Matt Calder: "There are lots of ways to die. Starving to death isn't my favorite." - from the 1954 movie River of No Return by Otto Preminger starring Robert Mitchum and Marylin Monroe.
Looking at the velocity in falling government bonds yields as well as the ever growing scarcity of highly rated bonds at the disposal of real money managers (courtesy of central banks buying: FED, ECB, BOE, BOJ) and decline in new issuance for fixed income spread products, we thought our analogy to Otto Preminger's great movie would indeed be appropriate this time around.
Therefore we thought it would be interesting to focus our attention on the consequences of "travelling", like Matt Calder heading downriver, on our flimsy log raft, and encountering trouble in the rapids (or markets), on this river of "No Returns". But first our credit overview!
ItraxxSOVx Western Europe Index (credit risk gauge on 15 governments with Cyprus replacing Greece) climbed three basis points to 334 bps, adding to the gauge’s 50 basis-point jump in May. The Sovereign CDS on Italy climbed 14 basis points to 575 bps , approaching the record of 602 basis points of the 15th of November according to Bloomberg data. Meanwhile Spain Sovereign CDS reached 620 bps while Spanish Telecom company Telefonica rose 13 bps to an all-time high of 481 bps.
In conjunction with sovereign risk, as always, financial risk rose in synch, with the cost of insuring bank debt also increasing, with Itraxx Financial Senior 5 year CDS index (linked to senior debt of 25 banks and insurers) rising5 basis points to 303, after surging 23% in May. Itraxx Financial Subordinated5 year index increased5 basis points to 501 bps. Itraxx SOVx 5 year index is trading closely to the Itraxx Financial Senior 5 year index which is anindication theongoing issue of circularity and the impossibility so far indecoupling both.We have been discussingon numerous occasions this very subject of circularity(most recently in our conversation "The Daughters of Danaus")- source Bloomberg:
The Itraxx Crossover5 year index(linked to 50 European High Yieldcompanies) increased 10 bps to 730 bps, after a 70 bpsrise in May.Itraxx MainEurope 5 year index representing the risk gaugeforInvestment Gradecredit(125 companies with investment-grade ratings) advanced 2 basis points to 183 bps. The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:
"Mind the gap", we have been warning for a while, given the disconnect between the Eurostoxx and the flight to quality mode experienced with the rapid drop in the German Bund 10 year yield with rising volatility as indicated in the bottom graph. The gap is in fact closing.- source Bloomberg:
The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 1.20% yield) touching a new record low around 1.12%, with 5 years Germany Sovereign CDS rising slightly above100 bps - source Bloomberg:
A story of volatility as far as "safe haven" government bonds are concerned (German Bund, 10 year US Treasuries), looking at the intraday picture for the German Bund yield movement - source Bloomberg:
Touching a low of 1.1238% before bouncing back at the close towards 1.18%
In fact, another indicator we have been monitoring, has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes - source Bloomberg:
While touching again on our recent subject of asset correlation (see our post "Risk-Off Correlations - When Opposites attract"), in "Risk Off" periods we have noticed that the 120 days correlation has been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level. The correlation between both the German Bund and US10 year noteis rising very fast, now above 70%. The above graph was our reasoningbehind our30th of March call:
"One has to ask oneself if the time has not come to start taking a few chips off the table." -Macronomics -"Spanish Denial".
Nota Bene: ("Risk On" refers to a period of time in which investors are putting money into risky assets such as stocks, commodities, etc. "Risk Off" meaning the exact opposite with investors putting money into safe haven assets such as cash and treasuries or German Bund).
As far as asset correlation are concerns, the weakness in Oil prices warrants caution when looking at the relationship with the SPX 500 since QE 2, so, "Mind the gap":
Oil fell on Friday to an eight month low, falling as much as 4.6% after the disappointing employment data in the US (Non-farm payrolls coming at 69K with jobless rate at 8.2% from 8.1%. Crude futures declined to 83.59 dollars a barrel after touching 82.56 dollars, the lowest intraday level since the 7th of October according to Bloomberg. Brent for July delivery fell 3% to 98.78 dollars a barrel. The European benchmark has fallen about 8% this year. The SPX 500 Index declined 1.8 percent and touched 1,286.63, the lowest intraday level since the 13th of January validating our recent comments on the relationship.
"Mind the gap" because the Euro Swap Curve is theflattest it has beensince the Lehman collapse according to Bloomberg:
"The gap between short- and long-term euro-denominated interest-rate swaps is the narrowest since the months following the collapse of Lehman Brothers Holdings Inc. as Europe’s debt and banking system crisis worsens. The top panel of the CHART OF THE DAY shows the difference between rates on two- and 10-year euro-denominated interest-rate swaps fell last month to the least since December 2008. The bottom panel is the so-called euro FRA/OIS spread, or the forward market projections for the gap between three-month Euribor and expectations for the euro overnight index average, known as Eonia." - source Bloomberg
Eonia index:
"The Eonia index is a gauge of the cost for banks in Europe to borrow from each other overnight in euros, similar to the U.S. effective federal funds rate. Euribor is the rate at which European banks say they see each other lending in euros, according to the European Banking Federation."- source Bloomberg.
As a reminder and from the same Bloomberg article:
"In November, the FRA/OIS spread surged to a 33-month high as concern over contagion from the sovereign crisis drove Italian debt yields to levels that forced Greece, Portugal and Ireland to seek bailouts. The 10-year German bund yields fell yesterday to a record low on concern European leaders won’t agree on measures to contain the debt crisis. If funding conditions in the European banking sector worsen to levels reached in the fourth quarter the two-year swap rate could increase and cause the swap curve to “flatten significantly” according to Societe Generale strategist Sandrine Ungari."
German 2 year notes falling in negative territory versus 10 year Bund - source Bloomberg:
The current European bond, from convergence to divergence with Spain experiencing a serious bout of volatility in conjunction with Italy and core countries experiencing an important drop in yields with France and Belgium even touching record low yield levels (France at 2.21%) - source Bloomberg:
While Italian bond yields dropped 21 bps to 5.69%, Spanish yields only receded 9 bps to 6.47% at mid-day as many pundits are speculating on an activation of the SMP (Securities Market Programme) by the ECB.
As far as credit is concerned as one market maker puts it:
"We keep waiting for capitulation in the credit space. It hasn't happened yet for several reasons:
-Hedge Funds are short and reducing.
-Real Money (Asset Managers) have not capitulated yet on cash bonds given they hedge using index and futures but the German Bund is saving them given the bund is up 11 points and if credit spread are wider by 2.5 points, they are still doing well (German Bund moving up a point a day versus ItraxxCrossover - HY risk gauge-moving 20 bps or Itraxx Main Europe - Investment Grade risk gauge- by 5bps).
-Credit was the first to react and now all other markets have followed suit. But Credit has stopped widening as we are expecting intervention and credit is mostly correct."
Following up on our assertion: "In fact, the only commodity that appears to be running scarce in "Risk-Off" periods appears to be the dollar"("Risk-Off Correlations - When Opposites attract"), dollar is indeed the big winner in this "Risk-Off" environment.
The dollar posted its biggest monthly gain since May 2011, beating everything in its path, bonds, stocks, commodities as investors sought refuge in the U.S. It climbed 5.5%. And as Douglas Borthwick, head of foreign-exchange trading at Faros Trading LLC in Stamford, Connecticut, said in a May 29 interview with Trish Regan and Adam Johnson on Bloomberg Television’s “Street Smart.” in relation to investors seeking the safety of the dollar:
“They’re forced into owning the dollar,” he said. “Not because they like it or they think the dollar is going to rally, but because there’s nothing out there for them to buy.”
