It will come as no surprise that the Spanish 'experiment' with the euro is not going well. Spain now relies more heavily on the ECB than at any time and today's bill auction sums up all that is wrong about our financial markets when an event that absolutely should be expected to be a non-event (a sovereign nation selling a small amount of short-dated debt) becomes a catalyst for algorithmic excess. In perhaps the greatest analogy for today's auction, Micheal Cembalest pronounces "throughout my career, central banks having to buy or finance sovereign debt to avoid a debt crisis was like going to the prom with your sister: there’s something very unnerving about it, even though it looks normal from a distance." It did not take long for the honeymoon following LTRO2 to end and despite today's exuberance, Italian and Spanish equity markets (as well as financial credits) have collapsed as Spain's sovereign risk has skyrocketed. While Spanish bank holdings of Spanish govvies, ECB lending to Spanish banks, and Spanish credit risk are surging so is one other much more worrisome fundamental trend - that of corporate non-performing loans. Dismissing the dichotomous relationship between consumer and residential delinquency calmness relative to unemployment's explosion (much as the market has in its pricing of bank stocks), the JPM CIO remains underweight Europe arguing that while contrarian calls are often the most profitable, this time being underweight European equities is the gift that keeps on giving.
The Bonds in Spain will drain without restrain showing utter disdain for the Euro domain. Research that Rhymes!!!
We have been warning of the uncomfortable current similarities to last year's (and for that matter cycle after cycle) high-yield credit underperformance / lagging behavior 'canary-in-the-coalmine' relative to the exuberant equity market for a month now. Now, Bank of America provides - in two succinct charts - the fundamental underpinning of this grave concern as across the high-yield credit universe revenues are not catching up with costs - creating significant margin pressures - and at the end of the day, a market that cares more for cash flow sustainability than the latest headline or quarter EPS upgrade from some sell-side pen-pusher is waving a red-flag as margins are the lowest they have been since March 2009 and is falling at a much faster clip than in the fall of 2008 as the reality of money-printing comes home to roost. And just to add salt to this fundamental wound, technicals are starting to hurt as supply picks up and 'opportunistic' issuance turns notably heavy - perhaps helping to explain how the ongoing inflows have been unable to push prices further up in the US. Lastly European high yield is trading tick-for-tick with sovereign risk still - as it has since the middle of last year and so as LTRO-funded carry fades, we would expect it to underperform - especially as austerity slows growth.
The sad reality of an austerity induced slowdown in Europe and an ESFS/ESM as useful as a chocolate fire-guard seems to be creeping into risk asset premia across Europe (and implicitly the US). GGB2s are all trading back under EUR20 (that is 20% of par), Sovereign yields and spreads are leaking wider despite the best efforts of their respective banks to back-up-the-truck in the 'ultimate all-in trade' and the LTRO Stigma has reached record levels as LTRO-encumbered banks' credit spreads are the worst in over two months. Spanish sovereign spreads are back at early January levels and with Italian yields comfortably back over 5% and the bonds starting to reality-check back towards the much less sanguine CDS market. It seems apparent that much of the liquidity-fixing LTRO benefits are now being washed away as investors realize nothing has changed and in fact things are considerably worse now given encumbrance and subordination concerns and the increased contagion risk that the LTRO and the Sarkozy trade has created.
Germany's recent 'agreement' to expand Europe's fire department (as Goldman euphemestically describes the EFSF/ESM firewall) seems to confirm the prevailing policy view that bigger 'firewalls' would encourage investors to buy European sovereign debt - since the funding backstop will prevent credit shocks spreading contagiously. However, as Francesco Garzarelli notes today, given the Euro-area's closed nature (more than 85% of EU sovereign debt is held by its residents) and the increased 'interconnectedness' of sovereigns and financials (most debt is now held by the MFIs), the risk of 'financial fires' spreading remains high. Due to size limitations (EFSF/ESM totals would not be suggicient to cover the larger markets of Italy and Spain let alone any others), Seniority constraints (as with Greece, the EFSF/ESM will hugely subordinate existing bondholders should action be required, exacerbating rather than mitigating the crisis), and Governance limitations (the existing infrastructure cannot act pre-emptively and so timing - and admission of crisis - could become a limiting factor), it is unlikely that a more sustained realignment of rate differentials (with their macro underpinnings) can occur (especially at the longer-end of the curve). The re-appearance of the Redemption Fund idea (akin to Euro-bonds but without the paperwork) is likely the next step in countering reality.
Since Draghi's second savior LTRO, European markets have been flip-flopping gradually lower. These four charts do not seem to suggest a market that is confident about tail-risk containment, sovereign firewalls, or an orderly restructuring by Greece. Sovereign spreads are broadly higher (Spain, France, and Portugal the most), CDS spreads are underperforming (as protection is sought and CDS seen having value as a hedge), non-financial and financial credit is notably weaker, LTRO Stigma remains notably wide, stocks are broadly lower, and the EURUSD is back at 'fair' with its swap spreads (removing its over-pessimism). There has been no change in the price trends for UK-law versus Greek-law GGBs (i.e. noone believes this is over) and even if it were, a renewed focus on growth is hardly a market positive given lending trends and macro prints in Europe recently.
"Emotions exceeding known parameters cause extreme events, such as stock market booms and busts. They are self-reinforcing spirals upward and especially downward that, once established, keep diverging from equilibrium until the driving forces fade or stronger counter forces reverse them. Ever-increasing desires for accumulating ever greater wealth faster and faster ignited a credit bubble that spiralled upwards until it burst in 2007 from a lack of new borrowers. The multi decade credit bubble and its bursting were extreme events. No model recognized the credit bubble or its collapse and no model is giving any indication of the plethora of problems now brewing in Europe."
Analysts are questioning the "double-down effect" the ECB's LTRO exercises are creating in eurozone sovereign spreads. Citi notes a spike in the purchase of government securities since the initial take-up in December.
Here's concrete proof of a mass European bank run. If you missed it, don't worry - there'll be plenty more from where these came from...
As the ECB supposedly takes it foot off the gas, and EU Summits and 'events' loom large for the careening wagon of shared sacrifice, unity, and sovereign risk, perhaps it is the nodding donkeys of Greek and Italian technocrats juxtaposed with Ireland's feistier "R" word gambit (and of course Zee German Overlords) that makes Art Cashin reflect somewhat philosophically on recent headlines. Their stereotypical interpretation has him concerned as the potential for ever-increasing culture clashes increases across the pond as sour memories and generational hatreds abound.
As the ECB has stopped its SMP bond-buying and now the LTROs are all done (until the next one of course), Portuguese bond spreads have been increasing rapidly and post-LTRO today even more so. While broadly speaking European sovereign risk is modestly higher this week (and notably steeper across the curve) leaving funding costs still very high for most nations, Portugal has exploded over 100bps wider (and almost 70bps of that today post-LTRO) to back over 1200bps wider than Bunds. Only Italian bonds are better and even there they are leaking back to unch from pre-LTRO. Perhaps, shockingly, more debt did not solve the problem of too much debt and with growth and deficits being questioned in Ireland and Portugal (and Spain), it's clear the newly collateralized loan cash the banks have received won't be extended to the medium-term maturities in sovereign bonds.
It appears markets have re-converged in the last few days across asset classes as European credit markets have rallied to meet a modestly underperforming European equity market after quite significant drops in the former a week or so ago. In the US, equity futures have reconverged with CONTEXT (our proxy for broad risk assets) as Treasuries have weakened and FX carry has improved tone overnight while futures themselves have drifted sideways. Commodities have largely drifted also with a modest improvement in Copper and slow drift up in WTI (back over $107 now). For some perspective, GDP-weighted European Sovereign risk has improved 80bps from its Nov2011 wides (or around 23%) but remains over 200bps wide of Post March 2009 lows and over 500% higher still - back only to levels seen in August 2011. Consensus appears to be that a larger than expected LTRO is positive for risk assets with Equities and then Credit the main beneficiaries (with FX the least) and a notable divide between European traders and non-European traders with the former believing the EUR will strengthen vs USD and the latter not so much (more focused on carry trades). For now, Italian and Spanish sovereign yields are leaking higher but in general wait-and-see mode remains with anxiety high.
An explicit contagion path chart, since you probably won't get info like this anywhere else...
We have discussed, at length, the symbiotic (or perhaps parasitic) relationship between the banking system in Europe and the governments (read Central Banks). The LTRO has done nothing but bring them into a closer and more mutually-reinforcing chaotic relationship as we suspect many of the Italian and Spanish banks have gone all-in on the ultimate event risk trade in their government's debt. It should come as no surprise to anyone that the bulk of the Greek bailout money will flow directly to the European banking system and Credit Suisse has recently updated the bank exposure (by country) to peripheral sovereign debt that shows just how massively dependent each peripheral nation's banking system is on its own government for capital and more importantly, how the core (France and Germany) remains massively exposed (in terms of Tier 1 Capital) to the PIIGS. Retroactive (negative) salary cuts may well not be the worst of what is to come as the bankers deleveraging returns to bite them in a phoenix-like resurrection of sovereign risk on now even-more sovereign-bloated (and levered) balance sheets.