Yield Curve

You may recall that one of the “tricks of the trade” was the use of people in the audience. They stood up and claimed that they had taken the magic potion and were cured of rheumatism, arthritis, cancer and that ninety year old Uncle Elijah and been able to throw away his cane after imbibing the stuff. This may remind you of what is going on in Europe presently as politicians from each and every nation claim that the newest European snake oil will cure the ailments of Europe for all time, for forever and for always. Yes, well, the printing of money has a cost besides the paper and brandishing yourself as the next new Savior of Europe is the trick of Kings and countless empires on the Continent and yet here we are after being saved so many times in the past. So I will tell you this; you produce the Vampire and then I will buy the garlic and we’ll leave it at that!

There has been much confusion over last week's remarks by Mario Draghi, with the prevailing narrative being that the market first got what Draghi meant wrong (when it plunged), then right (when it soared). The confusion is further granulated by attempts to explain what was merely a desperate attempt at delaying a decision for action, which was inevitable considering the now open opposition by Buba's Weidmann, into a formal and planned plotline: "Inverse Twist" or other such technical jargon is what we have seen floating around. The reality is that, just like all other central bankers, Draghi did what he does best: use big words and threats of action in hope it will buy him a few extra days of time. The reality is also that, just like when the LTRO was announced, the market did get it right initially, when peripheral bonds plunged, and got it wrong over the subsequent 3 months when bond prices rose, only to collapse to new lows (and in the case of Spain - record high yields as of two weeks ago). Back then, the ECB merely bought a few months time with its transitory intervention. This time it has at best bought a few days with the lack of any actual action. And yet, Draghi did leave a way out, for at least another brief respite (where unless Europe expands the available bailout machinery yet again, the respite will have an even briefer half life than that from the LTROs). The way out is simple, and in order to avoid any confusion, we will use an allegory from the movie Batman: Spain and Italy can be saved. But first they must be destroyed.

The short-end of the Spanish curve is collapsing rapidly, and at last check was tighter by nearly 70 bps even with the 10 Year essentially unchanged, for one simple reason: more hope and prayer. This time we have completely unconfirmed and unverified talk that either the ECB will hold another conference, or that Spain will finally request a full blown bailout. Neither is likely to happen, certainly not on a Friday. In other words, the rapid steepening of the curve on more "talking" will not last. What will however, is increasingly negative sentiment toward the longer end of peripheral country bond curves. To wit, here comes JPM recommending a new short position in Spanish 10 Years. Below is the full text of JPM's Gianluca Sanford saying to short the Spanish 10 Year until it touched 7.75%. Why 7.75%? Because that is the level at which Rajoy will have no choice but to demand a bailout. The irony is that the market, by frontrunning politicians, continues to make the required political decision impossible - welcome to the new normal. Paradoxically, only after the market has fully abandoned hope, can the desired outcome happen. But it will take the broken market a few more weeks to figure this out.

Summary of what has been said so far: Nothing, just as we said last week. Draghi basically repeated the June 29 summit bottom line that the EFSF should buy PIIGS bonds, the ECB "May" act, which means Germany is still not on board, and that after talking markets up by 5%, he has delivered nothing but a delay. This is a huge blow to his and the ECB's credibility.

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With speculation ripe out of everyone from Reuters to the FT about what Draghi may or may not say, with or without Germany's blessing, the best at this point is just to hand over the microphone to the former Goldmanite. Here is the live webcast of Draghi's press conference. Pay attention as a word out of place will send the EURUSD plunging by 200 pips. Or soaring.

The European Equities are in positive territory at the North American cross over. The CAC-40 was the initial outperformer following SocGen’s earnings. Despite reporting a drop of more than 40% in Q2 net profits year over year, the co. beat analyst expectations on Q2 CIB net and announced the completion of its cost cutting measures and traded up to highs of EUR18.57, though shares have since pulled back into negative territory. The FTSE-100 now leads the way despite a sharp decline in July’s UK Manufacturing PMI, which came in at 45.5, the lowest reading since May 2009. This saw GBP/USD also tumble to intra-day lows of 1.5619, though the pair has since stabilised around 1.5650. Elsewhere, comments from ECB’s Weidmann that “governments overestimate ECB possibilities”, going against general consensus and speculation that the ECB will announce further stimulus measures at tomorrow’s meeting, provoked a sharp drop in the riskier assets and the Bund to gain 8 ticks, though as it came to light that these comments were taken from an article published on June 29th, the move was pared.

While in principle central banks around the world can talk up the market to infinity or until the last short has covered without ever committing to any action (obviously at some point long before that reality will take over and the fact that revenues and earnings are collapsing as stock prices are soaring will finally be grasped by every marginal buyer, but that is irrelevant for this thought experiment) the reality is that absent more unsterilized reserves entering the cash starved banking system, whose earnings absent such accounting gimmicks as loan loss reserve release and DVA, are the worst they have been in years, the banks will wither and die. Recall that the $1.6 trillion or so in excess reserves are currently used by banks mostly as window dressing to cover up capital deficiencies masked in the form of asset purchases, subsequently repoed out. Which is why central banks would certainly prefer to just talk the talk (ref: Draghi et al), private banks demand that they actually walk the walk, and the sooner the better. One such bank, which has the largest legacy liabilities and non-performing loans courtesy of its idiotic purchase of that epic housing scam factory Countrywide, is Bank of America. Which is why it is not at all surprising that just that bank has come out with a report titled "Shipwrecked" in which it says that not only will (or maybe should is the right word) launch QE3 immediately, but the QE will be bigger than expected, but as warned elsewhere, will be "much less effective than QE1/QE2, both in terms of boosting risky assets and stimulating the economy."

"This market isn't real. The two percent on the ten-year, the ninety basis points on the five-year, thirty basis points on a one-year – those are medicated, pegged rates created by the Fed and which fast-money traders trade against as long as they are confident the Fed can keep the whole market rigged. Nobody in their right mind wants to own the ten-year bond at a two percent interest rate. But they're doing it because they can borrow overnight money for free, ten basis points, put it on repo, collect 190 basis points a spread, and laugh all the way to the bank. And they will keep laughing all the way to the bank on Wall Street until they lose confidence in the Fed's ability to keep the yield curve pegged where it is today. If the bond ever starts falling in price, they unwind the carry trade. Then you get a message, "Do not pass go." Sell your bonds, unwind your overnight debt, your repo positions. And the system then begins to contract... The Fed has destroyed the money market. It has destroyed the capital markets. They have something that you can see on the screen called an "interest rate." That isn't a market price of money or a market price of five-year debt capital. That is an administered price that the Fed has set and that every trader watches by the minute to make sure that he's still in a positive spread. And you can't have capitalism if the capital markets are dead, if the capital markets are simply a branch office – branch casino – of the central bank. That's essentially what we have today."

UPDATE: *ITALIAN TWO-YR NOTE YIELD RISES ABOVE 5%, 1ST TIME SINCE JAN 11

While every wannabe bond-trader and macro-strategist can quote 10Y Spanish yields, and maybe even knows what the front-end of the Spanish yield curve is doing (and why), there are three very significant events occurring in the Spanish sovereign credit market. First is the inversion of the 5s10s curve (5Y yields were above 10Y yields at the open today); second is the velocity with which 2s10s and 5s10s have plunged suggesting a total collapse in confidence of short-term sustainability; and perhaps most critically, third is the record wide spread between the bond's spread and the CDS (the so-called 'basis') which suggests market participants have regime-shifted Spain into imminent PSI territory (a la Greece and Portugal) as opposed to 'still rescuable' a la Italy for now. As we pointed out earlier, there is little that can be done (or is willing to be done) in the short-term, and the inevitability of a full-scale TROIKA program request is increasingly priced into credit markets (though its implicatios are not in equities of course).

Just as the summer finally arrives in Northern Europe, the Eurozone crisis is heating up once again. With an increasingly flat (heading to inversion) yield curve, and spreads at record wides,  Spain appears to be in a downward spiral of market turmoil that might require a full-fledged TROIKA bail out. However, as UBS points out, rather than taking the country off the market, the program would have to allow Spain to keep borrowing from private investors. Any bail out of Spain would have to be designed in a way that would also be applicable to Italy. Spain has been the most recent crisis focus, and looks to intensify further with nothing immediately in sight that could reverse the trend. We, like UBS, have argued for some time that a full-fledged TROIKA program will ultimately be unavoidable and the following six reasons briefly explain why anything else is a pipe-dream - as we remember Draghi's recent shift: "creditors should be part of the solution of the crisis. It is a matter of limiting the involvement of taxpayers. They have already paid a great deal."

While Monti claims there is no need for an emergency summit and Spain and Italy ban short-sellers (but not long-sellers yet), Europe's Dow-equivalent is down around 2.5%. Interestingly Italy and Spain 'bounced' off ugly lows intraday (which we are sure Monti/Rajoy are patting themselves on the back briefly) but France's CAC40 and Germany's DAX were sold hard - both down around 3% (as proxies as much as contagion-gatherers). More critically, equities are catching down to European credit markets. European financial credit is now notably wider than pre-Summit levels but it is the front-end of the Spanish and Italian sovereign yield curves that has been absolutely monkey-hammered in the last few days. Spain 2Y is now at 16 year highs in yield (biggest 1- and 2-day jumps in over two years) but all-time record wides in spread as we await for the ultimate death cross of inversion to signal the approaching endgame. EURUSD hovered around 1.2100 (down around 50 pips from Friday) and while oil prices slumped, Brent priced in EUR remains above its levels 2 months ago. Meanwhile, Swiss 2Y rates are at a new record low of -44.4bps, German 2Y same at -8bp, and Denmark remains -31bps - though we do note some of the other higher quality 2Ys leaking a little higher in yield such as Austria and France.

While it seemed somewhat inevitable given the trend, the dismal reality from Europe has sent investors scurrying for the 'safety' of the US Treasuries overnight. The entire yield curve has fallen to all-time record lows with 10Y trading below 1.40% and 30Y below 2.48%. 7Y - the seeming cusp of Twist - is below 90bps now and 2Y below 20bps. The shortest-dated T-Bills still trade around 4-6bps (as opposed to the deeply negative rates in Switzerland and Germany this morning with FX risk premia expectations, and Twist+, affecting this differential). Not a good sign at all - and definitely not yield curve movements on the basis of renewed QE as we see stock futures plunging to the old new reality (as those pushing dividend yields as the 'obvious move here may note that since Friday's highs, you've lost half a year's dividend as equity capital has depreciated 2%). Perhaps the sub-1% 10Y we noted yesterday is not such a crazy idea after all...

There is no mystery to the “headwinds” that continue to plague and mystify monetary policymakers.  The global economy is not pulled into re-recession by some unseen magical force, conspiring against the good-natured efforts of central bankers.  Instead, the very thing central banks aspire to is the exact poison that alludes their attention.  Conventional economics will continue to believe and empirically “prove” that the theory of the neutrality of money is valid, giving them, in their minds, unrestricted ability to intervene and manipulate over any short-term period (though it is getting harder to argue that these emergency measures are “short-term” nearly five years into their continued existence).  The occurrence of panic in 2008 and the unresolved and unremoved barriers to recovery in the years since, however, fully attest to nonneutrality, an ongoing form of empirical proof that their models will never be able to refute.  And we are all condemned by it.

What's Ben gonna do?

Two years ago, in January 2010, Zero Hedge wrote "This Is The Government: Your Legal Right To Redeem Your Money Market Account Has Been Denied" which became one of our most read stories of the year. The reason? Perhaps something to do with an implicit attempt at capital controls by the government on one of the primary forms of cash aggregation available: $2.7 trillion in US money market funds. The proximal catalyst back then were new proposed regulations seeking to pull one of these three core pillars (these being no volatility, instantaneous liquidity, and redeemability) from the foundation of the entire money market industry, by changing the primary assumptions of the key Money Market Rule 2a-7. A key proposal would give money market fund managers the option to "suspend redemptions to allow for the orderly liquidation of fund assets." In other words: an attempt to prevent money market runs (the same thing that crushed Lehman when the Reserve Fund broke the buck). This idea, which previously had been implicitly backed by the all important Group of 30 which is basically the shadow central planners of the world (don't believe us? check out the roster of current members), did not get too far, and was quickly forgotten. Until today, when the New York Fed decided to bring it back from the dead by publishing "The Minimum Balance At Risk: A Proposal to Mitigate the Systemic Risks Posed by Money Market FUnds". Now it is well known that any attempt to prevent a bank runs achieves nothing but merely accelerating just that (as Europe recently learned). But this coming from central planners - who never can accurately predict a rational response - is not surprising. What is surprising is that this proposal is reincarnated now. The question becomes: why now? What does the Fed know about market liquidity conditions that it does not want to share, and more importantly, is the Fed seeing a rapid deterioration in liquidity conditions in the future, that may and/or will prompt retail investors to pull their money in another Lehman-like bank run repeat?

The world's largest hedge fund is not as sanguine about the hope that remains in the markets today. The firm's founder, Ray Dalio, who has written extensively on the good, bad, and ugly of deleveragings, sounds a rather concerned note in his latest quarterly letter to investors as the "developed world remains mired in the deleveraging phase of the long-term debt cycle" and has spread to the emerging world "through diminished capital flows which have weakened their growth rates and undermined asset prices". Between China, Europe, and the US, which he discusses in detail, he sees the lack of global private sector credit creation leaving the world's economies highly reliant on government support through monetary and fiscal stimulation. The breadth of this slowdown creates a dangerous dynamic because, given the inter-connectedness of economies and capital flows, one country's decline tends to reinforce another's, making a self-reinforcing global decline more likely and a reversal more difficult to produce. After discounting a relatively imminent return to normalcy in early 2011, markets are now pricing in a meaningful deleveraging for an extended period of time, including negative real earnings growth, negative real yields, high defaults and sustained lower levels of commodity prices. Lastly he believes the common-wisdom - that the Germans and the ECB will save the day - is misplaced.