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US downgrade and ECB bond buying: conference call replay details

Yesterday Jim did a conference call covering both the S&P downgrade of the US sovereign credit rating and the ECB’s massive buying of Spanish and Italian government bonds.

You can listen to a recording of the call and view the slides by clicking here.


What is risk off?

Recent selling of risk assets into traditional haven government bonds has taken their yields back near their all time lows. Will people continue to buy them in a risk off trade? We are almost certainly nearer the beginning than the end of a western world sovereign debt crisis. That means quite clearly that Gilts, Bunds and Treasuries are not the ‘risk free’ investments they once were. In relative terms, their risks are low and perhaps falling. But in absolute terms, their risks are high and rising. The US was just downgraded from AAA by S&P, and yet their yields are still rallying, contrary to the expectations of many and contrary to traditional theory. If greater fiscal union is the final solution to the peripheral European sovereign debt crisis, then the transfer of wealth from Germany and other strong EU states to the weaker ones will see Bunds, amongst others, sell off dramatically. Yet if fiscal union is unacceptable to some EU states and it fails to get parliamentary approval, then surely Bunds will remain firmly within the very top echelon of government bonds in the world, with yields potentially less than 1%? Perhaps the austerity plan which has been so important in supporting Gilt yields and the AAA rating in recent times sees UK borrowings become the last true safe haven in the Western world? Yet the low economic growth consequences of this approach could also scupper the plans and have just the opposite effect. As you can see, in each case traditional economic views and expectations about these ‘risk free’ safe havens could prevail, or could be utterly wrong. That doesn’t sound to me to be very risk free at all!

So, to where do we retreat in a new paradigm in which traditional safe havens are no longer such? Given the recent widening in credit spreads, I believe that some of the high quality investment grade credit now looks good value again. Maybe, just maybe, the new safe haven could become the high quality, low beta, internationally exposed, lowly geared, corporate bond universe?


The economy continues to lead credit

Two months ago I questioned whether the decoupling between credit spreads and economic fundamentals could continue for much longer. I felt at the time that at some stage the weakening economic data would start to drag credit spreads wider, at least relative to government bonds. I also asked whether we might enter an environment in which high quality investment grade credit could see a flight to quality rally, whilst some of the lower quality, higher beta credit could sell off. Let’s see how government bonds and credit have fared since this blog was posted.

Bunds, Gilts and Treasuries have had a fantastic couple of months as shown in the chart below, with 10 year benchmark returns of 7%, 5.25% and 5%, respectively. However, this did not happen solely because economic data turned so horribly south, although it clearly did. These government bonds were boosted because of the peripheral sovereign debt concerns in Europe, and debt ceiling negotiations almost bringing about a technical default in the US. The markets panicked and sold risk and bought traditional, relative safe havens.

It’s been a great couple of months for treasuries, bunds and gilts

How has credit performed over the same period? The broad European, Sterling and US investment grade indices’ spreads have widened over the last two months. European spreads have risen from an average of +143 basis points to +172 (20% spread widening), Sterling spreads have risen from +193 to +218 basis points (13% spread widening), and US spreads have risen from +162 to +173 basis points (7% spread widening). Credit default swap spreads paint a similar picture of rising credit premia and rising risk aversion in the last two months, although the extent of the credit spread sell off has been greater in this market than in cash, largely due to far superior liquidity and therefore activity. The index of the 125 investment grade names in Europe has risen from a weighted average spread of 104 to 134.5, or a 29% spread widening, and the equivalent US index has risen from 96 basis points to 105 basis points, a widening in spreads of 9%.

Market participants in all risk assets have reacted typically: selling higher risk assets for perceived lower risk ones. In fixed income, we have observed this both in the cash market and in the CDS market.

Riskier corporate bond spreads have widened

The CDS market has also widened

However, in June I expected to see this as a result of a fundamental worsening in the economic data and environment, rather than as a result of a global panic in risk that has actually transpired. But the panic sell off in all types of risk has seen all sorts of participants sell whatever they can and buy anything traditionally perceived as risk free. Assets of all classes have been sold into higher quality government bonds.


The US is headed for recession – if 63 years of economic data are any guide to the future

Think the US is out of the woods now that congress has come to an agreement on the debt ceiling? Not according to this chart from Rich Yamarone, an economist at Bloomberg. It’s called the “2 percent rule”. When US GDP falls below 2%, it usually means the world’s largest economy is headed for a recession.

Last week, we received confirmation that US GDP was just 1.6% in Q2 2011. Combined with yesterday’s much weaker than expected ISM report and an unemployment rate at 9.2% , it suggests that the US Federal Reserve won’t be in any rush to hike interest rates this year. Fed Governor Ben Bernanke may even be warming up the printing press (as Mike alluded to here) if US employment and growth outcomes don’t start to improve – and quickly.


@bondvigilantes: theTwitter feed is live!

We’ve finally activated our long dormant Twitter account, and you can now follow us.

Click here to follow @bondvigilantes.

To start with we’ll simply be tweeting links to new articles on this blog, but once we’ve got the hang of it we will use Twitter to link to articles we think are interesting, retweet stuff by people we follow ourselves, and, on exciting days (budgets, elections, economic meltdowns) maybe give our blow-by-blow thoughts on the world. In common with the blog itself, tweets about our funds, performance etc. will be off limits. We’ll keep it entirely focused on bond markets and economics.

All of this will be subject to getting the day job done of course, so forgive us if it takes us a while to match Stephen Fry’s 9,145 tweets. In the meantime I am trying to work out the difference between an @ and a #.

Please also let us know if there’s anybody that we should be following. My favourites so far? @zerohedge, @lcdnews, @boe_news and @ftfmforum.

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The quest for the safe haven; one haven that’s justified, one that’s certainly not

A lot of the cash that’s been created over the past few years is sloshing around the world trying to find somewhere to hide. There has been a huge bid for anything deemed a safe haven asset, a bid that has been propelled by an imploding Eurozone and US politicians that are seemingly looking to bring its $14 trillion poker game to a spectacular finale by committing collective hara-kiri.

The problem is that if you take the US out of the picture, there aren’t enough non-shaky AAA assets to go around. Germany and France have about $1.7tn of sovereign debt outstanding, although France is probably the next AAA-rated country to find its credit rating under threat. The UK has about $1.2tn of sovereign debt, and gilts have been big beneficiaries recently, but a double dip recession in the UK (which MPC member Martin Weale recently highlighted as a risk) will cause a U-turn on austerity measures which in turn will place the UK’s AAA rating at risk. After the UK, Canada has about $1 trillion of sovereign debt. After that you’re pretty stuck – Australia has about $0.3tn, Sweden has $0.1tn, and there are a few countries with even less debt.

Norway is the safest sovereign in the world if you take the cost of insuring against default from the CDS market, but as you’d expect for the world’s best quality sovereign, Norway has very little sovereign debt. As a result, the demand for Norwegian government bonds has massively outstripped supply, and a large gap has opened up between the yield on Norwegian government bonds and the Norwegian Krone 10 year swap rate. The difference between the cash rate and the swap rate is now at a similar level to that seen in October 2008. We think that the strong bid for government bonds issued by Norway, Sweden and Germany is totally justified though – indeed, we’ve been filling our boots with the stuff over the past few months, and given our well documented ongoing nervousness regarding a number of sovereign states’ creditworthiness, we think that there’s still significant value in the safest AAA markets.

Norwegian government bonds are seeing huge demand

The big safe haven bid has also been hitting some emerging markets, but in contrast to the money flying into Norwegian government bonds, the EM safe haven bid looks plain bonkers.  The chart below shows the recent price action of Brazil’s 30 year US dollar denominated government bond, where spreads over US Treasuries have tightened from 140 basis points at the beginning of June to under 100 basis points now.  Credit ratings don’t count for all that much these days, but if markets think a risk premium of less than 100 basis points is a fair price for a 30 year bond denominated in US dollars that is benchmarked over US Treasuries and is issued by a country that’s rated one notch above junk status then the market’s smoking crack.

Brazil the new safe haven

This isn’t to say that emerging markets as an asset class are poor value. Much of what has driven financial markets over the past 15 years has been a direct consequence of emerging market countries maintaining artificially undervalued exchange rates. The global current account imbalances that have resulted from these policies go a long way to explaining the behaviour of various asset classes over this period. These global imbalances have lessened since 2007, but they still persist. Developed countries need a sharp devaluation versus many of their emerging market counterparts to restore competitiveness, restore economic growth, and ultimately help reduce debt levels. Overheating emerging markets need their currencies to appreciate, and EM currencies should (with a few exceptions) continue to rally versus developed market currencies.

But buying long dated Brazilian US$ denominated bonds is not how to implement this view. We think that the implied default risk from a number of emerging market bonds is far too low – an implied default risk that has been squished by the huge flow of money into EM debt and a relative lack of supply – and we have selectively put on trades across a number of our bond funds that reflect the view that some areas of the hard currency EM debt market are getting dramatically overvalued.


A light in the storm – the German economic boom

There is a shining light amidst the storm of the European sovereign debt crisis. Europe’s largest economy, Germany, is booming. Since June 2009, the German Federal Statistical Office has had the pleasure of notifying financial markets that the German unemployment rate has fallen. Today we received further confirmation of the strength of the German labour market, with the German unemployment rate remaining at a record low of 7.0%. This equates to a fall in unemployment of 11,000 in the month of July. In total, around 550,000 jobs have been created in the German economy since June 2009. Consequently, German consumer confidence is around record highs.

Divergent Unemployment outcomes across Europe There are many reasons for the stellar performance of the German labour market. The German economy grew at 1.5% in the first quarter of 2011, or 4.9% over the year. Importantly, the growth numbers were mainly underpinned by strong domestic demand. Initially, the fall in the euro due to concerns over peripheral Europe provided the conditions for a boost in German exports.  Now, the growth base has broadened, with domestic investment and consumption becoming increasingly supportive. It is our view that without the euro currency in place, the German Deutschmark would be the strongest currency in the world, German bunds may have negative yields, and the German economy would probably be in recession. The Swiss are experiencing this phenomenon through the strong appreciation of the Swiss franc in recent times. Is the Swiss franc a new safe haven?

the devaluation of euro has helped German competitiveness Of course, GDP is entirely backward looking. It is important that we also assess what the forward looking indicators are telling us as well. German business surveys are a good place to start. Despite the current concerns, German purchasing and manufacturing indices (PMIs) for both the manufacturing and services sector continue to suggest that the expansion of the German economy continued in Q2. It isn’t the stellar growth experienced earlier in the year, but a growth rate of around 0.5% in Q2 isn’t too bad considering the concerns around Greece. Despite the worries, the Ifo business climate and expectations index both suggest that the German corporate sector is in a relatively good mood. German firms are telling us that they are planning on spending record amounts on capital expenditure and investment in the coming 12 months as indicated by the German DIHK business survey. Consequently, it is not unreasonable to expect that the German labour market will continue to improve in coming months as firms look to invest in profitable projects.

Growth looks to have slowed down in Germany during Q2In a way, the strong German growth outcome is directly related to the peripheral sovereign woes. The euro is currently far too weak for Germany, which means that the German economy is extremely competitive, its economy is booming, and its inflation is starting to accelerate. This is why the ECB has been hiking rates and may hike again before the year is out. But the flip side of German growth is the utterly miserable growth rate in Southern Europe, which is because the euro is far too strong for these deeply uncompetitive economies. Fernanda Nechio, an economist at the Federal Reserve Bank of San Francisco, estimates interest rates based on a Taylor rule analysis for peripheral Europe and core Europe. Her analysis suggests an ECB target rate of around 3% for core Europe, and a target rate of around -3% for peripheral Europe. On the one hand, the ECB is hiking rates to tighten monetary policy for the stronger core European nations, and on the other it is retaining loose monetary policy by maintaining liquidity arrangements for the weak peripheral European banks.

Some might say, the German economic party is the result of the peripheral European economic funeral. The German public bailing out southern Europe is the cost that they need to pay for strong growth outcomes and rising standards of living. Bailing out peripheral Europe is like a tax that has until now been deferred. To quote Dolly Parton: “If you want the rainbow Germany, you sometimes have to put up with the rain”.

Forget stress tests – ring fencing banks from sovereigns is the real issue

So the results of the bank stress tests are out. Do they add anything from an investor viewpoint?

Well, despite the best efforts of the European banking Authority, we didn’t get the harmonised EU data we were hoping for. To say that there are inconsistencies in the data would be an understatement.

Disclosure varies hugely bank by bank, especially in areas such as their Loan to Value ratios for real estate lending, and that’s before you start trying to factor in the differences in the way property valuations are performed or indexed in each country. Banks, and in particular the tax systems and legal systems in which they operate, are still national. We’re a long way from a harmonised, EU wide banking sector.

There’s also no real information on banks’ liquidity positions. Assumed funding cost increases over the next two years are simply driven by the interest rate assumptions used, with little or no linkage to the banks’ actual and increasing costs of funding. It’s impossible to analyse what is happening to individual banks’ funding sources and costs. The EBA admits liquidity and funding is a critical issue but has backed away from making public its liquidity stress testing, presumably because they are concerned this might provoke further concerns.

One of the most frustrating issues for investors is that the EBA doesn’t stress test the legal entities to which investors and market counterparties are exposed or potentially exposed. So the French mutual groups are tested on a consolidated basis, when in fact debt and equity investors are taking exposure to very specific legal entities within the group, such as CASA within the Credit Agricole group, whose risk profile will be very different to that of the consolidated group.

However, the most important statement from the EBA in our view was the instruction to national regulators to require banks to raise core capital by any means possible, “including where necessary restrictions on dividends, deleveraging, issuance of fresh capital or conversion of lower quality instruments into Core Tier 1 capital.

This means conversion of debt into equity where other sources of equity are unavailable. In Ireland this has already been accepted as necessary but in most EU countries regulators still do not have the legal powers to push through a forcible debt for equity conversion. Banks could of course try to achieve this via voluntary conversions, but ultimately the incentive for bondholders to agree to a conversion is limited unless there is the very real threat of a more draconian resolution regime to act as a “stick”.

Regulators and governments alike are well aware of this issue. The Financial Stability Board will this week put forward a consultation paper on the subject of international resolution regimes, along similar lines to the EU consultation published in January. These proposals aim to ensure governments can’t be forced to bail out the banking sector and thereby to ringfence the sovereign’s finances from those of its banks.

Equally, the critical issue of private sector burden sharing by the banks in any sovereign debt default also remains unsolved – until we get a clear framework for clarifying the role of banks in investing in sovereign debt, and find a mechanism for ensuring that all creditors, including banks, can and do take losses on investments in insolvent sovereigns, the umbilical cord between banks and sovereigns remains intact.

So rather than waste time sifting through stress test result spreadsheets, investors would be advised to analyse and understand the FSB resolution regime proposals for banks and the European Stability Mechanism framework for private sector burden sharing on sovereign debt. These are the critical issues facing investors right now, and all the stress tests do is highlight how important it is that a solution is found to enable banks and sovereigns to ringfence themselves from each other.

(For those interested in how the results might differ had sovereign debt haircuts been taken into consideration, see this calculator from Reuters Breakingviews)


Greece and the Deathly Hallows

This weekend’s family activity centred on the final film in the Harry Potter series, Harry Potter and the Deathly Hallows, 10 years on from when we saw the first instalment of the magical film series in 2001. Meanwhile in the Monday to Friday muggle world, the markets are focusing on the modern classical tale of Greece, that also began 10 years ago in 2001 when they entered the European Monetary Union. How will that blockbuster story end?

In the final instalment of Harry Potter, the story centres on the deathly hallows. Spookily, the three elements of the deathly hallows are comparable to some of the magical instruments Greece has at its disposal.

Sadly, they have already used the invisibility cloak to hide the true extent of their debt, in order to gain entry into the Eurozone back in 2001. Unfortunately, for them that magical charm has been exposed and its protection is lost. This leaves them with two further deathly hallows to get them through their current nightmare. They could use the resurrection stone, i.e. they can default and their debt will reappear as a shadow of its former self, remaining in the Euro, but angering the European Central Bank, and investors.  Alternately, they could take the option of using the elder wand to threaten to destroy the whole system, and therefore gain support from fellow Eurozone members to band together to keep their debt whole, the Eurozone dream alive, and the European Central Bank happy. Both give very different economic and bond outcomes. Their fate however, like in the Potter series, is not just in their hands but that of their friends and adversaries.

So what other spells can the participants in this economic fable use? The Greeks would love to cast the “Evanesco” spell (makes the target vanish). This would involve full economic union and therefore making the Greek debt really disappear – a perfect outcome for Greece, unlike the previous attempt to hide it under the invisibility cloak. The Ministry of Magic, better known in the muggle world as the IMF, would love to use its usual magical curse of “Crucio” (inflicts unbearable pain on the recipient of the curse), insisting the over indulgent borrower amends its ways. Hard for the Greeks to bear, but would have the support of the houses of the north. A third potential conclusion to the tale would involve the casting by the invisible hand of the markets (or as politicians might term it, the death eaters) of the appropriately named “Expulso” (a spell that causes an object to explode), the Greeks leave, or are expelled from the Euro, with the potential disorderly reintroduction of a new national currency by the Greek authorities.

Like in this weekend’s movie, battles and losses lie ahead under all scenarios. We think that the “Expulso” conclusion as touched on previously is the likely final denouement. If it happens, it will be very painful in the short term unlike the other options, but in the long term the natural order of national economic stability would emerge as nation states and markets would set domestically appropriate exchange rates, fiscal and monetary policies, thus allowing the efficient distribution of labour and capital, and hopefully an eventual happy ending.

European bank stress tests, Road to Nowhere or Highway to Hell?

The European Banking Authority’s bank stress test results are due out on Friday evening.  Do the results mean anything or is it one for the talking heads? In our view it is a bit like taking a driving test – you can pass the test and yet still be a terrible driver.

The real test of whether anyone trusts you is whether people are prepared to get in the car with you. So whether or not banks pass the 5% Core Tier 1 stress test hurdle, the real test is whether investors and depositors trust them with their money over the long term, and there’s a long way to go before the European banks rebuild their reputation after a series of offences such as speeding, failing to indicate and poor steering.

Of course any raising of the bar in terms of testing could, in theory at least, reduce the number of accidents on the road going forward. The stress tests will give a degree of disclosure that we haven’t seen before, and it’s no surprise that German banks are reportedly squealing about giving so much information in a transparent standardised format. Even those banks not subject to the stress tests, such as Banca Popolare di Milano and Nationwide Building Society, will be expected by the market to provide the same disclosure, and a refusal will inevitably be seen as a sign of having something to hide, a bit like refusing to be breathalysed.

We also need to see how failures will be dealt with. There’s no point the traffic police simply letting offenders off with a caution and allowing them to stay on the road – they need to be locked up, rehabilitated and prevented from causing future accidents. Several European countries, including France and Italy, still do not have a credible resolution regime for dealing with failing banks, which could make driving in those countries potentially hazardous.

And it’s not just about the banks. There also needs to be major improvement in market infrastructure to make the roads safer for all drivers, such as improved repo and derivative market disclosure and practice, better payment and settlement system risk management and clearer international regulatory and accounting standards.

But ultimately what we need to test is the ability of sovereigns to separate themselves from their banks. Not only have the sovereigns guaranteed the banks, both explicitly and implicitly, but the banks are also funding the sovereigns, so there’s not much point stress testing the banks separately from their governments. After all, nobody has yet come up with a credible plan to recapitalise the Spanish banking sector, other than raising yet more quasi government debt via the FROB and injecting it as equity into the banks, perpetuating the excessive leverage of both banks and sovereign.

Regulators are hoping that proposals to ringfence the banks from the sovereign, such as senior bank debt bail-ins, higher capital requirements, and legal ringfencing of specific activities will break this link. These are all steps in the right direction, albeit slow ones. But until holders of sovereign debt, including the banks, can also be bailed-in and forced to take their share of losses in sovereign restructurings, the symbiotic link between the banks and their sovereigns remains. Until then, the roads remain dangerous, and the question is whether we’re on a Road to Nowhere or the Highway to Hell.

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