As EURUSD leaks very gently lower into the new year (but stocks popped excitedly across quiet European markets that lacked a bond market supervisor to keep them honest), we thought it might be interesting to look at the relative strength of the Euro against six different measures. From FX option risk-reversals to ECB's European Bank Lending statistics, QE and sovereign risk relationships to Fed/ECB balance sheet dynamics, and finally from futures commitment of traders data to EUR-USD swap spread frameworks, the results are unsurprisingly mixed with a bias towards EUR weakness. Between the European auctions (and redemptions) of the next two weeks, and the FOMC meeting on the 24-25th January, we face quite a rude awakening from the low volume holiday week malaise.
UPDATE: Spanish bonds are leaking wider after the defiict projection looks set to be significantly worse than previously expected.
Something strange is happening in European risk markets this week. While that sentence is entirely 'normal' for what has become a diverging/converging flip-flopping correlation microstructure but the clear trend this week has been European Sovereign derisking and European Stock rerisking. The Bloomberg 500 index (that tracks a broad swathe of European stocks) is up 0.75% from Christmas Eve (and 1.6% from yesterday's lows) while 10Y sovereign spreads are wider by 10 to 30bps in the same period. France stands out as one of the worst performers - more than 25bps wider this week alone. Only Spain is notably improved on the week (-17bps) but all 10Y sovereigns are well off their best levels as stocks make new highs. Whether this is a front-run on asset rotation into the new year or expectations of the same risk-on ramp-job we saw on the first trading of this year is unclear - we do remind those front-runners that mutual fund cash levels are significantly lower this year than last. It is clear that yet another 'sensible' correlation (such as BTPs to equities) has broken but when volumes return and the reality of the huge supply calendar we face in the next month alone sinks in, perhaps equity ebullience will pull to bond bereavement. If stocks are reacting to a quasi-QE from the ECB, why wouldn't sovereigns who are the direct beneficiaries in that surreal LTRO-driven-carry trade?
Risk markets are tearing higher globally with equities, commodities, and credit all considerably higher. Equities and CONTEXT are back in line as this is a very systemic shift up as the dollar tanks and TSY yield surge. US equities are back to 11/18 levels but are stalling out a little here as the initial spike wears off - whether this liquidity surge fixes the insolvency crisis is the question it seems markets are considering now that they have had some time to think (and squeeze). Silver and Copper seem the largest movers for now along with AUD relatively speaking as most equity and credit assets are back to 11/18 levels. We do note that while sovereign spreads in Europe are narrower, the moves are not dramatic and in some cases are actually deteriorating still.
European sovereign credit curves are bear flattening (inverting wider) in almost all cases as short-dated yields breaks to new records in several names. At the same time, European credit is breaking to new lows in Corporates and financials with Subordinated financials underperforming. Somewhat strangely - though not exactly surprising given the market's behavior in the last few weeks - European equities are holding up as they ignore the reality priced into credit. It seems equities see the light at the end of the tunnel, but credit knows its an oncoming train. US markets are in sync with the broad risk-asset basket (CONTEXT) for now but correlations are tending to be much lower than on average so far.
Expectations of a grand plan may be on hold for a little while as the reality sets in for traders and asset managers alike this morning. Despite EUR strength, back above and holding a 1.40 handle, risk assets in general are less excited. European credit indices are opening tighter, as we would expect with higher beta outperforming. XOver -32bps and SENFIN -16bps may seem impressive but there is little follow-through in the underlying credits with most of the major European financials at best 5bps tighter (and notably BARC and LLOYD are wider). SovX is tighter by 14bps while underlying single-name Western European sovereigns are generally tighter with PIIGS unsurprisingly outperforming (though we have seen very few runs on Greece yet leaving it unch - which makes sense given the uncertainty). CEEMEA sovereigns are wider though (even if the index is compressing) as hedge unwinds seem the raison d'etre of trading desks today. Most importantly, the yield of EFSF bonds is rising (as we discussed yesterday), with the 2021s breaking back below Par. This makes sense as the sovereign risks are transferred to the supra-national EFSF entity and concentration risks are increased.
FT Reports Europe To Sacrifice Its Banks To Bailout Sovereigns - Under €100 Billion In Bank Recap Funding AvailableSubmitted by Tyler Durden on 10/19/2011 15:22 -0400
It's 3pm: do you know where you last hour of trading bailout rumor is? Today, the Guardian passes the baton back to the FT, which however has released a report which when digested will be very negative for the zEURo.qq. It appears that in order to accommodate more funds for sovereign bailouts under the total max EFSF guarantee cap, as reported on several occasions yesterday by Zero Hedge, only €100 billion will be set aside for bank recapatialization. There is a problem with this number: it is predicated on the European Banking Authority's estimates of capital shortfalls of between €70-90 billion, the is the same EBA which 4 months ago said Dexia was in sterling health when it passed the 2nd Stress Test in pole position. As a reminder, Goldman predicted a €1 trillion capital shortfall, while Credit Suisse said €400 billion. No matter: the EU will come out with a number from its lower colon, just to make the residual maximum sovereign debt "guarantee" notional appear that much bigger. Too bad, however, that in the process it will once again crush Europe's banks which the market will suspect, rightfully so, that they are undercapitalized even post the recap, anywhere between 90% and 75% and will have to accelerate their asset liquidations to fund themselves one more day in lieu of a functioning interbank liquidity market. And so the risk flaring will shift from Europe's sovereign to Europe's banks, and their main proxy in the US - none other than Morgan Stanley which repeatedly refuted it has any exposure to France... but said nothing about its gross (gross because counterparties will blow up fast and furious) to French banks. End result: this is very bad for Europe because it means they have finally done the math and realize that to get the €2 trillion or so in EFSF insured capital they have to sacrifice their banks. Alas, there is no outcome that saves both the banks, and guarantees future European sovereign issuance under the currently contemplated structure. None.
Regardless whether one or more of the Big 3 agencies would deal a credit downgrade to the U.S., the CDS market has already spoken.
"In the depths of the 2008 crisis it was the governments that stepped in to provide a guarantee on financial assets. It was the governments that backed our savings accounts, money market funds, day-to-day business banking accounts, as well as debt issued by US banks. But what happens when confidence in the government guarantee begins to erode? We’ve seen what happened to Greece. Leverage inherent in the banking system elevated a bank run, equivalent to a mere 3.6 percent of deposits, into another full blown banking crisis. In our view it’s time for investors to acknowledge sovereign risk. The ratings agencies can opine all they want, but it seems clear to us that the only true AAA asset to protect your wealth is gold. " Eric Sprott
The most recent broker to realize that private risk does not exist as a result of global moral hazard is Deutsche Bank, which is actively promoting ta long risk/short sovereign CDS trade. That is happening as IG13 trades at its all time record tights of 77 bps. In other words, buying an index of 125 investment grade credit provides less than 1% of incremental risk return. Pretty soon the ABX trade will be buying IG. Until then, however, the only risk continues being that of sovereign balance sheet, courtesy of onboarding of virtually all private sector risk at the Central Bank and via other backstop mechanisms.