Take it away, Martin!
Markets update - Credit - Ecce Creditor
"ecce creditor venit ut tollat duos filios meos ad serviendum sibi."
"behold, the creditor has come to take away my two sons to serve him" - Holy Bible, The Second Book of the Kings, Chapter 4.
Given everyone has been waiting for the white smoke of the ISDA determinations committee relating to CDS trigger in true "Vatican papal conclave style" (see below), following the Greek PSI outcome, and the ultimate enaction of Collective Action Clause; we thought a religious analogy was more than an appropriate rambling thanks to the "voluntary" leap of faith Greek creditors have been coerced to take.
Voting of the papal conclave:
"On the afternoon of the first day, one ballot may be held. If a ballot takes place on the afternoon of the first day and no-one is elected, or no ballot had taken place, four ballots are held on each successive day: two in each morning and two in each afternoon. Before voting in the morning and again before voting in the afternoon, the electors take an oath to obey the rules of the conclave. If no result is obtained after three vote days of balloting, the process is suspended for a maximum of one day for prayer and an address by the senior Cardinal Deacon. After seven further ballots, the process may again be similarly suspended, with the address now being delivered by the senior Cardinal Priest. If, after another seven ballots, no result is achieved, voting is suspended once more, the address being delivered by the senior Cardinal Bishop. After a further seven ballots, there shall be a day of prayer, reflection and dialogue. In the following ballots, only the two Cardinals who received the most votes in the last ballot shall be eligible, and a two-thirds majority of the votes shall not be required. However, the two Cardinals who are being voted on shall not themselves have the right to vote." source Wikipedia
As far as our economics beliefs are concerned, and if economics was a religion, we would be polytheists. But yet again, we divagate, and it is time for our credit market overview, looking at the effect of the second round of LTRO, and what's next for Europe following the Greek PSI and more.
The Credit Indices Itraxx overview - Source Bloomberg:
Following the much awaited results of the Greek PSI, according to a market maker, today's price action was in the sovereign space, with some renewed buying on Italy and Spain. Indeed, there is a flurry of government bonds issuance next week in Europe: Italy issuing next Wednesday 2 year, 3 year and 15 year bonds (6.5 billion euro), and Spain issuing on Thursday 3 year, 4 year and 6 year bonds (4.5 billion euro), France as well issuing on Thursday, 2 year and 5 year BTAN bonds (8.5 billion euro).
Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS level finally moving clearly above Italy, 27 bps, a trend we have been monitoring for a while - source Bloomberg:
The spread between the Itraxx Financial 5 year CDS index versus the SOVx Western Europe is still at record level (139 bps) indicating the ongoing divergence of support courtesy of LTRO 2 - source Bloomberg:
In addition to the ongoing disconnect between the Itraxx Financial Senior 5 year CDS index and the Sovereign CDS SOVx index Western Europe, there is an interesting decorrelation between the SOVx index and the Eurostoxx Volatility (6 month implied volatility at 100% Moneyness Default Model) - source Bloomberg:
This indicates that the stress on Sovereign CDS remains elevated.
Meanwhile, the Eurostoxx index continues to rise while Sovereign Risk remains a concern for caution:
No surprise therefore to see no change in our "Flight to quality" picture. Germany's 10 year Government bond yields continue to remain well below 2% yield and 5 year CDS spread for Germany has fallen as well: Demand for precautionary assets remains elevated and the widening for the 10 year German benchmark bond remain somewhat capped - Source Bloomberg:
The liquidity picture, as per our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:
As we argued previously in our conversation "Modicum of relief":
"We think the "modicum of relief" of LTRO 2 will be relatively neutral to risky assets compared to LTRO 1."
The current European bond picture with Italy and Spain 10 year government yields accelerating their fall in yields, courtesy of the LTRO 2 - source Bloomberg:
In our previous credit conversation we also indicated the following:
This trend has indeed been confirmed by Barclays in their European Banks note published on the 9th of March:
Every cloud has a silver lining, and Italy and Spain can indeed thanks their respective domestic financial system for the ongoing support.
But, courtesy of LTRO 2, our ECB "Ecce creditor" faces significant risks going forward:
Guilt, Bad Conscience:
"Guilt has its origin in `debts', in the contractual relations between creditor and debtor, in which the latter pledged that if he should fail to repay, he would substitute his debt by something else that he possessed (body, limbs, wife, freedom)." - Michael Mahon, "Foucault's Nietzschean genealogy: truth, power, and the subject".
As indicated by Barclays in their latest note:
"Let us not ignore the downside
As we extol the success of the 3y LTROs, we must also reiterate the risks, ECB funding has become an integral part of bank funding and, at €1.1trn, it now accounts for approximately 5% of liabilities.
Although the LTRO may have helped avert a funding shortfall and credit crunch, it also increased balance sheet encumbrance and added refinancing risk for 2013-15. After the February LTRO, we estimate that approximately €5.0trn of European bank assets are now encumbered to support covered bonds or ECB borrowings. This reduces the potential recovery pool for unsecured creditors in the event of default. Once depositor preference and bail-ins are factored in, the recovery rate on senior unsecured bonds is likely to be close to zero. In addition, the large LTRO usage heightens refinancing risks for banks during 2013-15, despite the flexible repayment schedule, with banks holding the option to begin repayment in one year."
As a reminder from our last credit conversation:
"A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios."
Going forward, we think you should be focusing on the ECB's monthly lending surveys, loan-to-deposit levels, deposits flights from peripheral countries as well as the rise in nonperforming loans (see our post "The European Opprobrium") as indicated by Barclays:
We indicated previously that Spanish banks ratio of non-performing loans to total loans came in at 7.61% in 2011 which is the highest percentage since 1994, hence our current negative stance on Spain.
So, what's next for Europe given credit markets have now been stabilised courtesy of liquidity injections via "LTRO Alkaloid" 1 and "LTRO Alkaloid" 2?
We thought Cheuvreux analyst Jolyon-Charles Montague made some interesting points in his note "Atlas shrugged" on the 7th of March:
"With credit markets stabilised in core Europe and the endgame for eurobonds on the horizon, investors will increasingly focus on the bigger challenge of structural reform. A deft touch will be required to implement fiscal austerity yet avoid recession. In any case, growth will be at best anaemic as debt brakes are applied. But, to quote the catchphrase of Japan’s longest serving post bubble Prime Minister, Junichiro Koizumi, there can be “no growth without reform”.
Lessons from Japan: failure to reform
Japan provides two important lessons for European investors: first, a case study of the perils of failing to achieve structural reform; second, how to invest in and trade a 20-year bear market. We conclude that for the current rally to continue beyond 2012 structural reform must be implemented, deflation averted and regulatory forbearance reversed: no small feat. It is often underappreciated that in 1989 Japan's net public debt to GDP was just 14.4% and the major driver for its explosion was a lack of tax revenue not fiscal largesse. Europe arguably is in a worse position than Japan as it has little room to raise taxes. Furthermore, Japan's government spending excluding social security and interest payments is among the lowest in the world. Given an aging population, Europe is on the verge of experiencing the same surge in social security spending.
A history of Japan's banking crisis
Based on the insights from Japan, most rallies will last around 12 months before topping out. The major warning sign will be any form of central bank tightening, including shrinking its balance sheet. The longest rally was from 2003 to 2006, when hopes of inflation returning and reform proved a heady mix, and banks rallied 308%. It ended with the reform agenda dying and central bank tightening, all before the global financial crisis began.
How to trade a 20-year bear market?
In every rally brokers outperformed but not banks. Commodity-driven trading companies also always outperformed. Autos and precision equipment companies mostly outperformed the rallies. These two sectors were the best along with pharma since the 1989 peak. However, pharma and food and beverage always underperformed the rallies as did airlines, utilities and construction companies. Just picking the right sectors is not enough. Toyota and Honda were among the market's best performers since 1989 rallying 56% and 240% respectively whereas Mazda fell 87% and Mitsubishi Motors 91%."
It appears to us that Europe could end up "lost in translation/deflation" and could face indeed a similar Japanese fate with the central bank tightening sooner rather than later and the reform agenda dying, which is in fact a similar view taken by Nomura in their note from the 8th of March - ECB: Still in a wait-and-see mode, but now with a hawkish bias:
"We think the longer inflation stays above 2%, the greater the risk of a pre-emptive ECB rate hike. We are not there yet, but risks have increased that market expectations will start to price in rate hikes sooner rather than later."
On a final note, please find Bloomberg Chart of the Day, indicating that Price swings in the Standard &Poor’s 500 Index have become more muted this year, making investors complacent about the outlook for stocks, according to Canadian brokerage firm Brockhouse and Cooper Inc:
"The CHART OF THE DAY shows closing percentage moves in the S&P 500. There have been no daily swings of 2 percent or more in either direction this year, compared with more than 25 occurrences in the second half of 2011, when Europe’s sovereign-debt crisis triggered a drop in equities. The lower chart panel tracks the Chicago Board Options Exchange Volatility Index, or VIX, known as the market’s “fear gauge.”
“Volatility tends to come with negative surprises, and it’s been quiet since December,” said Pierre Lapointe, a strategist at the Montreal-based brokerage. “But quiet periods usually don’t last. There is a risk of complacency. This is a low volatility environment and investors shouldn’t think this is the new norm.”
"It is easier to find men who will volunteer to die, than to find those who are willing to endure pain with patience."
Julius Caesar
"behold, the creditor has come to take away my two sons to serve him" - Holy Bible, The Second Book of the Kings, Chapter 4.
Given everyone has been waiting for the white smoke of the ISDA determinations committee relating to CDS trigger in true "Vatican papal conclave style" (see below), following the Greek PSI outcome, and the ultimate enaction of Collective Action Clause; we thought a religious analogy was more than an appropriate rambling thanks to the "voluntary" leap of faith Greek creditors have been coerced to take.
Voting of the papal conclave:
"On the afternoon of the first day, one ballot may be held. If a ballot takes place on the afternoon of the first day and no-one is elected, or no ballot had taken place, four ballots are held on each successive day: two in each morning and two in each afternoon. Before voting in the morning and again before voting in the afternoon, the electors take an oath to obey the rules of the conclave. If no result is obtained after three vote days of balloting, the process is suspended for a maximum of one day for prayer and an address by the senior Cardinal Deacon. After seven further ballots, the process may again be similarly suspended, with the address now being delivered by the senior Cardinal Priest. If, after another seven ballots, no result is achieved, voting is suspended once more, the address being delivered by the senior Cardinal Bishop. After a further seven ballots, there shall be a day of prayer, reflection and dialogue. In the following ballots, only the two Cardinals who received the most votes in the last ballot shall be eligible, and a two-thirds majority of the votes shall not be required. However, the two Cardinals who are being voted on shall not themselves have the right to vote." source Wikipedia
As far as our economics beliefs are concerned, and if economics was a religion, we would be polytheists. But yet again, we divagate, and it is time for our credit market overview, looking at the effect of the second round of LTRO, and what's next for Europe following the Greek PSI and more.
The Credit Indices Itraxx overview - Source Bloomberg:
Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS level finally moving clearly above Italy, 27 bps, a trend we have been monitoring for a while - source Bloomberg:
The spread between the Itraxx Financial 5 year CDS index versus the SOVx Western Europe is still at record level (139 bps) indicating the ongoing divergence of support courtesy of LTRO 2 - source Bloomberg:
In addition to the ongoing disconnect between the Itraxx Financial Senior 5 year CDS index and the Sovereign CDS SOVx index Western Europe, there is an interesting decorrelation between the SOVx index and the Eurostoxx Volatility (6 month implied volatility at 100% Moneyness Default Model) - source Bloomberg:
Meanwhile, the Eurostoxx index continues to rise while Sovereign Risk remains a concern for caution:
No surprise therefore to see no change in our "Flight to quality" picture. Germany's 10 year Government bond yields continue to remain well below 2% yield and 5 year CDS spread for Germany has fallen as well: Demand for precautionary assets remains elevated and the widening for the 10 year German benchmark bond remain somewhat capped - Source Bloomberg:
The liquidity picture, as per our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:
"We think the "modicum of relief" of LTRO 2 will be relatively neutral to risky assets compared to LTRO 1."
The current European bond picture with Italy and Spain 10 year government yields accelerating their fall in yields, courtesy of the LTRO 2 - source Bloomberg:
"While yields are falling, support for peripheral debt is coming from peripheral banks which are in effect encouraged by the LTRO in purchasing their domestic debt, other European banks are not participating to the party."
This trend has indeed been confirmed by Barclays in their European Banks note published on the 9th of March:
"In addition, we believe that buying of peripheral sovereign bonds by domestic institutions in the January and February auctions and buying of bank bonds by Italian banks that used the first LTRO played a role in the recent tightening of bank credit spreads. As shown below, Spanish and Italian banks increased their purchases of government bonds in December and January. This contributed to a substantial tightening of secondary sovereign curves since the beginning of the year and lowered the perceived level of systemic risk. Bank holdings in financial institutions increased by €80bn in December and January. This was largely a result of retained government-guaranteed issues by Italian and Spanish banks, but also included additional purchases in the primary and secondary markets, in our opinion."
Every cloud has a silver lining, and Italy and Spain can indeed thanks their respective domestic financial system for the ongoing support.
But, courtesy of LTRO 2, our ECB "Ecce creditor" faces significant risks going forward:
Guilt, Bad Conscience:
"Guilt has its origin in `debts', in the contractual relations between creditor and debtor, in which the latter pledged that if he should fail to repay, he would substitute his debt by something else that he possessed (body, limbs, wife, freedom)." - Michael Mahon, "Foucault's Nietzschean genealogy: truth, power, and the subject".
As indicated by Barclays in their latest note:
"Let us not ignore the downside
As we extol the success of the 3y LTROs, we must also reiterate the risks, ECB funding has become an integral part of bank funding and, at €1.1trn, it now accounts for approximately 5% of liabilities.
Although the LTRO may have helped avert a funding shortfall and credit crunch, it also increased balance sheet encumbrance and added refinancing risk for 2013-15. After the February LTRO, we estimate that approximately €5.0trn of European bank assets are now encumbered to support covered bonds or ECB borrowings. This reduces the potential recovery pool for unsecured creditors in the event of default. Once depositor preference and bail-ins are factored in, the recovery rate on senior unsecured bonds is likely to be close to zero. In addition, the large LTRO usage heightens refinancing risks for banks during 2013-15, despite the flexible repayment schedule, with banks holding the option to begin repayment in one year."
As a reminder from our last credit conversation:
"A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios."
Going forward, we think you should be focusing on the ECB's monthly lending surveys, loan-to-deposit levels, deposits flights from peripheral countries as well as the rise in nonperforming loans (see our post "The European Opprobrium") as indicated by Barclays:
"As shown above, the average non-performing loan ratio rose 6bp to 5.6% in Q4 11, after rising only 2bp in Q3. Uncovered NPLs rose 3.2%, the largest quarterly increase since Q2 10. In some countries, asset quality pressures are more acute. In Spain, the banking system’s nonperforming loan ratio rose 45bp in the last three months of 2011, to stand at 7.6% at the end of December. Our economists forecast that euro area GDP will contract between Q3 11 and Q2 12, and will only return to growth in the fourth quarter of the year. We expect this to result in an acceleration of the pace of quarterly nonperforming loan increases and higher loan loss charges." - Source Barclays.
We indicated previously that Spanish banks ratio of non-performing loans to total loans came in at 7.61% in 2011 which is the highest percentage since 1994, hence our current negative stance on Spain.
So, what's next for Europe given credit markets have now been stabilised courtesy of liquidity injections via "LTRO Alkaloid" 1 and "LTRO Alkaloid" 2?
We thought Cheuvreux analyst Jolyon-Charles Montague made some interesting points in his note "Atlas shrugged" on the 7th of March:
"With credit markets stabilised in core Europe and the endgame for eurobonds on the horizon, investors will increasingly focus on the bigger challenge of structural reform. A deft touch will be required to implement fiscal austerity yet avoid recession. In any case, growth will be at best anaemic as debt brakes are applied. But, to quote the catchphrase of Japan’s longest serving post bubble Prime Minister, Junichiro Koizumi, there can be “no growth without reform”.
Lessons from Japan: failure to reform
Japan provides two important lessons for European investors: first, a case study of the perils of failing to achieve structural reform; second, how to invest in and trade a 20-year bear market. We conclude that for the current rally to continue beyond 2012 structural reform must be implemented, deflation averted and regulatory forbearance reversed: no small feat. It is often underappreciated that in 1989 Japan's net public debt to GDP was just 14.4% and the major driver for its explosion was a lack of tax revenue not fiscal largesse. Europe arguably is in a worse position than Japan as it has little room to raise taxes. Furthermore, Japan's government spending excluding social security and interest payments is among the lowest in the world. Given an aging population, Europe is on the verge of experiencing the same surge in social security spending.
A history of Japan's banking crisis
Based on the insights from Japan, most rallies will last around 12 months before topping out. The major warning sign will be any form of central bank tightening, including shrinking its balance sheet. The longest rally was from 2003 to 2006, when hopes of inflation returning and reform proved a heady mix, and banks rallied 308%. It ended with the reform agenda dying and central bank tightening, all before the global financial crisis began.
How to trade a 20-year bear market?
In every rally brokers outperformed but not banks. Commodity-driven trading companies also always outperformed. Autos and precision equipment companies mostly outperformed the rallies. These two sectors were the best along with pharma since the 1989 peak. However, pharma and food and beverage always underperformed the rallies as did airlines, utilities and construction companies. Just picking the right sectors is not enough. Toyota and Honda were among the market's best performers since 1989 rallying 56% and 240% respectively whereas Mazda fell 87% and Mitsubishi Motors 91%."
It appears to us that Europe could end up "lost in translation/deflation" and could face indeed a similar Japanese fate with the central bank tightening sooner rather than later and the reform agenda dying, which is in fact a similar view taken by Nomura in their note from the 8th of March - ECB: Still in a wait-and-see mode, but now with a hawkish bias:
"We think the longer inflation stays above 2%, the greater the risk of a pre-emptive ECB rate hike. We are not there yet, but risks have increased that market expectations will start to price in rate hikes sooner rather than later."
On a final note, please find Bloomberg Chart of the Day, indicating that Price swings in the Standard &Poor’s 500 Index have become more muted this year, making investors complacent about the outlook for stocks, according to Canadian brokerage firm Brockhouse and Cooper Inc:
“Volatility tends to come with negative surprises, and it’s been quiet since December,” said Pierre Lapointe, a strategist at the Montreal-based brokerage. “But quiet periods usually don’t last. There is a risk of complacency. This is a low volatility environment and investors shouldn’t think this is the new norm.”
"It is easier to find men who will volunteer to die, than to find those who are willing to endure pain with patience."
Julius Caesar
Stay tuned!