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!
While not to the level of US sophistry, European equities enjoyed the day driven by further compression in Europe's VIX. The big winners were Spanish and Italian stocks (now up 2% on the week) as Europe's VIX drops to one-month lows. However, the correlated risk-on awesomeness did not flop over into anything but the high-beta nominal prices of equities. EURUSD slid all day (with a slight bump into the close); Italian and Spanish sovereigns bled wider all day (with a slight give back in the latter part); and corporate and financial credit stayed wide as stocks soared. With EUR weakness (remember the Fed/ECB framework), we wonder if European equity strength is merely rotation from US to Europe? Or is it merely front-running the sell-the-news event at the ECB tomorrow?
The epic farce that is the opaque balance sheets of European banks, sovereigns, NCBs, and the ECB, continues to occur under our very eyes. Only when one sniffs below the headlines is the truth exposed with no apology or recognition of 'cheating' anywhere. To wit, following November's farcical over-payment on collateral by the ECB to Spanish banks (that was quietly brushed under the carpet by Draghi et al.), Germany's Die Welt am Sonntag has found that the Bank of France overpaid up to EUR550mm ($720mm) on its short-term paper financing to six French and Italian banks. The reason - incorrect evaluation of the crappy collateral (i.e. the NCB not taking a big enough haircut for risk purposes) on 113 separate occasions. The problem lies in the increasingly poor quality of collateral the CBs are willing to accept (and the illiquidity of the underlying markets) - as higher quality collateral disappears; which leaves the central bankers clearly out of depth when it comes to 'risk management', no matter how many times Draghi tells us this week.
It has been an 'epic' week in European sovereign bonds. Whether it was returning traders or pension fund asset managers forced to reach-around, Spain and Italy 10Y spreads are 44bps tighter this week and Portugal a ridiculous 92bps (on what!!? - US fiscal cliff?), though Spain and Italy stabilized today. Broad European equities surged the most during the first 3-days of 2013 in five months (with Spain and Italy up 3.6-4%) but today saw credit notably divergent from the ongoing exuberance in stocks. EURUSD gave up some significant strength this week as repatriation flows reversed but Europe's VIX has been crushed just like in the US. Europe's Composite PMI is still below (though modestly rising) but it is the stagnation of the New Orders sub-index that should be most concerning - perhaps that is what credit is anticipating.
There is much debate whether when it comes to the total notional size of outstanding derivatives, it is the gross notional that matters (roughly $600 trillion), or the amount which takes out biletaral netting and other offsetting positions (much lower). We explained previously how gross is irrelevant... until it is, i.e. until there is a breach in the counterparty chain and suddenly all net becomes gross (as in the case of the Lehman bankruptcy), such as during a financial crisis, i.e., the only time when gross derivative exposure becomes material (er, by definition). But a bigger question is what is the actual collateral backing this gargantuan market which is about 10 times greater than the world's combined GDP, because as the "derivative" name implies all this exposure is backed on some dedicated, real assets, somewhere. Luckily, the IMF recently released a discussion note titled "Shadow Banking: Economics and Policy" where quietly hidden in one of the appendices it answers precisely this critical question. The bottom line: $600 trillion in gross notional derivatives backed by a tiny $600 billion in real assets: a whopping 0.1% margin requirement! Surely nothing can possibly go wrong with this amount of unprecedented 1000x systemic leverage.
Presenting Dave Collum's now ubiquitous and all-encompassing annual review of markets and much, much more. From Baptists, Bankers, and Bootleggers to Capitalism, Corporate Debt, Government Corruption, and the Constitution, Dave provides a one-stop-shop summary of everything relevant this year (and how it will affect next year and beyond).
Bingo Bongo, Good News hailing, Sleepily digesting in the South to end Stuck… What an uninspiring week… Felt slow as a Sunday Afternoon– for 5 days in a row… The only thing that wasn’t lazy and laid back was the EUR.
The euro has been the strongest currency this week. At pixel time it is up about 1.2%. The Dow Jones Stoxx 600 made new 18-month highs earlier in the week before consolidating in the second half of the week. Bond markets were mostly lower, though Greece, for obvious reasons, Spain and Portugal were exceptions to the generalization.
Since the crisis first began in 2006, developed world equities are still lower, real GDP has struggled to grow above its pre-crisis peak in most countries, core bond yields are sharply lower with peripheral yields higher and with credit yields generally performing well albeit it with fairly extreme volatility. Credit has been helped by the fact that the authorities way of dealing with this crisis to date has been through money printing and liquidity facilities to help prevent mass defaults which, as is is clear in the chart below, has led to a weakening in the normal relationship between GDP and defaults. Just as one of the features of the last 20 years in Japan’s post-bubble adjustment and lost growth period is that defaults have remained very low; it appears as long as money printing props up the debt market, defaults are likely to be much lower than the underlying economic environment suggests they should be. However, as we noted previously, the mark-to-market volatility on the way may just become too much to bear for all but the most long-term bond rotators.