Tick By Tick Research Email - A Delirious Mr Mario Draghi

Dear All

When contemplating what I was going to write about for the first instalment of this weeks' market comment, I thought I had it cracked.  However, by 2pm on Friday, my original subject matter had to be put on the back burner so that I could explain exactly what just happened.  By what, I am referring to the mass cull of Sovereign Credit ratings across the Eurozone and the profound effects that it will have globally despite what Mr Sarkozy may opine.

Where to start? Where to start?  Well, whilst the ratings are a significant blow to the ego of a certain brown-haired little French man, the market - at least the rational participants - had been expecting such a move for a couple of months now.  The team at Zerohedge even seemed to joke about the matter on Twitter weekly.  It seemed that every Friday the hope filled equity markets would be thrown into turmoil by a "downgrade rumour", only to find the murmurs unfounded and for participants to resume their hope fuelled rally on Monday morning.  However, this time, the new "i've grown a pair" S&P decided to actually follow through with the threats and warnings that have been emanating for months.  A move that we should all applaud.  Someone had to bring things back to reality.

"A man in debt is so far a slave"

Ralph Waldo Emerson

Those following the Sovereign bond yields or viewers of the mainstream press could have been fooled into thinking that things were actually on the up.  On Wednesday, Germany successfully managed to auction off their 5 year bonds at a record low yield (by the end of the trading day) of 0.74% with a healthy bid-to-cover of 2.8 which, compared to a couple of shaky previous auctions, is a move in the right direction.  Despite the low yields suggesting a bearish formation going forward, the primary focus was on the elusive bid-to-cover that reflected a strong uptake of the new debt.  Roll on Thursday and the ever delusionary Spaniards manage to issue both 3 year and 10 year debt at significantly better levels than expected which, of course, sent the equity markets in pandemonium.  Were saved.  Hoorah!  Later that afternoon, Mr Draghi bought us back down to the real world with a sobering speech warning of the threats that still exist in the Eurozone but was quite clear that the measures HE has put in place seem to be working.  (We will elaborate next paragraph).  To add a cherry to the already glorious week for the Eurocrats, even Italy managed to secure the first 4.75bn Euros of funding it needs this year.  Just another 305bn Euros to go then.  No sweat.

"A second reason why science cannot replace judgment is the behaviour of financial markets" 

Martin Feldstein

Now for the Who? What? and Why? Well back in December, the "genius" that is Mr Draghi set up the ECB's Long Term Repo Operation to plug the liquidity crisis (yes, he still struggles with the liquidity solvency differentiation).  In doing so, he offered all of the European banks colossal amounts of cash - just the cool half a trillion freshly printed Euros - at the dirt cheap interest rate of 1% in exchange for any collateral they could muster.  A similar situation to one of us mere mortals swapping an old car for Buckingham Palace.  Of course, the banks took up Mr Draghi's kind offer and proceeded to hoard the money back with the ECB within the hour.  Hmmm.   

Now without full verification via the ECB holdings data, it can only be assumed, and not proved, that some of these insolvent illiquid banks have finally plucked up the courage to purchase the profligate nations' debt to earn a carry.  A decision that they are now, almost certainly, regretting following the downgrades.  The issue is a little more complex than the media suggest, but in the simplest of terms, when a bank is asked to fulfil a certain level of capital adequacy, there needs to be some form of security assumption behind that capital.  As a result, the clever fellows over at the Basel Committee decided that a discount factor needs to be applied dependent on the different credit ratings.  For instance, before Friday, holdings of Italian debt would have been assigned a risk weighting of 20%, a figure that after the announcement is now 50%.  Great news all around ey?  This is not the only factor either, as I have previously stated, holding assets of (soon to be) deteriorating value on your balance sheet will also increase your financial leverage and, after both Bear Stearns and MF Global, we all know how that story ends.  

"When you combine ignorance and leverage, you get some pretty interesting results"

Warren Buffet

So now that the banks have reduced the quality of their capital and loaded up on even more risk assets, we can all rest assured that there is no more liquidity issue according to Mr Draghi.  Do remember, his measures are "working".  Only solvency to fix now..but wasn't that the...  Moreover, it isn't like pension funds have to sell debt instruments when they fall outside a band of credit ratings is it? 

Before, I share a number of articles for the start of the week.  I cannot help but mention the late Friday afternoon QE3 rumour that wiped out almost all of the downside experienced following the S&P leak.  I ask only two questions of you:  If QE3 were to happen, what level do you think the price of Oil would reach?  And secondly, if the high price of one commodity asset was going to accelerate a US decline, what do you think it would be?

This week, we have a great selection of articles for you to read.  These include the full S&P FAQ sheet on the downgrade which is a must read, Macro Man's annual predictions, David Rosenberg's review of the bullish argument, the Economist looks at Purchasing Power of Parity and a truly scary Spanish Unemployment graph.  Enjoy.

1) Credit FAQ: Factors Behind Our Rating Actions on the Eurozone Sovereign Governments - Standard and Poors (Click HERE)

2) 2012 Non-Predictions - Rates - Macro Man (Click HERE)

3) David Rosenberg Explains What (If Anything) The Bulls Are Seeing - David Rosenberg (via Zerohedge) (Click HERE)

4) The Big Mac Index - The Economist (Click HERE)

5) Spanish Unemployment (23.3%) - Zerohedge (Click HERE)

Before I go, I would like to remind you all that this week will see the US Congress debate the raising of the upper limit of the US debt limit which always proves interesting.  More to come later in the week.

Best Regards

George Adcock 








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