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On Sounding Like A Broken European Record
From Peter Tchir of TF Market Advisors
At the risk of sounding like a broken record...
Europe remains extremely weak. At least the credit markets.
Short dated Greek bonds remain weak. They have not bounced. You can buy the 2 year bond at 50. With a 4% coupon, that is 8% current yield with the chance to double in price in 2 years. Clearly the bond market is expecting a default or massive write-offs for Greek debt. I have heard the argument that equities must be pricing that in at this stage. That is possible, but I find more equity people believe that "something" will be done to avert default than credit people. Looking back at 2007 and 2008, it often seemed like equities had to be hit over the head with a stick before they would price in problems in credit. Stocks hit their high in October 2007 - after strong signs of problems in the credit markets had appeared. They also managed to shrug off the Bear Stearns problems after JPM bought them and rallied hard after that, completely missing the impending doom of FNMA, LEH, GM. I would not feel comfortable that stocks have "priced in" the problems in Europe. I think they have failed before on credit problems and with such a high percentage of daily volume just "churn" from traders and computers who go home flat every day and funds trying to avoid showing a monthly loss, the value of stocks as a pricing mechanism seems diminished.
Credit remains the same, limited upside, lots of downside, no liquidity, so decisions are made with far more fear and a slightly longer investment horizon. Maybe credit is being too bearish, but maybe they are just being realistic.
SOVX is out to 330. A new record. Main is back above 181, it got to 188 on Tuesday at the depths of Tuesday's sell-off, so it has improved, but is certainly not at a level that should be encouraging for stocks. Here in the US, IG16 is back to 127. It has been above 130, but again this weakness should be a warning sign for stocks.
SocGen stock is down hard again today and has traded below its March 2009 closing low of 18.01. It is harder for the banks to ignore the brutality that is the credit market. BAC is giving up some of Wednesday's gains. I am still trying to figure out what portion of BAC's gains came from firing some people and shifting the focus from retail to institutional? What are the odds that they are timing that move exactly wrong? Given their track record, I would be willing to bet that we have seen the peak of earnings at the investment bank - that would certainly match up with other evidence that investment banks are struggling this year relative to the past couple of years.
Italian and Spanish 10 year bonds are both weaker again today and back to being lower on the week for Italy. Spain does actually seem to be weathering the storm, for now. I remain convinced that Italy still has the most potential to be the first to leave the Euro. It is still a low probability event, but should be watched. Germany is too big and has benefited too much from the Euro and has spent too much time defending it to walk away. Greece is too small to push the issue, and doesn't have enough industry to truly benefit from a weaker currency. Italy on the other hand would see its industry be able to export with a cheap Lire, they could avoid squabbling about austerity, and if they paid back existing bondholders in Lire, it would NOT be a CDS Credit Event. I am not sure why that language is included in the Restructuring Event for G-7 countries, but it is.
The EUR has broken through some key support. Somewhere between 140 and 139 had seemed to be strong support. It has traded below 138 now. This needs to be watched closely. It certainly doesn't bode well for US exports. The encouraging July trade deficit numbers came with Euro averaged about 143. If so much of the export growth has come from a weak dollar, then it is time to be nervous about future sales growth and profits.
The EU is talking about new taxes. These seem to be ways to let the governments collect money to use to bail out the banks. Completely circular, but totally logical in a pretend and extend culture. It reminds me too much of dealing with Japanese banks in the 1990's. They couldn't sell a particular bond at 94, because the loss would be too much. They could sell the bond at 97 and pay a 3 point finders fee. We all know how well the Japanese banks did by pretending things weren't so bad and coming up with convoluted schemes to avoid the pain - the term Zombie bank was coined.
There is also noise that the EU is trying to figure out how to ban trading in sovereign CDS. First, I think after a brief rally, they will realize that it causes more problems than it fixes. For all the talk about how CDS drives countries into trouble, I would argue that debt to GDP over 100% in a declining economy drives countries into trouble. Put options on stocks have existed for a long time and have not attracted as much negative press as CDS. Why such scrutiny on CDS, I don't understand (bad lobbyists?) other than it is actually more liquid and slightly more transparent than the bond markets (for weak entities) so it shines the light where politicians don't want the light to shine? If they ban it, I believe that quickly the lack of hedging tools for banks and the lack of short covering will ensure that the underlying bond markets sell off harder and faster than before.
If they really want to stop trading in sovereign CDS, they should focus on the sellers, rather than the buyers. They could simply force sellers of protection to take the same regulatory capital hit, and they could force them to post 100% margin so the cash is also used. Without any beneficial treatment, the sellers of CDS would potentially buy bonds instead or charge enough of a premium to sell CDS that basis trades don't work, and buyers of protection would need real conviction to buy the protection.
For all the EU finger pointing about CDS, it is inexcusable that sovereign and bank CDS isn't cleared through a central exchange. It is 3 years since Lehman and investors still have to think about the potential daisy chain of credit risk from a CDS Credit Event. I have written before, that I believe that risk is overstated, but it is more evident when banks themselves widen. A simple example. Lets say a bank hedging desk bought 250 million of BAC CDS from say Goldman. If the CDS has widened 200 bps, that is about 7%. They now have almost 20 million of mark to market exposure to Goldman. They could take off some of the CDS, but if they bought it to hedge another asset, they wouldn't want to take it off. If they think BAC could feel further pressure, they also wouldn't want to take it off. What to do? Buy GS credit protection. Heck, maybe they think with BAC being weak, and stories out there about GS, not only can they hedge some profits, but they might even make some money on buying GS protection. And as the market sees GS CDS trade up (and right now 20 million is a market moving size), someone might decide BAC looks rich and buy BAC CDS. Making the bank's original BAC short worth even more. This sort of self-reinforcing trading is less common when the Reference Entities are corporations as opposed to other financial institutions because the correlation is not so direct. If the CDS for banks and fins was already getting cleared, this shouldn't be a problem. 150 BILLION of just the ES minis trade daily and not once have I heard of anyone wanted to hedge their exposure to the exchange. Investors believe the ES minis are properly collateralized by the exchanges. And that is a product that has been move 5% in 24 hours! BAC CDS on the other, has traded in about a 100 bp range for the past few weeks. That is less than a 4% move. For credit indices, the vol is even less. MAIN moved 20 bps in one day! That is a HUGE move for MAIN. But in terms of amount of money owed, it was less than 3/4% move.
Letting this potential counterparty risk remain out there has been a massive failure of the regulators. At least in part because so few of them actually understand credit. They get stuck in the mind-set that if you sell 10 million of protection you can lose 10 million. While it is true, you can also lose 10 million if you buy 10 million of stock, and the reality is you would lose money in the stock investment faster than the credit investment since credit is SENIOR.
There is nothing inherently evil about CDS. It is no worse than allowing stocks to be shorted or people to trade options on stocks. If the latter are allowed, then there is no reason to clamp down on CDS by banning it. Implementing simple changes (a few of which already have been done) would go a long way to taking the small, but real additional correlated risks out of the market, and calming the most irrational fears.
Anyways, I guess now stocks can do okay today in spite of all this, because the Obama speech was better than some expected and we have a G-7 boondoggle this weekend that might just solve the world's problems. Hmmmm.
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"I would not feel comfortable that stocks have "priced in" the problems in Europe."
Equities mkts are always the dumbest mkts of all...
Agree. I hope no one actually pays this guy for his analysis.
JP Morgan only bought Bear Stearns' prime brokerage unit (about 1/3 of the employees). The rest of Bear Stearns was allowed to fail, about 8,000 people lost jobs, many had most of their bonus compensation in Bear Stearns' stock. Just to set the record straight.
Tylers you always do a fantastic job! A clear definition of" TROIKA'S" would be helpfull. Thank you.
Troika's - I always imagine a trois menagerie maniere complete with associated le fumier. But three stooges is good.
If you required no margin on CDS, wouldn't the pressure simply be transferred to bonds? Essentially the margin-induced CDS levels are keeping pressure off of bonds, right? With less incentive to purchase CDS, bond buyers will drive down the prices and drive up the yields of bonds, correct?
BAC the truck up, Bitchez!
On PM's
Nifty fell today...as expected in the morning....this might be a bigger fall if the count is right ....vth wave to complete the 3rd oc the C...
http://markettechnicals-jonak.blogspot.com/2011/09/nifty-updates_08.html
(chart doesnt include todays data)
Yes but it depends on the stock. Not all stocks need to priced in for a big credit shock. For instance McDonalds will probably not sell less hamburgers because Greece defaults. The world would need to come to an end for McDonalds to fare poorly.
For sure finance sector equities are correcting big time, which makes sense since the real fear currently is about sovereign and bank default.