Guest post by Macronomics. This credit market review includes comments and links to further readings on the possible leveraging of the EFSF. I've previously said "hire me" several times. Now I say hire him instead.
In case you missed it, I posted Weekender on Saturday, full of commented and summarized links to read on the euro crisis and some recreational material as well. The three European central bankers following my site are strongly recommended to check that update. I've also updated the Calendar. For news, check Monday Watch (Weekend headlines) by Between The Hedges. I will make a regular post later today.
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"Only the educated are free."
Epictetus
Misery loves company, and this quarter, there has been plenty, in nearly all asset classes.
We know from the last few credit posts, that the ongoing European debt crisis, led to liquidity concerns. As solvency issues became more acute, credit spreads started widening significantly and with liquidity deteriorating, we have had a shut down in effect of the unsecured term funding market for banks in the process. Poor economic data with US revised GDP figures, US and European downgrades, following the debt ceiling debate and the European game of kicking the can down the road, finally leading to equities taking the plunge, redemptions/liquidations in commodities, Emerging Markets, catching up as well, with various currencies impacted in the process and of course credit wasn't really spared either.
It is going to be another long post. Many important points to go through.
We will start with credit with a recap of what happened in the third quarter and what to expect next.
Societe Generale and its latest Credit Weekly published on the 30th of September sum it up nicely:
"New quarter, same problems: There’s no drawing a line in the sand as we enter Q4 after a disastrous third quarter for credit. The ratification by the German parliament of the EFSF helps at the margin, but it was what the market needed…. in July. We’ve moved on, and the politicians remain well behind the curve. With a leveraged/further expanded facility looking unlikely at the moment, we suspect the market will continue as is. That means low turnover, poor liquidity and pockets of supply where issuer curves get repriced aggressively. The iBoxx at B+316bp with 118bp of widening in the quarter still leaves us unable to answer what the next big three digit spread move will be. There might be some temptation to add, but we would stay sidelined until we get some clarity. The price action at the
end of the week serves to highlight how jittery and depressed the
market remains. It could be a long run into year-end."
So you can expect more of the same unfortunately given current dislocation in the credit space, where any new issue which is able to come to the market, leads to a vicious repricing of the secondary market:
The lowest level of issuance in September since 2001 in Investment Grade credit (BBB- minimum).
We also know from previous post that apart from covered bonds backed by pools of prime loans, the market of new issues for bank remains a concern.
But, this week, on Thursday, Deutsche bank came to the market with a 2 year Senior Floating Rate Note (FRN) having to pay significantly up to reopen the senior market. For instance, Deutsche Bank issued a similar two year FRN in February at 3month Euribor + 40 bps. This issue was trading at around Euribor +70 bps in the secondary market, yet they came to the market this time around paying Euribor +100 bps. But, on Friday, ABN Amro Bank tested the market for a similar 2 year Senior FRN, having a very close rating profile to Deutsche Bank (ABN Amro Bank - Aa3 / A / A+ / A High all stable outlook), this time around pricing thoughts were Euribor + 130 bps. 30 bps more. What a difference a day makes these days...
In terms of issuance, corporate credit markets have had their worst quarter in Europe since the demise of Lehman.
According to Ben Martin from Bloomberg on the 30th of September:
"The Markit iTraxx Crossover Index of credit-default swaps linked to 50 companies with mostly high-yield credit ratings climbed more than 400 basis points since July 1, the biggest rise since the fourth-quarter of 2008 when it surged 456 basis points, according to data compiled by Bloomberg. Relative yields on investment-grade company bonds have increased the most on record, Bank of America Merrill Lynch data show. Yield spreads on investment-grade bonds have surged 140 basis points since the start of the quarter to 309 yesterday, the EMU Corporate index of 1,763 securities shows."
And from the same article, Jim Reid, head of fundamental strategy at Deutsche Bank AG in London commented:
"The stats speak for themselves. You’ve got a situation where if the European authorities drop the ball it could be worse than 2008."
And my good credit friend to comment on Friday:
"The European Credit Market did not really perform and is very weak again today following both the European inflation figures at 3% and the understanding that the overall (IG Main Europe is trading at 198 bps, higher than 3 days ago).
So the outlook is still not positive, and it will not be as long as credit investors are ready to pay that much to remain short and/or insured against the risk of default. The actual cost is about 8 % for junk rated companies and 5% for subordinated debt (LT2 … not Tiers 1 for which there is no CDS and the only hedge is equity)."
And in relation to issuance, here is what Societe Generale had to say in their report:
"The French are close to being funded – any more will lead to saturation of the market (nine issues this month alone), German corporates are unlikely to print at these levels and don’t need the cash, while Italian and Spanish corporates are unable to access the capital markets and the slack is unlikely to be taken up elsewhere. The Deutsche Bank deal is the only one from the banking sector since the beginning of July and is unlikely to open the market for others in any big way – if at all. Covered bond issuance came in at just under €5.5bn, but again this is the lowest total for September since at least 2005. The high yield market is effectively closed after Heidelberg’s 9.5% deal on Wednesday essentially made the barrier for other issuers insurmountable."
We know:
"The recent significant increase in credit spreads for many financials has been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates."
The race for funding/capital is on, and even in the corporate high yield space. Survival of the fittest...and defaults we could have as it looks highly likely by know we might enter another period of recession.
Mind the gap...
The Itraxx CDS indices picture on Friday - source Bloomberg:
Itraxx Crossover 5 year index (High Yield), wider by 47 bps to around 842 bps
Itraxx Europe Main 5 year index (Investment Grade), wider by 12 bps to around 202 bps.
Itraxx Financial Senior 5 year index wider by 19 bps to around 280 bps
Itraxx Financial Subordinate 5 year index wider by 34 bps to 535 bps.
SOVx 5 year index western Europe (15 European countries, sovereign CDS risk) versus SOVx CEEMA (Central Eastern Europe, Middle-East and Africa) - source Bloomberg:
SOVx CEEMA trading now wider than SOVx Western Europe, as contagion has spread to other regions with the ongoing European crisis.
The liquidity picture - source Bloomberg:
Not really improving, ECB overnight facility deposits on the increase. The reserve period started on the 14th of September and is shorter this time, 28 days until next reserve period.
Flight to quality mode on Friday following the inflation figures in Europe coming at 3% (2.5% expected), German 10 year Government bond versus Germany 5 year CDS - source Bloomberg:
More delays and inactions by European politicians could therefore have significant consequences in the credit space.
Everyone is hoping the EFSF is the silver bullet for the European debt issues plaguing Europe. I do not believe it is and agree completely with my good credit friend, which is a good follow up on the post "Much ado about nothing" where we discussed EFSF being a CPDO redux:
"While everybody is waiting for “The Solution” and rumors are the investors’ daily bread, volatility remains high. I have been asked a lot of questions about the EFSF and its capacity to be used to sort out the current crisis… To be honest I do not know how the EFSF will help recapitalizing the banking system. But I can tell you that the EFSF is structured in a way that there is no pre-funding, that there is not implicit guaranteed by the full faith and credit of the guarantors, and that the structure will be subordinated to the new coming structure called ESM. This means that the cost of funding of the bonds issued by the EFSF will continue rising each time a European State will be downgraded. EFSF bonds are already trading 1% above German government bonds. In addition, any rumor about increasing the EFSF size is based on a totally misunderstanding of the consequences of such a bold act. With a lending capacity of 440 billion and a commitment of 780 billion of guarantees, the structure has already a leverage of 165 %...doing more would be inconsiderate and would imperil the ratings of France and potentially Germany! Keep in mind that any downgrade will impact the rating of the structure and its funding costs, which will weight on its ability to help the countries in need. In addition, any bond issued by the structure has a defined number of guarantors and this number is decreasing as more States cannot commit anymore: as an example, the first bond issued to help Ireland had Portugal among its guarantors …. And Portugal cannot guarantee new issues anymore! So the ability of the EFSF to raise money is impaired each time a country is downgraded, putting pressure on the countries which still have a strong rating.
Any solution will have to go through the ECB as there is no other viable possibility."
For more on why the EFSF is not the Holy Grail, I recommend reading the following opinion from M&G Mike Riddell:
M&G's Riddell: Ten reasons why the EFSF is not the Holy Grail
While all eyes are still focused on the ongoing European crisis, we discussed contagion to Emerging Markets in our post - "Markets update - the EM Contagion" and it could be a significant event - source CMA, Sovereign CDS 5 year Wideners on Friday:
Asian sovereigns 5 year CDS widening, the picture on Thursday - source CMA:
![[Graph Name]](http://i5.createsend1.com/ei/y/A9/3AF/65D/221501/images/dtrend1.gif)
And Japan affected as well - source CMA:
SOVx Asia 5 year CDS as of close 28th of September - source Bloomberg:
With the slowdown in Asia, we know China has been withdrawing subsidies program such as the one HAIER Electronics Group Co, one of the world's leading white goods home appliance manufacturers benefited from, leading to a significant sell-off of its shares:
Looks like there are some additional collateral damages, due to China withdrawing its subsidies/stimulus program. This time it is number two in the home appliance sector, namely Gome Eletrical Appliances Holding, which fell 22% on Friday, the most in almost three years. This time around following a Credit Suisse note on transparency and funding concerns according to Bloomberg.
GOME going?
In relation to the Emerging Markets contagion story we have been discussing recently, the currencies movements we have seen so far have been fairly important. In fact Asian currencies have had their biggest monthly loss in more than a decade:
South Korean won, worst month since February 2009 and Taiwan dollar dropped the most since 1997 according to Bloomberg:
"The Bloomberg-JPMorgan Asia Dollar Index slid 3.9 percent this month to 114.98, the biggest drop since December 1997."
Sinking Won and plunging Real leading to inflation concerns - Source Bloomberg:
Bloomberg chart indicates:
"THE CHART OF THE DAY shows the so-called breakeven rate on South Korea’s inflation-protected security due March 2017 rose 16 basis points this month to 2.93 percent yesterday, the most since February, as the won weakened 9.1 percent. In Brazil, the two-year breakeven rate jumped 40 basis points to 6.21 percent as the real slid 12.9 percent. The gauges measure the gaps between inflation-linked and conventional bond yields and indicate expectations for average annual inflation until the debt matures."
And we know Central banks in Emerging Markets have been busy trying to sustain the stability of their currencies: Russia, Argentina, India, Brazil, South Korea, selling dollars and for some starting to deplete their dollar reserves in the process.
But before we go through some of the reasons behind these currencies movements tied to commodities selling off, it is time for a coffee break:
Source Bloomberg
Epictetus
Misery loves company, and this quarter, there has been plenty, in nearly all asset classes.
We know from the last few credit posts, that the ongoing European debt crisis, led to liquidity concerns. As solvency issues became more acute, credit spreads started widening significantly and with liquidity deteriorating, we have had a shut down in effect of the unsecured term funding market for banks in the process. Poor economic data with US revised GDP figures, US and European downgrades, following the debt ceiling debate and the European game of kicking the can down the road, finally leading to equities taking the plunge, redemptions/liquidations in commodities, Emerging Markets, catching up as well, with various currencies impacted in the process and of course credit wasn't really spared either.
It is going to be another long post. Many important points to go through.
We will start with credit with a recap of what happened in the third quarter and what to expect next.
Societe Generale and its latest Credit Weekly published on the 30th of September sum it up nicely:
"New quarter, same problems: There’s no drawing a line in the sand as we enter Q4 after a disastrous third quarter for credit. The ratification by the German parliament of the EFSF helps at the margin, but it was what the market needed…. in July. We’ve moved on, and the politicians remain well behind the curve. With a leveraged/further expanded facility looking unlikely at the moment, we suspect the market will continue as is. That means low turnover, poor liquidity and pockets of supply where issuer curves get repriced aggressively. The iBoxx at B+316bp with 118bp of widening in the quarter still leaves us unable to answer what the next big three digit spread move will be. There might be some temptation to add, but we would stay sidelined until we get some clarity. The price action at the
end of the week serves to highlight how jittery and depressed the
market remains. It could be a long run into year-end."
So you can expect more of the same unfortunately given current dislocation in the credit space, where any new issue which is able to come to the market, leads to a vicious repricing of the secondary market:
We also know from previous post that apart from covered bonds backed by pools of prime loans, the market of new issues for bank remains a concern.
But, this week, on Thursday, Deutsche bank came to the market with a 2 year Senior Floating Rate Note (FRN) having to pay significantly up to reopen the senior market. For instance, Deutsche Bank issued a similar two year FRN in February at 3month Euribor + 40 bps. This issue was trading at around Euribor +70 bps in the secondary market, yet they came to the market this time around paying Euribor +100 bps. But, on Friday, ABN Amro Bank tested the market for a similar 2 year Senior FRN, having a very close rating profile to Deutsche Bank (ABN Amro Bank - Aa3 / A / A+ / A High all stable outlook), this time around pricing thoughts were Euribor + 130 bps. 30 bps more. What a difference a day makes these days...
In terms of issuance, corporate credit markets have had their worst quarter in Europe since the demise of Lehman.
According to Ben Martin from Bloomberg on the 30th of September:
"The Markit iTraxx Crossover Index of credit-default swaps linked to 50 companies with mostly high-yield credit ratings climbed more than 400 basis points since July 1, the biggest rise since the fourth-quarter of 2008 when it surged 456 basis points, according to data compiled by Bloomberg. Relative yields on investment-grade company bonds have increased the most on record, Bank of America Merrill Lynch data show. Yield spreads on investment-grade bonds have surged 140 basis points since the start of the quarter to 309 yesterday, the EMU Corporate index of 1,763 securities shows."
And from the same article, Jim Reid, head of fundamental strategy at Deutsche Bank AG in London commented:
"The stats speak for themselves. You’ve got a situation where if the European authorities drop the ball it could be worse than 2008."
And my good credit friend to comment on Friday:
"The European Credit Market did not really perform and is very weak again today following both the European inflation figures at 3% and the understanding that the overall (IG Main Europe is trading at 198 bps, higher than 3 days ago).
So the outlook is still not positive, and it will not be as long as credit investors are ready to pay that much to remain short and/or insured against the risk of default. The actual cost is about 8 % for junk rated companies and 5% for subordinated debt (LT2 … not Tiers 1 for which there is no CDS and the only hedge is equity)."
And in relation to issuance, here is what Societe Generale had to say in their report:
"The French are close to being funded – any more will lead to saturation of the market (nine issues this month alone), German corporates are unlikely to print at these levels and don’t need the cash, while Italian and Spanish corporates are unable to access the capital markets and the slack is unlikely to be taken up elsewhere. The Deutsche Bank deal is the only one from the banking sector since the beginning of July and is unlikely to open the market for others in any big way – if at all. Covered bond issuance came in at just under €5.5bn, but again this is the lowest total for September since at least 2005. The high yield market is effectively closed after Heidelberg’s 9.5% deal on Wednesday essentially made the barrier for other issuers insurmountable."
We know:
"The recent significant increase in credit spreads for many financials has been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates."
The race for funding/capital is on, and even in the corporate high yield space. Survival of the fittest...and defaults we could have as it looks highly likely by know we might enter another period of recession.
Mind the gap...
Itraxx Europe Main 5 year index (Investment Grade), wider by 12 bps to around 202 bps.
Itraxx Financial Senior 5 year index wider by 19 bps to around 280 bps
Itraxx Financial Subordinate 5 year index wider by 34 bps to 535 bps.
SOVx 5 year index western Europe (15 European countries, sovereign CDS risk) versus SOVx CEEMA (Central Eastern Europe, Middle-East and Africa) - source Bloomberg:
The liquidity picture - source Bloomberg:
Flight to quality mode on Friday following the inflation figures in Europe coming at 3% (2.5% expected), German 10 year Government bond versus Germany 5 year CDS - source Bloomberg:
More delays and inactions by European politicians could therefore have significant consequences in the credit space.
Everyone is hoping the EFSF is the silver bullet for the European debt issues plaguing Europe. I do not believe it is and agree completely with my good credit friend, which is a good follow up on the post "Much ado about nothing" where we discussed EFSF being a CPDO redux:
"While everybody is waiting for “The Solution” and rumors are the investors’ daily bread, volatility remains high. I have been asked a lot of questions about the EFSF and its capacity to be used to sort out the current crisis… To be honest I do not know how the EFSF will help recapitalizing the banking system. But I can tell you that the EFSF is structured in a way that there is no pre-funding, that there is not implicit guaranteed by the full faith and credit of the guarantors, and that the structure will be subordinated to the new coming structure called ESM. This means that the cost of funding of the bonds issued by the EFSF will continue rising each time a European State will be downgraded. EFSF bonds are already trading 1% above German government bonds. In addition, any rumor about increasing the EFSF size is based on a totally misunderstanding of the consequences of such a bold act. With a lending capacity of 440 billion and a commitment of 780 billion of guarantees, the structure has already a leverage of 165 %...doing more would be inconsiderate and would imperil the ratings of France and potentially Germany! Keep in mind that any downgrade will impact the rating of the structure and its funding costs, which will weight on its ability to help the countries in need. In addition, any bond issued by the structure has a defined number of guarantors and this number is decreasing as more States cannot commit anymore: as an example, the first bond issued to help Ireland had Portugal among its guarantors …. And Portugal cannot guarantee new issues anymore! So the ability of the EFSF to raise money is impaired each time a country is downgraded, putting pressure on the countries which still have a strong rating.
Any solution will have to go through the ECB as there is no other viable possibility."
For more on why the EFSF is not the Holy Grail, I recommend reading the following opinion from M&G Mike Riddell:
M&G's Riddell: Ten reasons why the EFSF is not the Holy Grail
While all eyes are still focused on the ongoing European crisis, we discussed contagion to Emerging Markets in our post - "Markets update - the EM Contagion" and it could be a significant event - source CMA, Sovereign CDS 5 year Wideners on Friday:
Asian sovereigns 5 year CDS widening, the picture on Thursday - source CMA:
And Japan affected as well - source CMA:
SOVx Asia 5 year CDS as of close 28th of September - source Bloomberg:
With the slowdown in Asia, we know China has been withdrawing subsidies program such as the one HAIER Electronics Group Co, one of the world's leading white goods home appliance manufacturers benefited from, leading to a significant sell-off of its shares:
Looks like there are some additional collateral damages, due to China withdrawing its subsidies/stimulus program. This time it is number two in the home appliance sector, namely Gome Eletrical Appliances Holding, which fell 22% on Friday, the most in almost three years. This time around following a Credit Suisse note on transparency and funding concerns according to Bloomberg.
GOME going?
In relation to the Emerging Markets contagion story we have been discussing recently, the currencies movements we have seen so far have been fairly important. In fact Asian currencies have had their biggest monthly loss in more than a decade:
South Korean won, worst month since February 2009 and Taiwan dollar dropped the most since 1997 according to Bloomberg:
"The Bloomberg-JPMorgan Asia Dollar Index slid 3.9 percent this month to 114.98, the biggest drop since December 1997."
Sinking Won and plunging Real leading to inflation concerns - Source Bloomberg:
"THE CHART OF THE DAY shows the so-called breakeven rate on South Korea’s inflation-protected security due March 2017 rose 16 basis points this month to 2.93 percent yesterday, the most since February, as the won weakened 9.1 percent. In Brazil, the two-year breakeven rate jumped 40 basis points to 6.21 percent as the real slid 12.9 percent. The gauges measure the gaps between inflation-linked and conventional bond yields and indicate expectations for average annual inflation until the debt matures."
And we know Central banks in Emerging Markets have been busy trying to sustain the stability of their currencies: Russia, Argentina, India, Brazil, South Korea, selling dollars and for some starting to deplete their dollar reserves in the process.
But before we go through some of the reasons behind these currencies movements tied to commodities selling off, it is time for a coffee break:
The reason behind the Real currency's weakness is the start of the great unwind of the "Double-Decker" funds, and I am not talking about the variety of Double-Decker one can find visiting London.
Investors Take Risky Ride on Double Deckers - John Jannarone -WSJ
"Compared with Americans, the Japanese are veterans of ultralow interest rates. Japan began monetary easing two decades ago, only rarely raising rates much above zero since. In response, even regular Japanese investors have gone great distances to find countries with better growth prospects and higher interest rates.
The latest answer from Japan's financial laboratory: "double-decker" funds that bundle high-return assets with high-yield currencies. Double deckers were insignificant at the end of 2008, but now manage ¥9.65 trillion ($126 billion), according to Morningstar. The first layer of the strategy is to invest in assets such as stocks or bonds that often carry big coupons or dividends. Those returns are turbocharged with foreign-exchange derivatives, which make an equal-sized bet on one or more currencies.
The result is potential yields that are too attractive to resist. Take double-decker funds stacked with bets on the Brazilian real, the most popular currency category. One such fund, Mitsubishi UFJ Bond Currency Select Brazilian Real, has a dividend yield of 21% and has generated a 17% annualized return over the last two years, Morningstar says."
And John Jannarone to comment in his article:
"To fight inflation, Brazil continues to raise interest rates, putting the economy under strain. If that or, say, a correction in commodity prices triggered a downturn, the central bank could respond with interest-rate cuts, leading to a depreciation of the real. Any underlying double-decker assets with exposure to Brazil also could suffer."
And suffered it has, with commodities selling off after the bubble popped (Copper, source Bloomberg, 22nd of September 2011):
JP Morgan commented on the "Double Deckers":
"Interesting to note we have an analyst monitoring this situation…He reckons BRL overlay funds amount for $ 44bn of Japanese retail money and that, while these investors have net sold BRL overlay funds for the 7th consecutive biz day, total net sales only amount to $ 4bio this year.
Should we see a Lehman-type financial crisis and further JPY appreciation (20% more vs BRL) he reckons up to $ 31bn of this Japanese retail money could be unwound."
Ouch!
And John Jannarone to conclude his article:
"The lesson in Japan and elsewhere: Sustained low interest rates force investors into risks they may not fully appreciate. And with markets already volatile, investors should beware sudden unexpected moves that leave them out of pocket."
And we know the following from an article published in Bloomberg on the 30th of September:
"Japanese investors, who hold $102 billion worth of Brazilian assets, are pulling the most money out of the Latin American country’s currency market since April, deepening a slide in the real that’s fueling bond losses.
Pensioners and other individual investors took 52.7 billion yen ($689 million) out of so-called currency overlay funds that speculate on the real this month through yesterday, according to data compiled by JPMorgan Chase & Co."
So yes, you have a big rush towards the exit from Japanese retail investors.
Its forced liquidations/redemptions time - source Bank of America Merrill Lynch:
"EPFR Mutual Fund data for week ending September 28th
-US HY puts together 4 straight weeks of inflows, +$424mm of inflows
-Non US HY outflows remain remorseless with $1.5bn of outflows, $-13bn for qtr.
-Loan outflows (10 straight weeks) continue to wipe out YTD inflows: -$176mm
-EM Debt see largest outflow ever, 17% of YTD inflows with $3.2bn outflows
-High Grade inflows rip to a record $6.8bn:Big EM to DM with in Fixed income
-Munis deliver inflows in every week in September with $552mm of inflows
-All Fixed Income saw inflows of $10.5bn
-Commodities see outflows of $915mm, large outflow from precious metals
-Equities officially deliver $70bn of outflows for qtr after -$4.8bn this week
*Despite S&P flat since last week, data flow would suggest many investors are clearly in risk off mode, with a high bias to increase credit quality of portfolio ($8bn into HG). EM equity outflow streak reaches longest streak since 2002."
So, the differential in FX between DM (Developed countries) and EM (Emerging Markets) is leading to big outflows and the Japanese "Double Deckers" getting whacked in the process.
And on a final note, in addition to ECRI pointing towards another recession, I give you Bloomberg's April Oil price jump as an additional indicator:
"THE CHART OF THE DAY shows that 10 of the last 11 U.S. recessions were preceded by jumps in oil prices, at least four of which were associated with Middle East conflicts and embargoes by the Organization of Petroleum Exporting Countries: the OPEC oil embargo of 1973-74, the Iranian revolution of 1978-79, the beginning of the Iran-Iraq War in 1980, and the first Persian Gulf War in 1990."
"Leadership is the art of getting someone else to do something you want done because he wants to do it."
Dwight D. Eisenhower
Stay tuned!