Sovereigns

For a while now we have said that the very weakest link in Europe is not the banks, not the ECB, not triggered CDS, and not even the shadow banking system (well, infinitely rehypothecated Greek bonds within a daisychain of broker-dealers, which ultimately ends up at the ECB at a negligible repo discount, that could well be the weakest link - we will have more to say about this over the weekend) but two very specific insurers: Italy's mega insurer Assecurazioni Generali, which at last check had more Greek bonds as a % of TSF than anyone else, and Europe's biggest insurer and Pimco parent, Allianz, which is filled to the gills with pretty much everything (for more on Generali, or as we like to call it by its CDS ticker ASSGEN read here, here, here, and here). Well, Moody's just gave them, and the entire European space, the evil eye, and soon the layering of margin calls upon margin calls, especially if and when Greece defaults and a third of ASSGEN's balance sheet is found to be insolvent, will make anyone who still is long CDS those two names rich. Assuming of course the Fed steps in and bails out the counterparty the CDS was purchased from.

The divergence between credit markets and equities accelerated today in Europe (and the US) as Senior and Subordinated financial credit spreads have increased dramatically in the last week. While risk has risen over 25% in financials, European stocks have gone sideways since the NFP print. The Subordinated financials spread has risen the most (in percentage terms) over the last 4 days since Nov2010 - and of course the broad equity markets are flat. It would seem that every trader and their mom is selling European financials and buying AAPL.

European corporate and financial credit markets are opening weak this morning - ignoring the exuberance in overnight ES futures (11,000 contracts in seconds on rumor of China for 10pt jump?) which is also leaking back rapidly to VWAP (even as European equity markets continue to levitate). Financials especially are now beyond yesterday's wides with subordinated spreads the underperformer for now. This extends from our comments yesterday that were picked up on CNBC with regard to the 'stigma-trade' in LTRO-encumbered banks (which is widening further this morning) as well as broad divergence between stocks and credit. Concerns over Ireland's fiscal consolidation plans balanced with a very slight beat on German GDP (though still negative) are seeing EURUSD leak back off its best levels of the night after it bounced off 1.31 in late US trading (on Samaras rumors then extended by this China chatter). Gold and Silver are pushing higher while Copper and Oil are stable for now (though notably up from yesterday's European close). European sovereigns are quiet for now while US Treasuries are slightly better bid.

You know there is a reason why Europe just came crawling with an advance handout looking for US assistance: Moody's just went apeshit on Europe.

• Austria: outlook on Aaa rating changed to negative
• France: outlook on Aaa rating changed to negative
• Italy: downgraded to A3 from A2, negative outlook
• Malta: downgraded to A3 from A2, negative outlook
• Portugal: downgraded to Ba3 from Ba2, negative outlook
• Slovakia: downgraded to A2 from A1, negative outlook
• Slovenia: downgraded to A2 from A1, negative outlook
• Spain: downgraded to A3 from A1, negative outlook
• United Kingdom: outlook on Aaa rating changed to negative

In other news, we wouldn't want to be the company that insured Moody's Milan offices.

Since last Wednesday, European financials have seen credit spreads widen dramatically. After some initial gains today, they once again retreated and traded out to their widest levels in two weeks as both financials and non-financials closed wider and at their worst levels of the day in European credit. Sovereigns also deteriorated significantly after around 8amET with 10Y BTPs for instance adding 20bps or so to close unch (as the rest of the major sovereigns saw de minimus +2 to -4bps changes). Bunds and Treasuries stayed close together and we note TSYs rallied 7bps (from +4 to -3bps) from early morning Europe trading and leaked off a little into the close. WTI is holding above $100 even as Copper is down 1% while Gold and Silver's gains are in sync with USD's modest losses - though EUR is leaking back lower (holding just above 1.32) into the close to around unch. While this post-Thanksgiving Day rally was perhaps predicated on global growth (US decoupling, China soft landing) and extended by LTRO (contagious bank insolvency runs risk containment), the underperformance of banks' credit risk in the last few days should be very worrisome with Senior unsecured credit wider by over 30bps in 3 days, its largest deterioration in two months.

Earlier in the week we began discussing the stigma that would likely be attached to the banks that decide to borrow from the ECB via the LTRO. Many talking heads including Mario Draghi himself, arbiter in chief of all risky collateral in Europe, dismissed this - reflecting back at the compression in credit spreads in the market-place as evidence that all was well and confidence was returning. In the last week our (senior unsecured debt) index of LTRO-ridden banks has underperformed non-LTRO-ridden banks by 23bps to a 75bps differential. This is the largest divergence since the LTRO began and corrects off mid-Summer tight levels of difference as the critical flaw that we also pointed out earlier in the week (that of the implicit subordination of bank assets via ECB's LTRO collateralization). Credit Suisse agrees with us and expounds on 'the flaw' in the LTRO scheme noting that the market is fickle and self-sustaining at times (as we have seen) but over time (and that time appears to be up this week), the market will weigh the liability side of the balance sheet versus the asset side, less haircuts (which implies haircuts will become the de facto capital requirements) and inevitably (given bank earnings potential) reflect this huge differential - most specifically in the senior unsecured debt market. With few shorts left to squeeze, spreads back at pre-crisis levels and financials having dramatically outperformed even large gains on sovereigns, the weakness in senior financial debt in Europe this week is more than just a canary in the coal-mine, it should become the pivot security for risk appetite perception.

We have been warning of the bearish divergence in European credit markets all week and today saw that trend continue as the best-performers of the year-to-date become the biggest losers on the week. Financials and high-yield (crossover) credit have dramatically underperformed this week (with XOver +50bps touching 600bps once again) as credit overall trades considerably wider than before the NFP-print jump. Investment grade is wider but diverging a little today as decompression trades are laid back out and up-in-quality trades are reconsidered - and away from financials which have seen their senior unsecured credit spreads jump from under 190bps to almost 220bps on the week. Broad equity markets in Europe also saw their worst week of the year but are lagging the credit sell-off for now and sit (for context) right around the pre-NFP jump levels. Sovereigns were mixed on the week with the last couple of days seeing notable deterioration. Spanish spreads are +33bps, Italian spreads are -9bps on the week but are 25-30bps off their tights but it appears Portugal was the darling of the ECB this week as it managed an impressive 100bps compression (10Y now almost 500bps off its wides on 1/30) but this impressive tightening only gets the peripheral nation back to 1050bps (and mid-January levels - still triple the level of risk of a year ago).

Since the start of the year, global markets have been apparently buoyed by the understanding that Draghi's shift of the ECB to lender-of-last-and-first-resort via the LTRO has removed a significant tail on the risk spectrum with regard to Euro-banks and slowed the potential for contagious transmission of any further sovereign stress. In fact the rally started earlier on the backs of improved perceptions of US growth (decoupling), better tone in global PMIs, and potential for easing in China and the EMs but it does seem that for now the ECB's liquidity spigot rules markets as even in the face of Greek uncertainty, as George Magnus of UBS notes, 'financial markets are most likely to defer to the ECB's monetary policy largesse' as a solution. Both Magnus and his firm's banking team, however, are unequivocal in their view that the next LTRO will unlikely be the last (how many temporary exceptions are still in place around the world?) and as we noted earlier this morning, banks' managements may indeed not be so quick to gorge on the pipe of freshly collateralized loans this time (as markets will eventually reprice a bank that holds huge size carry trades at an inappropriate risk-weighting) leaving the stigma of LTRO borrowing (for carry trades, substitution for private-sector funding, or buying liquidity insurance) as a mark of differentiable concern as opposed to a rising tide lifts all boats as valuations reach extremes relative to 'broken' business models, falling deposits, and declining earnings power.

They expect a EUR300bn take up of the next LTRO, somewhat larger than the previous EUR200bn add-on - but not hugely so - as the banks face a far different picture (in terms of carry profitability) and yet-to-be-proven transmission to real-economy credit-creation that will make any efforts at a fiscal compact harder and harder to implement as its self-defeating austerity leave debtor countries out in the cold. The critical point is that unless the market believes there will be an endless number of future LTROs, covering the very forward-looking private funding markets for banks, then macro- and event-risk will reappear and volatility will flare.

Overnight excitement from the RBA (no rate cut) and concerns at China's GDP growth given a European recession did nothing to initially slow risk markets early on as they reached up to yesterday's highs as ES (the e-mini S&P 500 futures contract) and BE500 (the broad Bloomberg equity index for Europe) pushed higher out of the gate (as AUD strength sustained carry trades - which appear now to be leaking back off). EUR managed to get back to yesterday's highs and found resistance and once it began to leak lower (and USD lower implicitly) then equities (and commodities on China un-easing concerns) started to stumble pretty hard. Following China's Shanghai Composite, European stocks are now down around 1% and credit is slowly gathering pace to the downside (though not as weak as stocks for now). Portugal showed some strength early on but has given that back as most sovereigns are trading 0-3bps wider in 10Y cash spreads for now (likely the trigger for non-sovereign credit). Some comments from Juncker on special Greek accounts and Klass Knot on the Euro's success top off a quiet morning with some risk off starting to gather pace.

When all else fails, pretend it's all good. Like what Australia did, following the just released announcement by the RBA that it is keeping the cash rate unchanged at 4.25% on expectations of a 25 bps rate cut. Which begs the question: is China re-exporting the lagging US inflation it imported over 2011? So it appears to Glenn Stevens, who just said that "Commodity prices declined for some months to be noticeably off their peaks, but over the past couple of months have risen somewhat and remain at quite high levels." Or maybe they are not pretending and inflation is still alive and very much real? It also means that Chinese inflation continues to be far higher than what is represented, but we probably will just take the PBoC's word for that. Or not, and wonder: did the RBA just catch the PBOC lying about its subdued inflation? And if that is the case, does anyone really wonder why that very elusive RRR-cut is coming with the same certainty as the Greek creditor deal? Either way, the AUDJPY spikes by 80 pips on the news, however briefly, and if the traditional linkage between the AUDJPY and the market is preserved, it should have a favorable impact on risk as it means at least one hotbed of inflation remains. On the other hand, it also means that Chinese easing is a long way off... and in a market defined solely by hopes for central bank intervention this is not good. And amusingly, just as we write this, Bloomberg release a note that the PBOC is draining funds: "China’s money market rates rose after PBOC resumed fund drain via a repo operation, showing it remained cautious toward policy easing." Translation: "Hopes for a near-term RRR cut could be dashed, Credit Agricole CIB strategist Frances Cheung writes in note to clients." Oops. Furthermore, the PBOC did 26 billion yuan in repos, meaning it is set to conduct a net liquidity withdrawal for this week according to Credit Agricole. Withrawing liquidity when the market expects RRR cuts? Fughetaboutit. (and reread the Grice piece on why only idiots define inflation by the CPI or the PCE).

With the IMF cutting its global growth forecasts and signs of slowing evident in the dramatic contraction in World Trade Volume in the last few months, it is perhaps no surprise that the central banks of the world have embarked upon what Goldman Sachs calls an 'Unprecedented Alignment of Monetary Policy Across Countries'. Our earlier discussion of the European event risk vs global growth expectations dilemma along with last night's comments on the impact of tightening lending standards around the world also confirms that this policy globalization is still going strong and is likely to continue as gaming out the situation (as Goldman has done) left optimal CB strategy as one-in-all-in with no benefit to any from migrating away from the equilibrium of 'we all print together'. Perhaps gold (and silver's) move today (and for the last few months) reflects this sad reality that all your fiat money are belong to us, as nominal prices rise (but underperform PMs) in equities (and risky sovereigns and financials).

There are two pillars that have supported the recent cross-asset class rally: 'improving' macro news and a reduction in concerns about European and financial risks. While this pattern is not new, as the interplay between the two has been a key focus for some time, Goldman manages to differentiate the impact of both and quantifies which assets have more sensitivity to each pillar. Unsurprisingly, European assets have been driven more by Euro area risks than non-European assets, equities (even in Europe) have been driven more by growth views, and credit spreads (including in the US) have been more responsive to Euro area risks. A number of other assets are much more closely to the market's view of growth than to the Euro are risk perceptions and global FX ranges from highly cyclical to highly Euro-sensitive while many of the major EM currencies are stuck in the middle. Overall they find that the market has more confidence in global growth (with markets pricing little more than +1.75% US growth for instance so not over-confident) but that Euro-area risk has been discounted excessively given the nature of the ECB's actions relative to the underlying problems (as we discussed this morning). Goldman provides a good starting point for consideration of which risks (and how much is priced in) across global asset classes.

You're about to hear a big boom come from across the Atlantic, but I've yet to hear a peep from the rating agencies. And many of you guys think they were delinquent during the other credit bubble!!!????

It appears from the Treasury's announcements and the Treasury's Borrowing Advisory Committee (TBAC) recommendations that we will shortly see Treasury FRNs. While details remain murky (what maturities, the underlying index, reset frequency, and so on) we would be surprised if they did not after all this analysis and the potential problems they may face. Given the weight of short-dated maturing Treasury debt, if the Treasury were roll/term this debt out at the same pro-rata distribution of maturities as it has currently, then the weighted average maturity of their debt would rise significantly. While avoiding the short-term limit of zero-date issuance that many European sovereigns face is a positive clearly, the problem for the Treasury lies in the non-domestic (read Fed) demand is waning significantly for any longer-dated Treasuries (while bid-to-covers on Bills remain very high and active for foreign buyers). FRNs would implicitly provide the lender with upside coupon on a rise in rates (a potential plus for foreign demand given their angst and the low level of rates priced into the market) and would benefit the Treasury by reducing potential demand issues at the long-end (and potentially offering the Treasury upside if rates stayed low for longer). The bottom line is that the structural decline in the stock of global high-quality government bonds, coupled with an increase in demand for non-volatile liquid assets, should make U.S. government issued FRNs extremely attractive. Of course, the benefits to the Treasury from issuing FRNs also relies significantly on the Fed's monetary policy stance - savings are likely to be greater when the change in the funds rate is negative, and especially when such change is more negative than the expectations priced into forwards (and it seems reasonable to assume that the risk to short-rates is somewhat one-sided against the Treasury FRN).

While sounding just a tad preachy in his February newsletter, Bill Gross' latest summary piece on the economy, on the Fed's forray into infinite ZIRP, into maturity transformation, and the lack thereof, on the Fed's massive blunder in treating the liquidity trap, but most importantly on what the transition from a levering to delevering global economy means, is a must read. First: on the fatal flaw in the Fed's plan: "when rational or irrational fear persuades an investor to be more concerned about the return of her money than on her money then liquidity can be trapped in a mattress, a bank account or a five basis point Treasury bill. But that commonsensical observation is well known to Fed policymakers, economic historians and certainly citizens on Main Street." And secondly, here is why the party is over: "Where does credit go when it dies? It goes back to where it came from. It delevers, it slows and inhibits economic growth, and it turns economic theory upside down, ultimately challenging the wisdom of policymakers. We’ll all be making this up as we go along for what may seem like an eternity. A 30-50 year virtuous cycle of credit expansion which has produced outsize paranormal returns for financial assets – bonds, stocks, real estate and commodities alike – is now delevering because of excessive “risk” and the “price” of money at the zero-bound. We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time." Yet most troubling is that even Gross, a long-time member of the status quo, now sees what has been obvious only to fringe blogs for years: "Recent central bank behavior, including that of the U.S. Fed, provides assurances that short and intermediate yields will not change, and therefore bond prices are not likely threatened on the downside. Still, zero-bound money may kill as opposed to create credit. Developed economies where these low yields reside may suffer accordingly. It may as well, induce inflationary distortions that give a rise to commodities and gold as store of value alternatives when there is little value left in paper." Let that sink in for a second, and let it further sink in what happens when $1.3 trillion Pimco decides to open a gold fund. Physical preferably...