Sovereigns

The moment BTPs broke above 500bps over Bunds this morning, it was clear that the ECB was in buying (and confirmed by desk chatter). Early in the day, European corporate, financial, and sovereign credit markets were in quite positive territory with the former at highs of the year. As downgrade rumors broke, and then were exacerbated by the increasing realization that Greek PSI is not going to happen, sovereigns broke wider rapidly and corporates and financials fell off a cliff (their biggest drop of the year so far) with XOver (the European high-yield credit index) widening 30bps almost instantly. EURUSD took out recent lows trading back to 1.2624, its lowest since August 2010 and EFSF (the much-heralded firewall) widened 9bps off its tights. The last hour or so of trading was dominated by improvements in BTPs and OATs as the SMP went to work and this provided some relief across all assets leaving European stocks at day's highs and modestly lower (after nearing the lows of the year so far earlier), non-sovereign credit marginally wider but sovereigns (Belgium, Spain, and Austria worst) still decently wider. While the impact of the downgrades on EFSF's structure and Germany's willingness to shoulder even more implicit guarantees is critical, we wonder if the PSI talks breakdown is the more important driver as investors face yet another a-ha moment and just as when the USA was downgraded, that the impossible may actually be possible (disorderly Greek default). In the US, ES (the e-mini S&P 500 futures contract) has also rallied nicely off the earlier lows but is holding at VWAP (and is in line with broad risk drivers for now).

Almost six months ago we discussed the dramatic shifts that were about to occur (and indeed did occur) the last time the New York Fed tried to unwind the toxic AIG sludge that is more prosaically known as Maiden Lane II. At the time, the failure of a previous auction as dealers were unwilling to take up even modest sizes of the morose mortgage portfolio was the green light for a realization that even a small unwind of the Fed's bloated balance sheet would not be tolerated by a deleveraging and unwilling-to-bear-risk-at-anything-like-a-supposed-market-rate trading community. Today, we saw the first glimmerings of the same concerns as chatter of Goldman's (and others) interest in some of the lurid loans sent credit reeling. As the WSJ reports, this meant the Fed had to quietly seek confirming bids (BWICs) from other market participants to judge whether Goldman's bid offered value. The discreteness of the enquiries sent ABX and CMBX (the credit derivative indices used to hedge many of these mortgage-backed securities) tumbling with ABX having its first down day since before Christmas and its largest drop in almost two months. The knock-on effect of the potential off-market (or perhaps more reality-based) pricing that Goldman is bidding this time can have (just as it did last time when the Fed halted the auction process as the market could not stand the supply) dramatic impacts as dealers seek efficient (and critically liquid) hedges for their worrisome inventories of junk. The underperformance (and heavy volume) in HYG (the high-yield bond ETF we spend so much time discussing) since the new-year suggests one such hedging program (well timed and hidden by record start-of-year fund inflows from a clueless public which one would have thought would raise prices of the increasingly important bond ETF) as the market's ramp of late is very reminiscent of the pre-auction-fail-and-crash we saw in late June, early July last year as credit markets awoke to the reality of their own balance sheet holes once again.

UPDATE: EURUSD at highs of day now 1.2790, sovereigns and corps/fins tightening back modestly

The ECB press conference has begun and immediately the headlines are flying and driving EUR weaker (ironically not helped by the dismal US macro data that just printed). European sovereign spreads are leaking wider, stocks are underperforming, treasuries outperforming bunds, and corporate and financial spreads are widening rapidly on his comments, via Bloomberg:

• *DRAGHI SAYS ECONOMIC OUTLOOK FACING SUBSTANTIAL DOWNSIDE RISKS
• *DRAGHI SAYS FISCAL COMPACT MUST HAVE UNAMBIGUOUS WORDING
• *DRAGHI SAYS FISCAL CONSOLIDATIONS ARE UNAVOIDABLE
• *DRAGHI SAYS ECB WILL ACT AS AGENT FOR EFSF
• *DRAGHI SAYS HARD DATA DON'T YET SHOW STABILIZATION
• *DRAGHI SAYS HILDEBRAND WAS `VERY, VERY GOOD' GOVERNOR
• *DRAGHI SAYS ECB DIDN'T DISCUSS CUTTING DEPOSIT, MARGINAL RATES
• *DRAGHI SAYS ONGOING TENSIONS KEEP DAMPING ECONOMIC ACTIVITY
• *DRAGHI SAYS ECB `VERY CONCERNED' ON HUNGARY
• *DRAGHI SAYS ANY WAY TO INCREASE THE 'FIREWALL' FIREPOWER WELCOME
• *DRAGHI: NATIONS SHOULD HAVE HAD CAPITAL READY ON STRESS TESTS
• *DRAGHI SAYS NEW COLLATERAL RULES EXPANDED POTENTIAL RISK
• *DRAGHI SAYS PSI WAS RESPONSE TO `SELFISH' BEHAVIOR
• *DRAGHI SAYS ECB EXPECTS SUBSTANTIAL DEMAND FOR SECOND LTRO
• *DRAGHI SAYS GREEK CASE IS `UNIQUE'

Following yesterday's extravaganza in European credit markets, which saw XOver (European high-yield credit) surge to highs year-to-date (wiping out a week's worth of leaking wider in one fell swoop), today's open suggested some follow-through but as macro data combined with France downgrade rumors (denied rapidly) sovereign and corporate credit markets sold off quite rapidly into the close. Interestingly, financials (senior and sub debt) managed to hold gains from yesterday's close as XOver and Main (Europe's investment grade credit index) along with the broad stock market lost ground to close near their lows (though well off yesterday's open still). EURUSD (holding under 1.27 at the EUR close) weakened fairly consistently after Spanish industrial output and German GDP did nothing to inspire and while sovereign spreads (Spanish and Italian mostly) were outperforming, as the French rumors hit, they sold off rapidly (France and Italy back to unchanged). As usual into the close there was a modest risk rally and sovereign spreads leaked modestly tighter (by around 6-9bps) with France underperforming but we did not see that bounce in corporate credit. The weakness in 'cheap-hedge' investment grade credit suggests risk appetite is not returning and decompression trades are back in vogue after yesterday's snap and perhaps a growing realization that no PSI agreement is looming anytime soon.

It will come as no surprise to anyone (other than Dallara and Venizelos perhaps) that all is not rosy in the Greek Public Sector Involvement (PSI) discussions. Whether it is the Kyle-Bass-Based discussions of the need for non-Troika haircuts to be 100% for any meaningful debt reduction, or the CDS-market-based precedent that is set from chasing after a purely voluntary, non-triggering, agreement, the entire process remains mired in a reality that Greece needs much broader acceptance of this haircut (or debt reduction) than is possible given the diverse audience of bondholders (especially given the sub-25 price on most GGBs now). As Goldman points out in a note today, the current PSI structure does not encourage high participation (due to the considerable 'voluntary' NPV losses), leaves effective debt-relief at a measly EUR30-35bln after bank recaps etc., and as we have pointed out in the past leaves the door open for a meaningful overall reduction in risk exposure to European sovereigns should the CDS market be bypassed entirely (as the second-best protection for risk-averse investors would be an outright reduction in holdings). The GGB Basis (the package of Greek bond plus CDS protection) has been bid up notably in the last month or two suggesting that the banks (who are stuck with this GGB waste on their books) are still willing to sell them as 'cheap' basis packages to hedge funds. This risk transfer only exacerbates the unlikely PSI agreement completion since hedgies who are holding the basis package have no incentive to participate at all.

10Y Italian bonds (BTPs) ended the day at their second-widest closing spread to Bunds ever (at 533bps). Only November 9th saw a wider closing print and of course we saw margin hikes at LCH CC&G. 10Y yields are at 7.16%, their highest since just after Thanksgiving but we do note that 2Y yields have stabilized at around 5.00% yields (having peaked near 8% during thin Thanksgiving trading). It seems apparent that perhaps traders front-running LTRO's impact have compressed the 2s10s term structure but much clearer to us is Mr. Market's obvious desire for more money-printing now as BTPs are pushed to unsustainable levels once again - and the banking-to-sovereign vicious circle transmission of insolvency cranks up.

Peter Tchir submits: "The market is essentially frozen ahead of yet another Merkozy press conference. I have lost count of how many of these press conferences they have had. I haven’t lost count of how many resulted in anything particularly useful – zero is an easy number to remember."

I go schizoid.

We discussed the start of a new breed of bond issuance in Europe earlier in the week. The Ponzi Bond was born and today Banco Espirito Santo, of Portugal, came to the market (was there really an external demand?) and issued EUR1bn of three-year debt guaranteed by none other than the 16.4% yielding-equivalent three-year Portuguese government. Peter Tchir notes that "If the Japanese created the 'zombie' banks, the Europeans are perfecting them." On the bright side, the ECB has saved itself the effort of creating a "bad bank" and has just become one.

We have previously eschewed the constant refrain of any and every talking head who pounds the table on adding to equity risk on the basis of 'low' interest rates - why wouldn't you earn the higher dividend? or how much lower can rates go? However, aside from the drawdown-risk and empirical failure of the stocks-bonds arguments, there are three very pressing reasons currently for reconsidering the status quo of bonds against equities. Volatility in equity markets has been considerably higher than bonds and even at elevated earnings yields, it is no surprise that risk-savvy investors prefer a 'safer' lower-vol yield. Furthermore, when compared to a long-run modeling of business cycle shifts in stocks and high yield credit markets, stocks remain notably expensive to the credit cycle. Simply put, corporate bonds are at best offering better value than stocks if your macro position is bullish (and are forced to put money to work) and at worst suggest being beta-hedged is the best idea (or market-neutral) or in Treasuries.

One of the ironclad assumptions in CDS trading was that recovery assumptions, especially on sovereign bonds, would be 40% of par come hell or high water. This key variable, which drives various other downstream implied data points, was never really touched as most i) had never really experienced a freefall sovereign default and ii) 40% recovery on sovereign bonds seemed more than fair. Obviously with Greek bonds already trading in the 20s this assumption was substantially challenged, although the methodology for all intents and purposes remained at 40%. No more - according to CMA, the default recovery on Greece is now 20%. So how long before both this number is adjusted, before recovery assumptions for all sovereigns are adjusted lower, and before all existing risk model have to be scrapped and redone with this new assumption which would impact how trillions in cash is allocated across the board. Of course, none of this will happen - after all what happens in Greece stays in Greece. In fact since America can decouple from the outside world, it now also appears that Greece can decouple from within the Eurozone, even though it has to be in the eurozone for there to be a Eurozone. We may go as suggesting that the word of the year 2012 will be "decoupling", even though as everyone knows, decoupling does not exist: thank you 60 years of globalization, $100 trillion in cross-held debt, and a $1 quadrillion interlinked derivatives framework.

As seems obvious from the market's reaction over the last week, European problems are not solved by short-term liquidity band-aids. In fact, as Goldman notes this week, the same economic and political risks remain even if some funding relief has been put in place. With sovereigns and financials leading one another to new lows since the LTRO, the negative feedback loops remain in full force. Given the difficulties on the road ahead – and significant ongoing differences across governments on how to resolve them – the risk of political miscalculation or errors is unfortunately still very clear. In the limit, those instabilities could still put the union on a path towards a break-up. Economic weakness in the meantime will intensify the challenges for the weaker sovereigns.

The New Year has ushered in a new pattern for the market - or perhaps has clarified an old one. The last 3 days has seen European credit markets notably underperform equity markets but stage a significant rally around the equity close each day. This rally then flops into US markets. Today was no different from yesterday - EURUSD leaked lower (holding under 1.28 here) all through the European day session - the question is whether we will see the same stability we saw during yesterday's US afternoon session in FX which will enable the equity strength to hold. We suspect not given that broad risk assets (CONTEXT) has notably not participated in the equity markets pull higher so far. At the same time as Europe closed, with financials massively underperforming, US financials were breaking out as XLF went green and BofA broke above $6. Volumes are above yesterday but below Tuesday for this time of day - still notably low on a medium-term basis. TSYs have been very volatile this morning but European sovereigns have been on a one-way path wider all day - closing near their wides. Commodities are lower (USD strength) but Gold is holding up relatively best for now - well above $1600.

Gold's fifth day of price rises is the longest rally we've seen in two months. Concerns about the solvency of European banks and sovereigns is overcoming the 'risk on' appetite of late 2011 and early 2012. The euro has fallen to 1.2840 USD and to €1,256/oz. Growing tensions with Iran including the European Union's preliminary agreement to ban Iranian oil, will fuel gold's  safe haven status for investors. Gold is trying to consolidate above psychological levels of $1,600/oz, £1,000 and €1,200/oz. The 200 day moving average is $1,631.60 which remains resistance. The intraday high hit $1,624.66, was gold's highest price since December 21. We expect gold demand to pick up ahead of the Chinese Lunar New Year, The Year of the Dragon, which begins on January 23.

UPDATE: EFSF said to get EUR4bn of orders for 3Y issue is providing some cover (at what rate? We offer to buy 1tn at 300% yield...)

With plenty of time left until France unleashes its supply (and a dismal consumer confidence print earlier), there is a plethora of notable market moves: Unicredit is halted down 7.9% (seems to be the culprit for the initial risk-off turn in Europe), but Deutsche Bank is down over 5% on liquidity problem rumors, EURUSD traded under 1.2850 at its lowest level since September 2010, 10Y Italian bonds have pushed well above 7% yields and 510bps spread to Bunds as Unemployment rises to 8.6%, Belgian 10Y yields are over 4.5% - highest in 3 weeks, and the rest of European Sovereigns are all leaking wider (near wides of the year). Risk assets (CONTEXT) broadly are under pressure but ES (the S&P 500 e-mini futures contract) is holding off yesterday's early morning lows for now. Commodities are all dropping fast with Gold (actually outperforming in this slide) back at $1615, Oil at $102.50, and Copper approaching $340. Treasuries are bid but trading in line with Bunds' movements so far in general. Some chatter of ECB buying in the last few minutes is stabilizing things a little here.