Previously
on MoreLiver’s:
31.8. - US Close: Bernanke's Apology (comments on Fed)
31.8. Best of August most read pieces + all my ’views’
Credit - Structural Instability
"The markets don't like instability and they don't like uncertainty." - Peter Mandelson
Hence our title. But reading through Hyman Minsky's 1982 paper "Can "It" Happen Again? A reprise (H/T Zero Hedge), the roots of instability according to Hyman Minsky are: "...velocity-increasing and liquidity-decreasing money-market innovations will take place. As a result, the decrease in liquidity is compounded. In time these compounded changes will result in an inherently unstable money market so that a slight reversal of prosperity can trigger a financial crisis".
As indicated by John Glover and Andrew Reierson in their Bloomberg article - Europe Trounces U.S. as Corporate Gains Reach 9%":
"Corporate bonds in Europe last outperformed U.S. debt in 2008, when they lost 3.3 percent, less than the 6.8 percent drop in value of American company debt. Last year, Europe gained 1.99%, while the U.S. soared 7.51%."
-
Source: Citi Research, Bloomberg. Average moves are calculated as
avg(x|p) = sum(abs(x)|x>=p)/count(x|x>=p) for upper tails, and
done similarly for lower tails., for a given data point x and a
percentile p.
Our equities friends would be well advised to remain cautious September wise and take a few chips off the gambling table, September being statistically volatile (September: The Worst of Months - Cullen Roche - Pragmatic Capitalism). The lower earnings estimates will be the biggest risk to come in coming months as indicated by Bloomberg Chart of the day:
The Itraxx CDS indices picture, ending this month on a weaker note in the credit derivatives space - source Bloomberg:
"In numerous fields of
study, the component of instability within a system is generally
characterized by some of the outputs or internal states growing without
bounds. Not all systems that are not stable are unstable; systems can
also be marginally stable or exhibit limit cycle behavior.
In control theory, a system
is unstable if any of the roots of its characteristic equation has real
part greater than zero (or if zero is a repeated root)." - source Wikipedia
Zero being a repeated root in terms of
monetary interest rate policy (ZIRP) it is leading to "Structural
Instability", we thought we would follow up on our recent computational
analogy (Banker's algorithm)
and delve into control theory this time around in our title analogy.
The great Hyman Minsky thesis was "stability leads to instability", we
would argue that dwindling liquidity and excessive spread tightening in
core quality credit spreads courtesy of zero interest rates policy in
both the US and Europe is extremely concerning and are already
indicative of a great build up in structural instability. Back in July
in our conversation "Hooke's law", we indicated that Hooke's law of elasticity says in simple terms that strain is directly proportional to stress: "The
level of stress that can be ascertained from the level of core European
yields making new record lows (Germany, France, Austria, Netherlands),
which we think is indeed, directly proportional to the aforementioned
stress. But it not only in Europe, we are seeing an extension of the
"negative yield club", the United Kingdom as well poised for joining the
club."
"In structural
engineering, a structure can become unstable when excessive load is
applied. Beyond a certain threshold, structural deflections magnify
stresses, which in turn increases deflections. This can take the form of
buckling or crippling. The general field of study is called structural stability." - source Wikipedia
Hence our title. But reading through Hyman Minsky's 1982 paper "Can "It" Happen Again? A reprise (H/T Zero Hedge), the roots of instability according to Hyman Minsky are: "...velocity-increasing and liquidity-decreasing money-market innovations will take place. As a result, the decrease in liquidity is compounded. In time these compounded changes will result in an inherently unstable money market so that a slight reversal of prosperity can trigger a financial crisis".
The ever growing lack of "liquidity" in the secondary credit markets which we discussed at length in our previous conversation (Banker's algorithm),
as well as the ever tightening spread levels of quality investment
grade corporate bonds (-30 bps in August 2012 as per Iboxx Euro
Corporate Index) is a cause for concern in relation to the "structural
stability" of credit markets. For instance, very high quality German
corporate issuer Siemens (rated Aa3 by Moody's Investors Service Inc.
and A+ by Standard & Poor's Corp) is paying investors 20 basis
points over the reference midswap rate for its 7.5-year latest
euro-denominated bond. To put that in perspective, French government
bonds maturing in April 2020 are trading around 34 basis points over
midswaps, and its 500 million euro 2 year bonds was issued at midswap
rate -10 bps instead of the initial +5 bps guidance given the demand,
equating to a coupon of 0.40%. With inflation coming at an annual pace
of 2.6% in the Euro Zone, now you also have negative yield in the high
quality corporate bond space. A negative yield means investors who hold
these notes to maturity will receive less than they paid to buy them.
The proceeds of the new issues raised by Siemens will be used to buy-back up to 3 billion euros worth of shares. This is a negative development from a credit perspective indicative of this growing structural instability we think. In our previous "Hooke's law" ending remarks we argued:
The proceeds of the new issues raised by Siemens will be used to buy-back up to 3 billion euros worth of shares. This is a negative development from a credit perspective indicative of this growing structural instability we think. In our previous "Hooke's law" ending remarks we argued:
"Given the "Yield Famine"
we are witnessing, we believe our credit "spring-loaded bar mousetrap"
has indeed been set and defaults will spike at some point, courtesy of
zero interest rates."
As indicated by John Glover and Andrew Reierson in their Bloomberg article - Europe Trounces U.S. as Corporate Gains Reach 9%":
"Corporate bonds in Europe last outperformed U.S. debt in 2008, when they lost 3.3 percent, less than the 6.8 percent drop in value of American company debt. Last year, Europe gained 1.99%, while the U.S. soared 7.51%."
Yes,
one might argue that given the U.S. two-tear interest-rate swap spread,
a measure of stress in debt markets has extended its third straight
monthly decline to 16.46 bps, down from this year high of 48.32 bps on
the third of January and returns in 2012 on Europe corporate bonds are
on pace to total about 14 percent which would be exceeded only by the
14.9% gain in 2009 all is well and stable. We do not think this
complacency or stability in "instability" can remain for an extended
period of time.
"Measures showing U.S. financial market conditions have improved put little pressure on Federal
Reserve Chairman Ben S. Bernanke to signal added monetary stimulus this week, according to Credit Suisse Group AG. The CHART OF THE DAY shows the Bloomberg U.S. Financial Conditions Index moved above zero on July 27, a threshold that signals receding market risk. It was below negative 1 last year when Bernanke spoke at the Kansas City Fed’s annual economic symposium in Jackson Hole, Wyoming. The bottom panel shows the spread between the rate to exchange floating for fixed-interest payments and Treasury yields for two years, a gauge of investors’ perceived risk in the banking sector, fell yesterday to the lowest since May 2011. Bernanke speaks at this year’s Jackson Hole conference on Aug. 31." - source Bloomberg.
But, this false sense of "stability" is increasingly indicative of growing signs of "instability". Back in our July conversation "Hooke's law we argued: "The fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets. The conjunction of low interest rates with higher taxations will undoubtedly damage companies, particularly in Europe, and in a country like France, for instance, where public expenditure as a % of GDP is much higher (56%) than in Germany (45%)."
Reserve Chairman Ben S. Bernanke to signal added monetary stimulus this week, according to Credit Suisse Group AG. The CHART OF THE DAY shows the Bloomberg U.S. Financial Conditions Index moved above zero on July 27, a threshold that signals receding market risk. It was below negative 1 last year when Bernanke spoke at the Kansas City Fed’s annual economic symposium in Jackson Hole, Wyoming. The bottom panel shows the spread between the rate to exchange floating for fixed-interest payments and Treasury yields for two years, a gauge of investors’ perceived risk in the banking sector, fell yesterday to the lowest since May 2011. Bernanke speaks at this year’s Jackson Hole conference on Aug. 31." - source Bloomberg.
But, this false sense of "stability" is increasingly indicative of growing signs of "instability". Back in our July conversation "Hooke's law we argued: "The fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets. The conjunction of low interest rates with higher taxations will undoubtedly damage companies, particularly in Europe, and in a country like France, for instance, where public expenditure as a % of GDP is much higher (56%) than in Germany (45%)."
We would like to use again a reference to Bastiat in relation to liquidity and Credit Markets (from our conversation "The Unbearable Lightness of Credit"): "That Which is Seen, and That Which is Not Seen"
In
similar fashion to what Hyman Minsky posited, this false sense of
"stability" is in fact indicative of rising "instability" in the
monetary system with the "improbable" being inaccurately priced in the
US rates markets. In Citi Research US Rates and MBS weekly note from
the 30th of August, they indicated the following:
"Large Moves in a Low Yield Environment
Over
the last three months, we have seen 10y swap rates move lower almost 40
bps within two months and subsequently move higher 40 bps over the
following three weeks. Much of this movement was not driven by a slow
grind, but rather through a series of violent single-day moves
interspersed with a series of benign moves. We’ve also seen significant moves in volalitility vs rates, where implied vols tend to fall when yields fall."
"Over the last several
years, it is somewhat surprising to see that, despite the steady move
lower in 10y swap rates, the magnitude of a single-day or a one-month
tail event (as defined above) has stayed relatively constant, or has
even become somewhat larger over time. In general, we would
like to note that 10y swaps have moved at least 7bps/day 20% of the time
(cumulative probability of the two extreme deciles). Similarly, they
have generally moved at least 30bps per month, with a probability of 20%
based on the past 22 years of data."
This
growing false sense of stability is clearly indicated in the current US
swaptions market given the "improbable" is currently "equally priced"
by the market at the same level of the "probable" according to Citi:
"Here
we can see that markets have priced in roughly a 30bp move/month with a
20% probability, which is in-line with historical levels. Indeed, we
use this data to compare with realized tail moves to create an
implied-to-realized ratio on 10% and 90% moves. In this case, we compare
the market-implied moves given probabilities with historical
percentiles of various time periods." - source Citi.
"The
degree to which the implied/realized ratios tend towards one,
especially using two-year realized percentiles, is quite surprising.
Not only do we see that rate volatility in the past, where yield levels
were as much as 200bps higher, to be good indicators for percentiles in
the future, but also that considering implied levels of high and low
strikes are similar, the market expects that the probability and magnitude of a large move higher are almost equivalent to that of one lower. In other words, the market implies that large moves in yield today are not impacted by the perceived lower bound on rates. A 30bp move higher is equally probable as a one move lower, regardless of whether current rate levels are at 2% or 4%.
Even under more stringent criteria of a “tail” move, despite small
differences between the implieds on high and low strikes, we see very
similar results – the chances of a
50bp move higher or lower are roughly the same. It is equally surprising
to see that implied/realized ratios still tend towards one.
Given this data, we can see that it is impossible to simultaneously have a bounded market where tail risk isn’t valued separately evaluated by its direction. In other words, one can only make one of the following two conclusions:
a) Market levels are incorrect, and a move in rates lower should be viewed differently from a move higher.
b) Market levels are correct, and the supposed lower bound on rates currently has no impact on the size and directionality of a move.
Given recent moves in the market, we are inclined to take the latter conclusion. Potential tail risk scenarios seem to abound,
varying from Jackson Hole to the Grexit to a hard landing in China. In
any of these scenarios, it is easy to imagine large rate moves higher or
lower, regardless of current levels. As a result, we would be cautious in placing trades in duration based on beliefs that rate markets are bound, especially considering that it is not clear on what level that bound would come into play." - source Citi.
Our equities friends would be well advised to remain cautious September wise and take a few chips off the gambling table, September being statistically volatile (September: The Worst of Months - Cullen Roche - Pragmatic Capitalism). The lower earnings estimates will be the biggest risk to come in coming months as indicated by Bloomberg Chart of the day:
"Lower earnings estimates may be the biggest risk for stock investors in the next couple of months,
according to Barry Knapp, head of U.S. equity strategy at Barclays Plc’s securities unit.
As the CHART OF THE DAY shows, analysts lowered profit projections for companies in the Standard & Poor’s 500 Index more often than they raised them in the months of September and
October since 2000. The figures were compiled by Barclays and exclude periods in which the U.S. economy was in recession. October was the worst month for earnings revisions in the past 12 years, according to Barclays data. Based on the number of changes made by analysts, estimate cuts surpassed increases by 5.2 percentage points. September tied for the second-worst month with December. The gap between lower and higher estimates was 3.2 points on average. January was the only other month of the year in which reductions predominated." - source Bloomberg.
Back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."
according to Barry Knapp, head of U.S. equity strategy at Barclays Plc’s securities unit.
As the CHART OF THE DAY shows, analysts lowered profit projections for companies in the Standard & Poor’s 500 Index more often than they raised them in the months of September and
October since 2000. The figures were compiled by Barclays and exclude periods in which the U.S. economy was in recession. October was the worst month for earnings revisions in the past 12 years, according to Barclays data. Based on the number of changes made by analysts, estimate cuts surpassed increases by 5.2 percentage points. September tied for the second-worst month with December. The gap between lower and higher estimates was 3.2 points on average. January was the only other month of the year in which reductions predominated." - source Bloomberg.
Back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."
Following our usual Credit
Overview, we would like to turn our attention again between the
relationship between credit and equities correlation given the
significant outperformance of U.S. equities indices versus their
European peers, whereas in contrast, European credit as indicated
earlier, has been outperforming significantly U.S. credit. As a
reminder, we already discussed the reasons behind the performance of the
US economy versus Europe back in May 2012 in our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid...".
The Itraxx CDS indices picture, ending this month on a weaker note in the credit derivatives space - source Bloomberg:
In
similar fashion to last week, Credit indices were overall wider on
Friday, ahead of the long week-end in the U.S but around the exact same
levels as the previous week. Itraxx Crossover 5 year index (High Yield
risk gauge based on 50 European entities). While Credit Indices have had
a weaker tone in the last two weeks, cash credit has continued to
perform, supported by a flurry of new issues which came to the market,
quickly absorbed by yield starving investors in the need of placing
their cash to work courtesy of dwindling liquidity and rarity of quality
paper in the secondary corporate bonds market. For instance, although
Cargill (A2/A/A), top trader in the commodity space as well as
the leading food processor, grain and meat exporter reported an 82% drop
of quarterly earnings on the 9th of August, making it the company's
worst quarter in more than 20 years, it nevertheless managed to place
its 500 million euros 7 year issue at mid-swap +57 bps equating to a
meager coupon of 1.875%. A similar scenario consequent of the on-going "Yield-Famine"
environment played out, namely that as the book grew in size (4 billion
euros worth of orders), and the guidance was tightened, from mid-swap
+70 bps to end up mid-swap +57 bps.
So
what does that mean for credit? We would have to agree with UBS recent
Credit Strategy morning comment from the 29th of August:
"We are downgrading our stance on corporate credit, moving to underweight in Europe and to neutral in the US. The prevailing lack of confidence among agents amounts to an uncertainty shock, one that is taking its toll on economic growth and appears unlikely to abate soon. Recent data points on the macro (Europe, China PMIs) and micro (guidance from Cisco, Caterpillar, Hewlett Packard) fronts suggest growth, particularly in Europe, is running at stall speed.
Risks to the outlook are skewed to the downside, in our opinion. A confluence of factors constrains the outlook for economic growth and corporate profitability, particularly in Europe. They include: the Eurozone crisis, the US fiscal cliff and election uncertainty, political instability in Greece and Italy, doubts over the vitality of the Chinese recovery and rising geopolitical tensions in the Middle East.
In the meantime, the susceptibility of markets to a downside shock is high in an environment of weak growth.
On the other hand, the prospects for policy upside appear constrained versus expectations. In Europe, we expect clarification on the tenor and timeline for bond purchases. However, additional details would run into two major obstacles. First, the Eurozone is a heterogeneous bloc; peripheral countries have disparate problems which require different solutions in terms of aid and conditions, making a “one size fits all” programme an ineffective remedy. Second, there is a moral hazard issue associated with a fully transparent programme; if the terms are too generous, the incentives to reform swiftly would vanish. In the US, we expect Chairman Bernanke to explain the mechanisms the Fed would use to ease further at Jackson Hole, but avoid promising easing is forthcoming. Our economists peg the odds of QE in September at roughly 50/50.
Credit valuations look extended, particularly in higher beta European corporates. Our regression models using economic indicators (Europe composite PMIs, global manufacturing PMIs) suggest iTraxx Xover spreads are c100bp rich to fair value (Chart 1). Given substantial, albeit well flagged, event risks in September, we recommend investors set shorts in higher-beta European credit and take some profits in credit globally."
The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:
As we posited in "Yield-Famine": "Credit
is increasingly becoming a crowded trade, forcing yield hungry
investors to get out of their comfort zone and reaching out for High
Yield as well as Emerging Markets in the process. While everyone is
happily jumping on the credit bandwagon in this "yield famine"
environment, we would advise caution given liquidity, as we discussed on
numerous occasions (and liquidity mattered a lot in 2011...), is an
important factor to consider in relation to investor confidence and
market stability."
Both the Eurostoxx and German 10 year Government yields are still moving in synch but most likely towards "Risk-Off" in the coming weeks with fast falling German Bund yields towards 1.30% yield level and a slightly weaker Eurostoxx 50 at the end of the week - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:
Our "Flight to quality" picture marking pointing towards "Risk-Off" with Germany's 10 year Government bond yields falling again towards 1.30% and the 5 year CDS spread for Germany rising above 60 bps - source Bloomberg:
As far as the EUR/USD is concerned we told you in our conversation "Sting like a bee - The European fight of the Century" to watch out for political "sucker punches" during this summer "lull" because they do sting like a bee! Friday's "sucker punch" on EUR/USD as displayed by the significant intraday move - source Bloomberg:
In relation to the European bond picture, Spanish 10 year yields climbing towards 6.70, slightly below 7% whereas Italian 10 year yields are still below 6% around 5.80% and German government yields fell towards 1.36% - source Bloomberg:
The
recent rise in Spanish government yields is related to the recent
request for bailout by three Spanish regions, Catalonia, Valencia and
Murcia in quick successions. Catalonia asked for 5 billion euros,
Valencia asked for an additional 3.5 billion euros and southeastern
Murcia asked for 700 million. Valencia has already borrowed 25% of the
18 billion euro-bailout fund set up by Prime Minister Rajoy, amounting
to 4.35 billion euros. The size of the bailout fund will soon prove to
be insufficient. Catalonia region was subsequently cut to junk on Friday
by Standard and Poor's with a negative outlook.
The regions were responsible in 2011 for most of Spain's overspending, 8.9% of GDP (unchanged from 2010) while the debt level of the regions as a percentage of GDP are still rising as indicated by Bloomberg:
"The
total debt outstanding of Spain's 17 regions doubled from 4Q08 to 1Q12
and now stands at 145 billion euros, equivalent to 13.5% of GDP. With 15
billion euros of maturities due by year-end, the 18 billion fund
announced in July to support the regions may prove insufficient, and
addressing this will form a pivotal part of any Spanish request for a
bailout." - source Bloomberg.
In addition to the rapidly debt picture, for the three Spanish regions asking for a rescue, unemployment has been rising as well in all three:
In addition to Regional woes, Spain has been busy as well with its banking sector woes this week, given Bankia Group announced 4.45 billion euros of losses for 1H2012 versus a 205 million profit in 2011 (year of its nicely priced IPO...). Bankia had 6.63 billion euros of provisions for 1H impairments costs, and its group clients funds fell 37.6 billion euros from December to 173.8 billion euros. Consequences for Bankia was that its banking rescue FROB has had to immediately inject capital given Bankia group's BIS II Core Capital ratio fell to 6.3% and its bad loans ratio jumped to 11% from 6.3% in 1H 2012.
During the same week, we had the secretary of state for the economy, Fernando Jiménez Latorre, telling us that there was no significant drop in Spain bank deposits. Reading the following comment from HSBC made us wonder about the delusional state of some members of the Spanish government:
"ECB deposit data out and the usual health warnings apply, for anyone of a remotely nervous disposition. This latest set of data show an alarming increase in the pace of deposit flight from Spain - see the graph below. After what appeared to be something of a moderation in June, with 'only' EUR8.6bn disappearing vs EUR30bn+ in both April and May, last month saw EUR74bn leave the Spanish financial system. This brings the YoY pace of decline to a rather Greek 12%. Deputy Finance Minister Latorre is on the tape this morning saying that there's no significant drop in deposits, which one would have to assume refers to this month, as the July data is alarming."
'Other
financial institutions' are responsible for the bulk of the outflows,
with 50% of the deposits being of an 'agreed maturity', so presumably
these depositors are so keen to get their money out of the country that
they'd take an early withdrawal penalty (which would presumably be
cheaper than hedging any redenomination risk). Unless there was a large
seasoning of term deposits in the numbers, but that seems an unlikely
coincidence. Given that Spanish bond yields were getting a little hairy
in July, this shouldn't be a huge surprise.
Since Draghi's verbal Chuck Norris intervention and subsequent spread tightening, however, one would imagine that the pace of deposit flight would moderate, so August's data should mellow. Yet the MoM flow in domestic govt bonds held by Spanish banks has been declining again, consistent with the trend this year since the LTRO induced peak. Makes you wonder who is there in the background buying these assets given the headlines and risks, as the domestic bank bid has been so supportive over the last few years.
Were the Spanish financial system capable of shedding assets at the same rate, or ideally, faster, all would be well. But look at the loans to deposits graph below and note that the Spanish system LDR is still climbing. It's not as large a funding gap as you might see elsewhere in Europe (currently 117% LDR, vs e.g. Finland on 143%, Ireland on 129%, Italy on 122%, or the Netherlands on 120%), but more the trend that's concerning, as Spain belong to the unfortunate minority of countries where the funding gap is widening - Greece, Cyprus, and more recently, Portugal. No wonder there's a sense of urgency at the ECB these days." - source HSBC
Back in our conversation "Agree to Disagree" in June we wrote:
"If our European politicians had studied carefully what had happened in Argentina before their default in 2002, they would not be pressing for a "Banking Union" but should rather be more concerned about a deposit guarantee scheme if they are "really serious" about keeping Greece in the Euro. Back in March we argued the following in our conversation "Modicum of Relief":
"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.
Unless our European politicians rapidly introduce European laws guaranteeing depositors money ("insurance for depositors against the risk of euro exit" is qualitatively different from "deposit insurance"), capital flight might start in Spain as it has already in Greece."
As far as Spain is concerned, deposit outflows have been confirming our June call:
"The dangers of deposit outflows. While complacency is prevailing so far in relation to Spanish deposits, it cannot be taken for granted, as shown by the situation in Argentina which quickly spiraled out of control and led to its default in 2002:
"the most puzzling aspect of the crisis so far is the relative complacency of the public. This is starting to be tested." - CreditSights, 31st of July 2001 paper "Defining the Default Path".
We might be rambling again in our longer than usual conversation but we have long argued the impact the LTRO has had on the Spanish banking system. amounted to "Money for Nothing":
- source HSBC - Spain - Loans growth month to month.
We hate sounding like a broken record but: no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits (All Quiet on the Western Front - April 2012):
"In August 2011 we wrote in our conversation "It's the liquidity stupid...and why it matters again...":
"Lack of funding means that bank will have no choice but to shrink their loan books. If it happens, you will have another credit crunch in weaker European economies, meaning a huge drag on their economic recovery and therefore major challenges for our already struggling politicians.
As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.
"So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans."- "Subordinated debt - Love me tender?" - Macronomics, October 2011
One can easily conclude that not only will the regional bail-out fund will need to be recapitalized but FROB as well given the Bankia group will certainly need additional capital injunctions as the economic outlook deteriorates further in Spain because no loan growth means no earnings, rising non-performing loans and rising deposit-outflows mean rising loan-to-deposits level. Capital injections mean additional strain on the budget with weaker tax receipts.
Back in our conversation "Modicum of Relief" we indicated the following:
"On the subject of systemic risk diagnosis, wholesale bank deposits flights and tracking the loan-to-deposit ratio of banks can be used as a simple gauge of risk profile. It is as well a good indicator of banks 'capacity in supporting lending in their respective economy. Maintaining lending and credit flows is paramount to avoid a credit crunch which would essentially impair GDP growth in the process (as per our "car" analogy used in our previous conversation)."
As far as similarities between Spain and Argentina and in relation to capital flight:
"the lack of liquidity in the system has forced the central banks to provide unprecedented level of repos to the system and also relax reserve requirements. The problem is that this is very unclear whether that additional liquidity is funding anything but capital flight at this point." - CreditSights 31st of July 2001 paper "Defining the Default Path"
Moving on to the subject of the relationship between credit and equities correlation, the significant outperformance of U.S. equities indices versus their European peers, is interesting given the outperformance of European credit versus U.S. credit.
We have been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:
We have on various occasions discussed the relationship between credit and equities. Back in January 2011, in our credit conversation "A tale of two markets - Credit versus Equities", we indicated the following in relation to credit and the relationship with equity volatility:
"In theory Credit can be assimilated to a long OTM (Out of the Money) equity option. A Credit Default Swap (CDS) is a proxy for a Put Option on the Assets of a Firm. This means that by going long on bonds the bondholders are long the face value of the bond and short a put option on the assets of the firm with the strike price being the face value (principal) of the bonds.
In recent years, according to a research published by Morgan Stanley in March 2009 by Sivan Mahadevan, correlations between changes in credit spreads and changes in various implied volatility metrics, have been very similar to short-dated ATM (At The Money) equity options. Liquidity being an important factor and short-dated ATM being the most liquid in equities, whereas the 5 year point being the most liquid CDS point (Credit Default Swap). Given there is an extremely low probability of an entire equity index going bankrupt, Morgan Stanley's research team further comment that ATM volatility can be used to make comparisons between equity and credit. The cash equity/credit relationship is apparently less stable than the volatility/credit relationship according to Morgan Stanley's study."
We would like to go further given the R2 (coefficient of determination of a linear regression) between Credit/Spot equities and Credit/Equities Volatilities (ATM for At The Money) in both Europe and the U.S. tell a different story courtesy of our good cross-asset friend. An elevated R2 level indicates a significant relation. One can see in the below table the higher correlation between European Itraxx Credit indices (Itraxx Main Europe being the investment grade risk gauge and Itraxx Crossover being the European High Yield risk gauge) and the Eurostoxx 50 equity index. In the U.S. in the table below you can see the relationship between CDX IG (Investment Grade) and CDX HY (High Yield) with the Standard and Poor's 500 (SPX) and the Russell index.
The correlations between Credit Indices in Europe versus Spot equities remain very significant in Europe and in Japan but less so in the U.S. At current levels the relationship between the Standard and Poor's and Credit is weak, whereas the Russell Index is more positively correlated to Credit in the U.S. The fact that the Standard and Poor's volatility is strongly correlated to Credit is counterintuitive.
The overall underperformance of Japanese credit spreads which continue to weaken is at present the only notable disconnect between credit spreads and spot equities:
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According to our good cross asset-friend, this weak Japanese relationship warrants monitoring and could be played by selling CDS and buying Nikkei Put Options, which benefit from absolute low volatility levels. Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Japan 5 year CDS since March 2010 until the 21st of August 2012 - source Bloomberg:
Monitoring levels of correlation in the short-term is fundamental if you are looking at adding relative value positions or if you would like using historical signals to position yourself on either credit or equities.
"If you want stability, prepare for instability" - Martin T - Macronomics.
Stay tuned!
"We are downgrading our stance on corporate credit, moving to underweight in Europe and to neutral in the US. The prevailing lack of confidence among agents amounts to an uncertainty shock, one that is taking its toll on economic growth and appears unlikely to abate soon. Recent data points on the macro (Europe, China PMIs) and micro (guidance from Cisco, Caterpillar, Hewlett Packard) fronts suggest growth, particularly in Europe, is running at stall speed.
Risks to the outlook are skewed to the downside, in our opinion. A confluence of factors constrains the outlook for economic growth and corporate profitability, particularly in Europe. They include: the Eurozone crisis, the US fiscal cliff and election uncertainty, political instability in Greece and Italy, doubts over the vitality of the Chinese recovery and rising geopolitical tensions in the Middle East.
In the meantime, the susceptibility of markets to a downside shock is high in an environment of weak growth.
On the other hand, the prospects for policy upside appear constrained versus expectations. In Europe, we expect clarification on the tenor and timeline for bond purchases. However, additional details would run into two major obstacles. First, the Eurozone is a heterogeneous bloc; peripheral countries have disparate problems which require different solutions in terms of aid and conditions, making a “one size fits all” programme an ineffective remedy. Second, there is a moral hazard issue associated with a fully transparent programme; if the terms are too generous, the incentives to reform swiftly would vanish. In the US, we expect Chairman Bernanke to explain the mechanisms the Fed would use to ease further at Jackson Hole, but avoid promising easing is forthcoming. Our economists peg the odds of QE in September at roughly 50/50.
Credit valuations look extended, particularly in higher beta European corporates. Our regression models using economic indicators (Europe composite PMIs, global manufacturing PMIs) suggest iTraxx Xover spreads are c100bp rich to fair value (Chart 1). Given substantial, albeit well flagged, event risks in September, we recommend investors set shorts in higher-beta European credit and take some profits in credit globally."
The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:
Both the Eurostoxx and German 10 year Government yields are still moving in synch but most likely towards "Risk-Off" in the coming weeks with fast falling German Bund yields towards 1.30% yield level and a slightly weaker Eurostoxx 50 at the end of the week - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:
Our "Flight to quality" picture marking pointing towards "Risk-Off" with Germany's 10 year Government bond yields falling again towards 1.30% and the 5 year CDS spread for Germany rising above 60 bps - source Bloomberg:
As far as the EUR/USD is concerned we told you in our conversation "Sting like a bee - The European fight of the Century" to watch out for political "sucker punches" during this summer "lull" because they do sting like a bee! Friday's "sucker punch" on EUR/USD as displayed by the significant intraday move - source Bloomberg:
In relation to the European bond picture, Spanish 10 year yields climbing towards 6.70, slightly below 7% whereas Italian 10 year yields are still below 6% around 5.80% and German government yields fell towards 1.36% - source Bloomberg:
The regions were responsible in 2011 for most of Spain's overspending, 8.9% of GDP (unchanged from 2010) while the debt level of the regions as a percentage of GDP are still rising as indicated by Bloomberg:
In addition to the rapidly debt picture, for the three Spanish regions asking for a rescue, unemployment has been rising as well in all three:
In addition to Regional woes, Spain has been busy as well with its banking sector woes this week, given Bankia Group announced 4.45 billion euros of losses for 1H2012 versus a 205 million profit in 2011 (year of its nicely priced IPO...). Bankia had 6.63 billion euros of provisions for 1H impairments costs, and its group clients funds fell 37.6 billion euros from December to 173.8 billion euros. Consequences for Bankia was that its banking rescue FROB has had to immediately inject capital given Bankia group's BIS II Core Capital ratio fell to 6.3% and its bad loans ratio jumped to 11% from 6.3% in 1H 2012.
During the same week, we had the secretary of state for the economy, Fernando Jiménez Latorre, telling us that there was no significant drop in Spain bank deposits. Reading the following comment from HSBC made us wonder about the delusional state of some members of the Spanish government:
"ECB deposit data out and the usual health warnings apply, for anyone of a remotely nervous disposition. This latest set of data show an alarming increase in the pace of deposit flight from Spain - see the graph below. After what appeared to be something of a moderation in June, with 'only' EUR8.6bn disappearing vs EUR30bn+ in both April and May, last month saw EUR74bn leave the Spanish financial system. This brings the YoY pace of decline to a rather Greek 12%. Deputy Finance Minister Latorre is on the tape this morning saying that there's no significant drop in deposits, which one would have to assume refers to this month, as the July data is alarming."
Since Draghi's verbal Chuck Norris intervention and subsequent spread tightening, however, one would imagine that the pace of deposit flight would moderate, so August's data should mellow. Yet the MoM flow in domestic govt bonds held by Spanish banks has been declining again, consistent with the trend this year since the LTRO induced peak. Makes you wonder who is there in the background buying these assets given the headlines and risks, as the domestic bank bid has been so supportive over the last few years.
Were the Spanish financial system capable of shedding assets at the same rate, or ideally, faster, all would be well. But look at the loans to deposits graph below and note that the Spanish system LDR is still climbing. It's not as large a funding gap as you might see elsewhere in Europe (currently 117% LDR, vs e.g. Finland on 143%, Ireland on 129%, Italy on 122%, or the Netherlands on 120%), but more the trend that's concerning, as Spain belong to the unfortunate minority of countries where the funding gap is widening - Greece, Cyprus, and more recently, Portugal. No wonder there's a sense of urgency at the ECB these days." - source HSBC
Back in our conversation "Agree to Disagree" in June we wrote:
"If our European politicians had studied carefully what had happened in Argentina before their default in 2002, they would not be pressing for a "Banking Union" but should rather be more concerned about a deposit guarantee scheme if they are "really serious" about keeping Greece in the Euro. Back in March we argued the following in our conversation "Modicum of Relief":
"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.
Unless our European politicians rapidly introduce European laws guaranteeing depositors money ("insurance for depositors against the risk of euro exit" is qualitatively different from "deposit insurance"), capital flight might start in Spain as it has already in Greece."
As far as Spain is concerned, deposit outflows have been confirming our June call:
"The dangers of deposit outflows. While complacency is prevailing so far in relation to Spanish deposits, it cannot be taken for granted, as shown by the situation in Argentina which quickly spiraled out of control and led to its default in 2002:
"the most puzzling aspect of the crisis so far is the relative complacency of the public. This is starting to be tested." - CreditSights, 31st of July 2001 paper "Defining the Default Path".
We might be rambling again in our longer than usual conversation but we have long argued the impact the LTRO has had on the Spanish banking system. amounted to "Money for Nothing":
We hate sounding like a broken record but: no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits (All Quiet on the Western Front - April 2012):
"In August 2011 we wrote in our conversation "It's the liquidity stupid...and why it matters again...":
"Lack of funding means that bank will have no choice but to shrink their loan books. If it happens, you will have another credit crunch in weaker European economies, meaning a huge drag on their economic recovery and therefore major challenges for our already struggling politicians.
As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.
"So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans."- "Subordinated debt - Love me tender?" - Macronomics, October 2011
One can easily conclude that not only will the regional bail-out fund will need to be recapitalized but FROB as well given the Bankia group will certainly need additional capital injunctions as the economic outlook deteriorates further in Spain because no loan growth means no earnings, rising non-performing loans and rising deposit-outflows mean rising loan-to-deposits level. Capital injections mean additional strain on the budget with weaker tax receipts.
Back in our conversation "Modicum of Relief" we indicated the following:
"On the subject of systemic risk diagnosis, wholesale bank deposits flights and tracking the loan-to-deposit ratio of banks can be used as a simple gauge of risk profile. It is as well a good indicator of banks 'capacity in supporting lending in their respective economy. Maintaining lending and credit flows is paramount to avoid a credit crunch which would essentially impair GDP growth in the process (as per our "car" analogy used in our previous conversation)."
As far as similarities between Spain and Argentina and in relation to capital flight:
"the lack of liquidity in the system has forced the central banks to provide unprecedented level of repos to the system and also relax reserve requirements. The problem is that this is very unclear whether that additional liquidity is funding anything but capital flight at this point." - CreditSights 31st of July 2001 paper "Defining the Default Path"
Moving on to the subject of the relationship between credit and equities correlation, the significant outperformance of U.S. equities indices versus their European peers, is interesting given the outperformance of European credit versus U.S. credit.
We have been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:
We have on various occasions discussed the relationship between credit and equities. Back in January 2011, in our credit conversation "A tale of two markets - Credit versus Equities", we indicated the following in relation to credit and the relationship with equity volatility:
"In theory Credit can be assimilated to a long OTM (Out of the Money) equity option. A Credit Default Swap (CDS) is a proxy for a Put Option on the Assets of a Firm. This means that by going long on bonds the bondholders are long the face value of the bond and short a put option on the assets of the firm with the strike price being the face value (principal) of the bonds.
In recent years, according to a research published by Morgan Stanley in March 2009 by Sivan Mahadevan, correlations between changes in credit spreads and changes in various implied volatility metrics, have been very similar to short-dated ATM (At The Money) equity options. Liquidity being an important factor and short-dated ATM being the most liquid in equities, whereas the 5 year point being the most liquid CDS point (Credit Default Swap). Given there is an extremely low probability of an entire equity index going bankrupt, Morgan Stanley's research team further comment that ATM volatility can be used to make comparisons between equity and credit. The cash equity/credit relationship is apparently less stable than the volatility/credit relationship according to Morgan Stanley's study."
We would like to go further given the R2 (coefficient of determination of a linear regression) between Credit/Spot equities and Credit/Equities Volatilities (ATM for At The Money) in both Europe and the U.S. tell a different story courtesy of our good cross-asset friend. An elevated R2 level indicates a significant relation. One can see in the below table the higher correlation between European Itraxx Credit indices (Itraxx Main Europe being the investment grade risk gauge and Itraxx Crossover being the European High Yield risk gauge) and the Eurostoxx 50 equity index. In the U.S. in the table below you can see the relationship between CDX IG (Investment Grade) and CDX HY (High Yield) with the Standard and Poor's 500 (SPX) and the Russell index.
The correlations between Credit Indices in Europe versus Spot equities remain very significant in Europe and in Japan but less so in the U.S. At current levels the relationship between the Standard and Poor's and Credit is weak, whereas the Russell Index is more positively correlated to Credit in the U.S. The fact that the Standard and Poor's volatility is strongly correlated to Credit is counterintuitive.
The overall underperformance of Japanese credit spreads which continue to weaken is at present the only notable disconnect between credit spreads and spot equities:
According to our good cross asset-friend, this weak Japanese relationship warrants monitoring and could be played by selling CDS and buying Nikkei Put Options, which benefit from absolute low volatility levels. Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Japan 5 year CDS since March 2010 until the 21st of August 2012 - source Bloomberg:
Monitoring levels of correlation in the short-term is fundamental if you are looking at adding relative value positions or if you would like using historical signals to position yourself on either credit or equities.
"If you want stability, prepare for instability" - Martin T - Macronomics.
Stay tuned!