Armageddon Averted? Not So Fast.
Mario Draghi was eager yesterday to point out that the measures taken by the ECB have 'avoided an imminent credit crunch' in the euro area and pointed to the decline in various government bond yields as a measure of success.
Italy sold € 12 billion of bills yesterday, at the upper end of the target range and at a far better yield than on occasion of the last sale, seemingly underscoring Draghi's assertions.
„European Central Bank President Mario Draghi said the bank has averted a serious credit shortage and there are signs the economy is stabilizing, signaling policy makers may resist cutting interest rates further for now.
“According to some recent survey indicators, there are tentative signs of stabilization of economic activity at low levels,” Draghi said at a press conference in Frankfurt today after the ECB kept its benchmark interest rate at 1 percent following two straight reductions. While the debt crisis poses “substantial downside risks” to the economic outlook and the ECB remains “ready to act,” Draghi gave no indication that another rate cut is imminent.
With the euro area on the brink of a second recession in three years, some signs of economic resilience have given the ECB room to assess the impact of its stimulus measures to date, which include lending a record amount of cash to banks. Draghi said those loans prevented a “serious” credit contraction. He also noted that borrowing costs for governments across the 17- nation region have dropped.“
Well, not so fast. It seems everybody has forgotten about Standard & Poors. The rating agency reminded people today that it is still around – and that a raft of downgrades of euro area sovereigns is imminent.
„The Standard & Poor's ratings agency could announce the downgrades in the credit ratings of a number of European governments as early as Friday, said two government sources familiar with the matter. One person familiar with the matter said an S&P notice is being circulated among euro-zone governments and that an announcement "could be imminent."
S&P declined to comment on the possibility of an imminent announcement on euro-zone credit ratings. In December S&P placed 15 of the 17 euro-zone countries on watch for possible downgrade, citing new systemic stresses that are pressuring the euro zone's credit standing as a whole.
Talk that S&P is on the brink of downgrading several European countries pushed the euro to a fresh session low against the dollar in Friday trading in New York. The common currency dropped as low as $1.2688, down from $1.2814 late Thursday, according to EBS via CQG. It was most recently trading at $1.2698.
The biggest question for financial markets is whether France will lose its triple-A rating after showing signs of fiscal slippage during its economic slowdown over the past year.
Any downgrade of France's rating will, indirectly, raise the cost of borrowing for the European Financial Stability Facility, whose own rating depends largely on the credit quality of the countries that back it. The EFSF, which has also been placed on negative credit watch by the S&P, would then have to pass on those higher borrowing costs to countries such as Ireland and Portugal, making it even harder for them to reduce their budget deficits as planned. „
Sounds like 'festivus interruptus'. Of course, why anyone would be surprised by this is mysterious. It hasn't been a secret that these downgrades are coming. Nor has it been a secret that once France loses its AAA rating – which seems highly likely – the EFSF will turn into a lead balloon.
Moreover, Austrian media reported a rumor that not only France, but also Austria is highly likely to lose its AAA rating tonight.
Is The Party In 'Risk Assets' Over?
The rumor about downgrades being imminent has not surprisingly cut the recent party in stocks and euro area sovereign bonds short. As it were, the stock market was ripe for a downturn anyway – all it needed was a trigger. Recently complacency has scaled fresh heights. The AAII bear percentage has fallen to a six year low for instance. A blow-out in the spread between the OEX put/call ratio and the equity put/call ratio indicates that the 'smart money' has been buying puts while the public has piled into calls. The mutual fund cash-to-assets ratio is right back at an all time low.
The spread between the OEX and equity put/call ratios is at one of its most bearish extremes in all of history (via sentimentrader.com) - click chart for better resolution.
Yesterday's sinking spell in euro area sovereign yields (ex Greece of course, the one year note yield of which exceeded 400% for the first time) has reversed today as well, although not to the extent one might have expected. However, once the downgrades actually roll in, things are apt to become more dicey again.
Stock markets are a different matter: for some time the SPX has defied the downward trend in US treasury note yields. This divergence has been a big warning sign – but there are of course questions as to the extent to which 'Operation Twist' has made this signal less reliable than it normally is. We would however warn against such rationalizations – in the markets it is generally better to take things as they are.
Yesterday the financial media made a big deal about the Yale 'crash confidence index', which shows that market participants are now more worried about a crash than at any time since 2009. This is of course a contrary indicator, or so it is held. Again, we would warn about such generalizations.
The Yale crash confidence index – people are scared of a crash when it is low, but does this necessarily mean the market will rise? No, it doesn't - click chart for better resolution.
Consider the sentiment indicators in their totality: everything points to an astonishing degree of complacency, and only the 'crash fear' indicator says people are scared of a potential crash. We think this may well make a crash more rather than less likely, as any decline that happens on account of the current complacency is bound to intensify these fears and could lead to a wave of indiscriminate selling. Moreover, whenever the financial media make a lot of noise over a specific indicator and its alleged implications, it is usually a sign that the indicator no longer works.
Credit Market Charts
Below is our customary collection of charts updating the usual suspects: CDS spreads, bond yields, euro basis swaps and several other charts. Charts and price scales are color coded (readers should keep the different scales in mind when assessing 4-in-1 charts). Prices are as of Thursday's close.
During and after the ECB press conference, euro area CDS and bond yields generally softened further. However, as noted above, the threat of more downgrades seems apt to derail this recent happier state of affairs.
As noted before, the recent pullbacks have not yet altered the overall bullish look of CDS and bond yield charts (which by implication, is medium to long term bearish for euro area sovereign bonds and 'risk assets').
Only the recovery in euro basis swaps looks very solid at this point in time – yesterday the three month basis swaps recovered by another 10 basis points.
5 year CDS on Portugal, Italy, Greece and Spain - click chart for better resolution.
5 year CDS on France, Belgium, Ireland and Japan - click chart for better resolution.
5 year CDS on Bulgaria, Croatia, Hungary and Austria - click chart for better resolution.
5 year CDS on Latvia, Lithuania, Slovenia and Slovakia - click chart for better resolution.
5 year CDS on Romania, Poland, Lithuania and Estonia - click chart for better resolution.
5 year CDS on Germany, the US and the Markit SovX index of CDS on 19 Western European sovereigns - click chart for better resolution.
Three month, one year, three year and five year euro basis swaps – another solid move - click chart for better resolution.
Our proprietary unweighted index of 5 year CDS on eight major European banks (BBVA, Banca Monte dei Paschi di Siena, Societe Generale, BNP Paribas, Deutsche Bank, UBS, Intesa Sanpaolo and Unicredito) – also looking better - click chart for better resolution.
The three month euro basis swap, long term. This gives a good idea of the extent of the recent rebound in a big picture context - click chart for better resolution.
5 year CDS on two big Austrian banks, Raiffeisen and Erstebank – the latter is still subject to bad vibes from Hungary - click chart for better resolution.
10 year government bond yields of Italy, Greece, Portugal and Spain – Draghi's press conference was greeted with a big decline in bond yields across the peripheral board - click chart for better resolution.
The 9-year Irish government bond yield, the 2 year Greek note yield, and the yield on UK gilts and the Austrian 10 year government bond – we could entitle this chart 'Austria ignores Hungary' - click chart for better resolution.
5 year CDS on the debt of Australia's 'Big Four' banks – still firmly on the road to nowhere as a big triangle gets built – click chart for better resolution.
Charts by: Bloomberg
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