TED Spread

Many have argued that sovereign CDS markets 'caused' the problems in Europe - as opposed to simply 'signaled' what was in fact being hidden by cash market manipulation. But as the IMF notes in a recent paper, there are times when the CDS market leads the cash bond market and other times when it lags. But as far as looking at risk in Europe and the US, based on a wonderful model that uses Markov-switching to predict what the probability of the world being in a low-risk or high-risk state, we are as 'low risk' as we have been since the crisis began. Each time that level of complacency was reached before, equity markets have rapidly sold off. What is perhaps most notable is the systemic compression of every risk indicator, first VIX (Kevin Henry and the fungible excess reserves of every prime dealer whale), then the liquid SovX index (via Greece CDS auction uncertainty and 'naked' short bans), then the Euro TED Spread (via LTRO), then individual Sovereign CDS (via Draghi's 'promise'). The result, the 'free-market' signal of risk is non-existent.

It is hard enough to determine what, when and how to invest even with solid data. We live in an unpredictable and chaotic world, and the last thing that investors need is misinformation and distortions. That is why the LIBOR manipulation scandal is so infuriating; as banks skewed the figures, they skewed entire marketplaces. The level of economic distortion is incalculable — as LIBOR is used to price hundreds of trillions of assets, the effects cascaded across the entire financial system and the wider world. An unquantifiable number of good trades were made bad, and vice verse. Yet in truth we should not expect anything else from a self-reported system like LIBOR. Without real checks and balances to make sure that the data is sturdy, data should be treated as completely unreliable.

Unsurprisingly, it is emerging that many more self-reported figures may have been skewed by self-reporting bullshittery.

Many Other Core Economic Figures Manipulated As Well

Fed Chairman Bernanke should be impeached if he does not restore Fed surveillance over primary dealers immediately.

While the Lieborgate scandal gathers steam not so much because of people's comprehension of just what is at stake here (nothing less than the fair value of $350 trillion in interest-rate sensitive products as explained in February), but simply courtesy of several very vivid emails which mention expensive bottles of champagne, once again proving that when it comes to interacting with the outside world, banks see nothing but rows of clueless muppets until caught red-handed (at which point they use big words, and speak confidently), the BBC's Robert Peston brings an unexpected actor into the fray: the English Central Bank and specifically Paul Tucker, the man who, unless Goldman's-cum-Canada's Mark Carney or Goldman's Jim O'Neill step up, will replace Mervyn King as head of the BOE.

Insolvency will keep dragging the Euro-Area economy down until sovereign and bank balance sheets are repaired, but as Lombard Street Research  points out: eliminating the Ponzi debt without fracturing the entire credit system is impossible. The Lehman default occurred 13 months after the US TED spread crossed 100 basis points. The European equivalent crossed 100 basis points in September 2011, so its banking crisis would occur this autumn if a year or so is a normal incubation period. A Greek or any other significant default will precipitate a European banking crisis in the foreseeable future. Markets are already speculating on Portuguese negotiations for haircuts and Ireland can’t be far behind and the contagion to US (and global) banking systems is inevitable given counterparty risks, debt loads (and refi needs), and capital requirements (no matter how well hidden by MtM math). The contagion will likely show up as a risk premium in the credit markets initially as we suggest the recent underperformance of both US and European bank credit relative to stocks is a canary to keep an eye on.

The details of the European liquidity crisis are generally reported, but for some reason no media source wants to pull the pieces together so everyone can see the magnitude and futility of the crisis. A growing Collateral Contagion is being shrouded in the apparent belief that the solution to the European Financial and Banking crisis is a grand change in Treaty governance. Obviously the European Central Bank (ECB) was well aware of the reality, when it was forced to deploy a historic and unprecedented LTRO (Long Term Purchase Operations) on Wednesday December 21, 2011. 560 banks desperately and immediately grabbed what they could, to the tune of €489B. The LTRO bought the EU private banks some time. It did nothing to solve the EU Sovereign Debt Crisis. Gordon T Long describes 13 symptoms of the stark reality that forced the ECB to offer unprecedented three year loans at absurd rates and most alarmingly, the acceptance of collateral that no other financial institutions will accept. The ECB has sacrificed its balance sheet in yet another EU "kick at the can". He argues correctly that the problem short term is a shortage of real collateral and that US dollar cash, versus 'encumbered' cash flow, is now king.

So I don’t have a good answer for the fundamental problem of tails. But there is an observed regularity in life reflected in the sayings “it is always darkest before dawn” and “where the danger grows, so grows the saving power” to quote Holderlin. And when no one can know the future, and the mechanism governing the future is unstable, anticipation of heightened risk premia warrants a barbell. In financial markets, extreme meltdowns are met by extreme policy reactions. Practically stated, it seems best to play center bets when others do not, and the tails when others do not. After markets price in heightened risk, actively manage the position by lowering exposure to the big gain leg. Move the proceeds to the center or double down on the other tail. Perhaps this is how one should manage tails. Given that the known categories of human experience do not provide adequate predictions, luck dominates control. Nobody has it all figured out. Even when you think you have it all figured out, everything blows up in your face again. We'll never figure it all out. Nobody can predict the future, and we don't have good enough imaginations to dream up every contingency.

Given pressure on the central bank continues to build, today the ECB is widely expected to cut the benchmark borrowing rate by another 25bps, with an outside chance that members will push for a 50bps cut. Apart from cutting the interest rate, press reports indicated that some members of the ECB governing council have been debating on providing bank loans lasting up to two or three years. An alternative solution would be to broaden the range of assets banks can use as collateral to obtain funds from the central bank. Highlighting deteriorating condition in money markets in Europe is the last data from the Bank of Italy, which showed that funding from the ECB to Italian banks rose sharply to EUR 153.2bln in November from EUR 111.3bln in October. In addition to that, the head of UniCredit has urged the ECB to increase access to ECB borrowing for Italian banks, while the Bank of Italy launched twice-daily overnight liquidity auctions to boost access to capital. Still, despite the persistent widening in the 3-month Euribor-OIS spread and the TED spread, the 3-month EUR/USD cross-currency basis swap has edge back towards -100bps mark, that’s after trading -152bps only few weeks ago (Note: post Lehman Brothers collapse in October 2008 saw 3-month EUR/USD cross-currency basis swap trade at -215bps).

A week earlier, we presented Moody's proposed take on which banks are at risk of failing Europe's Stress Test version 2 (which is nothing but another huge waste of time), the results of which are due to be announced later today. The event will likely be market moving although we expect it will be at most 3 months before a bank that passed the test fails in spectacular fashion, laying the groundwork for next year's Stress Test part 3: the most stringent of all, and so forth. Below is RanSquawk's comprehensive take on what to expect from today's announcement. "Last years stress test results indicated that despite a modest capital shortfall of EUR 3.5bln, overall, the EU banking system was well capitalised and that there was no major risk stemming from sovereign exposure. However, policy makers suffered a massive credibility blow after Ireland was forced to seek monetary assistance after Irish banks lost access to capital markets following revelations of massive financing gaps which in turn endangered the country itself. As such, this year’s stress tests, which have been carried out on 90 banks, have been designed to be more stringent in nature and should provide market participants with some degree of relief."

All the talk about a dollar currency crisis is getting ahead of itself. Quoting Mises won’t make it happen overnight. It takes years, even decades for a reserve currency to dissipate. Instead of wholesale collapse, the most likely outcome is a steady decline in the dollar over an extended period of time. Of course there is a tail possibility of a collapse, and that is why hedges exist. But the high likelihood trend is persistent policy action to drive the dollar lower with respect the United States trading partners’ currencies, combined with a decline in the dollar’s use as a vehicle currency. This means serious dollar weakness for the next three years (or more), but not collapse.

Something interesting happened earlier today in the much underappreciated eurodollar market. As the Bloomberg chart below shows, just before noon, someone aggressively sold 100,000 contracts of the March 90 day Eurodollar future. Why is this notable? Because at a contract size of $1MM per, this is effectively a $100 billion notional bet that the eurodollar price will decline over the next month. What does this mean in simple terms is that since the eurodollar price is determined as the difference for par in 3 month Libor, someone just put a very sizable bet (probably one of the biggest single Euro$ blocks traded in recent months) that Libor is due for a jump. Now Libor, traditional economists will say, is a function of monetary policy and a reflection of the short-end of the curve (remember the now forgotten TED Spread?) which is driven almost exclusively by the Fed Funds rate. It is also driven by exogenous risks to the credit system such as what happened when Lehman blew up and Libor hit the stratosphere. In other words someone just put down up to $100 million in capital at risk ($82.5 million to be specific) that over the next month (contract expiration assuming no roll, is March 14, 2011) we will see one of two things: a bullish economic development: a rate hike (or expectations thereof) in the US, or to a lesser extent the ECB, or a very bearish one, such as a bank collapse, along the lines of what the recently disclosed surge in MLF borrowings may be predicting- recall what happened to Libor when Lehman fell... In other words your traditional barbell trade. Either way, should this single traded be imitated in the next week, one can bet that the Eurodollar trade will suddenly become far more popular.

Spreads compressed for the second day in a row modestly outperforming stocks as the big volume day from yesterday saw very little activity today as the path of least resistance appears higher for now. Intraday ranges today in credit were very narrow as what two-way flow there was seemed more concentrated in HY than IG for a change...Our super-short-term trading pivot is still long credit (from 111.5bps and 593bps for IG and HY respectively), stops never hit today and we would inch our stop to 110bps in IG and 590bps in HY but we get the sense that tomorrow's action will be early and extreme based on the NFP print. 112.25bps and 600bps are entry levels for the short credit should we run so not much room given the recent vol - and anxiety levels high into a long weekend. HY, IG, and the S&P all now closed above their 50-day averages so that offers some support for now but has offered little critical insight in recent weeks.

Spreads closed marginally wider, at the worst levels of the day, after an anemic volume day that only picked up in activity when we weakened. Overnight angst from Australia combined with some weakness in EU data was marginally trumped early on by M&A chatter and headline spin on US ECO data but further evidence of a deflationary view of the world (NSC 100Y issue) seemed to provide some downward pressure and despite valiant attempts to steepen the curve or drive AUDJPY up, stocks ended at their lows of the day as did spreads at their wides.

We have had a number of clients asking about our views on the forthcoming GM IPO. Suffice it to say, and in the interests of brevity, we are not overly impressed and worry about this on many fronts as anything but a flipper's fantasy (drop us a line for somewhat more coherent thoughts). Most notably we have noticed something rather fascinating in the Auto sector. The relationship between GM's 2016 bonds and the Ford Equity price has been amazingly (and we mean incredibly) consistent for many months now - a simple arb at around 2.5x Ford's stock price explains huge amounts of variance in the GM bond price and we suggest tracking this going into the IPO for any signs of a preference. One we would expect is selling of Ford to buy into the GM IPO in hopes of flipping soon after and still leaving the manager equally exposed to the Auto sector - this would also be interesting as the GM bonds have residual ownership in the new GM and may be a decent hedge here should the deal be 'better' than many expected. Just thinking out loud on this but we will keep an eye on it.

Spreads tightened across Europe and the US today with indices outperforming intrinsics thanks to rumors of JPY intervention and headlines proclaiming European sovereign fears over, the US recovery still in place, a 'coming' M&A boom, and the start of the Fed POMO encouraging risk-taking. The thinness of markets (given the summer slump and general lack of desire) enabled modest re-risking to move markets rapidly at the index levels across sovereigns, financials, and corporates in the US and Europe. The completion of the Irish and Spanish debt issues today seemed in and of itself enough to get everyone going (despite notably higher yields in the former and suspected 'help' from the ECB in both) and despite a major drop in German confidence, bond spreads and CDS compressed relative to Bunds with a feeling of squeeze to the move in SovX today - 9bps tighter vs 6bps intrinsics and leaving the index notably rich to intrinsics overall.