Sovereign Risk

The dead cat bounce in the most shorted names is taking some of the recent peripheral high fliers tighter, at the expense of increased widening at the "risk-free" core. We expect much more of this risk transfer from the zone of perceived risk to the heart of Europein the weeks/months to come. Some key levels: HY 600, IG 101, SovX 110., Greece 415, Portugal 225, UK 99.50

Sovereign risk was once again front and center on the minds of investors today. Despite the EU's efforts to 'back' Greece's cost cutting plans, investors remain far less sanguine than Almunia. Greek bonds managed a small 7bps rally relative to Bunds (which widened 2bps) as CDS were around 9bps wider (compressing the basis a little more). Don't read too much into the small rally in bonds (the basis remains wide at 55-60bps and we suspect given the convergence today that some are putting the trade on).

Spreads were mixed in the US with IG unch, HVOL wider, ExHVOL weaker, and HY rallying. IG trades 1.5bps wide (cheap) to its 50d moving average, which is a Z-Score of 0.2s.d.. At 92.25bps, IG has closed tighter on 30 days in the last 282 trading days (JAN09). The last five days have seen IG flat to its 50d moving average.

After the earlier announcement of record risk in Portugal, it was only a matter of hours before the epicenter would feel an aftershock. Indeed, Greece CDS is now back to over 400 bps, after tightening under 370 bps yesterday. Those poor protection sellers just can't catch a break. The dollar flight to safety trade is on again. Lack of robotic, or otherwise, volume means the stock market has yet to digest what all this means. Lastly, in pursuit of an efficient sovereign risk market, STUPIDity is now back to April 2009 levels.

"Judging from market valuations, I sense quite a gap between consensus market expectations and key political and economic realities, especially in the U.S. If the gap isn’t bridged by the validation of the more optimistic expectations, investors may well find that January’s global equity sell-off was just a precursor to a disappointing year for several asset classes, including stocks." - Mohamed El-Erian

The last thing that the fixed income market needs now, with ever greater uncertainty out of European bond land, is weakness where it hurts the most: the US balance sheet. Yet last Thursday's H.4.1 report indicated something which could be more troubling than even Greece's credit crisis morphing into a liquidity one, namely, that foreign central banks' UST holdings at the Fed declined for the first time in over two years. And while the indirect take down for auction after ever larger auction seems to not miss beat, we are very interested in how Mr. Geithner will explain this trend, especially should it persist into February, and maybe longer.

Yet another rumor denied vehemently by the Greek Finance Ministry, which automatically means it is 100% true, is that Greece rescue talks are reaching a fever pitch, and according to FT-Deutschland, Germany is seeing increasing pressure to bail out the struggling country. As Dow Jones reports "rescue talks are being held in the EU and with certain capitals about aid for Greece, according to the sources, the report adds. Several options are being discussed, one of which being bilateral loans from some euro zone countries, where Germany would have to shoulder a major part as the euro zone's largest economy."

"Once private demand has become self-sustained, the sequencing of exit from accommodative monetary and fiscal policy should be guided by a variety of considerations, including whether: high fiscal deficits and debt are raising concerns about sustainability and sovereign risk—which is the primary consideration in many countries; low interest rates might be contributing to asset price bubbles; the exchange rate is under pressure to appreciate or depreciate as well as its position relative to medium-term fundamentals; and how quickly monetary or fiscal policy can be adjusted to changes in domestic demand." - IMF

Must read: UBS Macro Sales (note, this is likely not the UBS house view) calls for a peak in Emerging Markets. "To me this is our Bhutan Dry Docks moment. The economic argument supporting EM investment is valid -as I pointed out earlier, you can't create a bubble without something that initially supports investment flows - but its gone too far. When I read market commentary that suggest that
the Shanghai composite share index (see below) is now better value because price earnings ratios have come down from 100 to 50 its like déjà vu all over again. I wrote stuff like that back in 94 - just before the peak - just before the crash - just before the US rate cycle turned. I'm calling a top in emerging markets. Q1 2010 will still see massive money flow into the asset class as portfolio decisions are driven by last year's stellar performance and developed market pessimism, but starting in Q2 as Paul's setting change comes closer, it is time to call a top to the twin liquidity bubble of this cycle - traded commodities and emerging markets."

Dubai - meet Greece. Apparently credit traders appreciate biblical allusions, as Greek Prime Minister George Papandreou "promised" for the third time today that all is good in the debt-stricken country, claiming there is "no way" the country would leave the euro or seek aid from the IMF. Credit's response: Greek CDS surges to an all time high of 327 bps, and the country now represents 24% of SovX risk.

In continuing the rant on the possibility of the US entering a stagflationary environment, as was hinted by Alcoa's quarterly report (see "Is My Warning of the Risks of a Stagflationary Environment Coming to Fore?"), I have decided to graphically illustrate the historically most successful inflation hedges as well as demonstrate where North America and Western Europe currently stand.

Big devaluation in Venezuela over the weekend. The locals knew about it in advance. The Black Market was trading at 3X's the official rate.

Does it matter? I think it might. It is just more of that 'sovereign risk" story that keeps popping up.

The most recent broker to realize that private risk does not exist as a result of global moral hazard is Deutsche Bank, which is actively promoting ta long risk/short sovereign CDS trade. That is happening as IG13 trades at its all time record tights of 77 bps. In other words, buying an index of 125 investment grade credit provides less than 1% of incremental risk return. Pretty soon the ABX trade will be buying IG. Until then, however, the only risk continues being that of sovereign balance sheet, courtesy of onboarding of virtually all private sector risk at the Central Bank and via other backstop mechanisms.

In a report "Predicting Sovereign Debt Crises: 2010 Update" RBS' Timothy Ash is the latest one to chime in on the sovereign risk theme, a topic that has been prevalent ever since Bernanke did the great private-to-public risk bait and switch, which in turn was followed to a great extent by all the countries in the world. Soon, in addition to a risk to the bottom in carry trades, and inflation expectations, we will see a risk acceleration, once countries realize the fringe benefits arising from being the first defaulting sovereign in a global moral hazard climate.

Funny how things can turn on a single word. Especially if that word is from a Central Banker.

The frenzy to cover dollar shorts seen over the last three weeks sent the greenback onto its first monthly increase since June; meanwhile, gold has fallen about 8.1%. How will the gold, dollar and euro triangle likely play out in 2010?