Sovereign CDS

Market Snapshot: Europe Down Large But End-Tone Better In Credit

Credit markets opened extremely weak last night in Europe, underperforming equities, and continued to slide lower for most of the day. The interesting divergence that appeared was equities underperforming credit all day long which provided some modest bid to credit as we closed and reflects what we have been discussing recently - that equities had yet to catch up to credit's perspective of the world. All-in-all things feel very weak out there with sovereigns cracking their all-time wides and even IG credit in Europe as wide as it was at the peak of the financial crisis in 2008/9. Equities remain well above levels appropriate to the credit market's perspective and downside risk remains the bigger threat in a vicious circle of capital reduction, counterparty risk management, and illiquidity.

The Sovereign Risk Dislocation Trade Means Big, Black Clouds Coming To "Risk Free"

As early as July, we pointed out the increasingly likely endgame in Europe with regard to the EFSF and centralizing/concentrating credit risk. Well sure enough, sovereign risk has risen dramatically for Germany (among many others obviously) as traders realized standing on the shoulders of giants does nothing but push them further into the dirt. What is becoming more worrisome, and dramatically escalating, is the rise in sovereign CDS relative to government bond yields - or the so-called 'basis' - as it becomes ever more clear that government-bond-yield-by-mandate may not be as 'real' a measure of the risk-free rate as CDS.

CDS Traders Haven't Lost Their Shirts, But They Can Be Naked

The European Union failed to approve a law or plan to bank naked shorts on sovereign CDS.  Their focus on CDS trading started over 18 months ago when the Greek Finance Minister said that all the short sellers would lose their shirts. There have been a multitude of rumors that it would be banned, but there are many better ways to control the CDS market. In all likelihood, the politicians will remain intent on banning CDS.  I think they will be disappointed with the impact and realize that CDS is not the root of all evil and Europe will still have a sovereign debt crisis, without the benefit now of some short covering and additional price discovery.

On Walking The Maginot Line

Over the weekend I wrote about what I thought the EU and the ECB needed to do to in order to prepare for a Greek default. Nothing that has been said or done this week goes against the view that Europe is preparing for Greece to default. In the past week someone went into all the EU officials' speeches and did a replace all and "default" became "controlled default". Notice how they have backed off how bad a Greek default would be and try and narrow it down to the fact that a default without adult supervision would be bad. After yesterdays conference call they said that Greece would remain in the Euro. They never said Greece wouldn't default. That conference call was as likely to be scripting out the roles for the next few weeks to control the default and arrange post default financing for Greece. The language was not that strong and I don't believe their words were chosen by accident. If Greece defaults the first obvious panic will be how do the European banks get funding, especially in dollars. Well, that question has been answered. The mechanism to avert short term liquidity problems after Greece defaults is now in place.

Here Is What Just Happaned

What just happened? The Central Banks have agreed to either create programs to lend in $'s or in the case of the ECB, expand their existing 7 day program. It is definitely globally co-ordinated, but for any central bank to offer a USD program, they need to work with the Fed, so assuming the ECB decided to work with the Fed, it seems like a no brainer to involve the other central banks. Bank of England is an obvious candidate - look at the share price declines of Barclay's and RBS. The Swiss Central Bank was likely to join already, but a day with UBS announcing a $2 billion loss, they had extra reason to go along. Japan always seems to be up for a good intervention. So it is globally co-ordinated, that is important, but it was also and easy and obvious co-ordination. What is the next action?  I suspect we will see some effort to push sovereign CDS spreads tighter.  Would it be something as intelligent as immediately forcing all sovereign and bank cds to be cleared?  Heck no, that might annoy someone.  It is more likely to be announcement of banning naked shorts, increased margins, and the ability for the EFSF if not central banks themselves to sell protection.  CDS would gap tighter and bonds are unlikely to react much.  When the ECB intervened in the Spanish and Italian bond markets, the initial reaction in the bond market was big.  Over 1% in yield terms across the board in a very short time frame.  The CDS never reacted as positively.  In any case, the market remained dubious of the effectiveness and we have seen yields rise in spite of continued buying.  CDS shorts will be painful if this occurs, but it won't fix anything long term.  There is nothing about the budget problems in various countries that are affected by CDS.  It also means that auctions are likely to do less well as the short covering bid dries up and that moves down will be exaggerated, just like the moves up. 

The Biggest EURUSD Bull, Goldman's Thomas Stolper, Throws In The Towel, Cuts His Forecast Across The Board

Three things are sure in life: death, taxes, and betting against the calls of Goldman's Thomas Stolper. Sure enough:

  • We lower our EUR/$ forecast path slightly but keep the same upward-sloping trajectory.
  • Our new EUR/$ trajectory is 1.40, 1.45 and 1.50 in 3, 6 and 12 months, from 1.45, 1.50, 1.55 previously.
  • The recent increase in the Euro area’s fiscal risk premium is likely to persist.
  • Very large short EUR/$ positioning is likely to last in the near future.
  • But the underlying Dollar downtrend should drive EUR/$ higher over time.
  • We discuss the CHF and safe-haven currencies after the SNB’s commitment to intervene.
  • Our new EUR/CHF forecasts are 1.21 flat in 3, 6 and 12 months.

Guest Post: Marked and Unmarked Bonds

Every "solution" to the European debt crisis, whether it is ECB purchase, EFSF, Eurobonds, or BRIC's, fails to account for the fact there are really two types of bonds out there.  There are those that are trading and marked, and those that remain on some bank balance sheet unmarked. That is a key distinction.  If all Greek bonds were marked at 45 (or even had 55 points of reserves held against them) then there would be a lot of potential solutions.

On Sounding Like A Broken European Record

Short dated Greek bonds remain weak. They have not bounced. You can buy the 2 year bond at 50. With a 4% coupon, that is 8% current yield with the chance to double in price in 2 years. Clearly the bond market is expecting a default or massive write-offs for Greek debt. I have heard the argument that equities must be pricing that in at this stage. That is possible, but I find more equity people believe that "something" will be done to avert default than credit people. Looking back at 2007 and 2008, it often seemed like equities had to be hit over the head with a stick before they would price in problems in credit. Stocks hit their high in October 2007 - after strong signs of problems in the credit markets had appeared. They also managed to shrug off the Bear Stearns problems after JPM bought them and rallied hard after that, completely missing the impending doom of FNMA, LEH, GM. I would not feel comfortable that stocks have "priced in" the problems in Europe. I think they have failed before on credit problems and with such a high percentage of daily volume just "churn" from traders and computers who go home flat every day and funds trying to avoid showing a monthly loss, the value of stocks as a pricing mechanism seems diminished.

Plunging German Investor Confidence Sends European Bank Risk To Record

Just like yesterday we have the makings of a perfectly schizophrenic day. While stock futures are rapidly higher to begin with, as on Monday, on news of a slightly better than expected PMI out of China, we are very concerned whether this algo induced ramp can be sustained. The reason is that earlier today we got an absolutely abysmal German ZEW investor confidence number which dropped to -37.6 from -26, a doubling of the previous -15.1, and the lowest since December 2008. This epic collapse can only be compared with the stunner out of the Philly Fed last week. The biggest component of the ZEW, the current situation, imploded from 90.6 to 53.5, trouncing (to the downside) expectations of 85.0. Additionally, the eurozone economic sentiment dropped to -40 from -7.0. So what is the immediate impact? Well, as we said equity futures are completely ignoring that Europe's growth dynamo is now confirmed to be in a double dip recession. However, not debt: as Bloomberg reports, "the cost of insuring European bank debt against default rose to a record as German investor confidence fell to the lowest 2 1/2 yrs+ on concern the region’s debt crisis will curb growth." Specifically, iTraxx Fin soared to record 255 bps, +5 overnight, while SovX (the sovereign CDS index) was 5 bps wider to 302, just off the record 206 form July 18. We give stocks, which are once again soaring on renewed expectations of a QE3, a few hours before they realize that the news is actually i) very bad and ii) as has been said countless times, stocks have to drop far more, before LSAP resumes for the third time.

Is The Next Domino To Fall.... Canada?

While two short months ago, "nobody" had any idea that Italy's banks were on the verge of insolvency, despite that the information was staring them in the face (or was being explicitly cautioned at by Zero Hedge days before Italian CDS blew out and Intesa became the whipping boy of the evil shorts), by now this is common knowledge and is the direct reason for why the FTSE MIB has two choices on a daily basis: break... or halt constituent stocks indefinitely. That this weakness is now spreading to France and other European countries is also all too clear. After all, if one were to be told that a bank has a Tangible Common Equity ratio of under 2%, the logical response would be that said bank is a goner. Yet both Credit Agricole and Deutsche Bank are precisely there (1.41% and 1.92% respectively), and both happen to have total "assets" which amount to roughly the size of their host country GDPs, ergo why Europe can not allow its insolvent banks to face reality or the world would end (at least in the immortal stuttered words of one Hank Paulson). So yes, we know that both French and soon German CDS will be far, far wider as the idiotic market finally grasps what we have been saying for two years: that you can't have your cake and eat it, or said otherwise, that when you onboard corporate risk to the sovereign, someone has to pay the piper. Yet there is one place where that has not happened so far; there is one place that has been very much insulated from the whipping of the market, and one place where banks are potentially in just as bad a shape as anywhere else in Europe. That place is.... Canada.

Shocker: JPM Sees Gold At $2,500 By Year End

We though we had seen it all... Then JPM's Colin Fenton came out with a prediction of gold hitting $2500 by year end. That's right: JP Morgan... $2500...."Gold and sugar have potential to run a lot higher. It has been clear for weeks that the prompt CMX gold price has been building in a rising probability of a reflaring of financial crisis, gaining by 9.7% since June 30 as the MSCI World Equity index dropped by 10.1%. The correlation in daily price changes between these two assets has dropped to –0.09 from +0.29 over the prior year. Gold’s correlation against TIPS has doubled to 0.35 from 0.18. Against Italian and Spanish 5-year sovereign CDS prices, the gold correlation has moved to 0.27 and 0.32, from 0.07 and 0.04, respectively. Before the downgrade, our view was that cash gold could average $1800 per oz by year end. This view will likely now prove to be too conservative: spot gold could drive to $2500 per oz or higher, albeit on very high volatility." Funny, when discussing yesterday's Goldman upgrade of gold we said: "Next up: everyone else." Little did we know...  Also, it is unclear if Blythe precleared this client note. But at this point it probably does not matter.

EFSF And Sovereign CDS Pitchbook Updates

Yesterday was a big day in the market for EFSF and Sovereign CDS. The announcements were big enough that some junior associates must be scrambling to update their pitchbooks. Here are my thoughts on what changes need to be done to the pitchbooks and the trading ideas that come as a result.

Some Perspective On Italian Bonds

Italy may not be Greece, but its important to remember that Greece wasn't Greece just 15 months ago. It seems like we have been talking about the problems in Greece for ages, but the reality is the market let them price a big "successful" bond deal in March of last year. While it is important to remember that the Troika has shown great support for sovereign debt, its also important to remember the market got it horribly wrong last year.

Italy May Enforce Naked Short Selling Ban As Early As Tonight To Prevent Market Rout

Once again the great diversionary scapegoating of speculators begins, after as Il Sole 24 Ora reported that the Consob, or Italy's regulator, may enact a naked short selling ban as early as tonight. The premise is that it is the shorters who are responsible for the ruinous state of the global ponzi. Not the fact that it is a, well, global ponzi. Distraction 101. And yes, it did not work back in 2010 when banning naked shorting was implemented in other European countries, it will not work this time either. But it won't stop bankrupt governments from trying. To wit: "Commissioners will assess the situation before markets open Monday, said a Consob spokesman, who declined to be named in line with the regulator's policy. Commissioners may decide to restrict "naked" short-selling in line with similar decisions taken in other European countries, he said.... The Consob meeting occurs after shares of Italy’s biggest banks fell to the lowest in more than two years on July 8, and government bonds dropped, driving 10-year yields to a nine-year high." 24 Ore adds: "Consob intervened several times in the past on short selling after the collapse of Lehman Brothers to protect stock markets."