Tuesday, July 12, 2011

Breaking the Euro's Bonds

Konrad Lorenz once said:
"The bond with a true dog is as lasting as the ties of this earth will ever be."
It is perhaps good fortune, then, that Sarko does indeed have a pet dog to chase around the office, because that other bond, to Germany appears to be breaking. The 20d rolling correlation of French OATs to Bunds (see chart below) appears to have decreased quite significantly since the beginning of June, hinting that France is no longer the safe haven it once was. TMM expect a French downgrade is imminent. Now TMM have (painfully) found themselves on the wrong side of recent moves, so their musings should be taken in the context of the latter stages of the Kubler-Ross model (!), but we do find this all terribly worrying...

...as French OATs are plumbing spreads not seen since the early-1990s (see chart below) and liquidity in the BTP market has deteriorated to somewhere between "I'm sorry mate we can't put a price on that" to "I'm an axed seller". TMM occasionally see reports of the Cavalry (aka the ECB) buying BTPs, but even though they sit 20bps off their earlier wides, the past two days have been notable for the reports of long-only selling (i.e. - people just don't want the bonds), and the dramatic spike in bond volatility which (as many, especially the fine chaps at FTAlphavile) have pointed out) kills the risk-adjusted carry argument and exacerbates the sovereign-bank feedback loop. TMM cannot help but think that confidence in the Italian bond market has now gone the way of that of the rest of Club Med. Which, as they wrote on Friday, they find perplexing given Italy's much stronger fiscal position. But as punters saw back in 2008, once confidence is gone, a policy response is needed.

The trouble is, that the A-Team have shown themselves singularly unable to come up with a TARP-like solution that finally draws a line under the solvency concerns (that have got significantly worse over the past week). TMM are also unconvinced that the financial resources exist for such a solution (now that Italy has been dragged into the fray, and French bonds are showing weakness), even if the political will does. So is Italy on its own...? To date, Spooz and the US in general have traded pretty much on their own data - softening, but then again no one is ringing the air raid siren. Yesterday, TMM decided that given the move in the Itraxx European Financials 5 year CDS that the brown-underpants trading paradigm had probably returned as we are getting past the Dec/Jan wides. Failing some maturity and cohesion in Italian politics (teambuilding bunga-bunga party?) it's hard to see things getting all that much better all that quickly...

*STOP PRESS*: Just as we wrote this, the following headline came across the wire:


TMM reckon that unless Italy sorts this mess out themselves, that it risks snowballing into a true systemic crisis given the lack of credible coordinated policy responses from Team Europe. So that means, earlier spending cuts, no tax cuts, public support for Tremonti, a further recapitalisation of the banks (to replace the cash erased by this week's 7% fall in BTP prices) and - most importantly - a return of the domestic bid in the bond market. Something that, after the moves of the past week, will be timid.

Either way, TMM reckon it is worth loading up on September 109.00 Schatz calls just in case they manage to screw it up monumentally.


abee crombie said...

i dont get this. Europe is melting down and the $/EUR is still trading at 1.40 (ok now 1.38).. shouldnt we be closer to 1.30 or 1.20 like last summer

This whole Euroshow is a prelim to what will happen in the US at some point. And good luck on the US congress being able to respond

Nemo Incognito said...

Abee crombie, depends on what happens. Last summer looked like wholesale monetization, now fiscal union is on the cards. They do differing things to monetary aggregates and inflation, hence spot fx.

And with the US.... not quite so sure. I'm a big believer in the secular decline of the importance of labor costs and the rise of energy costs. That tends to bring jobs closer to consumers and to make more of the supply chain taxable by uncle Sam. US population is still growing and I think tax revenues will have a few secular tail winds though medical/welfare need a serious haircut whatever happens even if more production moves back and the "double Irish" becomes better known as a cocktail than a tax scam.

Tyler said...

It was May 5 that TMM wrote ‘Was that the Gong?’

Is this another gong?

PPM said...

This talk of fiscal union is a huge red herring. It will take years to iron out all of the details of how that would work. This sucker will have long since gone down by the time anything close to fiscal union gets agreed upon.

Nemo Incognito said...

PPM - agree. This is bollocks. I just think Socgen/DB/et alia have to face up to the fact that PIGS are going to go (maybe not Ireland - they'll just tell bank creditors to go fuck themselves) and they will have to raise some equity. Italy just needs to cut the bunga bunga and get down to some fiscal and micro reform - while the south of the country is and always has been a joke the north has its merits and could carry the southern cousins along well enough for a while yet.

abee crombie said...

nemo I dont disagree with you. I was just saying that the US has similar debt and deficit problems to that of Italy (especiallay if the US actually accounted for its liabilities like other European countries)

If part of the worries over italy is due to this ruse with the finance minister (ie political) When/if the US ever faced a similar call, I would not want to bet on congress being able to do anything effectively to calm the markets (TARP)

Anonymous said...

Having gone through the integration of Eastern Germany, the idea that the Germans are about to decimate their savings and watch their living standards decline so that they can "integrate" with Spain et al is fanciful bullshit


Leftback said...

Abee crombie, LB has long maintained that the US would follow a Japanese trajectory in many respects, and here we are with ZIRP, QE as far as the eye can see and very low rates at the long end. The difference between Italy and the US is monetary sovereignty.

Printing your own currency allows one to debase the very unit in which the debt is denominated, thereby keeping rates low, reducing the interest on new debt issues and prolonging the unsustainable for an unfeasibly long period.

What happens in the end we don't know, but watch for developments in Japan once we get through this Euro shitshow. It will be 10-20 years before it happens here.

Nemo is right. Italy is a fascinating test case b/c of its economically productive and conservative North (more like Germany and Holland) being married to its less productive South (similar to Greece). In a way Italy is a microcosm of the EU.

Anonymous said...

An even better EU microcosm is Belgium (although I'll give you that, not as systemic as Berluscounty). Guys are so apart on pretty much every issue, they've been without a federal govt for 1+ year! No better example of Eurostriching your way into an even bigger mess than you had in the first place.

As for US/EU differences, and the role of monetary sovereignty, look no further than Britain, which despite being an epic basket case manages to attract a pretty solid safe haven bid (GUKG10s down 40bp in three sessions)

All hail Gordon Brown for saving ... Hmmm, nevermind

ntwsc said...

If anything, Belgium has improved its situation without a government.

Must be because of the no sex cos we're not ready drive imposed on them. Or was it no shaving?

What's the beard count these days?

PPM said...

Italy may have the fiscal wherewithal to pull themselves out of this, but they are the poster child of political disorder. Good luck trying to get the Italians to agree on anything and then all pull in the same direction. That hasn't happened for 2000 years. There is a huge cultural impediment to cooperation, and sacrifice for the greater good. It is quite scary to see that the future of Europe is now contingent upon the ability of Italians to get themselves organized. God help us.

Back to abee crombie's initial question, can Chinese buying be sufficient to keep the EUR at 1.40? I'm at a loss for any other explanation, but what do I know.

Nemo Incognito said...

I figure if the A team show any partiality to monetization, we are going right back to 1.28 just like January. Will Jean-Claude blink? If not, will Mario Draghi? I think so.

ntwsc said...

P'raps one of the teamsters can throw light on today's conundrum please: did China buy debt this morning or sell euro later on?

Postcard will do ta.

Alen Mattich said...

PPM--I agree about the fiscal union. I'd go further and say if they did somehow manage it in a timely way, they'd have to fudge on enforcement. And without enforcement, the whole thing falls apart anyway.

Anon 2:20--I'd say those German savins are already gone. All we're talking about now is who ends up with them.

Leftback--there's a consensus among academic economists that inflation is the way out of the problem. Mervyn's solution, in other words. 5%, 6% even 7% inflation is no problem to people who have tenure. And I'm afraid the academics have a lot of influence in the central banks.

Leftback said...

Alen - perhaps that's why Krugman spent his Nobel on a Manhattan apartment. 5-6% inflation for 10 years would make that 4% mortgage seem like a good deal, in the end.

Somehow I can't quite see the US ending up down the inflationary road. The demographics may be different from Japan, but we are still a greying nation with a massive group of wanton Boomers, many of whom haven't got a dime saved up and are expecting the rest of us to save them by paying taxes to support their health and continued consumption. A few years of steady 5-6% inflation and they will be eating cat food in their retirement.

As long as they elect the politicians, this will not be allowed to happen. Stagdeflation, where is thy sting? (See Japan). It will, of course, be miserable for young unemployed and under-employed (see Japan).

Tulsaguy said...

My favourite description of the Euro comes from FX Concepts "The German Euro is 1.80, the Greek Euro is 0.80" Not only does this summarise the disparity in the Eurozone, it has, more importantly, convinced me to stay away from trading the EUR all this year. Perhaps there will be opportunities to step in when the EUR goes closer to either ranges, but right now I feel that any view on the EUR must include some information about what the EUR politicians will do, and guessing what politicians will say, and then do (2 different things btw), what the Chinese will do, is beyond me. Its like solving 5 unknowns with 3 equations. I humbly feel that there are lower hanging fruits within an equal number of mouse clicks away.

JPK said...

"i dont get this. Europe is melting down and the $/EUR is still trading at 1.40"

Yah, I don't either. In fact, I haven't understood the Euro for the last twelve or so months. Am sticking to easier waters like the c-dollar. Less of a rubik's cube.

Leftback said...

If you think trading EURUSD is difficult, try USDJPY. Luckily, Polemic has convinced me to cease and desist.

Yes, here we are sub-80 again, I believe 78.50 was the number discussed....

abee crombie said...

LB, the analogy btwn US and Japan is very apt, with a massive credit deflation in each.. however I would point out that A) The US's response was more to the point and larger B) Secular trend is higher for commodity prices due to supply constraints C) Worldwide wage pressures starting to increase now vs Japan still had productivty gains from BRICs D) US more reliant on foreign buyers

I think these dynamics come into play over the LT. The recent turns of greece and italy, to me, just reinforce that the markets are fragile and all you need is a little catalyst to tip them, especially when they are longer term imbalanced.

I have no doubt that the dynamics in the 10 and 30yr treasury market in the US will reach a panic or semi panic in the near future (say 5 years)... HFT, convexity sellers and correlation with the Dollar etc will no doubt help

Leftback said...

Not to beat a dead horse but it is my favorite dead horse, after all...

Richard Koo of Nomura marshals some interesting data and a few arguments against those who persist in advancing the 1990s/2000s argument that the BoJ were a bunch of complete pillocks and that good ol' Uncle Ben has just the right recipe to avoid the liquidity trap and deflationary outcome that follows credit deflation and property crashes:

Koo on Japan, Greece and Argentina

(He also talks about Greece not being Argentina, we'll see about that one).

The problem with the US/Japan comparisons is that a credit deflation is a very slowly unfolding process of price discovery, that can be obscured and interrupted (but not prevented) by governmental interference and central bank tomfoolery.

Americans are constitutionally unable to imagine such slow events (e.g. evolution and cosmology), being generally possessed of the attention span of a gnat, and so assume that they cannot occur within the boundaries of the U.S. Hence the persistent faith in creationism, reflation and a "recovery in the housing market and construction employment". Ho ho ho.....

We are not yet convinced that the flag-waving John Wayne/Ronald Reagan/supply-side/trickle-down mob are correct about American exceptionalism carrying the day, the Fed cavalry riding to the rescue and the US avoiding Japanese malaise.

Nic said...

Here we are at 78.50 in USDJPY but I favour a retest of the spike lows, mainly because I don't see USDCHF bottoming until 80 but I could be wrong.


Chris of Stumptown said...


Curious if you have read or have an opinion on Adam Posen's characterization of Japan's experience. He maintains that basically fiscal and monetary policy both worked. The problem was that they were both carried out in half measures. As soon as any improvement was noted, they were ceased. Which seems to the same dynamic as the 1937 and 2011 US experiences. Maybe there is something about these situations that make them politically insoluble.

The Fed appears to be off the table from a political point of view. They took tremendous heat for QE2 from all corners. They are internally divided and I do not think that they want to appear to be aiding Obama prior to election.

Posen's paper is a pretty interesting read, agree or disagree. He's got papers with Bernanke so at the very least it is a possible data point on how BB sees things:


Anonymous said...

The problem with any stimulus is that the economy adapts to the stimulus, rather than the conditions that it needs to adapt to. The termination of any stimulus is going to slow the economy period.

I am sick of people throwing out 1937 as some kind of example of economic mismanagement. TO THIS DAY, the three years with the fastest real economic growth in U.S. history (OK, recorded history, and excluding the war years of 1941, 1942, and 1943) are 1936, 1934, and 1935. You think after the three best years of peacetime growth ever that it might be time to dial back the stimulus a bit? A recession was inevitable upon stimulus removal, and after a 3.4 percent contraction in 1938, the economy took off again, with 1939 and 1940 posting 8.1 and 8.8 percent growth respectively.

One purpose of stimulus is to postpone necessary adjustments. That never seemed like a good idea to me, and it now appears more counterproductive than ever.

Leftback said...

Look at it this way. The economy has terminal cancer. QE is at best a form of palliative care. It is politically unacceptable to harm the patient (create too much inflation alongside stagnant wages) in order to totally eradicate the tumour (credit deflation). So it will persist, and perhaps metastasize.

Anonymous said...

Well, EUR is not lower - because someone is switching out of USD. Be it china buying infrastructure in europe or anyone else is beyond the point. Real focus here is US - ok trading spreads like 80s convergeance/divergeance in declining liquidity with new risk parameters for the banks to risk manage. But market is not considering US position - and here is real risk. Like with every passing day it becomes more obvious.

Chris of Stumptown said...

Anonymous, the point of bringing up 1937 was not to apportion blame. It is informative of the future.

The US and much of the developed world is fighting a two front war: debt reduction vs fiscal expansion. Resources can be marshaled in either direction but leaves the other flank vulnerable.

Whatever response is chosen has to reflect political reality. My sense is that in the US voters are very worried about the debt. I think El-Erian called the psycholgy a state of fatigue - the man in the street just wants this stuff to be over. They want the govt to stop doing anything fancy. They think somehow there is a way back to 2006 or 1996. Maybe the Japanese public felt the same way.

In any case, I think you should stock up on earplugs and dramamine. The recent data have been awful, the Fed is on hold, and fiscal contraction is coming. Something tells me the media will be publishing more 2012=1937 stories in the near future.

Leftback said...

1939 and 1940 did experience rapid growth, but there were some special factors in play.... let's hope that we don't get a recovery via the armaments industry.

I wouldn't be too sure that fiscal stimulus is off the table. Even the dunderheads in DC now realize that the monetary stimulus is only effective for the rich, whereas a fiscal stimulus can help the middle class and poor by helping to stabilize a few jobs that might otherwise be eliminated (clearly none are created).

Son of Stimulus is coming, if only to help offset cuts by state and local governments. The only question is how long will they wait?

Anonymous said...

Because we know BB is very very twitchy I think it will only take another one more leg down on equities to get him back to the table. His pain tolerance threshold is shit.His middle name really should be marshmallow.

Anonymous said...

Leftback, I don't know how much of the 1939 growth was due to a military buildup. That was still quite early, and I am far from a WWII expert, barely remembering that the U.S. didn't really take it on until the Pearl Harbor attack at the end of 1941.

I have always seen a big war as a possible termination to the current situation - not something I want to think about much given the advances in both weapons and telecommunications (media coverage, including non-journalists able to capture the attention of the entire world).

Chris, you are right - I need earplugs and dramamine. My point is that certain people today (Keynesians, for whom there is no such thing as too much stimulus) are constantly whining that 1937 was "too early" to withdraw stimulus (to repeat myself, after the three fastest years of peacetime economic growth in U.S. history). I certainly can't claim that the stimulus removal was managed perfectly (nothing involving humans ever is), but it was NOT "too early."

You are probably also correct that we will (unfortunately) hear more comparisons to 1937 in the future.

The political (practical) facets of the current situation are extraordinarily difficult, but the theoretical aspects less so. Governments need to do some medium range planning - figure out what the world will look like in, say five to ten years (obviously that can't be determined in the finest details, but things like demographics and relative growth rates provide significant clues), and then figure out the best way to get to situations that maximize the utility of their citizens within that world (I see very few paths where more stimulus has a positive effect toward that goal).

Chris of Stumptown said...

I will say Leftback is making a very brave call in predicting more stimulus. I am much more in what I consider the consensus view: the politics an impediment given next year's elections.

Ben Bernanke believes that spending can be stimulated through asset appreciation. He's said as much. I'm sure that he continues to view this as a useful lever. But there are two factors that make the Fed Put a bad bet.

In the first place the Fed is internally divided. The hawkish faction of Plosser, Lacker, Fisher, and probably Kocherlakota won't go along. Prior to QE2 the swing faction came along with the doves. I'm talking about folks like Bullard who believed the inflation rate was too low and risked outright deflation. That is no longer the case.

The second difference from pre-QEII is the political pitch has risen dramatically. The "audit the Fed" movement seems to have died down a bit. I can tell you technocrats unanimously agree: keeping know-nothing politicians out of their turf is a top priority. They aren't going to want to anger the GOP by appearing to help Obama. My guess is that 1000 Dow points would be good for some words but not much action.

Anonymous said...

Actually, looking back at your original post Chris, the statement that caused me to hurl (I don't know if this represents your belief or Posen's) was "The problem was that they were both carried out in half measures. As soon as any improvement was noted, they were ceased. Which seems to the same dynamic as the 1937 and 2011 US experiences."

To keep beating the dead horse, the fastest three years of peacetime growth in U.S. history does not equal "As soon as any improvement was noted." I can't comment (with any knowledge, that is) about the strategies and timing of stimulus methods in Japan, but I would strongly disagree with a characterization of the actions taken in the U.S. (both in the 1930s and recently) as "half measures."