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Tuesday, October 23

23rd Oct - Credit Guest: Chadburn, on full ahead?

Another long piece of credit-goodiness from Macronomics

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Credit - Chadburn, on full ahead?

"If the highest aim of a captain were to preserve his ship, he would keep it in port forever." 
- Thomas Aquinas, Italian Theologian. 

Looking at the epic capitulation in the credit space and the significant rally of credit indices recently, which could lead the performance of credit in 2012 to match the performance of 2009 in terms of total return (around 12.5% for Investment Grade credit), we thought we would refer once again to one of favorite theme of shipping in our title, namely a chadburn which is the communication device for the pilot on the bridge to order engineers in the engine room to power the vessel at a certain desired speed. As far as credit is concerned it has been on full ahead.

An indicator we have been monitoring has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes. While touching again on the subject of asset correlation (see our post "Risk-Off Correlations - When Opposites attract"), in "Risk Off" periods we have noticed that the 120 days correlation had been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level. Currently the correlation is still falling towards 78%, albeit at smaller pace than when the first LTRO was initiated at the end of 2011, validating further this "Risk-On" phase we have been following  - source Bloomberg:
The correlation between both the German Bund and US 10 year note is still falling (77%).

The below graph from the 2nd of June highlighted our reasoning behind our 30th of March "Risk-Off" call, displaying the various "Risk-On" and Risk-Off" phases which we have been witnessing with the on-going European sovereign debt crisis which increased significantly in May 2010 - source Bloomberg:

In similar fashion to the liquidity LTRO induced rally of late 2011, the "whatever it takes" stance from Central Banks (Fed, ECB, BOE, BOJ) means the markets are provided with some tremendous firepower. Fighting one central bank is one thing, but fighting all central banks is another as indicated by the below Bloomberg graph highlighting 3.7 trillion of asset growths.
"The combined assets of the ECB and the Fed rose 220% from the start of 2008, as they injected more than $3.7 trillion of liquidity into the global economy. The IMF claims that U.S. bank recapitalization and restructuring has outstripped similar operations in the euro zone, implying that fiscal consolidation and central bank asset shrinkage may occur faster in the U.S." - source Bloomberg.
We will not discuss the problem arising from QE in the long term as we have already approached this subject in our conversation "QE - To infinity...and beyond".
Arguably, some have called the latest programme OMT (Outright Monetary Transactions) by the ECB as a game changer. It is not. This much awaited bond-buying programme has had the desired effect on peripheral yields as indicated by the significant rally in peripheral bonds and the significant drop in bond yields source Bloomberg:
Spanish yields have receded from their summer heights of more than 7% to around 5.50%, whereas Italian bonds have fallen from 6% to 4.75%.

For us it seems that so far our "Generous Gambler" aka Mario Draghi has been very apt in applying some of General Sun-Tzu's greatest concepts:
“The supreme art of war is to subdue the enemy without fighting.” ― Sun Tzu, The Art of War

Peripheral yields have been subdued even without the OMT being triggered and Spain requesting help, given the looming regional elections, which in effect, we think are delaying Prime Minister Mariano Rajoy official request.

So, in this week conversation, following our credit overview, we would like to focus on our credit chadburn given you can always have a disconnect between the order given (full ahead) and the real situation or the urgency of the situation that is. Urgent orders requiring rapid acceleration means the handle on a chadburn had to be moved three times so that the engine room bell was rung three times. So we will look at different indicators which could clearly indicate if effectively a proper rebound is on the way and if the credit bell has arguably rung three times which would mean an acceleration in global economic growth.

But first our usual credit overview!

We recently argued that the severing of the link between Sovereign risk / Financial risk would not happen ("Pareto Efficiency"). The main concern of European authorities as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index has been trying to break that close relationship, expecting that the European Banking Union will finally break this relationship - source Bloomberg:
My God! Lord, my God! Please make the devil keep his word!" - Charles Baudelaire, French poet, "Le Joueur généreux," pub
We mused around the latest round of "easiness" and voiced our concern in our conversation "The Uneasiness in Easiness":
"But what in effect our "Generous Gambler" did previously with the two LTRO operations have been reinforcing in effect the link between weaker peripheral financial institutions with their sovereign country, causing some to pile up on their domestic sovereign bonds and in effect precipitating their demise for some."

This sovereign-bank "Feedback Loop" cannot be broken to restore growth in the Eurozone as indicated by the below table from Bloomberg indicating the exposure of the ECB's exposure to peripheral Europe:
"With the ECB's estimated exposure to peripheral Europe exceeding 1 trillion euros or 30% of its total assets (purchased sovereign bonds, plus lending to banks) the fate of Europe's central banks, banks and sovereigns has become more closely aligned. Breaking this "feedback loop," which is distorting the effectiveness of monetary policy, is essential for economies to expand." - source Bloomberg

As displayed by the latest Spanish misery index making new highs, the deflationary spiral is still playing out - source Bloomberg:

As far as Spanish banks third quarter provisioning are concerned, the recent surge in non-performing loans (NPLs) is seriously raising question on the adequacy of the level of provisioning.

Back in February in our conversation "Money for Nothing", in relation to Spain we argued the following:
"What analysts should be concerned about is that BBVA’s bad loans as a proportion of total lending has remained little changed at 4.07 percent in the fourth quarter of 2011. They also should be concerned as well that its Chief Operating Officer Angel Cano said in April 2010 that asset quality was probably going to be “stable from now on.”Really?". Evolution of NPLs in Spain, source Bloomberg:
"Spanish banks' non-performing loans (NPLs) grew more than 30 billion euros in the five months to August 2012, raising the question of how their 3Q provisioning will evolve in light of an impending bailout. Median coverage ratios fell to 56% in 2011 from 240% in 2006, and the trade-off between profit and falling coverage will be key to results." - source Bloomberg

Sorry Mister Angelo Cano, but, we cannot really see the stability in asset quality...and we tried. Spanish Non Performing Loans rate - source Bloomberg:
"Mortgages get paid in good times and in bad". - Santander CEO Alfredo Saenz April 2012

We "agree" to "disagree" on that point. Assessing the impact of Spanish real estate prices on bank loans is not that difficult given that a large portion are real-estate related as indicated by Bloomberg data:
"Assessing the Impact of Spanish Real Estate Prices on Bank Loans: Bad loans at Spanish banks increased to a record 10.5 percent of total lending, according to the Bank of Spain. A large portion are real-estate related, and Bloomberg data show house prices may be lower than those captured by official figures and projected in consultant Oliver Wyman's stress tests. 
 The Spanish house price index collated by Tinsa, Spain's largest home appraiser, is sometimes thought to better reflect reality than official figures. 
 The chart shows an annualized price drop of 10.1 percent on the official index and 14.2 percent on the Tinsa index. Both show price declines accelerating relative to 2011
To put these numbers in context, the recently released Oliver Wyman stress test exercise uses a base case move of minus 5.6 percent in the house price index for 2012, followed by minus 2.8 percent in 2013 and minus 1.5 percent in 2014. The adverse case scenario uses minus 19.9 percent in 2012, minus 4.5 percent in 2013, and minus 2.0 percent in 2014. 
 With a visible acceleration of the drop in house prices as banks attempt to sell properties and fiscal consolidation takes hold, the adverse case might start to look optimistic." - source Bloomberg

"Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid." - Santander CEO Alfredo Saenz April 2012

As far as Spanish woes are concerned, we think the latest European summit has not dealt with the growing Spanish issues, courtesy of the "Banker's algorithm" concept:
"The Banker's algorithm is run by the operating system whenever a process requests resources. The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state."

So of course, our Banker's algorithm has avoided the deadlock in Europe because of Spain. Clearly by denying or postponing the request, it has determined the Spanish request could put the European system in a clear unsafe state! Indeed the worst-case scenario is playing out for Spain as indicated as well by Bloomberg article by Charles Penty from the 18th of October entitled - Spain Banks Face Pain as Worst-Case Scenario Turns Real:
"Spain’s request for 100 billion euros of European Union financial aid to shore up its banks is increasing concern about the nation’s growing liabilities. Standard & Poor’s downgraded the country’s debt rating by two levels to BBB-, one step above junk, from BBB+ on Oct. 10, saying it wasn’t clear who will bear the cost of recapitalizing banks."

Under Oliver Wyman’s worst-case projection, an economic contraction of 4.1 percent in 2012, 2.1 percent in 2013 and 0.3 percent in 2014 would contribute to 270 billion euros of credit losses and a 59.3 billion-euro capital shortfall for banks...
But maybe we are saying something stupid...

“If you wait by the river long enough, the bodies of your enemies will float by.” ― Sun Tzu

Request denied courtesy of the Bankers' algorithm:
"It is necessary that before we buy bonds, countries will apply to ESM" - European Central Bank Executive Board member Joerg Asmussen - 22nd of October 2012.
He also added:
"Let me say clearly, there is no automatism between an ESM application and our purchases".

Moving on to the relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge), the divergence is back - source Bloomberg:
The HY risk gauge indicated by the Itraxx Crossover is still is moving towards expensive territory, but the recent widening has pushed back towards the 500 bps level. The gap between the Itraxx Crossover and Eurostoxx volatility has re-opened with volatility remaining relatively muted with the fall in systemic risk courtesy of central banks intervention.
In fact the "Risk-On" environment has clearly been supportive for our "flight to quality" picture given the significant fall we have seen in the German 5 year sovereign CDS versus the German 10 year government bond yield - source Bloomberg:

“Appear weak when you are strong, and strong when you are weak.” ― Sun Tzu, The Art of War

Back in July, in our conversation "The Game of The Century", we argued that Angela Merkel had been the big winner so far in this European game of chess, given that:
"By managing to keep Germany’s liabilities unchanged Angela Merkel appears to us as the winner of the latest European summit (number 19...). Question being for us now, can Europe survive in the current form (number of countries) without making material sacrifices in true Bobby Fischer fashion? One has to wonder."

Moving on to the subject of looking at different indicators which could clearly indicate if effectively a proper rebound is on the way and if the credit bell has arguably rung three times which would mean an acceleration in global economic growth led by the US economy, we noticed recently a significant rebound in the Baltic Dry Index - source Bloomberg:

Why the rebound? As we have argued in our conversation "The link between consumer spending, housing, credit and shipping":
"The relationship between container shipping and consumer spending, traffic is indeed driven by consumer spending".

We also indicated:
"The on-going "green shoots" in US housing, the impact on the Containership industry led by consumer spending and consumer confidence is very significant"

Given consumer confidence in the US climbed to 83.1 in October according to the preliminary University of Michigan report (a 5 year high), improved sentiment and personal finances, could lead to a sustained level of optimism which could help jumpstart spending which accounts for 70% of the US economy. If the improving housing market leads to a rise in consumer spending, the GDP could surprise to the upside we think.

As far as containerized traffic is concerned as represented by the Baltic Dry Index, a change in consumer spending would have a direct impact on global traffic volume and economic growth. Looking at the Asia-Originated Containerized freight, on the 21st of September, it was up by 25%, although below May levels according to Bloomberg:
While Asia to Europe lanes worsen with volumes continuing to decline, trans-Pacific and Intra-Asia volumes are improving.

Whereas the US consumer confidence seems to be rising, falling European Confidence is hurting Air Travel Demand as indicated by Bloomberg:
"Demand for air travel in Europe will fall as business and consumer confidence is shaken by the sovereign debt crisis. The summer improvement in confidence has given way to weakness as debt problems in Spain, Italy, Ireland and Greece return to the forefront. The Bear Case is that uncertainty will lead consumers and businesses to pull back discretionary spending on air travel." - source Bloomberg.

One of the most important indicator we think in relation to our Credit Chadburn and the growth divergence between the US and Europe is the evolution of the Loans-to-Deposit ratio progress as displayed by Morgan Stanley in their recent report entitled - Tracking Deleveraging - from the 19th of October:

Another important point for the US chadburn, we think, comes from Citi's US Credit Strategy note from the 10th of October indicating the following:
"Bond vs. dividend yields: Back in ’07 the average HG non-financial bond was yielding 6.2%, while stocks for the same issuers offered a dividend yield of 1.9% (difference of 4.3%). The difference is now a negative 0.2% (2.7% vs. 2.9%), even before adjusting for factors such as high dollar prices. At some point the marginal dollar should flow from credit into equities, and it’s hard to see why we are not fairly close now."

In relation to US credit in general and US HY in particular, Goldman Sachs in their recent note from the 17th of October entitled - Assessing the interplay of macro surprises and spread products made some very interesting points:
"Macro surprises matter for spread products but in different ways.
We investigate the impact of macro surprises on the corporate bond and Agency MBS markets. 
We find that for both investment grade corporate bonds and Agency MBS, it is total returns (or equivalently yields) that respond to macro surprises. 
For high yield bonds, it is the spreads that respond to macro surprises. 
This difference reflects a trade-off between the ‘rates effect’, where positive surprises cause a back-up in rates, and the ‘spread effect’, where positive surprises lower the default premium. 
For investment grade bonds and Agency MBS, the ‘rates effect’ largely dominates the ‘spread effect’, while for high yield bonds the two effects cancel out. 
The impact is broader and larger since the global financial crisis Focusing on the post-global financial crisis (GFC) sample period, we document that the impact of macro surprises on both the corporate bond and Agency MBS markets has become larger and broader. 
Recent spread rally driven by declining premia, not better data.
Looking at the recent spread rally, we find that both high yield bonds and Agency MBS have outperformed the macro data, confirming our view that the rally has been driven mostly by risk premia compression as opposed to a better macro picture. 
The relationship with macro surprises is reasonably robust for both corporate bond spreads and MBS yields: CCC and B spreads are negatively related to the surprises, while the inverse pattern prevails for CMM yields. 
The intuition conveyed is simple: positive surprises lift growth expectations and thus cause the default risk premium to compress and Treasury yields to back up. The result is tighter corporate bond spreads and wider MBS yields.

Three key findings: Not all macro indicators are created equal (unsurprisingly). 
-For both the credit and mortgage markets, labour market indicators (non-farm payrolls, initial claims, the ADP employment report and the unemployment rate) tend to have the strongest impact. Survey data (such as the ISM – both manufacturing and nonmanufacturing – and Philly Fed) and hard data (such as retail sales and durable goods) also appear to have a significant impact on daily moves in credit spreads and total returns, as well as on CMM yields. 
-In spread terms, only high yield is sensitive to macro surprises. Moreover, the response of high yield spreads to macro surprises is monotonic in ratings: the lower the rating, the stronger the response. By contrast, investment grade credit spreads are virtually unresponsive to macro surprises for both financials and non-financials. 
-Lastly, CMM yields respond to macro surprises in a way that is almost identical to 10-year Treasury yields. This is consistent with the notion that agency MBS and 10-year Treasury securities are close substitutes of each other."

On a final  note, falling bond yields and the Fed's purchases of MBS (mortgage-backed securities) will erode further US banks profitability in the next few quarters according to David A. George, a Robert W. Baird and Co. analyst as indicated by Bloomberg Chart of the Day:
"As the CHART OF THE DAY illustrates, banks’ net interest margins have generally contracted for more than two years. The chart, based on data compiled by the Federal Deposit Insurance Corp., shows the gaps in percentage points between the average interest earned on loans and investments and the average rate paid to depositors. JPMorgan Chase and Co.’s third-quarter results showed the average yield on its securities holdings fell 18 basis points from the second quarter, George wrote on the 15th of October in a report. At Wells Fargo and Co., the drop was steeper: 27 basis points. Each basis point equals 0.01 percentage point. “Unfortunately, this headwind should accelerate” in the fourth quarter, the St. Louis-based analyst wrote. Refinancing rates for home loans have dropped as the Fed begins purchasing $40 billion of mortgage-backed bonds a month. The decline has resulted in faster payoffs on the mortgages underlying the securities, he wrote. Profits may also suffer as banks shift toward loans from securities and compete more intensely to draw borrowers, George wrote. He added that lenders may retain more of their mortgages, which would reduce fee income from selling the loans. Net interest margins peaked in 2010’s first quarter and narrowed in eight of the next nine quarters. Margins at banks with more than $10 billion in assets have dwindled more than the average for all federally insured institutions, as the chart shows." - source Bloomberg

Provided the fiscal cliff is avoided, we think the growth divergence between the USA and Europe will continue to grow and the chadburn on USS USA might indeed move on "Full Ahead" whereas for USS Europe (NCC-1792), we think it is on "Dead Slow Ahead", it is indeed in the credit prices...

"A sailing ship is no democracy; you don't caucus a crew as to where you'll go anymore than you inquire when they'd like to shorten sail." -   Sterling Hayden, American actor.

Stay tuned!