CDS

According to the Bank of International Settlements, as of June 2011 total over-the-counter derivatives contracts have an outstanding notional value of 707.57 trillion dollars, ( 32.4 trillion dollars in CDS’s alone). Where does this kind of money come from, and what does it refer to? We don’t really know, because over-the-counter derivatives are not transparent or regulated. With regulated economic markets, when an underlying real asset is impaired (i.e. the company in question is bankrupt, the mortgage has defaulted, etc.), market value is assessed, default insurance is paid up to replacement or full value, bond holders and stock holders make claims on remaining value and the account is closed. There is no need for bailouts because order and proportion of compensation has been established and everything is attached to the value of the underlying asset. When the unreal, counterfeit economy intrudes, you now have a situation where a person can put in an unregulated, but recognized, claim to be paid a thousand times over in case of impairment. Say market participants have negotiated for a bankrupt company a 70% payback for bondholders and (36% payback for insurance claims), and I come with not one but rather 1,000 CDS claims demanding to be paid for each CDS.

Stop us when this sounds familiar: 'While we expect central banks globally to continue to provide liquidity, it is the ECB’s position that has changed the most dramatically. The relative expansion of the ECB’s balance sheet is EUR bearish in our view....the liquidity being generated by the ECB is to a large extent absorbed by the bank refinancing process, hence the large deposits at the ECB. Although there is clear evidence that some of the funds have been used in the peripheral bonds markets, helping to stabilise sovereign yield spreads, lending into the real economy remains constrained. We believe that the relative performance of money multipliers will be a significant driving force for currency markets in the coming year. We see the ECB liquidity as a negative for the EUR" At this point the preceding should remind our readers, almost verbatim, of this Zero Hedge post from January 31, "Reverting back to our trusty key correlation of 2012, namely the comparison of the Fed and ECB balance sheet, it would mean that absent a proportional Fed response, the fair value of the EURUSD would collapse to a shocking 1.12 as the ECB's balance sheet following this LTRO would grow from €2.7 trillion to €3.7 trillion." And the reason why the latter extract should remind readers of the former is because it is the basis for the just released conclusion by Morgan Stanley cutting its EURUSD price target from 1.20 to 1.15.

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!!!????

Early Tuesday morning, the Portuguese 10Y bond was trading over 300bps wider than its close last Friday. Contagion from concerns in Greece and what that meant for a nation that while not in as dire a position as Greece economically was well on its way to totally unsustainable debt levels relative to what little and shrinking GDP they can garner. Market access is of course off the cards and there are reasonable chunks of debt maturing that will need to be funded. Since then the PGB has rallied an incredible 300bps, now trading a mere 5bps wider on the week as if nothing had ever happened. We know the ECB was active yesterday and it appears also today but what is also very notable and perhaps explains more of the compression is the huge drop in the basis between CDS and bonds for Portugal. The basis, as we have discussed before, was extremely wide for Portugal (a quite illiquid sovereign bond and CDS market) and we suspect at a spread between bonds and CDS of almost 850bps, it was just too tempting for hedgies not to buy the package en masse. This means they would have bought PGBs (bonds) and bought CDS protection to try and 'lock-in' the spread between the two. That demand for the basis has pushed it 200bps narrower and given the thinness of the PGB market, the marginal demand from basis traders has exaggerated that rally by the 300bps we noted above. So Portuguese bond risk remains elevated (CDS around 1400bps and and 5Y PGB around 20% yield) but the drop in the last few days is not a risk appetite signal but reflective of an ECB-spurred risk transfer to basis traders who we assume are more confident in Portuguese bond contracts and CDS triggers than Greek bonds for now. It seems they have found another pivotal security to manipulate down to show 'improvement' as Portugal leaves the global bond indices but is mysteriously bid this week - watch the basis for more compression and the signal for unwinds which will stress PGBs once again.

Gold outperformed (+0.5%) today (as the rest of its commodity peers lost ground on USD strength today) and Copper and Silver underperformed. But for January, Silver is the clear winner in the global asset return race (at almost a 20% gain) with Gold in 2nd place at around +11.2%. JGBs and the DXY (USD) along with UK Gilts and Oil lost the most ground among the major assets we track. The outperformance of the precious metals as the dollar ebbed along with the general 'last year's losers were January's winners' and vice-versa was evident as Asia Ex-Japan and EM equities surged along with Nasdaq (and Copper). Long-dated Treasuries have just limped into the money for the year as they rallied dramatically today - ending the day at their low yields (new record 5Y lows) with 30Y now -12bps on the week. FX markets gave a little of the USD strength back in the afternoon but the rally in stocks was almost entirely unsupported by risk assets in general (as it seemed like a desperate low-volume try to push ES back to VWAP into the close to hold the 50/200DMA golden cross in SPX) after this morning's dismal macro data. Financials rallied to fill some Friday close gaps but gave some back into the close as CDS inched wider and Energy underperformed as Oil came almost 3% off its early morning highs (managing to crawl back above $98 by the close). IG credit outperformed as HY and stocks were largely in sync but open to close, credit outperformed stocks on a beta basis (after overnight exuberance in stock futures faded).

While so many were hoping for the siren-call of private-equity or perhaps a reverse-merger MBO with RadioShack, CIT has once again managed to pour well-risk-managed-credit-extension cold water on Sears short-squeeze. SHLD is down 6% following Reuters reports (via The Orlando Sentinel) that CIT will again stop providing loans to suppliers of Sears Holdings as the lender/factor awaits further information of the company's health. Volume picked up dramatically as the stock fell and we note that SRAC (the more active 5Y CDS contract) is leaking wider but has surged around 400bps (to 1800bps) in the last week (as the stock has been treading water off its spike squeeze highs on 1/23).

The market is back to being excited and bullish. Yesterday’s announcement out of Europe was underwhelming, but no one cares as a Greek PSI announcement is expected any moment.  It will be interesting to finally find out how many bonds sign on at the time of the agreement and who the potential holdouts are. More importantly, once again LTRO is the talk of the town.  Talk is that the demand will be €1 trillion or more (as ZeroHedge discussed here first over two weeks ago).  It will be interesting to see if the number approaches that or is far smaller.  We continue to believe that banks are using it to prefund redemptions and not as cheap financing to start a new round of asset gathering.  All the talk about the “carry” trade makes it sound like something new that the banks have just figured out, when it is the exact trade that got them in trouble in the first place.  Why did banks sell naked CDS on companies and countries (write protection)?  Because they got carry with no funding worries. Listening to the “chatter” you would think the market is on fire, yet S&P is barely up in almost 2 weeks (it closed 1308 on the 18th).  For the past couple of weeks, fading rallies has been working well, and we don’t see that changing as more and more people become convinced that “Europe is priced in” and ignore that strong earnings were priced in and aren’t really materializing.

Panic at the mere thought of rising real wages.

The divergence between credit and equity marksts that we noted into the European close on Friday closed and markets sold off significantly. European sovereigns especially were weak with our GDP-weighted Eurozone credit risk index rising the most in six weeks. High beta assets underperformed (as one would expect obviously) as what goes up, comes down quicker. Stocks, Crossover (high-yield) credit, and subordinated financials were dramatically wider. Senior financials and investment grade credit modestly outperformed their peers but also saw one of the largest decompressions in over a month (+5.5bps today alone in the latter) as indices widen back towards their fair-values. The 'small moderation' of the last few weeks has given way once again to the reality of the Knightian uncertainty Europeans face as obviously Portugal heads squarely into the cross-hairs of real-money accounts looking to derisk (10Y Portugal bond spreads +224bps) and differentiate local vs non-local law bonds. While EURUSD hovered either side of 1.31, it was JPY strength that drove derisking pressure (implicitly carry unwinds) as JPYUSD rose 0.5% on the day (back to 10/31 intervention levels). EURCHF also hit a four-month low. Treasuries and Bunds moved in sync largely with Treasuries rallying hard (30Y <3% once again) and curves flattening rapidly. Commodities bounced off early Europe lows, rallied into the European close and are now giving back some of those gains (as the USD starts to rally post Europe). Oil and Gold are in sync with USD strength as Silver and Copper underperform - though all are down from Friday's close.

Portuguese 5Y bond yields just broke to Euro-era record levels at over 22.5% taking then up to the same levels at which Greece traded just four short months ago. Ironically, Bloomberg notes that:

• *ECB SAID TO BE BUYING PORTUGUESE GOVERNMENT BONDS TODAY

which appears to be wholly focused on the short-end, as the long-end is blowing out. It also seems that many want to talk about the CDS blowing out but as we have seen time and again with Portugal (since its bond market is less liquid than the already thin CDS market), bonds are underperforming notably as real money exits in a hurry. While comments are plenty that Portugal is smaller and is not Greece, they have (relatively speaking) notable maturities within the next few months (EUR 10bn by May2012) that will not be able to roll in the private markets and then a large lump of over EUR 10bn in June.

With a Greek default imminent, and this time ISDA having no chance to kill CDS as a hedging mechanism as the trigger event will be more than present, investors have once again jumped at the opportunity to close lucrative basis trade opportunities, as a result sending all of Europe broadly red in spread terms. Notable: Portugal CDS, which contrary to media reports elsewhere has been trading points up front for a few weeks now, just hit a record 40 pts up. And what is worse is that the 5/10s, which should be inverted for a country as distressed as this, isn't.

Both the ECB and the Fed are accepting poorer and poorer sludge and collateral to back various liquidity schemes.

German individual investors are gobbling up Greek sovereign bonds!

While Silver had a better week than Gold (+5.4% vs 4.3%), Gold managed its biggest gain in three months as the Fed's QE-ness seemed to separate the precious metals from other asset classes. Oil underperformed relative to the USD's weakness (-2% on the week in DXY) managing only a 1.3% gain (and ending below $100). Silver and Gold have no managed four weeks in a row of gains as the latter has more than retraced half of the all-time high sell-off range. With 5 minutes to go, NYSE volume was -32% from yesterday, by the close of the cash markets it was only down 2.5% leaving the week -10% from last week (so 32% of the day's NYSE volume was done in the last 1.3% of the day). In credit, HYG underperformed stocks, HY credit stayed synced with stocks and IG outperformed (touching 100bps as we closed). Treasuries ended the day (and week) at their low yields with 5s to 10s all lower by around 14bps on the week and 30Y rallying to -4bps on the week by the close. FX markets were a little odd as EURUSD squeezed higher and higher all day (largely ignored until a late ramp) by stocks as JPY's strength kept EURJPY (carry driver) relatively flat. EURUSD ended at 1.3227 (up around 300pips on the week) at its highest in 7 weeks as CFTC net shorts rose once again to new record highs at 171k. Broadly speaking risk assets and ES (the e-mini S&P 500 futures contract) have been highly correlated all week. This afternoon saw CONTEXT pull ES higher (mainly on EURJPY strength, and Oil stability versus TSY/Curve compression) but after the cash market close, ES limped back down to its VWAP to end its worst-performing week of the year (+0.15%) though not down (which we are sure would scare investors away) as stocks handily underperformed credit on the week as high beta starts to unwind.

While the ubiquitous pre-European close smash reversal in EURUSD (up if day-down and down if day-up) was largely ignored by risk markets today (as ES - the e-mini S&P 500 futures contract  - did not charge higher and in fact rejected its VWAP three times), some cracks in the wondrously self-fulfilling exuberance that is European's solved crisis are appearing. For the first day in a long time (year to date on our data), European stocks significantly diverged (negatively) from credit markets today. While EURUSD is up near 1.3175 (those EUR shorts still feeling squeezed into a newsy weekend), only Senior financials and the investment grade credit index rallied today, while the higher beta (and better proxy for risk appetite) Crossover and Subordinated financial credit index were unchanged to modestly weaker today (significantly underperforming their less risky peers). European financial stocks have dropped since late yesterday - extending losses today - ending the week up but basically unch from the opening levels on Monday. High visibility sovereigns had a good week (Spain, Italy, Belgium) but the rest were practically unchanged and Portugal blew wider (+67bps on 10Y versus Bunds, +138bps on 5Y spread, and now over 430bps wider in the last two weeks as 5Y bond yields broke to 19% today). The Greek CDS-Cash basis package price has dropped again which we see indicating a desperation among banks to offload their GGBs and needing to cut the package price to entice Hedgies to pick it up (and of course some profit-taking/unwinds perhaps). All-in-all, Europe's euphoric performance has started to stall as perhaps the reality of unemployment and crisis in Europe combine again with US's GDP miss to bring recoupling and reinforcement back.