Sovereign Risk

There is NEVER just ONE roach!!!

What Mario Draghi did today is the worst of all possible worlds: on one hand he is allowing more financial risk-taking on the ECB's dime courtesy of increased liquidity and relaxed collateral requirements as well as longer LTROs, on the other he essentially killed any provisional bailout rumors, saying that the ECB will not monetize, nor lend to the IMF. The result: sovereign risk is soaring, as seen by this CDS update.

It is no surprise that there is both an implicit and explicit link between financial entity risk and that of their local sovereign overlord. The multitude of transmission channels is large and the causalities, not merely correlations, run both ways, providing for both virtuous (2009 perhaps) and vicious (2010-Present) circles. Goldman Sachs, in its 2012 investment grade credit outlook takes on the topic of the feedback loop which is engulfing financials and sovereigns currently - noting that despite the 'optical' cheapness of financial spreads to non-financials (and equities) that it is unlikely to compress significantly without a 'solution' to the sovereign crisis being well behind us. The key takeaway is that pre-crisis sovereign credit premia were, in hindsight, uneconomically tight (unrealistic) and expectations of a return to those levels is incorrect as they see the current repricing of sovereign risk as a paradigm shift as opposed to temporary repricing due to market stress. "Sovereign spreads will likely emerge from the crisis both more elevated and more dispersed", meaning floors on bank spreads will be elevated and deleveraging pressures to be maintained raising the real risk, outside of spam-and-guns Euro-zone crashes, of a potential credit crunch. This is already evident in European loan spreads, which as we have discussed many times is the primary source of funds (as opposed to public debt markets as in the US).

It seems everywhere we look, talking heads are arguing that they expect a positive resolution to the EU debacle and yet market positioning does not suggest this is the case at all. Of course we have seen snap-back rallies and sell-offs but the dissonance between the seeming consensus of unbridled optimism that European policy-makers 'get it' and the market's anxiety should be very worrisome - especially for the 'money-where-your-mouth-is' crowd. Morgan Stanley put it best recently as they noted their sense that most investors assume there will be some solution found (or put another way, very few assume that the alternative - a catastrophe of disorderly banking and sovereign defaults - is a base case) but few investors seem willing now to position for that benign outcome (most evidently seen in European Sovereign debt markets currently).

Deutsche's Jim Reid, like us, is less optimistic and notes the same disconnect as he argues that at this point: "Who can honestly say they know exactly what rescue plans the EU governments are still discussing...". Investors are rightly confused and we agree with Reid that we don't think there is any chance of a quick fix to all of this. Furthermore, we fear that any belief in a reversion to pre-crisis levels of sovereign risk on the back of a solution is a pipe-dream as it is clear that risk premia are embedded now (like skews in options prices post 1987) and it is far more likely that Europe stabilizes at much wider levels - more like other leveraged regions.

I Think This Means I'm Not Getting Invited To The Squid's Christmas Party This Year :-( I understand that taking stabs at the Vampire Squid is risky, but the sources of these interviews stem from Russia and the Netherlands. Is it time for the guys stateside to represent?

Grandma said, "There is never just one roach". What damning characteristics does MF Global, Goldman Sachs, and JP Morgan have in common? Yes, I mean besides common CEOs and an auditor that gives the green flag months before historically record setting bankruptcies due to inadequate controls...

Whether its non-confirming volumeless rallies in stocks, hard-to-find collateral, sovereign risk, counterparty risk, USD funding stress, GDP growth dislocations, EM credit dispersion, or equity market outperformance, Nomura's EEMEA FX and Fixed Income team has a little for everyone in today's '10 Things We Did Not Know'. Today's obvious risk-on knee-jerk-response rally is perhaps not so broadly supported even as Ben's promise trumps a totally failed Grand Plan.

Buy the rumor, sell the news? Investors bought the rumor, then sold the lack of news, I think you are supposed to sell the news again, as there is nothing in this document that provides evidence that they get it, or that any scale can ever be achieved, and if anything, it makes you wonder if they will even get to the 440 billion of support the market thought they had back in July.

After being mocked and humiliated (repeatedly) by various blogs, not to mention losing a ton of money (for the clients, not the Goldman traders on the other side of the firm's clients) on his most recent horrendous EURUSD reco, Goldman's Tom Stolper has had enough (as a reminder, precisely the same thing happened at precisely the same time last year - sometimes even a broken clock is never right). And not only him, but all of Goldman appears to be withdrawing from making any future recos on Europe. To wit: "The lack of predictability in Euro-zone policy developments and the high degree of volatility it has created for markets have made it particularly challenging to recommend trades around that theme. Over time, our attempts to actively trade Euro-zone-related developments have had varying degrees of success. Our long EUR/$ trade recommendation was the latest to fall victim to this broader market uncertainty. We initiated the trade under the assumption that reduced political tensions in the Euro-zone ten days ago would also help the EUR move higher, given the significant degree of negative sentiment for the currency. Despite positive developments in Italy, Greece and Spain, however, market tensions have broadened. We therefore closed the trade yesterday at close to 1.34, as we thought that further deterioration in price action was likely." This is truly sad news: it means that the one sure source of (inverse) alpha in the past 2 years, Goldman's FX "advice", has been silenced, and if anything has now turned outright bearish on Europe - and all it took was 2 weeks for Goldman's expert strategists to completely invert their opinion. Oh well, nobody ever said trading was supposed to be easy...

We have extensively discussed the extremes to which European Sovereign spread risk has moved over the past few months. Furthermore, if we normalize by looking at a GDP-weighted credit spread across all of the members of the euro-zone, we are at all-time record wides on this measure. One question that has come up again and again is 'given the market's credit perceptions, why isn't the EUR lower?'. It appears that this is mainly due to regime shifts in the relationship as the correlation between EURUSD and European sovereign risk is extremely high when government intervention (specifically QE uncertainties and fed swap lines) is not rife. The point is that for the last four months, EURUSD and European sovereign risk have been almost perfectly correlated suggesting that as long as there is no ring-fence on risk, the EUR will continue to weaken significantly and at a minimum the EURUSD is an effective hedge against sovereign credit deterioration. Watching this relationship may provide insight into repatriation effects or government intervention as well as offer insight into how EURUSD will move given specific bond moves - a 100bps rise in Italian bond spreads alone infers a 140pip drop in EURUSD for example.

UPDATE1: ES -4pts from close yesterday now (-17pts from overnight highs)

UPDATE2: EURUSD below yesterday's lows

From the moment the words left Merkel's lips this morning that 'conditions weren't right' for euro-bonds and would send 'completely wrong signal', risk assets started to crack lower. Both ES and European markets are now well below yesterday's lows as EURUSD also turns red and sovereign spreads start to break wider (and bear flatten) again.

Geopolitical risk remains elevated and Middle East tensions are escalating globally with Russia appearing to be prepared to risk conflict over Syria with NATO and the US. Yesterday, Russian President Dmitry Medvedev threatened to target and, if necessary, destroy the U.S. missile defence shield in Europe once it is built. A marked deterioration in US–Russian relations and concerns of a new ‘Cold War’ may support gold prices.  While all the focus has been on Europe, and to a lesser degree the US in recent months, two of the other largest debtor nations in the world, Japan and the UK (including corporate and bank debt), have been under the market's radar.  This will change soon and will likely lead to the next phase of the global financial crisis. The fact that we have a global debt crisis which will almost inevitably lead to an international monetary crisis is as of yet not acknowledged or realized by the markets and the media. Today, the IMF warned in a new report that market concerns over fiscal sustainability could trigger a "sudden spike" in Japanese government bond yields that could "quickly" render the nation's debt unsustainable as well as shake the global economy. 

European equities marginally outperformed credit markets on the day but both ended dreadfully as markets went bidless into the close. Ending the day the lows, having retraced over 75% of the 9/23 to 10/28 swing rally, equity and credit markets are well into bear market territory as sovereign risk morphs back into financials and on into corporates. Sovereign spreads may look 'optically' marginally improved if one focuses merely on the 10Y levels, but a little more digging shows that almost without exception sovereign spread curves all bear flattened considerably today with the short-dated risk rising dramatically relative to mid maturities as jump risks become more and more of a concern.

Chatter across European trading desks, since confirmed by the EBA, is that medium- and long-term funding in Europe is now completely frozen. With Rehn still in denial and pointing to the problems in US and China, it seems things just got a little more desperate. Basis swaps at crisis levels, FRA-OIS at crisis levels, European GDP-weighted sovereign risk at all time highs, Belgium and Austria dislocating today, and EURUSD cracking through 1.3350.

Time to start stocking up on those long term, OTM armageddon puts yet?