Sovereigns

While equities are credit closed almost unch from last Friday but at their lows/wides of the week, there was plenty under the surface that clearly signals derisking is rife and discrimination active. HY dispersion and CMBX tranches among others point to some cyclical turning points that do not auger well.

Equities continued their path of convergence to credit's recently weak signals today as we saw the largest compression between debt and equity in two months. Up-in-quality and up-in-capital structure very evident as single-name vol rose notably.

Goldman on Greece: "We do not see a ‘haircut’ as a viable solution, particularly at this juncture, for a number of reasons: 1. The risk of potential financial ramifications (‘domino effects’) seem too large; 2. the level of debt that is sustainable will be guesswork until growth has stabilized and a primary surplus achieved; 3. the incentives for pursuing adjustment (in Greece and elsewhere) may wane if the debt stock is aggressively reduced; 4. finally, private-sector funding is unlikely to flow back at sustainable levels any earlier than under the current approach of conditional financial support....We still do not expect to see sovereign liability management exercises in Ireland and Portugal. Bonds in these two sovereigns will, however, likely remain subject to higher volatility, reflecting decisions taken on Greece in coming weeks, in addition to local events (e.g., the Portuguese elections, approval of the support package, etc.)."

This weekend’s not so secret meeting was the first step towards what could be a rapid end game of Greek debt restructuring. The lenders are unlikely to give Greece the exact same terms as Portugal and seem intent on demanding collateral against future loans. Greece must resist providing collateral since it now realizes it will not be able to pay back all the debt. Greece will push hard for better terms, but if collateral is required, it will be in Greece’s best interest to restructure sooner rather than later. Since the sovereign restructuring process is a negotiation without much ability to use the courts, Greece will find a way to minimize the damage to itself and its citizens while creating a debt structure that is sustainable. This will all be done while retaining the Euro as its currency. Greece may be looking at re-introducing new Drachmas, but this round of restructuring will still be in Euros.

Moody's Investors Service has today placed Greece's B1 local and foreign currency government bond ratings on review for possible downgrade...Moody's says that a multi-notch downgrade is possible if it concludes that there is large risk that Greece's debt metrics are on an unsustainable path. In Moody's view, such conditions would materially increase the risk of debt restructuring over the short to medium term. Under such conditions, euro area policymakers have stated that future loans from the Exchange Stability Mechanism would be extended only if private creditors were to bear some of the losses. If the path of Greek debt-to-GDP were to appear unsustainable, then Greece might itself have an incentive to seek a change in the terms of its debt obligations.

The correlation between the Euro and Spanish credit risk shows that Spain is a domino too big to fail. It is difficult to conceive of a situation where policymakers would say goodbye to their own jobs by permitting a default. These are fundamentals that matter. It is doubtful that policy can actually stave off default, because liquidity provision is the limits of their arsenal. However, liquidity policy can extend kicking the can down the road for a time. The bottom line is cost of funding. Once it reaches a threshold level, there is just too much pain and default becomes the politically acceptable option. We are nowhere near funding costs that in Spanish government bonds. If fact, the relative pricing of synthetic and cash makes for a compelling trade.

Away from the chaos that was the commodities sector today, recent themes in credit, equity, and vol contexts continued to gnaw away at the bullishness of every talking head. Shifts in CMBX tranches point to growing fears of systemic concerns in MBS markets and the up-in-quality trade (or up in capital structure) is in full force.

Equity underperformed credit as HY put in its worst close-to-close widening in two weeks and filled the gappy gamma-driven chasm from last week. CMBX activity starting to signal systemic fears perhaps and a pick up in vol skews (downside protection bid) remain worrisome as so many under-currents indicate less than stellar confidence.

Stocks and spreads lost ground today following an ebullient pre-open and relatively stable start as early up-in-quality themes played out. Breadth in credit was positive but low beta considerably outperformed high beta and there was notable net selling in the secondary corporate bond market especially in the Financials and Consumer NonCyclical sectors.

Two quarters ago it was the muni implosion, last quarter it was sovereigns blowing up (again). Now, it's oil, and the stench of out of control inflation sending precious metals to daily all time record highs, that is keeping Wall Street up at night (yet doing nothing than seemingly providing one after another "buy the dip" opportunity). Every quarter the prevailing investing and spec opinion focuses on one key bogeyman in the wall of worry and refuses to let go, even as, or particularly because of, the Fed, in conjunction with the HFT-controlled market, sells vol to the point where everyone pretends risk is under control. Of course, it isn't, and neither the muni crisis has gone away, nor the threat of sovereign insolvency, nor pervasive inflationary threats (just buy gas in Europe). However, the fact that the Fed systematically takes on one conventional wisdom risk factor after another, and sells into every vol rally, almost certainly via curve exposure, but arguably via equity volatility indices as well (see thought by Artemis Capital on the subject), masks the symptom of an underlying systemic collapse until the market focuses on the next hotspot, which the Fed may or may not be able to resolve. And since we have finally moved on the biggest Fed artifact of all: inflation (and rampant one at that), the Fed's ability to extend and pretend the inevitable correction that needs to happen to push oil down to sub-$100 may be now coming to an end.

While stocks seemed in a world of their own today relative to Treasuries, FX carry, PMs, oil, and even the USD, they managed to make solid gains amid above average volume following a series of dismal macro prints this morning. Credit outperformed but we outline why the velocity of moves may slow a little here.

Stocks ended the day higher, though off their highs, handily outperforming the HY and IG credit markets as the FX and PM markets exploded in the afternoon around Bernanke’s press conference. Divergence between high and low quality credit and equity suggests releveraging is starting to be priced in.

Headlines will crow of the strength in equities and credit today. However, the lack of high beta participation in credit, the underperformance of financials, and the clear continuation of the somewhat more risk-averse up-in-quality trade in credit and equity markets remains a concern.

S&P futures managed to creep up to the pre-USA outlook change lows of early yesterday amid the lowest volume day in over two weeks and while HY and IG credit also managed gains on the day, we note some interesting shifts under the surface that should be considered less sanguine.

For all those who read the initial attempt at damage control from Jan Hatzius over the S&P warning yesterday, this follow up from Goldman's Alec Phillips will come as no surprise. To all those who may have missed the prompt note which came out after Mohamed El-Erian FT oped, the below will still not come as a surprise. Bottom line: "Although the US already appears to be on the edge of AAA territory by rating agency criteria and further deterioration of those measures seems likely, policy credibility is likely to be more important than the level of fiscal ratios at any given time. While enactment of major structural reforms to entitlement programs or the tax code look challenging in the next year, today’s announcement from S&P may on the margin increase the likelihood that Congress enacts one or more fiscal rules along with the increase in the debt limit, which we already viewed as a good possibility. The most likely change would be discretionary spending caps, which could apply for multiple years and would be difficult to undo once put in place. A second possibility is some version of the “failsafe” concept that President Obama proposed last week, which would require automatic reductions in spending and “tax expenditures” if by 2014 the debt to GDP ratio has not yet stabilized and is not projected to decline in the second half of the decade." Of course as those who followed our notes during the S&P conference call, to a rational man, none of the above would come as credible, therefore inevitably pushing the US to an AA handle by 2013. Of course, this little piece of theater is once again very much irrelevant in the grand scheme of things: by 2013 we will have much bigger issues on our hands.