Sovereign Risk

Things are getting a little 'strange' in Europe. European equity markets (and voatility) have disconnected from the reality of European corporate, financial, and sovereign credit. As the massive bifurcation in sovereign yields continues - with Spain near record-highs and Swiss/German at record-lows - equities are still significantly higher post the EU-Summit (and vol massively so) as credit of any kind is dramatically wider. Specifically, 1) Europe's broad equity index is massively outperforming credit post EU Summit; 2) Europe's broad equity index Vol is majorly disconnected from XOver credit; and, 3) Europe's broad equity index is in-line with GDP-weighted sovereign risk BUT dramatically dislocated from Italian and Spanish risk (that is reflective of the core of the stress). Just as we have seen in the US, the method of choice for 'pumping hope' into equity market valuations is through the levered selling of volatility - it seems some-one/-thing with very deep pockets is getting awfully brave as Europe's VIX drops to near pre-crisis levels (and its steepest in months as short-term complacency surges).

EURUSD has tumbled hard following the FOMC minutes as the much-hoped for 'we promise to print USD to infinity at the next meeting no matter what we see' phrase was missing. Two months ago, when the EURUSD was at 1.30, we asked if a 1000 pip move lower, based on relative central bank balance sheets, is in the cards. Today, we are 80% of the way there, with the Euro having tumbled 800 pips against the dollar as NEW QE gets priced further and further out - now implying a 20% likelihood of getting a new USD printing from the Fed within the next 3 months.

So who's big enough to bailout France? How do you spell "No One" in French? This banking thing is about to get uglier than most comprehend!!!

Europe faces three systemic risks: Sovereign (GRExit vs. GERxit), Liquidity (unsustainable refinance rates and foreign capital outflows), and Banking (insolvency and under-capitalization). All of these can fundamentally be traced back to an era of excessive over-indebtedness, which as Pictet notes, leads to required deflationary policy responses that are incompatible with developed market government targets (of re-election, Keynesian pro-growth fiscal policy, and satisfying financial market's expectations). While LTRO did indeed address liquidity risk in the very short-term, it is now painfully clear (just look at European bank stock prices) that financials are driven by sovereign risk (not so much liquidity risk) at the margin. The following three charts provide a roadmap to Nirvana or Samsara (hell). With the Summit underway, Pictet's path to catastrophe roadmap (tactical and strategic) is critical to comprehend.

Today Italy had a rather critical Bill auction in which it sold €9 billion in debt due six months from today. Obviously, since the maturity is well inside of the LTRO, the auction itself was rather meaningless from a risk standpoint. Still, the good news is that Italy managed to place the entire maximum amount targeted. The bad news: it cost Italy more to raise 6 months of debt, or 2.957%, than it costs the US to borrow for 30 years (2.70%). Not only that but the average yield 2.957% was the highest since December when the Italian 10 Year was north of 7%, and nearly 50% higher compared to the 2.104% at auction on May 29, or less than a month ago. The Bid/Cover of 1.62 was unchanged compared to the 1.61 at the May 29 auction. From Reuters: "Today's bill sale points to the sovereign getting this supply away but at yield levels sufficiently elevated to leave a niggling doubt at least as to the medium-term sustainability of the country's public finances," said Richard McGuire, a rate strategist at Rabobank. On Tuesday, Spain paid 3.24 percent to sell six-month bills. Madrid is seen at risk of having to ask for more aid after formally requesting a European rescue for its banks this week. But doubts are also growing on Italy's ability to keep funding its 1.95 trillion euro debt, which makes it the world's fourth-largest sovereign debtor. Domestic appetite has so far allowed the Treasury to complete 56 percent of its 445-billion-euro annual funding plan."

The long anticipated downgrade of the recently bailed out Spanish banking sector has arrived. Moody's just brought the hammer down on 28 Spanish banks. Also apparently in Spain banks are now more stable than the country: "The ratings of both Banco Santander and Santander Consumer Finance are one notch higher than the sovereign's rating, due to the high degree of geographical diversification of their balance sheet and income sources, and a manageable level of direct exposure to Spanish sovereign debt relative to their Tier 1 capital, including under stress scenarios. All the rest of the affected banks' standalone ratings are now at or below Spain's Baa3 rating." Can Spain borrow from Santander then? They don't need the ECB.

We have no doubt that everyone is tired of bad news, but we are compelled to review the facts: Europe is currently experiencing severe bank runs, budgets in virtually every western country on the planet are out of control, the banking system is running excessive leverage and risk, the costs of servicing the ever-increasing amounts of government debt are rising rapidly, and the economies of Europe, Asia and the United States are slowing down or are in full contraction. There's no sugar coating it and we have to stop listening to politicians and central planners who continue to downplay, obfuscate and flat out lie about the current economic reality. Stop listening to them.

While we discussed the definitive new world geography last week, it appears the CDS market has decided to add a new parallel for us, Germany is now Chile (in terms of 10Y restructuring and devaluation risk). As a reminder, Germany's credit risk has risen by almost 50% in the last 3 months to record highs, and has converged higher towards Europe's GDP-weighted average sovereign risk in the last 2-3 weeks.

As Predicted Last Year, The French and the Greeks Are In A Race For The Biggest Bank Run! Each stock showcased has led the drop as well...

First it Egan-Jones (of course). Then S&P. Now Fitch (which sees the Spanish bank recap burden between €60 and a massive €100 billion!) joins the downgrade party of rating agencies that have Spain at a sub-A rating. Only Moody's is left. What happens when Moody's also cuts Spain from its current cuspy A3 rating to sub-A? Bad things: as we explained on April 30, when everyone has Spain at BBB or less...

Just in case there's somebody left who still believes so, Spain is not going to make it. In addition, Spain will crack the EU and bring the art of true fundamental analysis back into the fold.  Here's mucho evidence!

All you need to read.

A few days ago we suggested that this action by LCH.Clearnet was only a matter of time. Sure enough, as of minutes ago the bond clearer hiked margins on all Spanish bonds with a duration of more than 1.25 years. Net result: the Spanish Banks which by now are by far the largest single group holder of Spanish bonds, has to post even moire collateral beginning May 25. Only problem with that: it very well may not have the collateral.

There's a big, fat "I told you so" coming down the pike.