US data this week is relatively sparse (as usual in a post payroll week) leaving little evidence over the next few days to progress the seasonality debate but after a long weekend of derisking in mind and now in reality, Europe is front-and-center once again. Spain (and less so Italy) has decompressed to its worst levels of the year (5.96% yield and 425bps spread on 10Y) has now lost all of the LTRO gains as the curves of these liquidity-fueled optical illusions of recovery bear-flatten (as front-running Sarkozy traders unwind into the sad reality - most specifically for Spain - that we described in glorious must read detail here). Divergence and decoupling remain sidelined also as Deutsche Banks' Jim Reid notes the 4-week rolling beat:miss ratio in the US macro data has fallen to 24%: 73% (3% in line) from a recent peak at a string 70%:30% on February 29th. His view is still that in a post crisis world, especially as severe as the one we've just been through, Western growth is going to continue to be well below trend for many years and with more regular cycles. With Spain teetering on the verge of a 6% yield once again, we are still off the record wides from late November but not by much as the vicious cycle of sovereign-stress-to-banking-stress-to-banking-stress re-emerges in style. The European situation is still incredibly political and while we'd expect much more intervention down the line, expect the discussions and rhetoric to be fairly tough. The ECB last week indicated that they felt the recent widening in Sovereign spreads was more due to sluggishness in the pace of reforms. They are therefore unlikely to intervene in a hurry. So if Europe does need further intervention it is likely to need to get far worse again first.
Whether it was the truthiness of Willem Buiter's comments this morning, the sad reality of Spanish housing, or more likely the ugly fact that LTRO3 is not coming (as money-good assets evaporate), today was broadly the worst day of the year for European sovereigns. Spanish 10Y spreads jumped their most since the first day of the year, Italian yields broke back above 5% (and spreads broke back over 300bps), and Belgium, France and Austria all leaked notably wider. Since Friday's close, Italian and Spanish bonds have suffered their largest 2-day losses in over 3 months. Notably the CDS markets rolled their contracts into Monday and perhaps this derisking is real money exiting as they unwound their hedges - or more simply profit-taking on front-run LTRO carry trades but notably the LTRO Stigma has exploded in the last few days back to near its highs. European equity markets are now underperforming credit - having ridden the high-beta wave far above credit markets in the last few months (a picture we have seen in the US in Q2 2011 and HY is signaling risk-aversion rising in the US currently in the same way). Just how will the world react to another risk flare in Europe now that supposedly everything is solved?
Once again European credit and equity markets flip-flopped intraday from a gap up open (yay, the PSI deal is done) to a modest financial-led selloff on weak data, to a non-financial-led small rally (with equity beating credit post US NFP) to a slide weaker into the European close. Financials (most notably senior unsecured) were the worst performers on the day as stocks managed small gains and credit bigger losses. European sovereign spreads also leaked wider all day after some initial excitement with Italian 10Y spreads 15-20bps off their best levels of the week into the close (and Portugal also leaking wider). US Treasuries continued to selloff as US equities limped higher but EURUSD is pushing back to the week's lows near 1.31 as JPY is also deteriorating (which is modestly stable for carry FX and implicitly risk). Commodities surged (seemingly on Goldman's GDP cut implying great er hopes of QE?) with Gold up over $1710 and almost unch for the week as WTI nears $108 again. As Europe closes, there is a modest derisking across all asset classes (with US and European financials the most obvious rollers). The Precious metals rip and Treasury weakness makes us wonder how much is QE-driven (especially given the sterilized propositions) and how much is simply a rotation to a different kind of safety or quality collateral? The LTRO Stigma is around 8bps (or 10%) higher on the week while Senior-Sub spreads are stable for now.
Broadly speaking markets are derisking post the PSI deal announcements. Treasuries are 1-2bps lower in yields, EURUSD is down 35pips or so under 1.3230 (and JPY is rallying as carry is unwound), ES has dropped -5pts, Gold and Silver are sliding modestly, and WTI is off its peak but remains over $107.
Last night we noted the very concerning rise in margin calls for European banks thanks to collateral degradation at the ECB. This story has become very popular as traders try to figure out which assets were deteriorating rapidly and which banks face immediate cash calls. One thing that came to mind for us was - what about Gold? Coincidentally or not, the last time we saw a big surge in collateral margin calls by the ECB (in September of last year), not only did Gold lease rates explode (implode) but Gold prices fell off a cliff as the squeeze came on from gold liquidity providers pushing prices down to exacerbate the negative lease rates on the gold collateral. The point here is that as margin calls come in from the ECB, we wonder whether banks will be forced to liquidate their gold (last quality collateral standing) to meet the ECB's risk standards. The key will be to watch gold lease rates (as we explained here and here) and ECB Margin calls to see if Gold is merely suffering a short-term dip from USD strength derisking or if this is a more broad based meeting of collateral desperation need that might have legs - only to be bought back later. MtM losses combined with collateral calls (as we noted earlier) was never a recipe for success and we will be watching closely.
We have been warning that the stocks of the major US financials are on weak ground for a few weeks as credit (and implied vol) markets for the TBTFs had been underperforming notably. Today saw the financials ETF, XLF, have the largest down day in three months (dropping over two standard deviations), breaking its uptrend and heading for its 50DMA. As volumes in stocks and stock futures surged to year-highs, we note that the major financials were much worse hit than the broad ETF, roughly separated into 3 groups: Good (JPM, WFC), Bad (GS, C, BAC, GE), and Ugly (MS). While the market is 'only' down around 2%, it is worth noting that Financials and Energy stocks are back at five-week lows, while Industrials and Materials are back at two-month lows as the growthium hope fades. Risk was very highly correlated on the downswing today and along with significantly higher than average volume suggests more broad de-risking than idiosyncratic profit-taking as some would like to suggest. Commodities made headlines as Silver is now down over 5% on the week but Gold stabilized for much of the post-European close session around $1675. The vol term structure snapped flatter today, catching short-dated premium sellers fingers as it tends to, ripping to its flattest in 3 weeks as VIX jumped almost 3 vols to around 21% (back above its 50DMA for the first time since Thanksgiving), with its biggest rise in three months.
While we have noted the comparative weakness in European credit and sovereign markets, stocks had so far remained hopeful until today. Bloomberg's broad BE500 index of European stocks fell 2.8% today, its worse performance since mid-November when the recent rally began. This one-day drop has wiped out the gains of the last five weeks in stocks and credit is even worse as it continues to lead risk lower. European financial stocks are catching up to European credit's weakness (and we note US financial credit is really coming off today). Whether or not to BTFD is the question. We note that this sell-off is much more broad-based with stocks and credit dropping together (instead of just credit last time) and across asset classes the weakness is in CONTEXT with broad derisking. Furthermore, Sovereign credit stress re-emerged with Spain and Italy up 26bps and 18bps on the week as the former is now at almost 4 week wides. At some point, we wonder when MtM losses will hit all those aggressive Italian and Spanish banks who loaded up on chaotically procyclical carry trades?
As we pointed out on Friday, there is a clear stigma being priced into LTRO-encumbered European banks relative to non-LTRO-encumbered (due to many aspects but most notably the implicit subordination of senior unsecured debt via collateralized loans to the ECB). Today that stigma, proving as we said that Draghi is simply incorrect, continues to grow as there is a dramatic preference for non-LTRO names in today's modest post-Greece's gun-to-my-head decision relative to a small improvement in LTRO-accepting names. As this performance gap increases we suspect it increases the probability that LTRO II will be a disappointment in terms of size and the implicit derisking that could encourage.
UPDATE: EURUSD back over 1.32 and TSYs +2bps on Greek loan plan news.
Credit (and vol) continue to lead the way as smart deriskers as ES (the e-mini S&P 500 futures contract) ends down only 0.5% - which sadly is the biggest drop since 12/28. The late day surge in ES, which was not supported by IG or HY credit (and very clearly not HYG - the HY bond ETF - which closed at its lows and saw its biggest single-day loss since Thanksgiving), saw heavier volumes and large average trade size which suggest professionals willing to cover longs or add shorts above in order to get filled. Materials stocks underperformed but the major financials had a tough day as their CDS deteriorated to one-week wides. VIX (and its many derivative ETFs) had a very bumpy ride today. VXX (the vol ETF) rose over 14% (most in 3 months) at one point before it pulled back (coming back to settle perfectly at its VWAP so not too worrisome). After the European close, FX markets largely went sideways with the USD inching higher (EUR weaker) as JPY strength reflected on FX carry pair weakness and held stocks down. Treasuries extended their gains from yesterday's peak of the week yields as 7s to 30s rallied around 6bps leaving the 30Y best performer on the week at around unchanged. Commodities generally tracked lower on USD strength with Oil the exception as WTI pushed back up to $99 into the close (ending the week +1.1% and Copper -1.1%). Gold and Silver ended the week down almost in line with USD's gains at around 0.25-0.5%. Broadly speaking risk has been off since around the European close yesterday and ES and CONTEXT have reconverged on a medium-term basis this afternoon (to around NFP-spike levels) as traders await the potential for event risk emerging from Europe.
While the EURUSD's recovery post Europe's close seemed to modestly support stocks, the USD is still up from Friday's close as ES (the e-mini S&P 500 futures contract) closes marginally in the green against the direction of FX carry, Treasuries, commodities broadly, and credit. The volumeless (and gravitationally unchallenged) push from post-Europe dip lows this afternoon were generally ignored by VIX, investment grade, and high-yield credit markets, after the morning was a relatively significant amount of selling pressure in HYG (the increasingly significant high-yield bond ETF) to pre-NFP levels only be bough all the way back and some more into the close. Average trade size and deltas had a decidedly negative feel on every algo-driven push higher from VWAP to unchanged but the divergence between Brent and WTI dragged the Energy sector over 1% higher (as every other sector lost ground with Financials and Materials underperforming. Treasuries rallied well from the Europe close and closed just off low yields of the day as commodities all ended lower from Friday's close with Copper and WTI underperforming and Silver just edging Gold as they hovered around USD's beta for the day. VIX dropped modestly after the cash close but ended higher on the day with a notably low volatility of vol from mid-morning onwards (and the late-day vol compression seemed index-driven as implied correlation also fell commensurately). A quiet day in European sovereign and financials along with the disastrously low volume day in ES and on the NYSE really don't feel like signs of broad participation as Greek events slowly but surely unfold along the path of known resistance.
One of the major factors in the Central Banks of the world having stepped up the pace of flushing the world with increasing amounts of freshly digitized cash is writ large in the contraction in credit availability to the real economy (even to shipbuilders). Anecdotal examples of this constrained credit are everywhere but much more clearly and unequivocally in tightening lending standards in all of the major economies. As Bank of America's credit team points out, bank lending standards to corporates have tightened globally in Q4 2011 and the picture is ubiquitously consistent across the US, Europe, and Emerging Markets. Whether it is deleveraging, derisking, or simple defending of their balance sheets, banks' credit availability is becoming more constrained. While the Fed's QE and Twist monetization and then most recently the ECB's LTRO has led (aside from self-reinforcing short-dated reach-arounds in BTPs and circular guarantees supposedly reducing tail risk) to nothing but massive increases in bank reserves (as opposed to flowing through to the real economy), we suspect it was designed to halt the significantly tighter corporate lending environment (most significantly in European and Emerging Markets). The critical corollary is that, as BAML confirms, the single best non-market based indicator of future defaults is tightening lending standards and given the velocity of shifts in Europe and EM (and very recent swing in the US), investors reaching for high-yield may be ill-timed at best and disastrous credit cycle timing at worst (bearing in mind the upgrade/downgrade ratio is also shifting dramatically). Liquidity band-aids are not a solution for insolvency cardiac arrests as the dual vicious cycles of bank and sovereign stress remain front-and-center in Europe (with EM a close second) and the hope for real economic growth via credit creation kick-started by an LTRO is the pipe-dream the market is surviving on currently.
The so-called January-Effect is almost at an end and if the market closes near these levels, the S&P 500 will have managed a 4.4% gain or its 20th best January since 1928 (84 years) and best since 1997. The outperformance of banks and sovereigns (LTRO) and the worst-of-the-worst quality names (most-shorted Russell 3000 stocks +9% YTD vs Russell 3000 +5.2%), as Morgan Stanley noted recently, is not entirely surprising since the January effect is considerably larger in mid-cap and junk quality names than any other size or quality cohorts. We have pointed to the seasonal positives in high-yield credit and volatility and along with the obvious short squeeze in S&P futures (which has seen net spec shorts come back to balance recently), we, like MS, are concerned that the tailwinds of exuberance that virtuously reflect from seemingly pivotal securities (such as short-dated BTPs now or Greek Cash-CDS basis previously) very quickly revert to a sense of reality (earnings and outlook changes) and perhaps the slowing rally and rising volatility of the last few days is the start of that turbulence.
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.
Remember back in long distant memories (from a month ago) when all the chatter was for the US to decouple from Europe as the former (US) macro data was positive and a 'muddle-through' consensus relative to the European debacle took hold. Since 12/14, European markets have significantly outperformed US markets (both broadly speaking and even more massively in financials - which is impressive given the strength in US financials). Furthermore, we saw a decoupling of correlation (de-correlating) between EUR and risk as a weaker EUR was positive for risk as USD strength showed that the world was not coming to an end (and Europe was 'contained'). Well things are changing - dramatically. EUR and risk were anti-correlated for the first two weeks of the year and since then have re-correlated. The last few days have seen EUR weakness (Greek PSI and Portugal fears) coincident with risk weakness (ES and AUD lower for instance as US macro data disappoints and a dreary Fed outlook with no imminent QE). Given the high expectations of LTRO's savior status, European financials have been the big winners (+20% from 12/14 and +15% YTD in USD terms) compared to a meager +12% and +8.8% YTD for US financials - with most of the outperformance looking like an overshoot from angst at the start of the year in Europe (which disappeared 1/9). With EUR and risk re-correlating (and derisking very recently), perhaps it is time to reposition the decoupling trade (short EU financials vs long US financials) though derisking seems more advisable overall with such binary risk-drivers as Greek PSI failure, Portuguese restructuring (yields have crashed higher), and the Feb LTRO pending (which perhaps explains the steepness of vol curves everywhere).
Amid the best start of the year for the S&P 500 since 1987, Nic Colas of ConvergEx offers some deep thoughts on how behavioral finance concepts can help us understand the dichotomy between last year's derisking and this year's rerisking in terms of market participant psychology. Between delving into whether a short-sharp or long-slow colonoscopy is 'preferable' Nic reflects (antithetically) on 10 bullish perspectives for the current rally and how the human mind (which still makes up maybe 50% of cross-asset class trading if less in stocks) processes discomfort in very different ways. Critically, while it sounds counter-intuitive to him (and us), focusing on the pain of recent volatility is actually more conducive to investors' ability to get back on the horse especially when the acute pain is ended so abruptly (intervention). As studeis have found, "subjects who actually focus on a painful experience while it is happening are more willing to immediately undergo further pain than those who performed some distracting task"