By Martin T. - Macronomics
“It’s not enough to succeed. Others must fail.” – Gore Vidal
“In chess, a desperado piece is a piece that seems determined to give itself up, typically either (1) to sell itself as dearly as possible in a situation where both sides have hanging pieces or (2) to bring about stalemate if it is captured (or in some instances, to force a draw by threefold repetition if it is not captured) (Hooper & Whyld 1992:106–7). Andrew Soltis describes the former type of desperado as “a tactical resource in which you use your doomed piece to eat as much material as possible before it dies.” – source Wikipedia.
In continuation of our chess title analogy which we made in our conversation “The Game of the Century“, and looking at the recent headline evolution, with Merkel hinting towards concessions for Greece before Greek Prime Minister Antonis Samaras visit, as well as speculation around yield targeting by the ECB being a possible game changer with implicit German approval, we thought we would use this time around yet another reference to the game of chess, in the light of how politically driven markets’ behavior have become. Indeed, it appears to us that Angela Merkel has craftily played in our European on-going chess game (like a chess Grand-Master) and successfully applied operant conditioning!:
Early August in our conversation “Sting like a bee – The European fight of the Century” we indicated the following:
In chess games, sometimes it is possible for the inferior side to sacrifice two or three pieces in rapid succession to achieve a stalemate but, we ramble again.
Back in our 4th of August conversation we clearly indicated that you needed to focus on the process and become a behavioral therapist in relation to the on-going European crisis:
The Itraxx CDS indices picture, a much tighter week with spreads moving towards there March lows in the credit derivatives space – source Bloomberg:
Our “Flight to quality” picture displaying so far ”Risk-On” with Germany’s 10 year Government bond yields rising again towards 1.60% and the 5 year CDS spread for Germany well below 100 bps in the process, both converging - graph below, source Bloomberg:
And so did Euro Zone bank sovereign holdings which grew 30% from 2007 levels according to Bloomberg undermining in effect the efforts in severing sovereign risk from financial risk:
Although European authorities are determined in severing the link between financial institutions and sovereign risk, Spanish banks stopping recently their bond purchases has had circular effect and led to decoupling!:
If Irish banking woes can be used as a proxy for future Spanish banking woes, Bank of Ireland and Allied Irish results clearly indicated they continued to struggle during the first half of 2012 not only because of large loans impairments, but legacy problems, high funding costs and other headwinds meant that both banks were even loss-making on a pre-impairment basis according to CreditSights latest report – Irish Banking Mortgage Mayhem from the 19th of August:
The main concern has switched from losses on commercial property lending to a rapid and substantial deterioration in residential mortgage portfolios. A 50% fall in house prices from their peak, combined with a significant increase in unemployment and economic austerity measures, mean that banks’ losses on mortgage lending are at an unprecedented level.
Loans 90 days or more are 14% of total mortgage loans, and around two thirds of mortgages have a loan-to-value ratio of more than 100%. Loan impairments look set to remain high for some time and will possibly be inflated further by new personal insolvency legislation, but they will not be on the same scale as the banks’s losses on commercial real estate.” - source CreditSights
“In all, the state has injected or pledged about 64 billion euros to banks, and five of the six largest domestic lenders are now in government hands. State-owned Allied Irish, the country’s largest mortgage lender, said last month that payments on 37 percent of its Irish buy-to-let mortgage holdings are at least three months behind, compared with about 13 percent for its owner-occupier loans.”
“Spain’s net borrowings from the ECB rose in July to hit a record high of 375.5 billion euros, and gross drawings now represent one-third of the ECB’s total gross bank lending. Final details of up the banking bailout and the potential for a full sovereign bailout application are uncertainties that may continue to pressure availability of bank liquidity.” – source Bloomberg.
As far as our “European operant conditioning chamber” set up by Angela Merkel is concerned we do agree with Jacques Cailloux from Nomura’s recent arguments relating to unconditional yield targets being discussed:
“1. The ECB is attached to conditionality as a guiding principle for any future intervention.
2. The ECB has already restricted its remit in terms of bond buying.
3. Spreads versus yield targets.
4. Same spread for everyone unconditionally?
Overall, we do not believe the ECB is about to embark upon unconditional yield targets across all euro area countries. The only feasible option in the short term, in our view, would be to specify its intervention modus operandi for countries requesting help such as Italy and Spain. We believe this is very likely to take place at the September meeting (as hinted at by Asmussen’s interview in Frankfurter Rundschau this morning).”
One can therefore ponder in our European chess game if Spain is indeed a “desperado piece” that seems determined to give itself up. Oh well…
Moving on to the subject of the growing disconnect between fundamentals and markets indicating somewhat a reduction in tail risk and the on-going performance of risky assets in the short term, we agree with Suki Mann from Société Générale in his 21st of August 2012 in the sense that credit could experience some additional tightening in the short term:
“Fundamentals to take over, but when? Surely, they’ve got to come more into consideration, otherwise we’re doing away with the concept of relative value within IG cash corporate credit. For instance, there’s already a long list of casualties where normally we’d see price action reflect the broken limbs. Not anymore. Some of the more recent actions have seen ArcelorMittal being junked, while Banque PSA will be; Telekom Austria’s and KPN’s operating performances leave much to be desired while the latter’s asset sales have been postponed pressuring its creditworthiness; and Heineken is besieged by M&A risk. None of that is putting anyone off. All the bond valuations of the aforementioned entities are flat at worst, but mostly better than when the action/event occurred. That’s because technicals are smothering everything. In addition, it is probably convenient also to take the investment stance that the aforementioned credits – national champions and well-known blue chips – are unlikely to default over the next few years. There are some rating transmission risks, but that’s manageable. There’s an emerging comfort factor that it is relatively safe to park money in these assets, which clipping the yield govvies, for example, do not provide. Few are contemplating a reversal in spreads anytime soon with any volatility in macro taken through the iTraxx indices as the credit markets risk proxy (just as it was in H1). So we could easily get more tightening in fact, we will. That’s what we are seeing now, and if we do not get the heavy supply currently being anticipated (unlikely), then the August tightening could pale into insignificance in comparison with what could occur in September.“
In addition to the on-going technical support to credit as highlighted by Société Générale, Corporate pension plans shift towards bonds which has occurred in the past five years will sustain the “Yield Famine” and appetite for credit, hence our positive stance towards credit in this deleveraging environment.
“The CHART OF THE DAY displays the year-end percentages of pension-plan assets invested in equities and fixed income since 2003 for companies in the Standard & Poor’s 500 Index. The data were compiled by S&P’s Capital IQ Compustat unit and cited by David Bianco, Deutsche Bank AG’s chief U.S. equity strategist in a report on the 14th of August. Stocks amounted to 46 percent of S&P 500 plan assets at the end of last year. The allocation was 12 percentage points lower than in 2007, during a housing-driven bull market. Bonds were 42 percent of assets, a 10-point increase over the same period. Real estate and other assets accounted for the balance. “It is unlikely that the trend of diminishing equity allocations reverses,” Bianco wrote. He cited two reasons for the conclusion: the closing of many plans to new workers, which limits the amount of time plans have to invest, and accounting changes that make funding gaps easier to track.
S&P 500 pension plans have a $325 billion total deficit, according to Bianco, based in New York. Although this gap has narrowed from $355 billion at the end of last year, lower bond yields are hurting returns, the report said. The yield on the Barclays Capital U.S. Aggregate Bond Index has been as low as 1.71 percent in 2012, down from 2.24 percent when 2011 ended.
Companies outside the S&P 500 may be even less committed to stocks than those in the index. Only 32 percent of pension assets in the U.S. were invested in equities when last year ended, according to the Federal Reserve. Forty percent was allocated to bonds.” – source Bloomberg
As we indicated back in our conversation “Yield Famine“:
In our conversation “St Elmo’s fire“, we pointed out we had been tracking with much interest the on-going relationship between Oil Prices, the Standard and Poor’s index and the US 10 year Treasury yield since QE2 has been announced – source Bloomberg:
Given the Standard and Poor’s 500 is trading close to a multi-year high and that the US data picture appears to be somewhat improving, and looking at the on-going turmoil which has plagued the European markets, we have long argued that the difference in the behavior of financial conditions between Europe and the US had been credit conditions. We discussed at length this point in our conversation “Growth divergence between US and Europe? It’s the credit conditions stupid…“. Looking at Nomura’s recent note entitled “Does Europe Matter?” from the 21st of August, it looks to us that our call has indeed been validated:
“One explanation why the effects of the Euro-crisis have been more localized can be found in the behavior of financial conditions. In the 2009 slowdown, a key feature was a general tightening of financial conditions globally, as banks delevered indiscriminately.
In the context of the Euro-crisis, tightening financial conditions have been much more concentrated in the eurozone, while, remarkably, US financial conditions have been little affected. Figure below illustrates this basic observation: During the global financial crisis, the shock to financial systems was synchronized and hit the US and the eurozone with very similar intensity. During the recent European turmoil, financial conditions have deteriorated much more in the eurozone than in the US, especially in the second half of 2011, which is likely affecting growth dynamics throughout 2012.”
Nomura also makes the following important points in their recent note:
“Does Europe Matter: Strategy vs. Economics
European tensions have been a major driver of global financial market volatility since 2010. Lately, however, there has been evidence that global markets have become more resilient to eurozone specific market tension.
This is ironic, given that the Euro-crisis has yet to find a clear resolution. But it can be rationalized by a combination of various factors.
First, the economic spill-over effects from the Euro-crisis have been much more localized compared to what we saw in the global financial crisis in 2008-2009. With a key part of the explanation being that a global credit crunch and a global tightening of financial conditions has been avoided.
Second, various ECB interventions (actual and verbal) have reduced the tail risks for eurozone banks and for sovereign finance. This matters greatly for global risk assets, which are most sensitive to the most extreme forms of tensions, which are now seen as smaller tail risks. Moreover, reduced peripheral exposure in private sector portfolios globally imply that portfolio contagion effects eurozone asset price weakness have been reduced.
This leaves us with a weird new equilibrium, where global risk assets may be able to trade somewhat more independently from eurozone tensions, at least until we see a renewed increase in eurozone risk exposure (which seems a long way off given ongoing changes in benchmarks) or a dramatic escalation of eurozone crisis dynamics in its own right.
The Euro-crisis is obviously not the only risk, which may impact global risk assets. Tension around the so-called fiscal cliff in the US and/or a more pronounced slowing of global growth momentum is a key factor to watch. From a short-term trading perspective, we would argue that those risks are embedded in asset prices. But this could change over time, as the weak growth in Europe will remain a drag on the global cycle until policies which can support growth have been implemented. In addition, a further compression in global risk premia would leave global risk assets more vulnerable to downside growth surprises.
Europe is more globally significant in the long-term than in the short term. From a trading perspective, Europe is likely to be a less dominant driver. However from an economics perspective it is still a drag on global growth and trade. It will certainly matter longer term, especially if the Euro-crisis continues to escalate over time.”
“In all instances, we saw peripheral CDS (measured by the average of Spain and Italy’s 5-year CDS) widen more than 100bp. To facilitate comparison between the different periods, we have scaled the impacts to measure the impact per 100bp of peripheral CDS widening (Figure below).” – source Nomura
And Nomura to conclude:
“From a strategy point of view, our conclusion is that the current positive performance for global assets could have further to run in coming months. Moreover, we believe global risk assets could remain fairly resilient even in the face of moderate renewed deterioration in the eurozone.”
On a final note we leave you with Bloomberg Chart of The Day showing that Italy 150 years ago presaged Euro bond risk:
“Italy’s unification 150 years ago sent bond yields of its strongest state surging more than 100
basis points in an indication of the penalty Germany might endure if the euro region issues common debt, according to Stephanie Collet, a Universite Libre de Bruxelles researcher. The CHART OF THE DAY shows how yields on bonds of the Naples-led Kingdom of the Two Sicilies rose to align with those of the Kingdom of Piedmont-Sardinia in the year before unification in 1861, according to data collected by Collet. Italy at the time was divided into seven states, each with its own currency and bonds. Naples, the biggest economy with the lowest debt, suffered the largest increase in financing costs. “Naples had a really good standing at that time and as investors began to perceive it as part of a unified Italy, it started to pay a high risk premium,” Collet said in an interview. “Based on the Italian unification example, joint euro bonds wouldn’t solve anything. Germany would be the one that would suffer the most, unless a true fiscal union is put in place.” – source Bloomberg.
“The four most beautiful words in our common language: I told you so.” – Gore Vidal
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