Euro Area Credit Markets Continue to Calm Down

Below is our customary update of credit market charts: CDS on various sovereign debtors and banks, bond yields, euro basis swaps and a few other charts. Charts and price scales are color coded (readers should keep the different price scales in mind when assessing 4-in-1 charts). Where necessary we have provided a legend for the color coding below the charts. Prices are as of Monday's close.

It is amazing how much movement mere words were able to produce oiver recent days – with the exception of Slovenia, which remains in the market's crosshairs as long as it is not certain what type of bailout it will eventually require, sovereign CDS spreads and bond yields have continued to move lower across the euro area and the markets that generally tend to correlate with it (CEE and Middle Eastern markets).

In other words, it is 'crisis pause' time, until the markets begin to test whether the words will be followed by deeds. A tendency to differentiate a bit more between various debtors is also reemerging, as is usually the case when the euro-land debt crisis goes into one of its hibernation phases. Even Greek bonds have recovered a bit, following positive noises from the IMF.

If there is a pause in the debt crisis the markets will finally be free to begin focusing on the worrisome contraction in manufacturing that has become evident all over the world.

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 – here we see the only exception to the recent downtrend, the new worry Slovenia – click chart for better resolution.

5 year CDS on Romania, Poland, the Ukraine and Estonia - click chart for better resolution.

5 year CDS on Morocco, Turkey, Saudi Arabia and Bahrain – following euro area spreads lower – click chart for better resolution.

Our proprietary unweighted index of 5 year CDS on the senior debt of eight major European banks (BBVA, Banca Monte dei Paschi di Siena, Societe Generale, BNP Paribas, Deutsche Bank, UBS, Intesa Sanpaolo and Unicredito) – this index has also made a big move lower in recent weeks. Back to an area of short term support – click chart for better resolution.

Our euro bank CDS index (white line) compared to 5 year CDS on the senior debt of Goldman Sachs (orange), Morgan Stanley  (red), Citigroup (green) and Credit Suisse (yellow)  – as always, these are all in sync directionally – click chart for better resolution.

5 year CDS on two big Austrian banks (Raiffeisen and Erstegroup). While they also tend to correlate with the rest of the euro-land CDS, these also tend to be very sensitive to developments in CEE nations (for instance, one can conclude from the recent better tone that the problems in Hungary are taking a backseat as well at the moment) – click chart for better resolution.

10 year government bond yields of Italy (generic bid net yield, generic gross yield is at 6.041%), Greece, Portugal and Spain – click chart for better resolution.

Austria's 10 year yield (green), UK gilts yield (yellow), Ireland's 9 year yield (white) and the price of the Greek 2 year note (orange – yield prior to PSI deal). For some reason the 'safe haven' yields continue to remain extremely low. Perhaps this is because they reflect growing  worries about economic weakness rather than a 'safe haven' bid at the moment – click chart for better resolution.

US – hours worked. This is currently at odds with the still high unemployment rate, a sign that labor finds it difficult to adapt to the still reconfiguring post-boom production structure – click chart for better resolution.

US construction permits – an unusually slow recovery, which shows the severity of the  housing bust – click chart for better resolution.

A chart of commitments of traders in VIX futures, via sentimentrader. We're not sure what this means, mainly because it has never happened before. The fact is though that with the VIX at a very low level, speculators have amassed a record net short position in VIX futures. We're mainly showing this because the upcoming moves in the  VIX will make this valuable information next time around. Normally positioning extremes are a contrary indicator, but we can't be sure of that (it is not always the case) – click chart for better resolution.

A weekly chart of Molycorp (MCP), the leading rare earths company. This stock has now made a full round-trip (it was listed shortly before the point where the chart begins) – click chart for better resolution.

Janet Yellen's Growing Influence at the Fed

A recent Reuters article informs us that Janet Yellen nowadays wields 'outsized influence' at the Fed. This is bad news if you think the central bank should stop with its interventions – as Yellen is clearly the most senior figure of the 'preemptive easing' faction. She may be 'soft-spoken', but that doesn't make her any less dangerous.

“If the Federal Reserve delivers another jolt of monetary stimulus to try to stir the U.S. economy back to life, it will be in part because of the powers of persuasion of a soft-spoken, former Berkeley professor.

From her corner office just down the hall from Chairman Ben Bernanke's, Janet Yellen is one of the most influential economic policymakers in the world, backing bold action by the U.S. central bank at a time when much of Washington treats "stimulus" as a dirty word. With Congress and the White House locked in an election-year stand-off over spending and taxes, the Fed looks to be the only institution willing or able to stop the weak recovery from faltering yet again.

Power at the Fed is concentrated in a few hands – chief among them Bernanke and his No. 2 Yellen – even if the bank strives for consensus among its broader group of top officials. That distillation of power makes Yellen hugely influential on policies that impact the world's largest economy and the rest of the globe.

"Her influence at the Fed has increased steadily," said Alfred Broaddus, a former president of the Richmond Federal Reserve who served with Yellen when she joined the Fed almost 20 years ago and often disagreed with her.

"I think she is now, along with the chairman and one or two others, one of the most influential people in the system," added Broaddus.”

 

Some observers think Yellen would be an obvious pick to run the Fed, if President Barack Obama wins re-election in November and if Bernanke has had enough of being chairman after his term expires in January 2014. She turns 66 on August 13. Obama chose Yellen for the central bank's No. 2 position in 2010, drawing on both her academic credentials and previous experience working in a Democratic administration.

The child of Brooklyn doctor who saw patients in the family home, Yellen earned top honors at Brown University before opting to pursue a career in economics after hearing Yale University economist James Tobin speak.

Tobin, a Nobel prize-winning economist and an economic adviser to President John F. Kennedy, was heavily influenced by John Maynard Keynes, who argued governments can avert deep economic contractions like the Great Depression of the 1930s by increasing public spending.

Yellen was energized by Tobin's combination of theoretical accomplishment with public service.”

So we have the mad hatter himself at the Fed and as number two in command a 'committed Keynesian' whose hero was James Tobin – the economist with the dubious honor of having a tax named after him. Enough said.

China Troubles – 'The Golden Elephant' and More

An investment product popular in China called the 'Golden Elephant Nr.38' promises investors a 7.2% annual return – much more than they can earn in interest on savings deposits. This and similar 'wealth management products' are, as the article linked above notes, 'China's answer to sub-prime credit'. It seems this is a huge time bomb that could go off at any moment.

“Absent from the product's prospectus is any indication of the asset underpinning Golden Elephant: a near-empty housing project in the rural town of Taihe, at the end of a dirt path amid rice fields in one of China's poorest provinces.

 

"They haven't even built a proper road here," said Li Chun, a car repairman, who said he lives in the project. "The local government is holding onto the flats and only wants to sell them when prices go up."

Golden Elephant No. 38 is one of thousands of "wealth-management products", instruments aimed at monied investors, which have shown phenomenal growth over the last five years. Sales of them soared 43 percent in the first half of 2012 to 12.14 trillion yuan ($1.90 trillion), according to a report by CN Benefit, a Chinese wealth-management consultancy.

They are usually created in China's "shadow banking" system – non-banking institutions that are not subject to the same regulations as banks – which has grown to account for around a fifth of all new financing in China. Like the subprime-debt lending spree in the United States that helped spark the 2008 financial crisis, the products are often opaque, and usually dependent on high-risk underlying assets, such as the Taihe housing project.

Financial instability in the world's second-largest economy could have global ramifications, and warning bells have begun to sound about the way these products are marketed in China.

It has become a mammoth industry, comprising an array of financial products. Analysts have different ways of measuring the size of the sector. Barclays estimates some 22 trillion yuan worth of wealth management products will be issued this year. Fitch Ratings says China's banks had about 10.4 trillion yuan in wealth management product liability at the end of June this year.”

(emphasis added)

The problem is that the housing bubble in China has begun to deflate, and once a bubble breaks it is often nigh impossible to put Humpty-Dumpty back together again. That China's planners will manage to do just that is essentially the big hope of Western-based China bulls. However, as the WSJ reports, China's steel output is slated to decline for the first time in 31 years.

This is surely inter alia a sign that the construction boom is in trouble due to the recent fall in real estate prices. This in turn is the inevitable result of a decade or more of building so much office space and residential units that entire districts and even entire cities stand empty.

The danger of a big economic downturn in China continues to be widely underestimated to our mind. It is not that nobody is talking about it – many people certainly are – but the secret hope that it can all be turned around with another big round of monetary pumping is still a major factor influencing the debate. There is simply not enough worry out there yet, and this nonchalance may prove to be a costly and dangerous error for many. China's government undoubtedly has an inordinate amount of control over the economy and especially the banking system.  It has pulled inflationary rabbits out of its hat with unwavering regularity in the past -  but the time when this trick will no longer work is coming. Tic-toc.

Charts by:Sentimentrader, Bloomberg, StockCharts

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