Eurozone

Busy day in the markets today as Eurozone concerns took a breather and a backseat to a barrage of positive dataflow, starting with a big beat in Chinese November manufacturing PMI (55.2 vs 54.8 expected vs 54.7 prior) that helped boost markets. Significant support levels in the euro, which I pointed out in last night’s piece, and moving average ceiling in the US Dollar Index, set up a market ripe for a rally and the data catalysts followed through. A great beat in US November ADP employment (+93k vs +70k expected vs +82k prior) and a 56.6 print for US ISM PMI, higher than the 55.5 consensus estimates, helped send markets rallying further. Upward revisions by GS to its macro forecasts for both US & global growth added fuel to the fire.

D'oh!

Last November it was Dubai, this November it's Ireland. And the fear mongering continues, allowing the big banks and top hedge funds to set themselves up for the next leg up...

Here we go. European bailout #2. Eurozone sources say assistance to Ireland does not foresee any debt restructuring or 'haircuts' for bond holders. In other words, more strikes and riots in store, as taxpayers get stuffed with the full bill. Next up on the bailout wagin: Italy, Portugal, Spain, France, BeNeLux, Austria, and everyone else.

Sure looks that way....

Today the ECB completed a €104 billion 84 day liquidity providing LTRO, which saw the participation of 182 banks, receiving an allotted 1% fixed rate as part of the refinancing. Importantly, this amount was far less than was expected to be refied, as nearly €225 billion of 3, 6 and 12 month ECB loans were set to expire today and tomorrow, implying that the eurozone saw the extraction of about €120 billion in liquidity out of the system. As a result OIS has spiked on liquidity concerns, as well as expectations of future interbank borrowing to cover the lost liquidity. As per Market News: "The three month euro LIBOR/OIS spread narrowed sharply Wednesday, as a result in the spike of the OIS rate following the much weaker than expected demand at the European Central Bank's 3-month Long Term Refinancing Operation. Banks borrowed much less than widely expected, borrowing E104 billion in the 3-month LTRO, and driving predicted future lending rates sharply higher. There is E225 billion in ECB loans expiring this week, and the low take up at today's 3-month implies, on the face of it, there is going to be reduced liquidity in the euro area, although banks could use alternative central bank financing to get through the year end or wait until ECB conducts its 6-day fine-tuning operation on Thursday." The immediate result of this news pushed the EURUSD 50 pips higher, as it implied, at least on the surface, that European banks are in less need of ECB handholding than expected. Of course, it is also possible that European banks have simply found less obvious ways to use ECB backstops to prop their daily operations.

Greece's exit from the eurozone would be the "worst possible option", Europe's central bank chief said at the weekend amid concerns over the debt-stricken country's ability to pull itself out of crisis. Will Greece default and will this cause yet another global crisis?

The FT reports that an intimate group of 12 banks has been contacted by ISDA to begin preliminary contingency plans in anticipation of a European country leaving the euro. Don't panic: just because banks are mobilizing it simply means that there is no chance of Greece, er, any country ever getting kicked out of Europe, as this would be predicated by a sovereign bankruptcy. And the stress test even refused to consider that alternative, which once again confirms that the stress test is completely right and watertight while ISDA is simply being foolish for not having faith in the Kardinals of Keynesianism. In other news, the market will only go up always, faster, forever.

And now the latest joke - the increasingly more incorrectly named "stress" tests being conducted in Europe are now officially confirmed to be anything but. As Market News reports: "Planned stress tests for European banks will cover their resistance to a crisis in the market for European sovereign debt, but not the scenario of a default of a Eurozone state since the EU would not allow such an occurrence, a German newspaper reported Wednesday." Now that is some serious downside stress testing. Of course, by the time the stress tests are found to have been a joke, and the country hosting the bank blows up just becase the bank's assets are 3x the host nation's GDP, and the country is forced to bankrupt, it will be far too late. So let's get this straight - the very issue that is at the heart of the liquidity crisis in Europe, namely the fact that a bankrupt Greece has managed to destroy the interbank funding market in Portugal and Spain, and the other PIIGS, and has pushed EURIBOR and other money market metrics to one year stress highs, and forced the ECB to lend over $1 trillion to various central and commercial banks, will not be tested for? Fair enough - if the ECB wants to treat the CDS vigilantes as a bunch of idiots, only to be hounded in the press with derogatory words as "Wolfpack" and much worse, so be it. But it certainly should not be surprised if this is latest show of idiocy by Trichet's henchmen serves as the springboard for the latest round of spreads blowing up across Europe.

Is China about to start dumping its $630 billion in eurozone debt holdings? Maybe not yet, although the FT reports that China's State Administration of Foreign Exchange, the central bank's foreign reserves manager, has "expressed concern about its exposure" to the PIIGS. Obviously, with China moving away from dollar denominated assets for the past six months would represent a "big strategic shift" as "last year, the Chinese were trying to reduce their exposure to dollar assets by buying eurozone assets. This would be a complete reversal." Additionally a Chinese diplomat noted that, "The euro’s fluctuation will have an impact on China’s thinking, but it’s only one element” in any decision to allow the Chinese currency to rise, He Yafei, a vice foreign minister, said, according to Bloomberg." The question then arises of just what assets China would be comfortable holding? Alas, the only readily available answer we can come up with rhymes it old and has 79 protons.

This is supposed to calm down the markets Monday morning. The Fed opened its swap lines with other central banks and treasuries to provide dollar liquidity as investors flock to the euro. Mish says short squeeze.

European central bankers and politicians have been as dumb as their American counterparts ...

A massive arbitrage has developed in European sovereign CDS, where the differential between local and foreign-denominated (euro and dollar most typically) CDS has jumped to record spreads. Case in point Germany, where €-denom CDS trade at 30 bps, while the $ equivalent is 43 bps, a 30% spread differential. The reason for this is obvious: as concerns of pan-european defaults have hit the euro, getting paid off on euro-denominated default protection seems increasingly less attractive. Should, say, Germany default, €10MM worth of protection on a German credit event would be worth much less at default which would certainly be accompanied by an almost full devaluation of the euro, resulting in a huge hit to the "at converted" currency, presumably dollars (as the euro would no longer exist). This has led to a major drop in demand for EUR-denom German (and other European) protection, with the differential hitting the abovementioned 30% margin. As Fitch discloses, this spread was just 7% in January. As this is a second derivative play on both currency devaluation/vol and increasing default risk, arguably the most profitable way to bet on a the confluence of factors that impact the eurozone could be a simple quanto swap trade, which could reap massive rewards should peripheral or core European weakness persist.

And now for a Milken conference panel that isn't a waste of 99% of your time: Nouriel Roubini, James McCaughan and Bo Lundgren, moderated by TCW's very astute new Chief Global Strategist (presumably one with less of a fetish for dildos and marijuana than his predecessor) discuss the topic de chaque jour: the Eurozone, and specifically Greece. Roubini starts his presentation by saying that it ain't gonna work. Something tells us Roubini does not work for the IMF, the EU, the ECB, Germany, Greece or any other government organization (and thus CNBC).

Another glaring example of how broken the Greek funding market is, is the record negative basis spread in Greek 5 Year Cash-CDS, which as of today is almost -200 bps (see below). As a reminder, the basis trade's massive inversion in the days after the Lehman collapse is among the primary reasons for the implosion of Merrill, and the spectacular blow up of Deutsche's prop trading desk. What the primary implication of this observation is that the market is essentially saying that the imminent Greek bankruptcy will likely be in the form of a voluntary restructuring, which will not trigger CDS, although that is not the full story. The risk/return scenario, as Credit Trader points out, is assuming a 200bps upside to bond spreads, or a 400 bps downside to an inline level with the rest of Europe, in essence a 33% chance of a free fall bankruptcy, whose implication would most likely be the collapse of the Eurozone, as the EMU would be defunct if a member country escalates into an uncontrollable bankruptcy.