Sting Like a Bee
By Martin T. – Macronomics
August 8, 2012
“Boxing is the only sport you can get your brain shook, your money took and your name in the undertaker book.” – Joe Frazier
“And the first thing that came to mind was something that people said many years ago and then stopped saying it: The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years. And now – and I think people ask “how come?” – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis. The bumblebee would have to graduate to a real bee. And that’s what it’s doing.
Sting like a bee! – When words speak louder than action – “Within our mandate, the ECB is ready to
do whatever it takes to preserve the euro,” and “believe me, it will be enough.” – Mario Draghi
But what looked initially as a boxing game, is fast evolving into a “mixed martial arts” (MMA) contest as indicated by Bloomberg on the 2nd of August, in relation to the Draghi (ECB) – Weidmann (Bundesbank) stand-off – Gloves Off in Draghi-Weidmann Standoff over ECB Bond-Buying Plan:
And in this Bloomberg article, Weidmann recently declared in relation to the Bundesbank (being ECB’s Joe Frazier):
Looks like our European jungle is ready to rumble. This time around we would like to focus our attention to what we think might be analyzed from the ECB’s conference as well as an important point relating to the withdrawal of funding by core European banks from their peripheral branches to make them less reliant from the parent company. We always try to reflexionate like a behavioral therapist would, in the sense that, we tend to focus more on the process rather than on the content. But first our credit overview!
The Itraxx CDS indices picture, a tale of great volatility on Thursday and Friday following the ECB conference and the Nonfarm payrolls, tighter, wider, tighter – source Bloomberg:
The magnitude of the sell-off on Thursday was significant, with higher volumes traded than normal in a significantly volatile market context. For instance, Itraxx Financial Senior 5 year index (risk gauge for financial senior unsecured bonds) went from 240 bps offered to 270 bps in a matter of seconds given the initial market reaction of disappointment to the ECB’s conference. Friday was a different trading day which saw a significant tightening move, with the Itraxx Crossover 5 year index (representing 50 mostly high yield European companies) falling the most in 9 months by 52 bps to around 597 bps on the close, implying a significant improvement in investor sentiment which was boosted as well by the results from the latest Nonfarm payrolls in the US. The 5 year Sovereign CDS for Spain fell as well by 32 bps to around 539 bps, breaking three days of uninterrupted surge on Friday, on expectations of short-dated bond purchases by the ECB.
But, do not be fooled by the latest rally in the credit space in the Itraxx Financial 5 year CDS index (tighter by 29 bps on the day and the SOVx (representing 15 Western Europe sovereign CDS including Cyprus). Severing the Sovereign risk / Financial risk link remain to be seen as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index which remains broadly flat – source Bloomberg:
As far as “Yield Famine” is concerned in relation to investment grade cash bonds from quality issuers, as market maker rightfully commented are heavily sought:
“The grab for bonds is still on. The imbalance between supply and demand is huge at the moment. Consequently liquidity in the secondary market has declined and it feels street inventory is at multi year lows. So most low beta names grind tighter day by day amid low volume or spreads are just marked tighter without volume. Technicals clearly rule the market for now. Apart from some special situations low beta names remain well bid.”
In our “Yield Famine” conversation on the 19th of July we argued the following: “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.”
Our cautiousness has been validated by Lisa Abramovicz Bloomberg article from the 3rd of August – Bond Trading Least Since 2008 as Dealers Retreat:
“Investors are stockpiling corporate debt rather than trading as banks retreat from bond brokering,
with daily trading volumes in the U.S. slumping to the slowest July in four years even as offerings reached a record. Volumes averaged $9.97 billion last month, 8 percent below July 2011 and the lowest for the period since two months before Lehman Brothers Holdings Inc.’s failure ignited the credit crisis, according to Financial Industry Regulatory Authority data. Investment-grade sales rose 58 percent from the same month last year to $80.5 billion, data compiled by Bloomberg show.
Fund managers are struggling to pry loose bonds in the secondary market as new regulations to curb risk fuel an 82 percent decline in corporate-bond inventories at primary dealers since 2007. Issuance is failing to satiate investors who have plowed $63.5 billion into investment-grade bond funds this year, seeking alternatives to government debt as the Federal Reserve holds benchmark interest rates near zero through at least 2014. “There’s such an imbalance between supply and demand right now, investors aren’t willing to part with what they own,” said Jonathan Fine, Goldman Sachs Group Inc.’s head of investment-grade syndicate for the Americas in New York. “They’re just focused on getting new product through the door.” – source Bloomberg.
“Yield Famine” in conjunction with very poor liquidity, which will continue to deteriorate given market makers are continuing to reduce risk to meet capital-ratio goals (as recently announced by Deutsche Bank), could potentially be a very lethal combination indeed should the market experience a severe sell-off, so, “Mind the Gap” and do be too complacent about the prevailing situation.
“The 21 primary dealers that trade directly with the Fed have curbed trading of company bonds in the U.S. by 61 percent to an average volume of $107.9 billion in the week ended July 25 from the peak of $278.6 billion in June 2007, according to Fed data. Their holdings of the debt plunged to $37.5 billion as of July 11, the least since March 2002.” – source Bloomberg – Bond Trading Least Since 2008 as Dealers Retreat.
Euro Investment Grade Issuance at a glance – source Barclays:
“The last two weeks of July saw a flurry of supply, with several issuers accessing the market post their results and ahead of the Olympics. Despite volatile market conditions, non-financial issuance of €16.0bn was more than twice the €7.3bn issued last July. In part this reflects the strong demand-technical in the market, with investors seemingly willing to invest in the “right” corporates even in periods of stress. Significant investor cash balances, combined with heightened risk aversion, have deepened the divide between the “haves” and the “have-nots” when it comes to primary market access.” – source Barclays – Euro/Sterling High Grade Supply Update July 2012.
Mario Draghi’s lack of intervention to support Spanish yields on Thursday, led to them rising significantly again above 7% on Thursday before receding significantly on Friday as displayed in our European bond picture while German government yields rose back towards higher levels around 1.40% on the close – source Bloomberg:
Leading to our “Flight to quality” picture displaying an unconvincing medium term “Risk-On” environment with Germany’s 10 year Government bond yields rising again towards 1.40% and the 5 year CDS spread for Germany well below 100 bps in the process – graph below, source Bloomberg:
We say unconvincing medium term “Risk-On” because another 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 – source Bloomberg:
We first mentioned this medium term indicator in our conversation River of “No Returns” on the 2nd of June:
“While touching again on our recent 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 has been close to 1 in 2010, 2011 and 2012, whereas in “Risk On” periods, the correlation was falling to significantly lower level. The correlation between both the German Bund and US 10 year note is rising very fast, now above 70%. The above graph was our reasoning behind our 30th of March call:
“One has to ask oneself if the time has not come to start taking a few chips off the table.” – Macronomics – “Spanish Denial“.”
Considering the lack of liquidity in the credit space and the very high correlation between asset classes driven by the European politicians, the coming weeks could see another significant spike in volatility in the European space so watch out for that “sucker punch”. Both the Eurostoxx and German 10 year Government yields seems to be moving in synch for now in what seems to be a short burst of “Risk-On”, with rising German Bund yields and a higher Eurostoxx 50 index courtesy of the Nonfarm payrolls number on Friday. – 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:
Watch out for political “sucker punches” during this summer “lull” because they do sting like a bee! Thursday “sucker punch” on EUR/USD as displayed by the significant intraday move – source Bloomberg:
Moving on to what we think might be analyzed from the ECB’s conference but also the Fed’s stand-by decision, we agree with our good credit friend namely that:
“The markets were waiting for the Central Banks to deliver something…One could argue they deliver nothing, our understanding is more mixed as we think the message had been crystal clear for a while. Of course, some sentences from Mario Draghi or Ben Bernanke taken out of context have created in the past days a situation similar to the situation experienced by parents trying to motivate a 5 years old child to do something he does not want.
Let us explain:
1- The FED met and did not modify anything to its monetary policy, just declaring that it remains ready to act should the economy weaken or face exogenous shocks. Basically, nothing new there.
2- The ECB met and did not modify anything to its monetary policy. Mario Draghi delivered a speech which underlines a lot of possibilities in term of outright interventions. But all the suggestions were assorted to conditionality. Here some extracts: “ECB may take measure to ensure policy transmission, Investor concerns on seniority will be addressed, ECB may undertake outright open market operations, Governments must stand ready to activate EFSF, High yields are unacceptable, Euro irreversible, and left the door open to many possibilities, ECB discussed possible interest rate cut today, ECB will focus on shorter part of the yield curve,…”
Basically, the news are not that negative! Mr Draghi just tempered markets in their expectations, but left the door open to the re-opening of the SMP bond buying program on the front end of the curve, but only within its mandate. He also left the door open to non-sterilized interventions, which is an indication that talks are going on and that such a possibility could take place should deflation materialize.”
To summarize, a rate cut is in the cards, bond buying is in the cards if Spain ask for it (tap out in true MMA fashion), and unsterilized outright open interventions are a possibility:
“You shouldn’t assume that we will not sterilize or sterilize” – Mario Draghi.
The markets were too optimistic and do not seem to understand the European decision process, hence the importance, we think of focusing on the process and not the content in true behavioral therapist fashion. Investors should know by now that it takes some time for the ECB to change its policy as its main contributor, namely the Bundesbank, has a different concept of what a sound monetary policy is compared to other central banks.
But more importantly, one must understand that Central Banks ammunitions are scarce and precious, and that their ability to fight a balance sheet recession is limited, and that important decisions are in the hand of the politicians which is also what CreditSights point out in their recent report of interest – ECB Bond Buying and ESM Bank – Talk without Trousers:
“The proposal to grant the ESM the ability, as a bank, to access ECB liquidity facilities to underpin its own financing requirements could be an important step towards providing more breathing room for distressed sovereigns while a longer-term solution to the crisis can be worked out. As yet, however, there is no sign that German politicians have changed their opposition to the idea. Ultimately the decision to grant the ESM a banking license and whether to expand its lending capacity meaningfully will be taken by politicians.
Similarly the prospect of the ECB restarting its bond purchase programme will certainly be enough to give speculators pause. But no one believes that the ECB is currently willing to purchase bonds in perpetuity. The ECB views this is a crisis that requires Eurozone politicians to take difficult decisions about how much Eurozone governments are willing to share common funding and spending arrangements.
The comments of Nowotny, Draghi and also Juncker – who suggested that activation of the ESM’s bond purchases may be imminent – illustrate the extent to which brief periods of stability in stressed-Eurozone country government bonds can be achieved with statement of support and ECB liquidity. The result is that while financial markets repeatedly expect this crisis to reach some kind of conclusion within a timescale of days, weeks or months, the ability of the Eurozone policymakers to stretch this crisis out further seems to be practically inexhaustible.” – source CreditSights
Many pundits have been arguing that by focusing on the short end of the peripheral countries curves, the ECB via Mario Draghi, is in fact steepening the curve for both Italy and Spain which is apparently the opposite effect one needs to help these economies. We think these pundits are focusing too much on the content in their analysis and should be focusing on the process which are the basis for good understanding of Behaviorism. Basically in true MMA grappling/submission analogy, we think that implicitly, the Bundesbank (Weidmann with the support of Merkel) has conceded to bond purchases by the ECB, in order to keep a tight leash on both Italian and Spanish politicians to keep up with the pace of structural reforms. It seems to us, that Germany has learn from the Greek “experiment” in the sense that buying indiscriminately bonds on the whole term structure not only put the ECB’s balance sheet under great risk, but, it also alleviates significantly the pressure from politicians to make good on their commitments which they made in order to garner financial support. In fact we think the ECB has set up the stage for an operant conditioning chamber (also known as the Skinner box):“When the subject correctly performs the behavior, the chamber mechanism delivers food or another reward. In some cases, the mechanism delivers a punishment for incorrect or missing responses. With this apparatus, experimenters perform studies in conditioning and training through reward/punishment mechanisms.” – source Wikipedia
“We should not forget, and some of the statements tend to forget, that everything – the ESM recapitalisation, the stepping-in of the EFSF or the ESM in the primary or secondary markets – is subject to conditionality. There is nothing without conditionality. Conditionality is what gives credibility to these measures.” – Mario Draghi.
By targeting the short end of peripheral yield curves. It will permit the ECB to study behavior conditioning (training) by teaching Italy and Spain to perform certain structural reforms in response to specific stimuli/bond purchases. Truth is cognitive–behavioral therapy has demonstrable utility in treating certain pathologies such as “motivating a 5 years old child” or a European politician (but we ramble again…).
In continuation of our conversation “The Game of The Century“, we still think “that, after all Angela Merkel, could be one of the greatest chess players around and has just used “castling”.” The biggest winner from the last European summit was indeed Angela Merkel:
Jürgen Stark left on the 9 September 2011. It was reported that Stark left the ECB due to disagreement with the bank’s controversial bond-buying programme.
Make no mistake; Dr Angela Merkel (she obtained a thesis on quantum chemistry) appears to us as a highly intelligent political player. Angela Merkel was named Secretary-General of the CDU, a male-dominated, socially conservative party with strongholds in western and southern Germany, and the Bavarian sister party, the CSU, has deep Catholic roots. Being a Protestant woman, originating from predominantly Protestant northern Germany, it would be very foolish to underestimate her capacity in outmaneuvering/outplaying her European counterparts – Mario Monti, François Hollande, Mariano Rajoy.
In relation to the important point relating to the withdrawal of funding by core European banks from their peripheral branches to make them less reliant from the parent company (which we discussed with our good credit friend), please note that BNP Paribas announced that it is cutting funding to its Italian subsidiary BNL through securitization. BNL will resume debt issuances under its own name. The reason was that “new rules triggered change in funding Italian unit”.
The lesson from Emporiki and Credit Agricole seem to reach other banks. A kind of “balkanization” of the European financial system seem to be under way, even though Mr Draghi denied it (but he cannot acknowledge it, it would not be politically correct!).
As reported by Fabio Benedetti-Valentini in Bloomberg, BNP Joins Credit Agricole to Seek Escape From Euro-Exit Risk:
“France’s biggest banks are rushing to cut the more than 140 billion euros ($171 billion) they provide their operations in Europe’s troubled economies, seeking to protect themselves against a possible breakup of the euro. In a retreat, French banks, especially BNP Paribas SA and Credit Agricole SA — the largest by assets — are trying to make their businesses in Italy, Spain, Greece, Portugal and Ireland less reliant on funds from the parent company. In the decade after the creation of the euro, French banks were among the region’s most ambitious and acquisitive, investing about $36 billion in the five countries, lured by the prospect of growth in those markets. Their pullback now reflects the banks’ attempt to defend themselves against the risk, however remote, of an exit from the euro of any of the countries. “It’s an unhealthy sign,” said Philippe Bodereau, the London-based head of research for financial firms at Pacific Investment Management Co., the world’s largest bond investor. “It’s like shifting sands, with European banks protecting against invisible currency risks within the euro zone.”
Like other financial institutions in Europe, French banks are trying to match assets and liabilities on a national level to minimize risk. Reducing assets in the five countries to limit cross-border exposure may erode BNP Paribas’s after-tax earnings by 4.7 percent and Credit Agricole’s by 7.2 percent, estimates Benoit Petrarque, a Kepler Capital Markets analyst in Paris”.
This will accentuate even more future funding problems for weaker peripheral branches, which are already strained by falling time deposits (see our last conversation where we discussed the Spanish structural funding issues with the example of Santander):
“June data show that total deposits held by Spanish monetary financial institutions fell more than 60 billion euros yoy, with 90% of this drop in time deposits. While banks have found alternative funding sources including repo and ECB loans, this growing mismatch may create future problems as banks move to comply with the net stable funding ratio.” – source Bloomberg.
Looking at the recent financial results from various European banks, it looks to us increasingly evident that more “Goodwill impairments” are coming and will definitely be back on the agenda in Q3 in similar fashion to our November 2011 conversation “Goodwill Hunting Redux“:
“European banks carry 185 billion euros of goodwill, having written down more than 30 billion in 2011. Societe Generale’s 2Q write-down of 250 million euros for its Russia subsidiary and 200 million on its TCW U.S. fund manager refer to slower momentum and market conditions as rationale. Further impairments across the sector are likely, given ongoing market difficulties.” – source Bloomberg.
“It’s less about the physical training, in the end, than it is about the mental preparation: boxing is a chess game. You have to be skilled enough and have trained hard enough to know how many different ways you can counterattack in any situation, at any moment.” – Jimmy Smits