Portugal

Festive Friday fun:

• FITCH TAKES RATING ACTIONS ON SIX EUROZONE SOVEREIGNS
• ITALY LT IDR CUT TO A- FROM A+ BY FITCH
• SPAIN ST IDR DOWNGRADED TO F1 FROM F1+ BY FITCH
• IRELAND L-T IDR AFFIRMED BY FITCH; OUTLOOK NEGATIVE
• BELGIUM LT IDR CUT TO AA FROM AA+ BY FITCH
• SLOVENIA LT IDR CUT TO A FROM AA- BY FITCH
• CYPRUS LT IDR CUT TO BBB- FROM BBB BY FITCH, OUTLOOK NEGATIVE

And some sheer brilliance from Fitch:

• In Fitch's opinion, the eurozone crisis will only be resolved as and when there is broad economic recovery.

And just as EUR shorts were starting to sweat bullets. Naturally no downgrade of France. French Fitch won't downgrade France. In other news, Fitch's Italian office is about to be sacked by an errant roving vandal tribe (or so the local Police will claim).

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.

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).

Greek debt negotiations continue. They do seem less afraid of triggering a Credit Event (and some even think it could be a good thing - as we have argued for some time). Estimates are that only EUR100bn of Greek bonds are actually in hands that will follow the IIF recommendations but it is clear that the negotiations are getting tricky (actually they have always been tricky, it’s just that until recently no one was actually negotiating).  The IMF seems insistent that they won’t provide new money without a high participation rate in an exchange with worse terms than many thought.  There are questions about whether the ECB should participate or not and this is in direct opposition to the IMF's need for very high participation and while losses could be hidden by off-market trades to the EFSF, there will be lots more political bickering if that were the case. More importantly, we think, is the Portuguese debt problem, which is much smaller than that of Greece, but should be attracting more attention as we note Portuguese debt hitting new lows (especially post LTRO) unlike the rest of Europe's exuberance.

That Europe has been unable to do the simplest thing, and come to a conclusion in its negotiation with Greek creditors, now running into its six month, is not very surprising. After all this is Europe, where nothing gets done before the deadline, only in the case of Greece the deadline also means the risk of runaway contagion. And as of today there are about 53 days left before the March 20 Greek D-Day. Yet the one thing European should at least be able to do is to have their story straight on what happens once Greece defaults. If nothing else, to show solidarity for optics' sake. Alas, it can't even do that. Because just overnight we have two diametrically opposing stories hitting the tape. On one hand we have Spanish economic minister Luis de Guindos telling Bloomberg TV in Davos that the euro region could withstand a Greek default. This is very much in line with the Jamie Dimon line of thinking that there will be limited fallout. Yet on the other hand, it is that perpetual bag of hot air, Europe's very own head propaganda master Jean Claude Juncker, who ironically told Le Figaro that a Greek default must be avoided at all costs as it would lead to Contagion (read tipping dominoes all over the place). Too bad that both Fitch and S&P said that a Greek default at this juncture is inevitable. And while Juncker's statement in itself is absolutely true, the fact that discord is appearing at the very core of European propaganda - the one place it can afford to stay united until the very end - is troubling indeed. Especially since Juncker also told Le Figaro that Germany can not be asked to do everything alone. Is that a quiet request for the Fed to keep bailing out Europe since the ECB apparently has no interest in doing so?

The US market appears modestly enthused by earlier remarks from Jamie Dimon (who ironically is of Greek descent) who told CNBC that "The direct impact of a Greek default is almost zero."  Note the phrase "Greek default" because it takes us back to that long ago June of 2011 when Jamie Dimon was again giving predictions about events in Greece. In this case, the summary goes to Bloomberg, which penned a piece titled: "JPMorgan’s Dimon Says Greece Won’t Default, Australian Reports."  That's not all. He added the following, from The Australian: "I don't think they will default. I think the more likely outcome is that the European authorities and politicians will find a way to keep Greece from defaulting." It gets better: "It does reverberate because a lot of European banks own Greek debt and investors hold European bank debt. From all of the numbers I have seen, the European banks have enough capital to withstand it." We can only suppose that all the numbers probably excluded the $100 billion in FX swaps that the Fed conducted days after it told Congress it would not bail out Europe, or the OIS+100 to OIS+50 cut in interbank lending rates, because the banks had "enough capital" oh yes, and that €490 billion LTRO, that kinda, sorta indicates that the European banks did not actually have enough capital to withstand either "it" or pretty much any of the events in Q4 of 2011.

All you need to read.

As the world awaits resolution out of Greece and the debt exchange offer which even if passed today would have to cram 6 months of actual work into 54 days, the global bond vigilantes are not sticking around, and continue to attack the next weakest link - Portugal, whose 10 Year bonds just passed 15% in yield, and were trading well below 50 cents of par with CDS hitting a new record of 1350 bps. Naturally this has brought out the ECB's crack bond buying team (only at a central bank does a "trader" need only know how to buy, selling skills are optional) which tried to put the genie back in the bottle but now it is too late. After all, vigilantes are just wondering what form the Portuguese restructuring will take place considering that unlike Greece the bulk of its bonds have strong protections. So if one does use Greece as a benchmark how long does Portugal have? As the third chart shows, the last time 10 year GGBs passed 15% was back in August. So Portugal has 6 months. Give or take.

Easily the best news of the day:

GEITHNER SAYS OBAMA WOULDN'T ASK HIM TO STAY FOR A SECOND TERM - BBG

Oh well, life is tough. Surely that basement office at Goldman Sachs will have some daylight and a TruboTax manual to make post-administrative life bearable for Geithner.

As we have pointed out previously, the primary if not only driver of relative risk returns (because in a world of relative fiat value destruction, it is all relative, except for gold which is revalued relative to all on a pro rata basis), will be who of the big two - the Fed and the ECB - can print more. And up until now, at least since the end of December when the market "suddenly" realized that the ECB's balance sheet has soared to unseen records, the consensus was that it was the ECB that would be the primary source of easing. Especially when considering that there is another ~€500 billion LTRO due on February 29. Yet today's rapid reversal in the EURUSD, driven by Bernanke's uber-dovish comments suggest that something has changed and that the Fed is now expected to ease substantially. How much? For that we look to the latest balance sheet cross-correlation, where if we go by simple correlation, the market is now pricing in (based on the EURUSD cross ratio) that the relationship of the two balance sheets will rise from a multi year low of 1.08 as of a few days ago to 1.15, at least based on the rapid move in the EURUSD higher as can be seen in the chart below. Indicatively, the actual value of the two balance sheets is €2.706 trillion for the ECB and $2.92 trillion for the Fed (or a 1.08 ratio). So now that the EURUSD has risen as high as it has, it implies that the pro forma "priced in" ratio is about 1.15. But wait: one should also factor in the fact that the ECB's balance sheet will rise by at least another €500 billion in just over a month, which will bring the ECB's balance sheet to €3.2 trillion. Which means that to retain the 1.15 cross balance sheet relationship, the Fed's own balance sheet will have to rise to $3,687 billion, or a whopping $767 billion increase!

It was only yesterday that we noted that Spain (and its 23% unemployment) had tipped its cards to expose its utter desperation, when its PM basically begged for a Euroepan bailout. As a reminder, his words: "We support a rescue mechanism, the bigger the better, for it to act as a dissuading element for certain things that we've been going through lately," Rajoy told reporters after meeting his Portuguese counterpart, Pedro Passos Coelho." Certain things such as... a collapsing economy and the threat that neighbor Portugal may soon be in freefall bankruptcy? That said, we have no clue how to describe the escalation that just took place as Spain has once again indicated it is not only on the ledge, but one foot now off it. It probably is a gramophone (it's like an iPod only not made by children). Just not sure if Broken or Broke is the right adjective.

• Rajoy Says Spain Wants Europe Rescue Fund to be Bigger

It is less than two months until the Greek March 20 D-Day past which there is no more can-kicking? Check. Creditor negotiations which are going "so well" they may collapse at any given moment, have had their deadline extended indefinitely just because, and in which hedge funds now have every option to put the country into bankruptcy? Check. You would think Europe is prepared for this contingency right? Wrong. Per Ken Rogoff (who together with Simon Johnson are two former IMF chief economists who have become some of the biggest bears in the world - what is it about not being shackled to one's salary, that allows one to speak the truth), Europe is "clearly unprepared for a Greek default", less than two months from the day when it very well may finally occur. He adds: "there's going to be an endgame to this and it's not going to be pretty.... If you are just printing money and you are not making fundamental change you either lose money and you will have to recapitalize with the ECB or you will get inflation." And it gets worse: "it's not just Greece. You are going to see other restructurings before this is over." He ends with what we have been saying since mid-2011: "Once you set the precedent then say Portugal are going to say 'hey, look how much you gave Greece. How come we don't get the same?'." Unfortunately, the fact that Portuguese bondholders are far more protected than Greek ones will make an in kind restructuring virtually impossible. Which is something else for Europe to ponder as it prepares for the only key catalyst event between now and March 20 - the February 29 LTRO, which as Credit Suisse already suggested could be up to a ridiculous €10 trillion to firewall not only Greece and Portugal, but all the other PIIGS. Intuitively, this does make a lot of sense.

Over the past month, much has been said about the recent 3 year LTRO, and its function in stabilizing the European bond market. Certainly it has succeeded in causing an unprecedented steepening in European sovereign 2s10s curves across the periphery (well, except for Greece, and recently, Portugal) as by implication the ECB has made it clear that debt with a sub-3 year maturity is virtually risk free, inasmuch at least as the ECB is a credible central bank (and if it is perceived as no longer being one, there will be far bigger issues), along the lines of what the Fed's promise to keep ZIRP through the end of 2013, and today's likely extension announcement through 2014. Yet does filling a much needed for European stability fixed income "black hole" equate to a catalyst for Risk On? Hardly, because as in a new note today Brockhouse Cooper analysts Pierre Lapointe and Alex Bellefleur explains, the LTRO is "not a catalyst for a risk-on rally as the central bank is substituting itself for funding sources that have “dried up.” Sure enough - all the ECB is doing is preserving existing leverage (especially in light of ongoing bank deleveraging), not providing incremental debt, something which could only be done in the context of unsterilized bond monetization ala QE in the US. So just over a month in, what does the LTRO really mean for Europe (especially as we approach the next 3 Year LTRO issuance on February 29)? Here is Brockhouse's explanation.

The advance reading of Q4 UK GDP released today came in at -0.2%, slightly below expectations, however many market participants had feared a worse outcome for the indicator, allowing the GBP to pare the losses made in the lead-up to the GDP announcement. The Bank of England minutes released today have shown that the MPC unanimously agreed to keep the UK rate at 0.5%, and maintain the volume of the APF, however they also revealed that some MPC members saw the need for further QE in the future. Despite higher than expected German IFO Business Climate data this morning, European indices are trading in negative territory, with technology and financial stocks suffering the highest losses. This has seen asset reallocations into safe havens, which has seen Bunds outperform for the morning.

Even as the Euro-Dollar 3 Month basis swap has contracted to a nearly 6 month low at -75 bps, on residual hopes that the LTRO will do anything to fix Europe (it won't - just compare it to the €442 billion 1 year LTRO from June 2009 which worked until it didn't for the simple reason that Europe does does not have a liquidity problem), Europe has once again reemerged as a source of risk off (not least of all because the fulcrum security benefiting from the LTRO - the Italian 2 year BTP is for the first time in weeks wider by 17 bps). Why? The same reason as always: Greece, with a touch of Portugal. As BBG observes the positive sentiment in Asia earlier was retraced in the European session, with commodities, FX, equities lower, especially after ECB demurred from accepting losses on its Greek bond holdings. What that means is that as we patiently explained over the weekend, the imminent Greek default (just listen to Soros over in Davos spewing fire and brimstone on Europe for allowing the situation to get to a place where a Greek default is inevitable) will create so many subordinated junior tranches of Greek debt it will make one's head spin. But while the fate of Greece is all but sealed, and a CDS triggered virtually factored in (note: a Greek CDS trigger, in isolation, won't have much of an impact as repeated here before - in fact it will return some normalcy to the market as CDS will be a hedging vehicle once again over ISDA's corrupt trampled corpse), it is what happens to Portugal and its bonds that has the market gasping for air. Because as Zero Hedge pointed out first, a Greek default will be impossible to be enacted in Portugal in its currently envisioned format, as stupid as it may be. In fact, due to the pervasive and broad negative pledges in most medium-term Portuguese bonds, any priming Troika bailout is impossible without providing matching collateral for everyone else under UK indenture bonds!