's contagious panic reasserting - and that was after a weekend when Spain (and Spanish banks and every bullish trader out there) got everything they wanted. It would appear that the investing public has become better-educated at what is really going on in Europe and how these interim 'solutions' are all to be faded as Franco-German relations remain tense and Germany stoic. In liquidity/safety land, Swiss 2Y rates plunged 7bps to a new record -35.3bps.

Over the past 24 hours, Zero Hedge covered the various key provisions, and open questions, of the Spanish bank bailout. There is, however, much more when one digs into the details. Below, courtesy of Deutsche Bank's Gilles Moec is a far more nuanced analysis of what just happened, as well as a model looking at the future of the pro forma Spanish debt load with the now-priming ESM debt, which may very well hit 100% quite soon as we predicted earlier. Furthermore, since the following comprehensive walk-thru appeared in the DB literature on Friday, before the formal announcement, it is quite clear that none other than Deutsche Bank, whose "walk-thru" has been adhered to by the Spanish government and Europe to the dot, was instrumental in defining a "rescue" of Spain's banks, which had it contaged, would have impacted the biggest banking edifice in Europe by orders of magnitude: Deutsche Bank itself.

Morgan Stanley's *hilarious* comic strip on our *hilarious* credit markets.

Whether it was the deterioration in Consumer Credit, downgrade rumors for US financials, Greek bank restructuring/run chatter, or a final realization that near-term QE is off at these levels of equity prices (as signaled by Bernanke and Gold this morning), the equity short-squeeze stumbled hard in the last hour of the day to end unch. Utilities managed to outperform handily as all the high beta sectors dumped into the close as Tech and Financials closed red for the day. Treasury yields and the USD were signalling considerably more equity weakness than we got though the dive caught stocks up but Gold remained the biggest loser of the day (-2% on the week against the 0.7% loss in the USD). Silver remains positive for the week - though matched gold's weakness on the day as Copper and Oil whipsawed up and down on rumor and then lack of follow-through. Equities pulled back closer to the underperforming investment grade (and less so high yield) credit market at the close. Treasury yields ended marginally lower (with the long-bond underperforming) and 7s and 10s -2bps)leaving 5Y flat still up 9bps on the week (and outperforming). Risk markets in general slid as Bernanke's speech was delivered and the Q&A proceeded but stocks went almost totally dead with financials and the S&P 500 e-mini clinging to VWAP as volumes died - until that last hour plunge. MS and BofA took the brunt of the selling pressure (ending down 3-4%) - though they are still well of the lows from a few days ago. VIX cracked back above 22% as we dropped in the end but closed down 0.5vols at 21.7% (and the term structure of vol has steepened up to 5mth highs) but implied correlation rose back over the somewhat critical 70 threshold and equities remain notably rich to broad risk assets in general still and today's huge jump in average trade size is somewhat concerning.

First it Egan-Jones (of course). Then S&P. Now Fitch (which sees the Spanish bank recap burden between €60 and a massive €100 billion!) joins the downgrade party of rating agencies that have Spain at a sub-A rating. Only Moody's is left. What happens when Moody's also cuts Spain from its current cuspy A3 rating to sub-A? Bad things: as we explained on April 30, when everyone has Spain at BBB or less...

Three days after posting its biggest single-day loss in seven months, it makes perfect sense in this nonsensical market for the S&P 500 e-mini futures to post their best gain in six months (a 4-sigma drop to a 3-sigma gain). Volume was heavy (and we note came in size at the end). Financials went berserk with MS and BofA ripping around 8% higher along with Energy and Industrials all up near 3% today. The biggest jumps was pre-European close, but the very late day surge which just seemed ridonculous (and did disconnect stocks from other asset classes) dragged everything to close at the highs (with ES +2.25% and Dow +280pts). Just remind us why again? No meat from Draghi, but more pavlovian-bell-based hope for tomorrow's Bernanke speech? If that's the case, then why did the Beige Book's much-more positive tone than expected drive gold (QE-hope-fading) significantly lower and leave stocks and treasury yields, at their highs and the USD at its lows. Bonds are 18-22bps higher in yield this week now (with 5Y outperforming only 10bps wider as maybe the 5Y is now the new cash). Gold underperformed its commodity peers as Silver outperformed and Oil and Copper leaked higher with the weaker USD (now down 0.74% on the week). IG and HY credit underperformed as stocks (and HYG) took off into the close and CONTEXT (a proxy for broad risk assets) disconnected lower from equity's ebullience at the end of the day after being dragged higher for much of the day.

Everyone's worried about EU soveriegn debt. Once all of that rapidly depreciated real estate collapses mortgages that have been leveraged 30x, you'll really see the meaning of AUSTERITY! I'm trying to make it very clear to you people, you ain't seen nothing yet!!!

On the heels of Fitch's sovereign credit downgrade to A plus (the fifth-highest investment grade), Japan's government debt continues to swell. With its debt at over 200% of its GDP, the Land of the Rising Sun appears to be embarking on a trek into the debt-laden unknown. As with any well-known macro-trend, there are speculators eager to capitalize on it. A ballooning government debt is often associated with sovereign debt crises, as market shocks can send the interest rate paid on the debt to unsustainable levels. Coupled with Japan's shrinking population (and thus tax base), the country is setting itself up for a hairy situation (data for both charts are from the IMF's World Economic Outlook Database). Enter Kyle Bass, one of the few hedge fund managers who made a killing when he bet against housing during the subprime mortgage bust. He and his fund have now set their sights on Japan, specifically shorting Japanese yen and Japanese government debt. His thesis is simple: with a debt-to-GDP ratio over 200% and a contracting population, it's only a matter of time before a sovereign debt crisis sets in, thus triggering a rise in Japanese interest rates – which the government would be unable to service with a shrinking and aging tax base. So far this strategy hasn't worked as Bass intended: according to ValueWalk, Bass' fund lost 29% of its value in April alone. That's not to say Bass' assumptions are incorrect. But there are alternative ways of looking at Japan's situation.

It seemed the 'but but but we're oversold' argument was holding up in early trading in Europe as EURUSD, sovereign bonds, corporate and financial credit, and stocks rallied out of the gate. It didn't take long however for the technicals from CDS-Cash traders to wear off and Spain and Italy sovereign debt started to leak back wider. This accelerated pushing everything off the edge as European stocks and financials & investment grade credit fell to recent lows. Interestingly high-yield credit (XOVER) remains an outperformer. By the close, credit markets were pretty much unchanged from last night's close having given back all the knee-jerk improvements on the day but equities remained lower - with a late day surge saving them from total chaos. EURUSD gave back all of its early gains to end the European day lower once again - though off its lows - even as Germany 2Y trades with 0.2bps of negative and Swiss 2Y rates plunge below -25bps. For the month, EMEA stocks were a disaster - Italy and Spain down 12 and 13% and the broad Euro-Stoxx -8.3% (-8.7% YTD).

If we had a penny for every equity rally away from credit reality that converged back to credit's less-hopiness, we would now have made 5 pennies in the last 6 trading days. We pointed out last night that equities surged into the close on small average trade size as credit remained far less sanguine and the now-ubiquitous open in Europe started the reversion as stocks fell rapidly, below Friday's close - tracking back with high-yield credit's deterioration. HYG gave up yesterday's gains and pops back under fair-value but rather notably, investment grade credit (IG) underperformed significantly today - which is unusual in a sell-off day and signals either more fallout from JPM reaching for hedges (IG9 10Y 166bps offered +5bps) or investors grabbing the cheapest macro overlay from a carry perspective. Gold and Silver outperformed admirably on the day, however the upward move appears to be more of a reaction back to equity, treasury, and USD reality as the afternoon saw the 4 markets recouple and trade together (after disconnecting notable yesterday). Treasury yields dropped the most in 7 months to new record lows in 10Y and close for 30Y. Both implied correlation (systemic risk) and VIX (normal vol) jumped higher today as the latter moved almost 3 vols to close above 24% (its biggest pop in almost 3 months). A heavier volume open at highs, close at lows day for stocks with little to signal capitulation in terms of trade size - and across broader risk-assets, stocks appear to have room to fall - even after ES suffered its worst loss of the year today.

Bank Regulatory Capital has been in the news a lot recently - between the $1+ trillion Basel 3 shortfall, the Spanish banks with seemingly their own set of capital issues, or JPM's snafu.  There has been a lot of discussion about Too Big To Fail (“TBTF”) in the U.S. with regulators demanding more and banks fighting it.  After JPM's surprise loss this month, the debate over the proper regulatory framework and capital requirements will reach a fever pitch.  That is great, but maybe it is also time to step back and think about what capital is supposed to do, and with that as a guideline, think of rules that make sense. Specifically, regulatory capital, or capital adequacy, or just plain capital needs to address the worst of eventual loss and potential mark to market loss. Hedges are once again front and center.  The only "perfect" hedge is selling an asset. This "hedge" is also a trade.  The risk profile looks very different than having sold the loan and the capital should reflect that.

Jeff Gundlach discussed mortgages, models, math, and moronic delusion with Tom Keene on Bloomberg TV this morning. Starting with why Europe matters to US Treasury and mortgage markets, the DoubleLine boss goes on to address whether banks/hedge-funds have become too math-centric. "I don't believe in models" is how Gundlach begins his diatribe on the over-confidence in math and empirical relationships. Jeff believes there is no reason to hold any investment grade bonds that are inside of 3 years (and perhaps even 5 years) because they "just basically have no yield" and further, it is non-sensical to think that short-term interest rates are going up in the US. As Socrates said, Gundlach echoes the fact that 'one should not try to know everything; but respect the things that one cannot know' - don't delude yourself - which seems like good advice for all those with such high convictions of sustained reality. Towards the end he discusses his already-infamous short-AAPL, Long-Nattie trade - adding that the trade has 'monster legs' and the biggest mistake investors make is exiting winners too early.

Update: not so fast: Bloomberg reports that the whale is still beached: JPMorgan Chase Still Employs Trader Bruno Iksil, Spokesman Says. So... pile into the IG9 trade still?

Yesterday we speculated that the final confirmation that JPM has unwound its disastrous skew trade will only came once Bruno Iksil joins all the other members of the CIO team in being involuntarily retired: "As for the question of how much additional P&L loss JPM has sustained from Friday through today is a different matter entirely, and we are confident the next announcement from JPM will come momentarily, coupled with the announcement that Bruno Iksil, the last remnant of the CIO desk, and now having completed his duty of unwinding the trade that brought so much pain for Jamie Dimon, has been retired." Sure enough, the NYT reports that Iksil is now history.

It’s 1933 and the country has undergone several years of painful Depression following the 1920s speculation that crashed in the fall of 1929. Investigations into the bank related causes began under Republican President, Herbert Hoover and continued under Democratic President, FDR. Okay, that’s pretty common knowledge. But, here’s something that isn’t: of all the giant banks operating their trusts schemes and taking advantage of off-book deals, and international bets in the late 1920s, it was an incoming head of Chase (replacing Al Wiggins who shorted Chase stock in a network of fraud) that advocated for Glass-Steagall. Indeed, despite all pedigree to the opposite (his father was Senator Nelson Aldrich architect of the Federal Reserve and brother-in-law, John D. Rockefeller), Chase Chair, Winthrop Aldrich, took to the front pages of the New York Times in March, 1933 to pitch decisive separation of commercial and speculative activity arguments.  Fellow bankers hated him. His motives weren’t totally altruistic to be sure, but somewhere in his calculation that Chase would survive a separation of activities and emerge stronger than rival, Morgan Bank, was an awareness that something more – permanent – had to be put in place if only to save the banking industry from future confidence breaches and loss. It turned out he was right. And wrong. (much more on that in my next book, research still ongoing.) Financial history has a sense of irony. JPM Chase was the post-Glass-Steagall repeal marriage, 66 years in the making, of  Morgan Bank and Chase. Today, it is the largest bank in America, possessing greater control of the nation’s cash than any other bank.  It also has the largest derivatives exposure ($70 trillion) including nearly $6 trillion worth of credit derivatives. 

Europe's story today was multi-month record deterioration in equity and credit markets. The turning point appears to have been the market's recognition of what LTRO really is and LTRO2 pretty much marked the top. While recent weakness has been exaggerated by the JPMorgan debacle (contagion to 'cheaper' hedge indices in credit), the Greek reality and clear contagion of a Euro / No-Euro decision any minute has Spanish, Italian, and Portuguese equity and credit markets crashing lower (from already Tilson-clutching lows). Spanish bond spreads are 160bps wider since LTRO2 and Italy 87bps wider with today's +28bps in Spain taking it to all-time record wides (pay less attention to yields now as they will be flattered by the ripfest run to safety in bunds), Portugal is back above 1100bps in 5Y CDS, but most critically - given LTRO's unintended consequence of encumbering the weakest banks exponentially to the domestic sovereign - the LTRO Stigma is up more than 200% from its lows when we first pointed out the reality. Banks who took LTRO exposure are on average almost at record wides (with many of them already at record wides). European equities are weak broadly but remain above their credit-implied levels as investment grade and high-yield credit in Europe falls back to four-month lows (almost entirely eradicating the year's gains) while the narrower Euro Stoxx 50 equity index is down significantly YTD. short- and medium-term EUR-USD basis swaps are deteriorating rapidly once again as clearly funding is becoming a major issue in the Euro-zone.