Risk Off Gains a Foothold

By: Doug Noland | Fri, May 11, 2012
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There were important developments this week in the realm of market risk dynamics, developments that increased the likelihood that problematic de-risking/de-leveraging dynamics have begun to gain a foothold.

Let's start with Europe. First, the Greek elections have created great uncertainty, hence, market risk. Voters hammered the two establishment parties, the main New Democracy and Pasok parties that were responsible for negotiating the two EU Greek bailouts. Fully 70% of the votes were cast for parties committed to abrogating European-imposed austerity measures. The surprise beneficiary was Syriza, the "Party of the Radical Left," having placed second to New Democracy. Syriza is led by the radical and charismatic Alexis Tsipras, who this week gained additional support with his message that previous agreements are "null and void" and that Greece is well-positioned to call Europe's bluff (blackmail the blackmailer, some have suggested).

With leaders from the top three parties each individually failing to formulate a coalition government with sufficient seats to hold a majority in the Greek Parliament, it now appears likely that new national elections will be necessary (most-likely in mid-June). Polls this week showed Syriza building on recent momentum, so it is unlikely a coalition government can be created without Mr. Tsipras taking a leading role. The markets had been somewhat heartened by the prospect that new elections might be avoided. Now markets will likely face six weeks of uncertainty leading up to the next election. And while the Greeks for the most part state their desire to remain in the eurozone, there is little support for implementing austerity measures negotiated by previous governments. It's very difficult at this point to envisage a favorable market scenario.

And while the majority of party leaders prefer to stick with the euro, it is also clear that a strong political consensus has developed that Greece must at the minimum renegotiate previously made commitments. Various European officials, including German Finance Minister Schaeuble, have made it clear that the Greek government must remain committed to previous agreements. At this point, the Greeks lack credibility, and EU officials' patience has worn past quite thin. So, a dangerous game of chicken has begun, and contingency planning for a Greek exit from the euro will now command great attention. Such uncertainty supports risk aversion.

Now that a Greek exit appears unavoidable, it has become popular to surmise that this could be done without unmanageable financial and economic dislocation. Yet no one has a grasp of the consequences and ramifications for Greece, the euro, Europe, the markets, international finance and global economic prospects. It is very unfortunate Greece did not exit two years ago.

Today from Fitch Ratings: "In the event of Greece leaving EMU, either as a result of the current political crisis or at a later date as the economy fails to stabilize, Fitch would likely place the sovereign ratings of all the remaining euro-area member states on rating watch negative as it re-assessed the systemic and country- specific implications of a Greek exit.... A Greek euro exit would 'break a fundamental tenet' of the currency union, which was designed to be irrevocable..."

Along the lines of happenings in the periphery country Greece, things are also going from bad to worse at a European core country, Spain. After promising that no additional public money would be used to bailout Spain's troubled banks, Prime Minister Rajoy was forced to backtrack this week with the nationalization of the fourth largest Spanish bank, Bankia. And today's widely anticipated announcement of plans for addressing banking system issues was less than confidence inspiring.

Saddled with enormous real estate loan portfolios, confidence in the Spanish banking system is quickly evaporating. Analysts talk of the need for a massive (Irish-style) recapitalization program ($150bn-$200bn), an enormous sum for an already troubled sovereign borrower. Spain's Credit default swap prices jumped another 36 bps this week to a record 517 bps. This week provided added confirmation that the European crisis has decisively infiltrated the "core."

And especially now that a Greek euro exit is on the table, banking system and sovereign debt fragilities take on new urgency. Importantly, markets have returned to a crisis-prone backdrop where I expect capital flows both between euro zone nations and out of the euro to become critical issues. It is today perfectly rational for wealthy holders of euro deposits - along with risk-averse corporate Treasurers managing cash holdings - in periphery banking systems to shift these funds to more stable core institutions (or perhaps even out of the euro altogether). And if Greek and euro troubles further escalate, there will be increased economic impact as corporations move to more aggressively manage business risks in various economies.

Apparently, the issue of "Target2" (Trans-European Automated Real-time Gross Settlement Express Transfer System) balances now garners considerable attention in the German media. Recall that "Target 2" refers to the eurozone's inter-central bank payment system used for settling cross-border trade and financial flows. This system has not functioned as designed (trades have not fully settled) since the eruption of the financial crisis back in 2007. Instead of financial flows counterbalancing trade imbalances (the settlement of cross-border obligations), these days trade imbalances and financial outflows from the periphery combine to create enormous and mounting IOUs from periphery central banks to the German Bundesbank. With euro stability now a serious issue and capital flight out of even "core" banking systems a definite possibility, the Target2 drama is poised to create only greater intrigue.

And I could be off-track on this. But I just don't believe it is mere coincidence that JPMorgan dropped its bombshell $2bn loss announcement in the middle of market worries regarding Greece, Spain, the euro and European bank stability. And I know that in the grand scheme of JPMorgan's business, balance sheet, capital levels and EPS, $2bn is indeed a "rounding error." This news will certainly intensify the Volcker rule debate and there are, of course, very important longer-term issues to contemplate. But I think much of what I've been reading and hearing misses a key point with immediate market ramifications.

JPMorgan is a leading player in Credit insurance and prime brokerage. Their "synthetic credit securities" positions are integral to their business operations with hedge funds and the "leveraged speculating community." Furthermore, derivatives reside at the epicenter of the dysfunctional global "risk on, risk off" market dynamic. And it's also been my premise that "risk on" has been showing some vulnerability.

I'll assume that JPMorgan's enormous derivative portfolio was constructed with a particular market/risk environment in mind. It would make sense to me that JPMorgan has been comfortable building massive risk exposures throughout various markets, anticipating a relatively sanguine "risk on" landscape. Management was comfortable with the view that global policymakers had things under control - and were confident that global markets would remain abundantly liquid. They likely viewed the hedge fund community as relatively stable and likely to successfully work through recent challenges. And I will further presume that developments in Europe, throughout global markets and with the global leveraged players had recently made them much less confident in previous assumptions. It would make sense if they've made the decision to start hunkering down.

I'll guess that top JPMorgan management was forced to respond to recent changes both in the marketplace and in prospects for the market risk/liquidity backdrop more generally. Recent developments and the abrupt return of de-risking/de-leveraging dynamics significantly changed the risk-profile of their positions and market insurance products more generally. They bet big on "risk on" but now must position for the likelihood of "risk off."

In discussing Credit insurance and derivative markets over the years, I've invoked an analogy of writing flood insurance during a drought. It's a truly wonderful business - that is until torrential rains arrive and the complacent community of highly-speculative (and thinly-capitalized) insurers flood the insurance market as they desperately attempt to offload ("reinsure") the risk they accumulated during the profitable drought-period boom. Those seeking long-term survival (as opposed to the crowd trying to make a quick buck) better have a superior ability to discern weather patterns.

If I were JPMorgan top management, I'd surely be moving today to reduce the company's risk profile - especially with respect to myriad global market risks. The clouds are darkening and much better to move before the heavy downpours commence (and buyers, along with their liquidity, run for the hills). While I will give no Credit for their self-serving self-flagellation, they are a savvy group that has demonstrated their ability to manage through crises. Certainly, writing Credit and market risk insurance has, again, become a risky proposition. And I'll assume that JPMorgan's market-making operations will be reined in throughout various risk insurance markets - and I'll assume a similar change in tack will be afoot by the cadre of major derivatives operators. Importantly, this equates to less liquidity and more expensive market insurance. A less favorable insurance market equates to more restraint in risk-taking and an attendant tightening of financial conditions. As such, I would not be surprised if this week proves a major inflection point for global risk markets - and a major coup for "risk off."

 


For the Week:

The S&P500 declined 1.1% (up 7.6% y-t-d), and the Dow fell 1.7% (up 4.9%). The Morgan Stanley Cyclicals lost 1.7% (up 8.2%), and the Transports declined 1.7% (up 2.4%). The Morgan Stanley Consumer index slipped 0.6% (up 4.2%), while the Utilities advanced 0.9% (down 0.7%). The Banks were hit for 1.7% (up 17.8%), and the Broker/Dealers were slammed for 3.9% (up 9.2%). The S&P 400 Mid-Caps were little changed (up 9.7%), and the small cap Russell 2000 slipped 0.2% (up 6.6%). The Nasdaq100 was down 0.8% (up 14.8%), and the Morgan Stanley High Tech index declined 2.4% (up 13.5%). The Semiconductors dipped 0.8% (up 8.3%). The InteractiveWeek Internet index fell 2.0% (up 8.9%). The Biotechs jumped 4.1% (up 38.5%). With bullion declining $63, the HUI gold index sank 4.2% (down 18.9%).

One-month Treasury bill rates ended the week at 7 bps and three-month bills closed at 9 bps. Two-year government yields were little changed at 0.26%. Five-year T-note yields ended the week down 3 bps to 0.75%. Ten-year yields fell 4 bps to 1.84%. Long bond yields declined 6 bps to 3.01%. Benchmark Fannie MBS yields declined 5 bps to 2.76%. The spread between benchmark MBS and 10-year Treasury yields narrowed one to 92 bps. The implied yield on December 2013 eurodollar futures rose 4.5 bps to 0.67%. The two-year dollar swap spread jumped 6 to 35 bps. The 10-year dollar swap spread increased one to 15 bps. Corporate bond spreads widened meaningfully. An index of investment grade bond risk ended the week up 10 to 108.5 bps (high since 1/18). An index of junk bond risk jumped 34 to 629 bps (high since 1/17).

Debt issuance picked up. Investment grade issuers included Amgen $3.0bn, Ford Motor Credit $1.25bn, Bank of New York Mellon $500 million, Florida Power & Light $600 million, Beam $600 million, Discovery Communications $1.1bn, and Loyola University $160 million.

Junk bond funds saw inflows slow somewhat to $754bn (from Lipper). Junk issuers included Tekni-Plex $485 million, Magnum Hunter Resources $450 million, Louisiana Pacific $350 million, and Crosstex Energy $250 million.

I saw no convertible debt issued.

International dollar bond issuers included Sweden $2.25bn, Sinopec $3.0bn, Slovak Republic $1.5bn, Yancoal $1.0bn, Vietinbank$250 million, Banca Mifel $150 million, and Aguila $130 million.

Spain's 10-year yields surged 27 bps this week to 5.98% (up 94bps y-t-d). Italian 10-yr yields rose 7 bps to 5.50% (down 153bps). Ten-year Portuguese yields declined 16 bps to 10.69% (down 208bps). The new Greek 10-year note yield shot 401 bps higher to 24.23%. German bund yields were down 7 bps to 1.52% (down 31bps), and French yields dipped 2 bps to 2.80% (down 34bps). The French to German 10-year bond spread widened 5 to 128 bps. U.K. 10-year gilt yields declined 3 bps to 1.96% (down one basis point). Irish yields rose 8 bps to 6.80% (down 146bps).

The German DAX equities index increased 0.3% (up 11.6% y-t-d). Spain's IBEX 35 equities index rallied 1.7% (down 13.8%), and Italy's FTSE MIB recovered 0.9% (down 6.9%). Japanese 10-year "JGB" yields fell 4 bps to 0.85% (down 14bps). Japan's Nikkei sank 4.6% (up 5.9%). Emerging markets were under pressure. For the week, Brazil's Bovespa equities index fell 2.3% (up 4.7%), and Mexico's Bolsa declined 1.3% (up 4.9%). South Korea's Kospi index sank 3.6% (up 5.0%). India's Sensex equities index dropped 3.2% (up 5.4%). China's Shanghai Exchange fell 2.3% (up 8.9%).

Freddie Mac 30-year fixed mortgage rates dipped a basis point to a record low 3.83% (down 80bps y-o-y). Fifteen-year fixed rates declined 2 bps to a new low 3.05% (down 77bps). One-year ARMs were up 3 bps to 2.7% (down 38bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates down 2 bps to a record low 4.38% (down 83bps).

Federal Reserve Credit declined $0.6bn to $2.845 TN. Fed Credit was up $132bn from a year ago, or 4.9%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 5/9) rose $3.1bn to $3.499 TN. "Custody holdings" were up $79bn y-t-d and $38bn year-over-year, or 1.1%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg - were up $654bn y-o-y, or 6.7% to a record $10.473 TN. Over two years, reserves were $2.487 TN higher, for 31% growth.

M2 (narrow) "money" supply surged $57bn to a record $9.871 TN. "Narrow money" has expanded 6.7% annualized year-to-date and was up 9.2% from a year ago. For the week, Currency increased $0.6bn. Demand and Checkable Deposits declined $4.6bn, while Savings Deposits jumped $65.6bn. Small Denominated Deposits declined $2.1bn. Retail Money Funds fell $2.4bn.

Total Money Fund assets were little changed at $2.569 TN. Money Fund assets were down $127bn y-t-d and $182bn over the past year, or 6.6%.

Total Commercial Paper outstanding jumped $26.5bn to an 13-week high $966bn. CP was down $7.1bn y-t-d and $193bn from one year ago, or down 16.1%.

Global Credit Watch:

May 10 - Telegraph (Alex Spillius): "Greek leaders have failed in their desperate efforts to forge a governing coalition in a bid to avert a new election, which polls showed would be won by a young radical Leftist who could jeopardise the country's critical EU bailout. As Germany threatened to cut off Greece's economic lifeline, Evangelos Venizelos, leader of the socialist Pasok party and a former finance minister, failed to meet Saturday's deadline for bringing together a ruling majority. Alexis Tsipras, the head of the Radical Left Coalition, or Syriza, said he was unwilling to join a coalition government. The president now has until Wednesday to summon party leaders and exhort them to work together, but a new poll next month would be a much more likely outcome."

May 10 - Bloomberg (John Glover): "Greece's next government may hold a trump card worth more than $510 billion if it heeds voters' demands to renegotiate its bailout with the European Union. The nation owes about 400 billion euros ($517bn) to private bondholders, public bodies such as the International Monetary Fund and European Central Bank and other creditors... About 252 billion euros of that's due to official organizations that used their status to avoid the losses suffered by ordinary bondholders when Greece restructured its debt two months ago. Greek voters are demanding their leaders renegotiate the terms of rescue packages that have imposed unprecedented austerity on the country since 2010. One potential prime minister, Syriza party leader Alexis Tsipras, has pledged to tear up the EU-led bailout agreement. With Greece owing a sum roughly equal to Switzerland's economy, the fallout for taxpayers could be calamitous if the country walks away."

May 10 - Telegraph: "Francois Hollande has threatened to block the eurozone's new financial treaty unless Germany agrees to renegotiate its stringent austerity measures. The new French president wants the treaty, seen as crucial to ensuring the survival of the single currency, to focus more on encouraging growth. Angela Merkel, the German chancellor... told France that there was no alternative to spending cuts and painful deficit cutting measures, warning that 'growth through debt' would take Europe back to square one."

May 10 - Bloomberg (Esteban Duarte): "Spain's lenders are pledging some of their best assets to raise record levels of secured funding, including from the European Central Bank, eroding creditor safeguards at the same time the government is planning the country's largest bank bailout. Borrowing from the ECB rose 50% in March from the prior month to 227.6 billion euros ($294.3bn). Bankia Group is among lenders that increased mortgage-backed debt issuance by 35% since December 2007 to 535.1 billion euros, or 53% of their real-estate loans, according to Spanish Mortgage Association data at the end of 2011."

May 10 - Dow Jones (Christopher Bjork and Jonathan House): "The Spanish government said late Wednesday that it will rescue Bankia SA by taking a large stake in the troubled lender, a move considered to be a crucial element in its effort to overhaul the country's banking sector and shore up confidence in the euro zone's fourth-largest economy... The Bankia clean-up has long been seen as an acid test of Spain's resolve to put its financial house in order. Spain's fourth-largest bank by market value, Bankia has the industry's largest exposure to Spanish real-estate developers... 'The government would like to send a message of reassurance to Bankia's depositors, and of course, the government guarantees the stability of the overall banking system,' Prime Minister Mariano Rajoy told reporters..."

May 10 - Financial Times (Miles Johnson): "As shares in Bankia slid further away from their listing price on Wednesday, questions were being asked about the wisdom of having created and floated the Spanish lender in the first place. Billed as 'the leader of the new banks' in its own publicity, Bankia achieved something last year that almost no other company in Europe could - it sold shares in an initial public offering, raising €3.3bn in the midst of the continent's debt crisis. Anyone who bought into the offering, which was marketed as a solid savings investment to the bank's clients and sold in part through its branch networks, has now lost more than 40% of their money in less than a year. 'No foreign institutions really touched Bankia when it was being sold,' says one UK-based institutional investor... 'There were just too many red flags'. About 60% of the share issue was sold to retail investors, with the vast bulk of the remaining amount being placed with domestic Spanish companies. Mariano Rajoy, Spanish prime minister, insisted when he came to office that not one euro more of taxpayers' money would be used to bail out the banking sector."

May 9 - Bloomberg (Sonia Sirletti): "Italian banks purchases of their countries' sovereign debt surged to the most on record in March as lenders took up about one fourth of three-year funds offered by the European Central Bank. Banks boosted their holdings of Italian government bonds by 24 billion euros ($31bn) in March. The country's sovereign debt held by lenders rose 9% to 291 billion euros... 'Italian and Spanish banks remain the key source of demand at government debt auctions,' said Nicholas Spiro managing director of Spiro Sovereign Strategy... 'There is huge pressure on domestic banks to keep picking up the slack in the absence of foreign investors,' he said."

Global Bubble Watch:

May 11 - Bloomberg (Dawn Kopecki, Michael J. Moore and Christine Harper): "JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said the firm suffered a $2 billion trading loss after an 'egregious' failure in a unit managing risks, jeopardizing Wall Street banks' efforts to loosen a federal ban on bets with their own money. The firm's chief investment office, run by Ina Drew... took flawed positions on synthetic credit securities that remain volatile and may cost an additional $1 billion this quarter or next, Dimon told analysts... Losses mounted as JPMorgan tried to mitigate transactions designed to hedge credit exposure. 'There were many errors, sloppiness and bad judgment,' Dimon said... 'These were egregious mistakes, they were self-inflicted.'"

May 9 - Financial Times (Mary Watkins): "European companies could face serious challenges refinancing a wall of maturing debt over the next few years as the region's banks deal with the impact of regulation and fallout from the eurozone debt crisis, according to... Standard & Poor's. The rating agency predicted that companies round the world would need new funding or to refinance existing debt totalling as much as $46tn over the next five years."

Currency Watch:

The U.S. dollar index increased 1.0% this week to 80.26 (up 0.1% y-t-d). For the week on the the downside, the Japanese yen declined 0.1%, the Canadian dollar 0.4%, the British pound 0.5%, the Taiwanese dollar 0.6%, the Singapore dollar 0.7%, the Norwegian krone 1.0%, the Danish krone 1.2%, the Swiss franc 1.3%, the euro 1.3%, the South Korean won 1.3%, the Australian dollar 1.6%, the New Zealand dollar 1.6%, the Brazilian real 2.0%, the Swedish krona 2.0%, the Mexican peso 3.0%, and the South African rand 3.3%.

Commodities Watch:

May 9 - Bloomberg (Elizabeth Campbell): "Hedge funds raised bets on higher commodity prices for the first time in six weeks, just before the biggest three-day slump since October as U.S. jobs data fell short of expectations and European manufacturing contracted. Money managers increased net-long positions across 18 U.S. futures and options by 6.9% to 895,240 contracts in the week ended May 1, the biggest gain since Feb. 28... Bullish copper wagers surged sevenfold before prices fell for three days, and soybean bets reached the highest since at least June 2006 as the oilseed capped the biggest weekly loss since mid-January."

The CRB index dropped 1.8% this week (down 4.4% y-t-d). The Goldman Sachs Commodities Index fell 1.7% (down 0.4%). Spot Gold declined 3.8% to $1,579 (up 1%). Silver sank 5.1% to $28.89 (up 3.5%). June Crude lost $2.36 to $96.13 (down 3%). June Gasoline rose 0.8% (up 13%), and June Natural Gas jumped 10.1% (down 16%). July Copper declined 2.0% (up 6%). May Wheat ended the week down 1.8% (down 9.2%), and May Corn was clobbered for 8.2% (down 6%).

China Watch:

May 11 - Bloomberg (Fion Li and Michelle Yun): "Hong Kong's economy grew at the slowest pace since the global financial crisis in the first quarter as Europe's sovereign-debt woes undermined export demand and confidence. Gross domestic product rose 0.4% from a year earlier..."

Japan Watch:

May 10 - Bloomberg (Tsuyoshi Inajima and Yuji Okada): "Japan's government took control of Tokyo Electric Power Co., the center of the Fukushima nuclear disaster, and agreed to provide 1 trillion yen ($12.5bn), part of a bailout that is the nation's largest since the rescue of the banking industry in the 1990s."

Europe Economy Watch:

May 9 - Bloomberg (Scott Hamilton and Fergal O'Brien): "U.K. retail sales fell the most in more than a year last month as poor weather and consumer caution on spending curbed demand at stores. Sales at stores open at least 12 months, measured by value, declined 3.3% from a year earlier..."

Global Economy Watch:

May 11 - Bloomberg (Greg Quinn): "Canadian employment rose almost six times faster than economists forecast in April, led by private-sector and full-time positions, creating the largest two-month increase in more than 30 years... Employment rose by 58,200 following a March jump of 82,300 that was the biggest since September 2008..."

Fiscal Watch:

May 10 - Bloomberg (Michelle Jamrisko and Angela Greiling Keane): "Forty-one years ago Congress told the U.S. Postal Service to start acting like an independent business and pay its own way. Every time the Postal Service tries, something stands in the way: Congress. Facing annual losses of $18.2 billion by 2015 and a possible default this year, the Postal Service has a five-year plan for profitability. It wants to end Saturday mail delivery, close hundreds of letter-sorting facilities and thousands of post offices and consider breaking union contracts to fire employees. It also wants to set up an independent health plan, raise postal rates and enter lines of business such as delivering wine and liquor."

Real Estate Watch:

May 9 - Bloomberg (Kathleen M. Howley): "The number of Federal Housing Administration-insured home loans entering foreclosure jumped in March after half the mortgages it modified to ease repayment terms were in default again a year or more later. The FHA's role in lending to first-time buyers with poor credit and limited cash expanded after the 2008 collapse of the mortgage market put it at the center of government efforts to revive housing. The FHA allows down payments as low as 3.5% for borrowers with a credit score of 580, below the 640 defined as subprime by the Federal Reserve. 'The credit standards are way too loose -- you can get into a house with very little skin in the game, and if home prices drop by a small amount, you're underwater,' said David Lykken, managing partner at Mortgage Banking Solutions... 'We've got to start getting reasonable about standards. What they've done so far, some very slight attempts at tightening, doesn't really count.'"

Muni Watch:

May 9 - Bloomberg (Darrell Preston): "The Sisyphean task of funding U.S. state and local-government retirement plans, a hidden risk for municipal-bond investors, will get even more daunting under proposed new accounting rules. Pensions in Illinois, New Jersey, Indiana and Kentucky may have less than 30% of the assets needed to cover promised benefits under the measure, according to data from the Boston College Center for Retirement Research. The changes, which take effect starting in June 2013, will alter how liabilities are calculated and how assets are reported on financial statements. 'People are going to be really surprised,' Matt Fabian, managing director with... Municipal Market Advisors, said... 'It's one of the few things out there that could precipitate a major change in investor demand.'"

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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