Sovereign Debt

The "Excel Spreadsheet Error" In Context

It is a convoluted world. The money rolls in from the Fed, the ECB and various European funds where money is pledged by each country and put up by none. Pledges, contingent liabilities, guarantees of bank debt are not counted but have not vanished and show up when the bills are due decreasing the assets of everyone.  The newly printed money must find a home and so supports the sovereign debt yields while costing each European government more in the process. Austerity fails, unemployment rises, economies decline, more taxes are applied and the use of newly printed money is the only thing that separates us from some sort of financial chaos. The differential between the European economies and the European markets increases and the actual losses increase. Print forever. Lies without end. Reality redefined.

In the financial world at present the markets are fueled by the liquidity of the central banks. Not only is nothing else of importance but good news becomes the joyful noise of some divinity, bad news is elevated to good news and horrible news brings ecstasy as it will enlarge the contributions of Mr. Bernanke and Mr. Draghi. We live in a world where everything is ignored but the time will come when this ignorance will be shattered. We will pay the price for our stupidity because there is always a price to be paid. Mr. Bernanke and Mr. Draghi have been the Saviors but the church has been built on thin air and the weight of the building is increasing and increasing at an alarming rate. This kind of normal is unsustainable. The lessons of the past are being ignored once again but I caution you to not forget what you have learned.

When Spanish bonds traded at yields above 7% last Summer, the world's central banks went into a whirlwind to proclaim that these levels did not represent reality (in spite of the depression-era style economic data the nation was spewing). Fast forward nine months, the data is worse and getting worserer but yields - through the guiding hand of Draghi, the self-referential buying of domestic banks, and the BoJ's risk-is-no-object reach for anything non-JPY denominated - have crushed to 4.3% pre-crisis levels. Meanwhile, a few thousand miles south, the nation of Rwanda is issuing its first international debt today at a 7% yield (to the Japanese we are sure) as over 90% of the world's sovereign bond markets are at or near all-time low yields. But, the smart money is leaving, as PIMCO notes, "this central bank-inspired rally has made the markets expensive... relative to fundamentals"

Insider offered an alternative, a heresy for Germans, an exit strategy if you will, a Plan B.... And he predicted that the euro might not last another five years!

As we have discussed numerous times over the past year, there is a quiet movement among the world's central banks to diversify their reserves away from the pejorative USD. Whether it is direct trade linkages, hording physical precious metals, or simply buying foreign sovereign debt, there is a trend emerging. The latest defection, as BusinessWeek reports, is Australia's plan to invest about 5% of foreign currency reserves in China. The decision "represents the first time that the RBA will have invested directly in a sovereign bond market of an Asian country other than Japan," the country's deputy governor noted, adding that this step was an "important milestone" to "stronger financial linkages" leaving Australia "better positioned to benefit from the shift in global economic growth towards Asia." Of course, palling up to its closest trade partner is a big driver, but in a somewhat barbed comment on the strength of the AUD, Lowe noted, "quantitative easing that has taken place in a number of countries is having a significant effect on exchange rates of freely floating currencies... which is clearly making for difficult conditions in certain parts of the Australian economy."

Near multi-generational low bond yields, driven at least in part (and some think in full) by the undeniably large asset purchase program (Quantitative Easing (QE)) that the US Federal Reserve has been implementing in one form or another since the 2008 Global Financial Crisis (GFC), have pushed the question of whether or not the bond market is a bubble to the front of many people's minds. However, while the chart below of over 220 years of 10-year treasury yields shows the extraordinarily low bonds yields, they have resulted from many fundamental and rational drivers (expectations of weak economic growth and safe haven flows amid the European sovereign debt crisis) in addition to Fed purchases. So while bond prices look expensive, there is nothing particularly bubbly about the bond market today.

The paper price of gold crashed to $1,325 in the wake of this huge trade. It is now hovering around $1,400. Our first reaction is to suggest that this is only an aberration, and that the fundamentals of the depreciating value of paper currencies will eventually take the price of gold much higher, making it a buying opportunity. But what we can't predict is whether big players might again deliver short-term downturns to the market. The momentum in the futures market can make swings surprisingly larger than the fundamentals of currency valuation would suggest; but the fundamentals will drive the long-term market more than these short-term events. The fight between pricing from the physical market for bullion and that from the "paper market" of futures is showing signs of discrimination and disagreement, as the physical market is booming, while prices set by futures are seemingly pressured to go nowhere. In short, we think this is a strong buying opportunity.

Following yesterday's most recent Europe-led rout, the market is attempting a modest rebound, driven by the usual carry funding currency pair (EURUSD and USDJPY) levitation, although so far succeeding only modestly with not nearly enough overnight ramp to offset the bulk of yesterday's losses. In a centrally-planned, currency war-waging world, it is sad that only two key FX pairs matter in setting risk levels. But it is beyond hypocritical and highly ironic that according to a draft, the G-20 will affirm a commitment to "avoid weakening their currencies to gain an advantage for their exports." So the G-20 issues a statement saying nobody is doing it, when everyone is, thus making it ok to cheapen your exports into "competitiveness"? In other words, if everyone lies, nobody lies. Of course, also when everyone eases, nobody eases, and the world is back to square one. But that will only become clear eventually.

Every scheme in Europe than can be rigged has been or is being rigged and, in the end, it will only be the fools that are left in this game. It is not the greater fools either but the mandated fools who take directions from Brussels who takes their directions from Berlin. We cannot emphasize enough the great risk that anyone takes now by investing in anything in Europe. You can ignore liabilities, you can play pretend and not count liabilities but in the end they are still there and the losses must be finally acknowledged. Gold gave you a head's up.

As gold recovered overnight and JPY weakness sparked hope for risk-assets once again, European stocks opened down and rallied for much of the European day. However, just as with yesterday, once the US opened, European stocks decided enough was enough and rolled over quite significantly (led by the banks). Safety was well bid in general in Europe with 2Y Swiss rates dropping further to 3-month lows at -10bps at their lowest! It appears the appeal of European sovereign debt has worn off for a moment among the BoJ as Spanish and Italian bond spreads leaked back wider on the day. EUR strength (and JPY weakness) provided the impetus for US equities to levitate but it appears more like EUR repatriation given Europe's risk-aversion today.

The debate about the usefulness of sovereign credit default swaps (SCDS) intensified with the outbreak of sovereign debt stress in the euro area. SCDS can be used to protect investors against losses on sovereign debt arising from so-called credit events such as default or debt restructuring. With the growing influence of SCDS, questions arose about whether speculative use of SCDS contracts could be destabilizing - and this caused regulators to ban non-hedge-related protection buying. The prohibition is based on the view that, in extreme market conditions, such short selling could push sovereign bond prices into a downward spiral, which would lead to disorderly markets and systemic risks, and hence sharply raise the issuance costs of the underlying sovereigns. The IMF's empirical results do not support many of the negative perceptions about SCDS. In particular, spreads of both SCDS and sovereign bonds reflect economic fundamentals, and other relevant market factors, in a similar fashion. Relative to bond spreads, SCDS spreads tend to reveal new information more rapidly during periods of stress, admittedly with overshoots one way or the other. Given the current apparent 'stability' in many nations' bond market spreads, the chart below suggests an alternative way of judging what the credit market thinks - the volume of protection bid - and in this case some interesting names emerge.

Ponzinomics

We live in a world now which may be described as, "Nothing Matters."

The money pours in each month from America, Europe and Japan and overrides anything and everything else. With pre-payments and calls the estimated amount of money provided by the Fed for the world's monetary supply is approximately $100 billion every month. It is not just the American banks that are the recipients of the hand-out but the foreign ones who ship it back to Europe or buy European sovereign debt courtesy of Mr. Bernanke. I suspect that if the American taxpayers were aware of the scheme that the citizens would not be pleased but then what the Fed is doing is not generally part of polite conversation in America and so it is not discussed.

As SF Fed's John Williams notes (here), cash is king, but the strange thing is that while credit/debit transactions rise exponentially, the cash in circulation is also rising at a rapid pace. So where does all the cash go? The short answer is into large-denomination bills and out of the country by his findings. While low denomination bills suffer (as we discussed here) it is worth asking who is 'hoarding' the $100 bills? This is the question that BofAML asks in Europe as the huge EUR500 Bill (the developed world's highest value note in circulation) remains in great demand (apparanelty by shady offshore types). This is not good news for the central banks of the world as they run dry of monetary policy tools to drive velocity in money (or spending). BofAML's proposal: Ban the EUR500 Bill; force those shady people who 'stack' these high denomination bills to spend that money into circulation. This would appear to be the latest 'capital control' strawman, 'floated' to eliminate the people's right to keep cash segregated from a banking system and out of broad electronic circulation. So in both the US and Europe, high denomination bills are being hoarded (or exported to 'safe' havens) as Williams notes, "around the world, during periods of political unrest or war, cash - especially the currency of a stable country... - is seen as a safe asset that can be spirited out of harm’s way with relative ease." This, of course, is not what the elites want - and we suspect a "ban the EUR500 Bill" legislation will be coming soon to the EU Commission.