Sovereigns

Citi's Willem Buiter sums it all up: "...the improvement in sentiment appears to have long overshot its fundamental basis and was driven in part by unrealistic policy and growth expectations, an abundance of liquidity and an increasingly frantic search for yield. The key word in the recovery globally, and in particular in Europe, growth is fragile. To us the key word about the post summer 2012 Euro Area (EA) asset boom is that most of it is a bubble, and one which will burst at a time of its own choosing, even though we concede that ample liquidity can often keep bubbles afloat for a long time." His conclusion is self-evident, "markets materially underestimate these risks," as the EA sovereign debt and banking crisis is far from over. If anything, recent developments, notably policy complacency bred by market complacency, combined with higher political risks in a number of EA countries highlight the risks of sovereign debt restructuring and bank debt restructuring in the EA down the line.

The financial world is used to bubbles. We like to speak about them, point to them, bet upon their comings and goings and wave facts and figures about them like wild men when we appear in the media. It is the way of the markets. We have had bubbles in Real Estate, dot.com, bonds, stock markets and all kinds of other singular spaces. What we are faced with now is also a bubble but one unlike we have ever seen before because all of the major central banks have acted in concert which pumped money in from everywhere while, at the same time, limited what could be done with our new found small bits of paper because they playing field was leveled by distortion en masse. I would say that the entire financial system, every market, every space is in a bubble as a result of what they central banks have done.

Egan-Jones may have been barred from rating sovereigns for 18 months due to missing a comma here or there in its NRSRO application (when everyone knows this was merely retribution for downgrading the US ahead of all the other rating agencies), but now the time has come for that other rating agency which dared to follow in EJ's footsteps and downgrade the US of AmericaAA+ in August 2011 to be punished: Standard & Poors. Moments ago we learned that federal and state prosecutors will five civil charges against S&P for its mortgage bond ratings during the housing crisis.

We warned last week that European markets were beginning to show signs of cracking. European stocks had surged on to new highs while credit markets had decidedly not joined the liquidity-fueled exuberance. Sure enough a few days later and Europe in general is weak, but Italy and Spain are under significant pressure. The last four days have seen the biggest plunge in over six months with the IBEX (Spain -5.7%) and Italy's MIB -6.7%. At the same time, Europe's seemingly invincible OMT-promise-protected sovereign bond market has started to underwhelm. Italian bond spreads are 32bps wider and Spain 28bps wider - the biggest increase in risk in two months. Europe's VIX has surged from 14.5% to almost 19% today in the last 4 days and even Greek government bonds are losing their luster, -6.5% in the last few days. Whether this is exacerbated by European leaders jawboning the strength of the EUR down, or simply we hit the limit on reality amid Italian bank fraud, Spanish political fraud, referenda votes, and macro- and micro- fundamentals snapping; this is the worst performance in Europe in six months. It would seem that if the tail-risks in Europe are starting to re-appear then at least one of the legs of global equity exuberance is starting to break.

We have noted the similarities between the current risk rally and previous years but Morgan Stanley's Laurence Mutkin is "getting worried" that investors expect the second half of this year to be different (and consistently bullish). Much of the current risk-on rally around the world was sparked by Draghi's "whatever it takes" moment theoretically reducing the downside tail-risk in Europe. Well, systemic risk in Europe is now at recent lows and just as in 1H12 and 1H 11, core yields are rising notably, peripheral spreads compressing, money-market curves are steepening, and 2s5s10s cheapening. Of course, he notes, 2013 is different from previous years (OMT for example) but much rests on how ECB's Draghi responds to the recent (LTRO-repayment-driven) rise in EONIA forwards. Albert Einstein reportedly said that insanity is doing the same thing over and over again and expecting different results. Applying that to the European bond market - for the third time running, the year has opened well but it would be insane to expect a different outcome (than the typically bearish reversion) this time?

Prior to the crisis, the 29 largest global banks benefitted from just over one notch of uplift from the ratings agencies due to expectations of state support. Today, those same global leviathans benefit from around three notches of implied support. Expectations of state support have risen threefold since the crisis began. This translates into a large implicit subsidy to the world’s biggest banks in the form of lower funding costs and higher profits. Prior to the crisis, this amounted to tens of billions of dollars each year. Today, it is hundreds of billions. Too-big-to-fail is far from gone.

In one sense the trajectory of money is similar to what recently occurred with Lance Armstrong which is that he admitted to doping. The financial markets have been living on the drugs provided by the world’s central banks and that has been more and more and ever more money pumped into the system. We have become addicted to the stuff and never mind that more pieces of green and blue paper decrease the value of the currency because, with the possible exception of gold, there is nowhere else to go and so the global slosh of capital keeps driving the markets higher; all of the markets. Many point to the rise in the markets as a sign that conditions are improving but this is not the case. If things were getting better then the fundamentals would be telling a very different story.

How many European Union officials does it take to change a light bulb?
 
None. There is nothing wrong with the light bulb; its condition is improving every day. Any reports of its lack of incandescence are an illusional spin from the American media. Illuminating European rooms is hard work. That light bulb has served honorably, and any commentary not approved by the EU undermines the lighting effort. From the 'obvious 'encouragement' given to Europe's banks to pay back exceptionally cheap LTRO loans early to the world's addiction for freshly printed money and propaganda.The world seems devoid of politicians that sensibly lead though they have been quite adept at spending past what can be afforded. The worlds’ central banks have been left to pick up the bills.

While Chinese economic data seems designed to blow minds in its Schrodinger-like good/bad oscillation at the same time, it seems Europe's investors have now taken up the mantle. There is ammunition across every asset class to suggest all is well and things are progressing yet at the same time that risk is rearing its ugly head and momentum is fading. On the bright side, Swiss 2Y rates are at +4bps (having surged 25bps this year) and are back at 'normal' 10-month high rates; European stocks pushed 1-2% higher on the week; Europe's VIX dropped; and EURUSD gained over 1% (not necessarily a positive but seemingly signaling to the world that all is well) mostly in the last 24 hours. The LTRO repayment has pushed EONIA swaps up to six-month highs (liquidity needs remain high - though normalizing) but European credit markets are absolutely not playing along. European corporate and financial credit spreads pushed notably wider on the week and are grossly divergent from stocks now on the year. At the same time, European sovereign spreads ended the week practically unchanged - dislocated from EURUSD exuberance. Europe remains spellbound by the promise of OMT yet the very markets that benefit from that promise are losing their momentum...

Starting tomorrow and every Friday for the next few years, the ECB will report the number of banks and the amount of funds they will repay of the 3-year repo operations conducted in late 2011 and early 2012. For those who do not have the luxury of following these developments closely, I have put together a 10 point cheat sheet.

It would seem that the only 'asset' that finds the weak macro data this morning and deterioration in European sovereigns as a signal for risk-on is US Equities. While early on VIX gapped higher, it has recoupled in a compress-a-thon dragging stocks to the highs of the day as the USD drifts sideways and Treasuries are bid. Whether equity index strength is the long-AAPL hedgers unwinding (as AAPL is down 2% from its opening levels and sub-$500 once again), we can only stare in amusement at the low-volume liftathon that is exciting all around (especially the energy sector as oil hits 4-month highs).

With the BoJ and the Japanese government set to announce the now much-anticipated (and oft-repeated rumor) 2% inflation target in a joint (yet, rest reassured completely independent) statement, we have seen JPY swing from a 0.4% weakening to a 0.6% strengthening (sell the news?) and back to middle of the day's range by the time Europe closed. Cable (GBPUSD) has quite a day, dropping almost 100 pips top to bottom before bouncing back a little. This is 5 month lows for GBP as the triple-dip response of Mark Carney's new deal starts to get discounted. The USD ended practically unchanged despite all this as European sovereigns leaked wider, CHF strengthened modestly (2Y Swiss positive) and US equity futures did a small stop-run helped by the JPY crosses. It seems the zero-sum game in global FX competitive devaluation, as Steve Englander notes, has a long way to go, for if the UK and Japan, among others, are determined to crowd in growth by boosting exports, their currencies will have to fall a lot more than is now priced in.

It was the best of times, it was the worst of times. That just about sums up the divergence of opinion among credit (bad) and equity (good) traders had as the week ended on a very sour note for bonds. Financials, which have seen nothing but compression and exuberance, have swung notably wider in the last 36 hours or so - as the spectre of the repayment of LTRO begins to show forth. Meanwhile, stocks are flatly ignoring that reality and close (broadly) at the highs of the week. Sovereigns in general trod water (+/-5bps) except for Spain which rallied 21bps (of course it did, the awesome bad loans data must have been the bad-is-good driver?). EURUSD also started to sag today back to its lows of the week - even as Swiss 2Y rates broke back above 0% for the first time in 9 months and Europe's VIX is stable at around 16%.

In one sentence, during 2013, we expect imbalances to grow. These imbalances are the US fiscal and trade deficits, the fiscal deficits of the members of the European Monetary Union (EMU) and the unemployment rate of the EMU thanks to a stronger Euro. By now, it should be clear that the rally in equities is not the reflection of upcoming economic growth. Paraphrasing Shakespeare, economic growth "should be made of sterner stuff". Many analysts rightly focus on the political fragility of the framework. The uncertainty over the US debt ceiling negotiations and the fact that prices today do not reflect anything else but the probability of a bid or lack thereof by a central bank makes politics relevant. Should the European Central Bank finally engage in Open Monetary Transactions, the importance of politics would be fully visible. However, unemployment is 'the' fundamental underlying factor in this story and we do not think it will fall. In the long term, financial repression, including zero-interest rate policies, simply hurts investment demand and productivity.

The world has done everything humanly possible to put off any tough financial decisions and that is especially true in Europe and in America. The leaders on both Continents just cannot take the heat and so everything possible has been pushed forward in the hopes that economies will improve and that growth will cure the ills brought on by the lack of any real leadership. The centerpiece of the success of lower yields in all of the countries in Europe rests squarely upon Draghi’s “Save the World” plan where the ECB will backstop everything. A careful examination of the numbers and the possibilities limit what can be done in 2013 and the countries in question are Greece, Portugal, Cyprus, Spain and Italy. The other side of the coin here is social unrest that I believe will surface in the spring so that the present general belief that things have improved in Europe is nothing more than a hope which is fashioned by political design. The debt to GDP ratios for each nation in Europe are nothing more than gimmickry. The central banks, phony accounting and a promise by the ECB may well have saved 2012 from an implosion but 2013 brings a new set of circumstances that are far less appealing than last year. Stay safe!