Sovereigns

The rolling euphoria continues. European sovereigns have performed well again today with a significant surge into the close (helped earlier by ECB buying and optically successful auctions). Italian 10Y is trading back at 450bps over Bunds (one-month tights) and European banks ripped higher in equity and credit markets (as belief in capital raising plans takes hold). As we noted earlier, GGBs have been underperforming all week but equities and credit seem unstoppable here. USDJPY has crumbled in the last hour or so (around the same time as sovereign spreads started to accelerate their compression) and Treasuries (and Bunds) are very significantly underperforming (with the former now 13bps higher in 30Y for the week). While the dollar continues to weaken (and EUR strengthen back over 1.29) commodities are 'oddly' rolling over with Copper, Oil, Gold, and Silver all well off their earlier highs as Europe closes.

One reason for the severity of the financial crisis, and the losses incurred by banks, is that bankers and financial analysts were using linear tools in a non-linear, highly complex environment otherwise known as the financial markets.The models didn’t work. The problem we face now as investors will end up being existential for some banking institutions and sovereigns. Our (uncontentious) core thesis is that throughout the west, more debt has been accumulated over the past four decades than can ever be paid back. The question, effectively to be determined on a case-by-case basis, is whether bondholders are handed outright default (which looks increasingly like the case to come in Greece) or whether the authorities, in their understandable but misguided attempts to keep the show on the road, resort to a policy of inflation that could at some point easily spiral out of control. As Rothbard wrote, “The longer the inflationary boom continues, the more painful and severe will be the necessary adjustment process… the boom cannot continue indefinitely, because eventually the public awakens to the governmental policy of permanent inflation, and flees from money into goods, making its purchases while [the currency] is worth more than it will be in future.” “The result will be a ‘runaway’ or hyperinflation, so familiar to history, and particularly to the modern world. Hyperinflation, on any count, is far worse than any depression: it destroys the currency – the lifeblood of the economy; it ruins and shatters the middle class and all ‘fixed income groups;’ it wreaks havoc unbounded… To avoid such a calamity, then, credit expansion must stop sometime, and this will bring a depression into being.”

While his diagnosis of the balance sheet recessionary outbreak that is sweeping global economies (including China now he fears) is a useful framework for understanding ZIRP's (and monetary stimulus broadly) general inability to create a sustainable recovery, his one-size-fits-all government-borrow-and-spend to infinity (fiscal deficits during balance sheet recessions are good deficits) solution is perhaps becoming (just as he said it would) politically impossible to implement. In his latest missive, the Nomura economist does not hold back with the blame-bazooka for the mess we are in and face in 2012. Initially criticizing US and now European bankers and politicians for not recognizing the balance sheet recession, Koo takes to task the ECB and European governments (for implementing LTRO which simply papers over the cracks without solving the underlying problem of the real economy suggesting bank capital injections should be implemented immediately), then unloads on the EBA's 9% Tier 1 capital by June 2012 decision, and ends with a significant dressing-down of the Western ratings agencies (and their 'ignorance of economic realities'). While believing that Greece is the lone profligate nation in Europe, he concludes that Germany should spend-it-or-send-it (to the EFSF) as capital flight flows end up at Berlin's gates. Given he had the holidays to unwind, we sense a growing level of frustration in the thoughtful economist's calm demeanor as he realizes his prescription is being ignored (for better or worse) and what this means for a global economy (facing deflationary deleveraging and debt minimization) - "It appears as though the world economy will remain under the spell of the housing bubble collapse that began in 2007 for some time yet" and it will be a "miracle if Europe does not experience a full-blown credit contraction."

When it comes to attempts at predicting the future, it often appears that the most desirable outcome by everyone involved (particularly those from the status quo, which means financial institutions and media) is that of the "muddle through" which is some mythical condition in which nothing really happens, the global economy neither grows, nor implodes, and it broadly one of little excitement and volatility. While we fail to see how one can call the unprecedented market vol of the past 6 months anything even remotely resembling a muddle through, the recent quiet in the stock market, punctuated by a relentless low volume melt up has once again set market participants' minds at ease that in the absence of 30> VIX days, things may be back to "Goldilocks" days and the muddle through is once again within reach. So while the default fallback was assumed by most to be virtually assured, nobody had actually tried to map out the various outcome possibilities for the global economy. Until today, when Morgan Stanley's most recent addition, former Fed member Vince Reinhart, better known for proposing the Fed's selling of Treasury Puts to the market as a means of keeping rates at bay, together with Adam Parker, have put together a 3x3 matrix charting out the intersections between the US and European economic outcomes. Here is how Parker and Reinhart see the possibility of a global goldilocks outcome, and specifically those who position themselves with expectations of this being the default outcome: "A “muddle through” positioning is potentially dangerous: Our main message is that the muddle-through scenario might be the most plausible alternative, but its joint occurrence in the US and Europe is less likely than the result of a coin toss. Uncertainty is bad for multiples." Specifically - it is 37% (with roughly 3 significant digits of precision). That said, as was reported here early in the year, Morgan Stanley is one of the very few banks which expects an actual market decline in 2012, so bear that in mind as you read the following matrix-based analysis. Because at the end of the day everyone has an agenda.

When yesterday we presented the view from CLSA's Chris Wood that the February 29 LTRO could be €1 Trillion (compared to under €500 billion for the December 21 iteration), we snickered, although we knew quite well that the market response, in stocks and gold, today would be precisely as has transpired. However, after reading the report by Credit Suisse's William Porter, we no longer assign a trivial probability to some ridiculous amount hitting the headlines early in the morning on February 29. Why? Because from this moment on, the market will no longer be preoccupied with a €1 trillion LTRO number as the potential headline, one which in itself would be sufficient to send the Euro tumbling, the USD surging, and provoking an immediate in kind response from the Fed. Instead, the new 'possible' number is just a "little" higher, which intuitively would make sense. After all both S&P and now Fitch expect Greece to default on March 20 (just to have the event somewhat "priced in"). Which means that in an attempt to front-run the unprecedented liquidity scramble that will certainly result as nobody has any idea what would happen should Greece default in an orderly fashion, let alone disorderly, the only buffer is having cash. Lots of it. A shock and awe liquidity firewall that will leave everyone stunned. How much. According to Credit Suisse the new LTRO number could be up to a gargantuan, and unprecedented, €10 TRILLION!

As the buy-the-ratings-downgrade-news surge on European sovereigns stalls (following a few weeks of sell-the-rumor on France for example), the ever-ready-to-comment mainstream media remains convinced that the impact is priced in and that ratings agencies are increasingly irrelevant. UBS disagrees. In a note today from their global macro team, they recognize that while the downgrades were hardly a surprise to anyone (with size of downgrade the only real unknown), the effect on 'AAA-only' constrained portfolios is important (no matter how hard politicians try to change the rules) but of more concern is the political impact as the divergence between France's rating (and outlook) and Germany (and UK perhaps) highlights harsh economic realities and increases (as EFSF spreads widen further) the bargaining power of Germany in the economic councils of Europe. Furthermore, the potential for closer relationships with the UK (still AAA-rated) increase as the number of AAA EU nations within the Euro only just trumps the number outside of the single currency. This may be one of those rare occasions where politics is more important than economics.

As expected in the aftermath of the concluded S&P ratings action on European sovereigns, the next action is for the rating agency to go ahead and start cutting related banks and insurers, as we noted over the weekend with many of the main European banks anticipated to see one or two notch cuts potentially as soon as today. Which is why the just released report "How Our Rating Actions On Eurozone Sovereigns Could Affect Other Issuers In The Region" will be read by great interest by many to get a sense of when the next shoe is about to drop. Here is what it says on that topic.

All you need to read.

And so the latest inevitable outcome of the French downgrade from AAA has arrived, after the S&P just downgraded the EFSF, that pillar of European stability, from AAA to AA+. S&P adds: "if we were to conclude that sufficient offsetting credit enhancements are, in our opinion, not likely to be forthcoming, we would likely change the outlook to negative to mirror the negative outlooks of France and Austria. Under those circumstances we would expect to lower the ratings on the EFSF if we lowered the long-term sovereign credit ratings on the EFSF's 'AAA' or 'AA+' rated members to below 'AA+'." In other words, as everyone but Europe apparently knew, the EFSF is only as strong as the rating of its weakest member. And now the rhetoric on how AAA is not really necessary for the EFSF, begins, to be followed by AA, next A, then BBB and finally how as long as the EFSF is not D-rated all is well.

Despite disappointing auction results in France, the downgrade hangovers (sell the rumor, buy the news?), and increasingly likely Greek PSI talk epic-fail, most European sovereigns are rallying modestly on the day. Given the expected shift in the AAA benchmark used for margining (dropping higher yielding France 'AAA's as they are downgraded will lower AAA benchmark significantly and implicitly widen the yield differential for other sovereigns), it is perhaps no surprise that TPTB are active in BTPs (Italian bonds) but it appears that Portugal (admittedly illiquid) has been left to its own devices. Portuguese 10Y bond spreads to bunds just broke 1250bps, +180bps on the day and at record wides. Given the subordination concerns as ESM is accelerated, it is perhaps no surprise that the ECB's SMP has seemingly decided that Portugal has crossed the Rubicon into Greece territory.

When Zero Hedge correctly predicted the imminent rise of the "activist sovereign hedge fund" phenomenon first back in June 2011 (also predicting that the "the drama is about to get very, very real") few listened... except of course the hedge funds, such as Saba, York, Marathon, and others, which realized the unprecedented upside potential in such "nuisance value", long known to all distressed debt investors who procure hold out stakes, and quietly built up blocking positions in European sovereign bonds at sub-liquidation prices. Based on a just released IFRE report, the bulk of this buying occurred in Q4, when banks were dumping positions, promptly vacuumed up by hedge funds. More importantly, we learn from IFRE's post mortem of what is only now being comprehended by the market as having happened, is the realization that the terms "voluntary" and "collective action clauses" end up having the same impact as a retailer (Sears) warning about liquidity (and the result being the start of the death clock, with such catalysts as CIT pulling vendor financing only reinforcing this) to get the vultures circling and picking up the pieces that nobody else desires. As a reminder, it was again back in June we predicted that "the key phrase (or two) in the proposed package: "Voluntary" and "Collective Action Clauses"." Why? Because what this does is unleash the prospect of yet another word, which is about to become one of the most overused in the dilettante financial journalist's lingo: "subordination" or the tranching of an existing equal class of bonds (pari passu) into two distinct subsets, trading at different prices, and possessing different investor protections (we use the term very loosely) with the result being an even greater demand destruction for sovereign paper.

After the fairly muted Wellington open, the reaction of the European bond markets to the S&P downgrade will be the next focus of attention. One benefit of the S&P ratings action is that it takes away one source of uncertainty. Given a French downgrade wasn't widely anticipated, market focus on this issue may well be short lived. Related to the European downgrades is the rating of the EFSF, which was also put on credit watch in early December. S&P have commented that they are in the process of evaluating the impact of the sovereign downgrades on the EFSF rating. For the AAA rating to be maintained it would require further commitments from European governments. Remaining in Europe, newswires report that Greek debt talks will resume Wednesday, thus the Greek PSI is likely to remain a focus all week.

It has been a busy weekend for Wall Street, which has been doing all it can to spin the S&P downgrade in the best favorable light, although judging by the initial EURUSD and EURJPY reaction, so far not succeeding. Below we present a quick report written by Goldman's Lasse Nielsen on why in Goldman's view the downgrade's "impact is likely to be limited" and also the quick notes from an impromptu call MS organized for institutional clients (which had just two questions in the Q&A section, of which only one was answered - it appears virtually noboby believes that global moral hazard will allow anyone to fail at this point, so why bother even going out of bed).

All your questions about the historic European downgrade should be answered after reading the following FAQ. Or so S&P believes. Ironically, it does an admirable job, because the following presentation successfully manages to negate years of endless lies and propaganda by Europe's incompetent and corrupt klepocrarts, and lays out the true terrifying perspective currently splayed out before the eurozone better than most analyses we have seen to date. Namely that the failed experiment is coming to an end. And since the Eurozone's idiotic foundation was laid out by the same breed of central planning academic wizards who thought that Keynesianism was a great idea (and continue to determine the fate of the world out of their small corner office in the Marriner Eccles building), the imminent downfall of Europe will only precipitate the final unraveling of the shaman "economic" religion that has taken the world to the brink of utter financial collapse and, gradually, world war.

Today's worst kept secret just hit the wires, as S&P announces that it has officially downgraded France

• FRANCE CUT TO AA+ FROM AAA BY S&P, OUTLOOK NEGATIVE
• "we believe that there is at least a one-in-three chance that we could lower the  rating further in 2012 or 2013"
• "we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating,"

One notch, but the negative outlook means a future downgrade is likely.