Spain's and France's Bond Auctions Successful
In spite of some remaining apprehension ahead of today's big bond auctions by France and Spain, the auctions went better than feared earlier this week, no doubt as a result of the recently resurrected 'risk on' environment.
While Spanish, French and Italian bonds still closed at quite high yields yesterday (although much improved from last week's highs), yields declined sharply following today's auctions. CDS prices declined along with bond yields, as is usually the case.
„Spanish and French bonds rallied and the euro strengthened for a second day after the governments sold debt. European stocks and U.S. index futures pared losses.
The yield on France’s 10-year note dropped as much as 27 basis points, the most since 1991, and traded 23 basis points lower at 3.16 percent at 11:15 a.m. in London. Spain’s five-year yield tumbled 31 basis points to 5.54 percent. The euro appreciated 0.3 percent against the dollar. The Stoxx Europe 600 Index slipped 0.3 percent, after declining as much as 0.8 percent. Standard & Poor’s 500 futures slid 0.4 percent, following the stock gauge’s 4.3 percent surge yesterday.
Spain sold 3.75 billion euros ($5.1 billion) of bonds, the maximum amount planned, and French borrowing costs declined in its auction of 10-year notes. European Central Bank President Mario Draghi said the bank’s program of buying government bonds “can only be limited,” a day after six central banks made additional funds available to ease strains from the crisis and the People’s Bank of China cut banks’ reserve requirements for the first time since 2008.
“The French and Spanish bond auctions were well received and priced,” Matthias Fankhauser, who helps oversee the equivalent of $100 billion in assets at Clariden Leu in Zurich, said in an interview. “Until now, we just had disasters on that front. Some investors feel it would be a good chance to jump into these high yields.”
The cost of insuring against default on sovereign debt dropped for a third day with the Markit iTraxx SovX Western Europe Index of credit-default swaps linked to 15 governments dropping eight basis points to 359 basis points.“
Although the basic problems remain as unresolved as ever, it appears that the coordinated central bank action announced yesterday has altered risk perceptions appreciably and taken a lot of pressure off the euro area banks in terms of their deteriorating funding situation.
This immediately redounds on sovereign bond markets, because it means that the scramble for liquidity will ease a bit, making it more likely that banks will slow their selling of such bonds and show up to bid at auctions. After all, yields are quite enticing at current levels. If we are lucky, it means that there will now finally be a pause in the crisis. However, just as was the case with previous lulls in the debt crisis, it can be expected that it will return with a vengeance again at a later date – barring a successful tackling of the root causes, which seems highly unlikely given the eurocracy's record on the issue to date.
Spain's 10 year government bond yield – click for better resolution.
The intra-day move in Spain's 10 year yield following the successful conclusion of today's auction – click for better resolution.
Italy's 10 year government bond yield – still a bullish chart, but the situation has become less tense – click for better resolution.
The move in Italy's yield following the conclusion of the Spanish and French bond auctions today – click for better resolution.
It should be noted to the above that in spite of the success of the bond auction, Spain still paid the highest yield in six years for the 5 year notes it sold:
„Spain sold 3.75 billion euros ($5.1 billion) of bonds, meeting its maximum target, and it paid the most in at least six years to borrow for five years as European efforts to stem the region’s debt crisis fall short.
Spain auctioned five-year bonds today at an average yield of 5.544 percent, compared with 4.848 percent when notes of a similar maturity were offered on Nov. 3, the Treasury said. That was the highest since at least 2005, according to data compiled by Bloomberg. It paid 5.276 percent on bonds due in 2016, and an average 5.187 percent to sell notes maturing in April 2015, compared with 3.639 percent in October.“
The rally in bonds only began after the auction, as is usually the case in these situations. Below are charts of French yields, which have lately improved dramatically:
France's 10 year yield has turned down from resistance and seen a dramatic improvement over recent days – click for better resolution.
The big move in France's 10 year yield after today's successful auction – click for better resolution.
Well, here is hoping that we really do get a pause in the crisis. We would really like to move on to tackle some other topics that we wanted to write about for a long time. Crisis fatigue is setting in.
Leaks and Rumors
Yesterday, numerous observers noted that the intervention of central banks in the euro-dollar FX swaps markets, while producing some welcome relief for the euro-land bank funding situation, was hardly a good reason to celebrate. After all, it must be seen as a sign of growing desperation. Some people have speculated that a major euro area bank was actually close to failing – as an example see this article at Forbes by Nigam Arora, who asks:
„Did a big European bank come close to failing last night? European banks, especially French banks, rely heavily on funding in the wholesale money markets. Given the actions of the world’s largest central banks last night, it raises the question of whether a major bank was having difficulty funding its immediate liquidity needs.“
Given the ECB's recent failure to fully sterilize the SMP and the big spike lower in euro basis swaps on Tuesday, this idea is not totally far-fetched. Evidently the scramble for liquidity has become quite desperate recently. We know for a fact that the big three French banks have been the ones in the euro area most reliant on funding by US money market funds, which in turn have massively cut back on their buying of commercial paper issued by euro area banks over the past three months. We are talking about amounts of several 100 billion dollars here, so this is a quite serious spanner in the wholesale bank funding works. Anyway, we will probably never know for sure, unless the bank concerned still goes to the wall sometime in the next few weeks or months.
Meanwhile, others have noted that the central bank decision has apparently been leaked beforehand. Zerohedge reports that the Fed's vote on extending the swap lines to Europe was taken on Monday, which is held to explain the curious move higher in stocks and commodities on Monday on what was essentially an unflinchingly bad news backdrop.
Some circumstantial evidence was pointed out by Tim Backshall yesterday, who noticed a curious divergence between the CONTEXT index (an aggregate of risk indicators) and the SPX mini futures contract that began on Monday:
Via Tim Backshall, the divergence between the Context index and the mini S&P futures that occurred on Monday – click for better resolution.
To this we would note that it should be no surprise if something leaked out, given the recent revelations about Hank Paulson tipping off hedge funds about his plans for the GSE's in 2008, or the recent report at the WSJ about hedge funds getting tips directly from the Fed, or the recent study – which apparently is perfectly legal for the parasitic political class, while being illegal for everyone else (note: we are not complaining about insider trading as such, which we believe should not be criminalized at all; we merely note that the law evidently treats certain people differently).
One very perceptive comment on the concerted central bank action was written by Stephen Koukoulas, who noted:
„I am reminded of the shock interest rate cut in the US delivered by Federal Reserve Chairman Alan Greenspan on 3 January 2001. With the Nasdaq bubble starting to deflate, Greenspan rode to the rescue – it seemed – with an out of cycle interest rate cut that triggered a 10% jump in the Nasdaq on the day the cut was announced. Alas – the rate cut didn’t fix the core problem which was a speculative asset price bubble and when reality returned, the Nasdaq kept sliding to a point where its peak to trough fall hit around 80-% – and this despite yet more and more interest rate cuts from Greenspan. The US fell into recession.
Also recall the coordinated interest rate cuts in October 2008 from the same central banks at play last night. It helped support confidence for a while and was a necessary policy move, but again it reflected just how horrid the circumstances of the times were.”
Sure, this time it might be different. Let’s hope so. This may fix the global ills but it seems more likely that the move, while a good one, is just another desperate attempt from desperate policy makers helping out desperate bankers in desperate times.”
We would add to this that single day rallies in the DJIA of 400 points or more tend to occur mainly in bear market environments. We have e.g. seen such a rally in May of 2000, then there was a huge one day rally after the market reopened following the 2001 WTC attack, several jumps of this size and greater occurred just ahead of the crash in 2008, and there was a 400 point rally shortly after the 'flash crash' in May of 2010, which gave way to a fresh wave of selling shortly thereafter. In the pre-WW2 era, the biggest single day gains in the stock market all occurred during the devastating bear markets of the 1930's. So a very big one day rally is actually a good reason to remain apprehensive – it speaks mainly of an unstable market.
However, it appears to us that the rally from the October low is not yet finished – in all likelihood the market is now in wave C of 2 (a possibility we alluded to on Monday) and could conceivably rally into year end, based on the sentiment backdrop, the likelihood of further central bank interventions and time cycles we are watching.
At Bloomberg it was remarked that '400 Dow points aren't what they used to be', which is certainly true.
The DJIA jumps by more than 400 points – unfortunately for the bulls, such big one day moves are usually the hallmark of bear market rallies. However, it seems likely that the market will continue to advance for a while, possibly into year end. Sentiment, seasonality and the likely wave count all support this idea – click for better resolution.
Euro Area Economy Remains Weak
A 'chart of the day' article at Bloomberg got our attention yesterday – it depicts the cost of exports from China to Europe and China to the US. As can be seen, these shipping costs have plummeted sharply in recent months:
Shipping cost of exports from China to Europe and the US are in steep decline – click for better resolution.
This certainly confirms that the European economy is weakening dramatically, a fact that was once again highlighted by the release of euro area PMI data this morning. The official euro-area manufacturing PMI has now declined to 46.4 points, and is clearly indicating recessionary conditions. As Marketwatch reports:
„Activity in the euro-zone manufacturing sector contracted at the sharpest pace in 28 months in November, according to the purchasing managers index for the sector compiled by Markit. The index fell to 46.4 from 47.1 in October, unchanged from an earlier, preliminary estimate. A reading of less than 50 indicates a contraction in activity. Manufacturing PMIs were below 50 in all nations covered by the survey, with most declining from October levels, Markit said. "Both production and new orders fell at rates not seen since the height of the credit crunch in [the first half of] 2009. It was also the first month since mid-2009 that all countries saw output fall, highlighting the broadening-out of the downturn from the periphery to the core," said Chris Williamson, Markit chief economist.“
The euro area manufacturing PMI plunges further – click for better resolution.
Other fundamental news from Europe also continue to be rather worrisome. We already mentioned the continued outflow of deposits from Greece's banks in yesterday's update. However, the other PIIGS are also subject to a continued flight of depositors, with the latest update reaching us from Ireland. Specifically, there is apparently a run on deposits by institutional clients.
„Banks based in suffered a near 3 billion euros outflow in deposits in October, reversing two months of inflows, as the deepening euro zone debt crisis spooked some savers, central bank data showed on Wednesday.
Data for just the Irish-owned lenders — Bank of Ireland , AIB and Permanent TSB – showed that deposits had risen by 1 billion euros to 266 billion euros in October. The annual rate of deposit decline in Ireland ticked up to 11 percent in October from 10.5 percent the month before as insurers and pension funds upped their withdrawals.
Irish consumers, companies and pension funds have been withdrawing cash from Irish-based banks for the past year but the rate of decline in household deposits eased to 4.5 percent year-on-year in October after falling 4.7 percent in the previous month.
The rate of decline in deposits among pension funds, insurers and non-bank financial insitutions increased to 25 percent year-on-year in October from 22.9 percent in September.
Overall, banks based in Ireland had 100.9 billion euros of outstanding loans with the ECB at the end of October, of which 71.5 billion was held by banks servicing the local economy such as Bank of Ireland, Allied Irish Banks and Ulster Bank, up from 71.1 billion a month ago.“
Meanwhile, Moody's once again affirmed its negative stance on the Greek banks and issued a scathing update on the situation, highlighting the fact that the debt crisis has eroded the capital of Greece's banks to the point of no return. Greece's banks are clearly insolvent.
„Moody's believes that the banking system's massive Greek debt exposure (exceeding EUR50 billion) will trigger impairments rendering most Greek banks economically insolvent. A 50% haircut on Greek debt — together with additional loan loss provisioning charges — would generate capital needs of €20-€30 billion (compared to system Tier 1 capital of approximately €27 billion). The sheer size of recapitalisation requirements suggests neither shareholders nor the Greek authorities can meet those needs. In Moody's view, the recapitalisation support would likely come from the IMF and the EU, possibly via the Hellenic Financial Stability Fund, which will effectively lead to widespread nationalisations in Greece.
Moody's expects that Greek banks will remain locked-out of wholesale debt markets and see further deposit outflows over the outlook period. Moody's believes that the Greek banks will remain highly reliant on funding from the European Central Bank (ECB) and emergency liquidity assistance (ELA) from Bank of Greece, to replace additional deposit outflows and maturing market funding. ECB funding peaked at €103 billion in June 2011 and was gradually reduced to €78 billion in September. During this period, the ELA mechanism was activated but the amount of funding provided is not publicly available. As of September, Moody's estimates this at between €30-€40 billion.“
As an aside, S&P also reviewed the ratings of 37 banks worldwide, downgrading a slew of them, including all of the 'TBTF' banks in the US. As the WSJ reports:
„Standard & Poor’s Ratings Services today said it reviewed its ratings on 37 of the largest financial institutions in the world by applying its new ratings criteria for banks, which were published on Nov. 9, 2011. See the Ratings List for the ratings on these banks, their core and highly strategic subsidiaries, and other subsidiaries that we took rating actions on as a result of applying our new criteria to their parents. We will review all ratings that we placed on CreditWatch within 90 days. Ratings on CreditWatch are designated as Watch Neg or Watch Pos in the list below. „
They downgraded pretty much everybody of note in the US — BofA, Citigroup, Morgan Stanley, Goldman Sachs, Wells Fargo, J.P. Morgan, Bank of New York Mellon.
The Bank of China got cut to A from A-. Industrial and Commercial Bank of China was left alone. They also hit several UK banks — Barclays, HSBC, Lloyds, RBS. Notably, they left alone several European banks — Deutsche Bank, Credit Suisse, ING, BNP Paribas, Credit Agricole, Societe Generale, Commerzbank. They cut UBS, however, to A from A+.
Here is a link to the complete S&P report (pdf).
Meanwhile the UK faces a mass strike over its planned pension reform. So far the government's attempts to slash Britain's deficit have failed. The market still treats UK gilts as a 'safe haven', with their yields hovering close to 2%. The big question is for how long, given the deteriorating debt situation and the 'stagflation' backdrop.
As the threatened UK strike once again indicates, it is politically extremely difficult to cut the generous benefits promised by welfare states during the boom. And yet, there will be no other choice. Allen Mattich has written an interesting editorial for the WSJ in this context, „British Struggle to Live Within Their Means“.
„The whole of the U.K. economy of the past two decades or more has been built on the notion that the British are richer than they really are.
This was the underlying message in Chancellor of the Exchequer George Osborne’s autumn statement Tuesday. The debate now boils down to how the U.K. is made to adjust to this poorer state of affairs.
How did this notion of being richer than they thought come about? Largely, it was thanks to leverage. Since the mid-1990s, the global boom in leverage, but particularly among the Anglo-Saxon economies, allowed the British to spend more than they might have otherwise.
Leverage also allowed the Labour government to think it had more long-term spending firepower than it did. Booming house prices, strong consumption and a debt-fuelled expansion in the financial services industry boosted transitory government revenues.“
Tough times are ahead, not only for Britain, but the entire plethora of welfare states in Europe.
Something that may not have been noticed yesterday in the excitement over the central bank intervention in FX swap lines was a remark by German finance minister Schäuble on the for euro area deadbeats:
“We are prepared to increase the resources of the IMF through bilateral loans," Schaeuble told reporters, emphasizing that it was ultimately up to the central bank.
"If the IMF wants to widen its freedom to take action by increasing the special drawing rights, then we are prepared to talk about it. But, to be clear, this is about IMF instruments."
One proposal is for the 17 national central banks to lend money to the IMF so that it can on-lend it to euro zone countries that need it, with IMF conditionality applying.
Such a method would side-step the European Central Bank, whose mandate does not allow it to finance euro zone countries' deficits directly or act as a lender of last resort.
"Naturally, the details would have to be discussed," Schaeuble said, adding that it would be a matter for the 17 central banks in the euro area to address. "Bilateral loans are possible in principle."
In other words, instead of the ECB lending to the IMF, it would be done by the national central banks comprising the euro system. That's certainly a neat trick. The important point however is that Germany seems to be agreeing in principle to central bank financing of IMF loans to Europe. The printing press will swing into action after all. Also, by ensuring IMF monitoring of the recipients of the loans, a face saving device will be employed that is in the interest of all concerned on account of domestic political considerations.
Meanwhile, former ECB chief economist Otmar Issing, a noted hawk, has written an interesting editorial at the FT about the moral hazards ECB bond buying creates. A snippet follows below:
“All the arguments in favour of such a “solution” of the public debt problem imply that the central bank will be taken hostage by politics (history provides us with a number of bad examples). How would investors react to such a new regime? Would they expect higher inflation in the future? If so, what would be the effect on long term interest rates? If those rates rose substantially this would lead to new problems for the sustainability of public finance. It is futile to speculate on a possible spiral of dangerous developments, but ignoring this risk is irresponsible. Stressing the role of the central bank as the ultimate buyer of public debt should be seen as an indication of the pathological state of public finances not as a sign of strength.
Secondly, the situation in the euro area is fundamentally different from the US or the UK. No one would argue that the Fed should guarantee the debt of individual states. No need because there are strict limits for debt financing by US states. This is also a fundamental principle of European Monetary Union (EMU) as it was designed by the Maastricht treaty and presented to the people in countries getting the euro as the currency.
This is not a flaw in the institutional arrangement of EMU, but the prohibition of monetary financing is an indispensable element for a stable currency. Pressing the ECB into the role of ultimate buyer of public debt of individual member states would create the biggest conceivable moral hazard.
On top of these alarming economic and monetary consequences, providing monetary financing would break the law – a constitution ratified by all governments and parliaments. Should one be surprised that a number of well-known economists ignore legal principles? Who is disappointed by the fact that numerous politicians and European bureaucrats press hard on the ECB to violate the law? Now even some central bankers follow this line. Imagine: unelected technocrats as they are often called lifting themselves above the law.
This happens when big ideas are floated, eg to strengthen the rules of the Stability and Growth Pact and even to advance EMU in the direction of a fiscal union. How credible is an announcement of “strict future rules” if at present violation of law is so widely not only accepted, but requested by academics, politicians and even central bankers? Will the future new rules survive the next crisis? And what about investors and markets? Is it risky to predict that a crisis will occur again when the credibility of the central bank and solvency of public finance will be anew at stake? And that speculation will be blamed for conspiring against an otherwise stable arrangement?
If the ECB goes in the direction of becoming the ultimate buyer of the public debt of member states detailed consequences are hard to predict. However, one thing seems to be certain. It would be a daunting challenge to restore credibility.
We are of course of the opinion that the flaws of the euro and indeed of all fiat currencies, can ultimately not be rectified by simply sticking to the current planning regime. If we truly want to avert economic crises in the future and the associated endless debates over the alleged merits of employing the printing press, we should simply return money to the free market. A free banking system using a market chosen money and operating according to traditional legal principles – clearly differentiating deposit and loan banking - would once and for all lay all these problems to rest. It is high time to admit that the central planning of money has utterly failed.
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