And So It Begins…

I asked people about a scenario like this unfolding two years ago and was looked at like I had three heads…

The financial calamity of the European Union’s sovereign debt woes has shaken the pillars of the postwar ideal of a united Europe. The debt crisis and the global downturn have left many European countries looking inward these days and viewing Brussels as increasingly irrelevant.

Germany, long a postwar champion and financier of European integration, is flexing its muscles more independently. And more of its citizens are questioning the country’s leading role in the European project.

On a recent day, Christian Gelleri buys a sandwich and a glass of Hefeweizen at a rustic, sun-filled outdoor beer garden along the Inn River in the Upper Bavarian town of Stefanskirchen.

But the 40-year-old isn’t paying with euros. The bar also accepts chiemgauer, the thriving local currency named after a region in Bavaria.

via From Stalwart To Skeptic, Germany Rethinks EU Role : NPR.

Me and my other two heads aren’t looking so out of place anymore, I gather…

Obscure Rates Update

Because Libor rates aren’t obscure enough, I’m taking a quick look at EONIA swap rates and the EONIA swap curve.  This first chart is really busy since I put all the maturities on one chart going back to January, 2008.

I then took the data and tried to boil it down in terms of just looking at relatively recent experience with fewer maturities.  You’ll see over the past few weeks all maturities have seen an increase in rates.

This next chart takes a look at the EONIA swap curve.  I took daily snapshots for the past several weeks.  Again, it’s a little busy:

But why is EONIA important?  It’s important because it is used as the reference rate for interest rate swaps throughout the Eurozone.  So banks, insurance companies, multinational companies and others use it to either fix or float their borrowing costs, depending on their capital structure, how they want to achieve their weighted average cost of capital (WACC) objectives, etc.

Note the arrow I put in the chart.  You should see a kink where the longer dated rates widened from previous fixings and look to steepen.  Since most swaps are done in annual increments, I tend to focus more on longer dated curves  so the 1 yr and 2 yr swap rates are what I’m interested in the most.  Another sign Euro-denominated funding is getting more expensive.

Here’s another obscure rate to keep track of.  It’s actually a spread instead of a rate, but it’s still important: it’s the spread between 2yr Treasuries and 3mth Libor:

This one is interesting because of what it infers.  From David Goldman:

If LIBOR continues to creep up and reaches, say, 75 bps, it no longer will be economical for banks to own US 2-year notes. In that case the US Treasury market will be in trouble. That’s when you head for the bomb shelter.

via Inner Workings » Blog Archive » …unless LIBOR hits 75 bps, in which case head for the shelter.

That was written a little while back when dollar Libor was moving higher, almost unabated.  Now, it’s not moving much at all but the issues is still the same: it’s one of potential yield curve flattening/inversion and counterparty credit risk.  A quick check of rates as of July 1 shows the spread at about 10bps.  Precariously close to parity.  The green circle is from July ’05 and it was the first time the spread went negative – right around the same time housing peaked. So this can be a good tell regarding overall market conditions, but it’s not watched that frequently.

So bottom line: counterparty issues are taking center stage again, and as a series of fundamental macro metrics, they don’t look that good to me.  Growth looks like it has stagnated and is possibly contracting, job growth is weak at best and other metrics aren’t looking so cheery.  As this backdrop has really lingered since ’07 – with the conditions that set all of this up occurring beforehand – it’s probably time to think about what to do about it.

Yes, that means I’m going to look at the inflation/deflation, austerity/stimulus debate.

You’ve been warned…

Where the Streets Have No Names, Lights or Signs: A LIBOR Update To Remember

For reasons I’ll explain in a bit, this is going to be a critical week for Libor funding.  But before I get to that, I want to recap what has happened in the Libor markets this past week.  So let’s take a look at the usual suspects charts:

The kink between the 6mth and 1yr Dollar Libor maturities is flattening a touch.

Meanwhile, Euro Libor is shifting out.  Noticeably.

As for Yen Libor, well, just leave it alone.  It’s sleeping so soundly I don’t want to wake it.

But let’s take a look at some weekly snapshots of the Dollar and Euro Libor curves:

Dollar Libor is relaxing some.  Not that it’s relaxing that much, but the acute funding pressure we had seen building has softened a bit.  This shouldn’t surprise us as this move coincides with the Euro move to the upside.  Here I show the hourly chart going back two weeks.  This should tell the story well enough:

Which also shows up in Euro Libor:

What we’re starting to see is a kink formed at the one month point on the curve.  Mid-dated Euro funding is getting bid up while overnight funding remains dormant.  This next chart shows that:

Outside of the two hiccups 35 days apart, that is.

But now, things get interesting.  While I was on the road, zero hedge ran this post about funding conditions in Europe.  I took this screen capture of the ECB’s OMO page:

I circled those two transactions because they settle within a day of each other.  This week.  So within 2 days, we’ll see almost €600bn in ECB reverse transactions settle. What is a reverse transaction?  From the ECB’s General Documentation on Eurosystem Monetary Policy Instruments and Procedures:

Reverse transactions refer to operations where the Eurosystem buys or sells eligible assets under repurchase agreements or conducts credit operations against eligible assets as collateral.

So you can either structure these to take liquidity out of the system, or put it in.  Trust me, these were injecting liquidity in to the system.  But now they’re coming due, and I want to use this to show how inflation is not the issue to worry about and hasn’t been for a while.

How?  Well, take a look at how much is now owed to the ECB:

For the small facility on 6/30:

(€151.5114bn)[1+((7/360)(1%))]  = €151.5409bn

For the large facility due on 7/1:

(€442.2405bn)[1+((371/360)(1%))] = €446.7980bn

In a world where credit costs are minimal (extremely low default rates, good recoveries on collateral, charge-offs almost nil, etc.), this wouldn’t be an issue.  Heck, the facilities wouldn’t have been this well-bid in a good credit environment.  But we’re not in that kind of environment now and the credit cycle still has a ways to go before we can see a true recovery there.  Plus, other assets like sovereign debt securities are having their own issues.  Banks might hold some of these notes, so now you’re talking about a hit on the balance sheet again with the recent credit market action, in addition to the rising credit costs. Oh, and I forgot to mention falling loan demand.  So amidst this backdrop, banks are going to have to come up with this cash.

And to make matters worse?  Consider Spain:

Spain faces a confluence of events in July, whereby it will need to finance 21.7 billion euros within a single month. This combines shortfalls in its budget and a wave of scheduled government debt redemptions.

via Spain’s Debt Maturity Wave Hits Next Month And It’s Already Obvious They Don’t Have Enough Cash.

The problem here is two-fold: first, there are the questions about what the cost will be – i.e. how much will the spread to German bunds be.  Second, consider this (emphasis mine):

It goes without saying that the government’s priority will be smooth and well-bid auctions (see calendar below), with local banks playing a crucial role.

So Goldman obviously expects banks to be bidding on these notes.  Below is the Spanish debt auction calendar in question:

The 5yr bond auction takes place the same day the monster ECB facility expires. Can this get any crazier, or what?

Looks like the Euro Libor market is becoming less and less certain, of well, a lot.  Take a look at the spread term structure:

Dollar/Euro Libor spreads are widening a bit, but not for the right reasons.  It seems now that the increases in the term structure of Dollar/Euro Libor spreads are being driven by uncertainty over the June 30/July 1 settlements.  Given the nature of the activtiy in the funding markets, I’ll probably write something before next week on this (i.e. look for a post later in the week as we approach month end).

Because as of right now, this like driving in a foreign country where no streets are named, numbered and there are no traffic lights or signs.

But the sad thing is, we’re not driving.  We’re standing in the middle of the intersection while everyone converges from all 4 directions at death-defying speed.

There’s only one way I can see this ending “well.”  The ECB will have to announce a new facility to roll all of the collateral that has been pledged and the banks can keep the Euros the ECB lent them.  For now, anyway.  But there has been no indicator they’re working on this.

Better find something to hold on to and brace for impact…

LIBOR Update: From The Week That Was

Last week I started expanding my Libor updates to include Yen Libor along with Dollar and Euro Libor.  This week I wanted to continue breaking down recent activity in the space and maybe toss out some ideas about what we can see going forward.

So first, let’s take a look at some charts of the respective curves, month-over-month:

Euro Libor seems to be rising now a touch and the pace of the rise we’ve seen in Dollar Libor has slowed.  Although I’d offer it looks like both 6mth and 1yr Dollar Libor are rising faster than the front-end of the curve, so it’s steepening a bit.  These charts probably shows it better:

Curiously, another hiccup in overnight Euro Libor shows up.  35 days after the previous one.  I don’t want to jump to conclusions, because there may well be a logical explanation to this, so I went to the ECB’s website to see if there was a refi operation that may be distorting the curve.

The durations don’t match but the amounts that were refinanced are relatively close.  I posited before that I wondered if there was a funding issue then and I guess that’s still an open question.  Especially when you hear things about Spanish banks that are less than positive about their funding position.

Here are the updated graphs I made of the term structures of Libor spreads:

Here’s a weekly view of the Euro Libor/Dollar Libor spread term structure, because you need to see a blend of data frequencies to make a real assessment of the Libor market.

The spreads are starting to widen a little again, but as I shown earlier it’s not because Dollar Libor is retreating, but Euro Libor is rising at the longer end of the curve.  I’m getting the feeling we’re starting to see a run to boost liquidity, no matter what currency it’s denominated in.  Especially when you consider how Libor is calculated.  We’re only seeing the middle of the distribution, so we don’t have an assessment of how disperse the data is.  That’s an issue.

But the bottom line is this: the term structure of spreads is rising a little, but it’s not from a relaxation in risk aversion.  It seems that risk aversion is increasing.

And that’s not healthy…

More Fun with LIBOR

Since I’m home, thought I’d do an update on Libor to see where things stand.  Seems the trend of higher rates is still holding, so in other words: Not. Good.

The spread between dollar and euro Libor continues to contract, with the curve getting flatter and flatter as time moves forward.  This should give you all the evidence you’ll ever need to see that the Fed’s actions regarding cross currency swaps are not working.  This is fodder for a new post I have noodling around in my head at the moment.

The dollar Libor curve continues shifting up and it’s getting more asymmetric.  Mid and longer-dated Libor rates are shifting higher and faster than the front end of the curve.  That makes me think banks are not only more worried about funding, but also that they’re more guarded about funding in the second half this year than they have been previously.  I wouldn’t say it’s concrete evidence of a double-dip recession looming, but if they’re worried about funding and counterparty credit, that isn’t a good sign.  At all.  Also consider this: overnight Libor is above the Fed’s upper target of 25bps and has been 5bps higher for just about all of May.  I’ll need to dig up some data and compare overnight dollar Libor to Fed funds over time. to see what this means.  At the moment, a 5bp spread between the two is not that much to worry about.  But it shows short-term funding is still more volatile than I’m sure central bankers of all stripes would like.

Here’s proof of what I said about longer-dated dollar Libor moving higher faster than short-dated Libor.  3mth Libor has been pushing up 6mth and 1yr Libor rates.  You can see over this limited dataset that the correlation between 3mth, 6mth and 1yr is stronger than overnight and 1mth, which have remained relatively tight.  Also, it goes to show from a maturity vs. cost of funds standpoint that banks and counterparties that borrow at the short end of the Libor curve are relatively indifferent between overnight & 1mth money.  So there’s a high degree of confidence in the ability to roll short-dated paper and there’s little worry in funding costs when it is rolled.

Meanwhile…

Euro Libor is still cryogenically frozen.  Or is it being suffocated?  Can’t tell for sure but it makes me wonder when there will be any demand for euro denominated funding.  Plus, there’s this tidbit from Reuters that I’m thinking may explain that hump in overnight Euro Libor we saw in the middle of the month:

BBVA has been unable to renew about $1 billion of U.S. commercial paper since early May, The Wall Street Journal reported on Wednesday, citing people familiar with the matter. The report said the bank still has “substantial” funding and deposits in Europe and roughly $9 billion in U.S. commercial paper outstanding.

via U.S. funds wary of short-dated European bank debt | Reuters.

Not a smoking gun, but it points to short-term funding problems that I had suspected had been going on in Europe.

All the talk of liquidity drying up in European commercial paper markets suggests we’re closer to the end of the beginning rather than the beginning of the end in the European credit crunch, which I’m calling Credit Crunch v. 1.5.  I’m saving Credit Crunch v. 2.0 for leveraged lending and commercial real estate losses hit, which will be sometime after we get past the record delinquencies we’re seeing at this point.  Consider this tidbit:

Nationwide the delinquency rate for commercial mortgage-backed securities loans hit a record high 8.02 percent in April, according to New York-based data firm Trepp LLC. In 2009, the delinquency rate was 2.45 percent.

via Economic bellwether: Experts – and those in the trenches – watch commercial real estate with avid interest | GazetteNET.

More than three times higher than we were a year ago.  But the real losses will only come to light as the collateral (i.e. delinquent property) is sold off and loan recoveries are realized (or not).

At which point, the whole process more than likely repeats itself…

A Rant About Xenophobia Run Amuck

This is getting quite ridiculous, really.  No more than a week ago, I had a post about the idiotic comments coming from Europe on “wolfpacks” and “wolfpack behaviors” that were “rampant in the marketplace.”  Those comments about wolfpacks elicited a reaction from me:

It’s amazing what folks in his position do in reaction to market events. To me, it’s very clear that the market isn’t looking to take the Euro down, or as he put it “tear the weaker countries apart.” What the market wants is for Brussels to show they have some guts and draw a line in the sand with respect to their mantras of fiscal responsibility. Not just pay it lip service.

via Comments on “Wolfpack” Behavior Epitomize Idiotic Behavior « Deep Thoughts by Professor Pinch.

Now we have comments in the Financial Times from Wolfgang Schauble, Germany’s finance minister, who thinks markets are “really out of control.”  He also thinks “the ratio of financial transactions to the real exchange of goods and services” needs to be regulated.

Really?!

I guess my first question is define “out of control.”  Are prices only supposed to go one way, depending on the prevailing political winds (up for stocks, down for commodities)?  Puhleeze.  That will get you just as far as a kid gets complaining about a dog eating their homework.  Markets are a product of the people/institutions that participate in them, the products/services that are bought/sold/traded there and the rules that they can operate under.  Rules that are made by people.  So is he really saying people screwed up in setting up markets?  Or that people screwed up in the enforcement of those rules?  If that’s what he means, I’d buy it.  Sadly, I don’t think that’s what he meant.

Which leads me to this asinine idea of regulating “the ratio of financial transactions to the real exchange of goods and services.”  Who sets that ratio?  And who says they know better than me?  Or that they know better than you for that matter?

To me, this is clearly an outgrowth of some things I highlighted in another post.  Let’s take what I said about CDS for example.  There’s a huge disparity between inter-dealer trading volumes and client-based flow trading:

First, I have to say the volume differences between inter-dealer trading and non-dealer trading is staggering. But it leads me to some questions. Questions that need answers…

• What are the dealers doing? Is this how they are trying to make the market appear “liquid?”
• Is there another explanation? I’ve been toying around with this idea that there may be another reason completely unrelated to trading and market-making. The volumes are such to support the headcount in those departments – so this could be bureaucracy and bloat. It may be totally wrong, and a sign my medication needs to be upped dramatically, but I’m just saying there may be an alternative explanation.

via Quick Hits on Credit & Liquidity « Deep Thoughts by Professor Pinch

I’m just trying to come up with ideas as to explain what’s going on, I don’t assume for a minute I’ve hit on anything.  But sticking with CDS for a second, I picked this instrument strictly because it is, to borrow the words of Baudrillard (courtesy of  Kevin Depew), a manifestation of the simulacra.  CDS are a synthetic of an organic/cash instrument.  But yet, we talk more about CDS than cash bonds.  It’s like we talk more about Super Bowl bets than the actual game.

But there’s a point there.  Sports betting is a derivative of the event: an event occurs, people are betting on its outcome.  The same can be said of the markets.  The issue is not in the market action, it’s that the market has become so concentrated – so cartel-like and oligopolistic – that when we need true liquidity to facilitate things like “Flash Crashes” or massive carry unwinds, it’s not there to be had.  People have failed in their regulation of markets and in how regulations should be enforced.

So if Herr Schauble wants to talk about how to fix markets through better policy, fine.  If it’s to punish market participants for participating in the market, like what he said here, the only words that come to mind come courtesy of Gordon Ramsay:

“You!  Over there.  Shut it!  Now!”

The OECD’s Demographic Problem (i.e. We’re Turning Japanese)

Y’know, we’ve all been talking about Europe’s fiscal challenges quite a bit, myself included.  The deficits.  The retirement ages.  The entitlements.  And all during what may be shaping up to be a pretty good Formula 1 season…

But I digress.  We’ve all seen the charts:

But this excellent post over at Edward Harrison’s Credit Writedowns blog written by Edward Hugh from A Fistful of Euros (I love that name.  Where’s Sergio Leone when you need him?) really hits at the bigger issue at work:

The backdrop to the whole debt issue is the underlying problem of rapidly rising elderly-dependency ratios (and increasing population median ages) across the developed economy world. Normally this means the imminent arrival of a wave of heavily underaccounted-for-liabilities which will produce a massive pressure on the underlying structural (rather than cyclical) deficits in the worst affected economies. The strange thing is that this development had in principle been long foreseen, and indeed formed part of the underlying raison d’être for drawing the 3% deficit/60% debt Maastricht line-in-the-sand. The other part was, of course, an attempt to stop spendthrift governments being spendthrift. As is now abundantly clear, in neither case can the Maastricht package be said to have worked, but the unfortunate historical accident is that we have come to realise this in the midst of the worst global economic crisis in over half a century (indeed arguably the second worst one ever, and – disturbingly – it is still far from being over).

via Much Ado About (Some Of) The Wrong Things – Credit Writedowns.

And here’s some compelling data which tells the story.  It’s from the CIA Factbook.  Let’s take population growth rate.  Here’s a snapshot of the top 20 countries in this category.  You’ll see I pulled up Greece as an example.  It came in 188th:

France ranked 152nd while Germany ranked 210th and its growth rate is actually negative. So Sarkozy has it really easy: put Germany’s money where his mouth is while there are fewer Germans to yell at him for doing so.

Let’s look at birth rate.  Here, Greece came in 206th:

France?  They were 162nd while Germany was 220th.  I should point out the CIA tracks this data for 233 countries.  So to be ranked so close to the bottom consistently in these categories is of some consequence.

Last but not least, here’s a look at death rates:

Yes a lot of the names are the same, but the fact is birth rates among the top 20 are about double of the death rate the top 20.  That means net-net, population is growing.

Which brings me to this chart:

A flat-lining labor force will happen in most of the developed world given its demographic characteristics, it’s just a matter of time.  The question is do we measure it in years or decades.  My guess is years.  Eventually the confluence of declining birth rates, rising average median ages and declining population growth rates (in total, including immigration) will take its toll.

So total debt may not be the metric we need to watch.  It may be debt per capita.  My sense is this will only increase and continue doing so until the OECD countries collectively wake up and realize unfunded liabilities, bloated entitlements and other government transfer schemes won’t work.  Not because there won’t be enough money, but there won’t be enough people to earn money.

But we have countries led by people who only grew up with government expansion post-World War II.  They don’t know any better.  The older folks?  Well they kind of pushed us in that direction as a reaction to the Great Depression.  Policy in the US became about establishing safety nets and transfer mechanisms.  And it worked…

Until now… those programs were all based on two premises: an expanding population and marginal increases in labor would produce expanding GDP.  I don’t think they ever envisioned a world where you’d see slack in a labor market.  But because of technological advances, we’re here.  Productivity can still increase even though we’ve had a persistently soft labor market.

But meanwhile, those unfunded obligations keep increasing because compounded interest doesn’t care a wit about population growth.

Restructuring is needed, to put it mildly…

Commented on “Bond Squawk”

Rom,

Good post & I think you’re spot on. One thing that this does make me wonder is if this may be the first step in setting up a private placement market for wayward sovereign debt. Kind of like a shelter for disavowed pets – just not as cute and definitely doesn’t tug at your heart. But in order to set it up, they’d need to backstop and lend them money now – at discounted rates of course.

I don’t know about you, but I think the EU leadership as well as leaders of many of the European countries are really playing with fire. If this goes wrong (and I think the probability of it going wrong is significant), the *concept* of credit may cease to exist as nobody will believe in credit worthiness. And nobody will be there to backstop them.

Cash & carry could be the name of the game…

Originally posted as a comment
by professorpinch
on Bond Squawk using DISQUS.

Apparently Central Bankers Haven’t Heard of Osmosis

Building on my last two posts that you can read here and here, we see that central bankers don’t know what osmosis is.  So I’ll do them a favor and quote it from Wikipedia:

Osmosis is the movement of water molecules across a partially-permeable membrane down a water potential gradient..^[1] More specifically, it is the movement of water across a partially permeable membrane from an area of high water potential (low solute concentration) to an area of lower potential (high solute concentration). It is a physical process in which a solvent moves, without input of energy, across a semipermeable membrane (permeable to the solvent, but not the solute) separating two solutions of different concentrations.^[2] Osmosis releases energy, and can be made to do work^[3]. Osmosis is a passive process, like diffusion.

Now why is that important?  Simple.  Because I already outlined in my previous post that risk is neither created nor destroyed – it’s merely transferred.  Now, we hear this from the New York Times:

In an extraordinary meeting that lasted into the early hours of Monday morning, finance ministers from the European Union agreed on a deal that would provide $560 billion in new loans and $76 billion under an existing lending program to countries facing instability. Elena Salgado, the Spanish finance minister, who announced the deal, also said the International Monetary Fund was prepared to give up to $321 billion separately.

Officials were hoping the size of the program — a total of $957 billion — would signal a “shock and awe” commitment to such troubled countries as Greece, Portugal and Spain, in the same vein as the $700 billion package the United States government provided to help its own ailing financial institutions in 2008.

via E.U. Details $957 Billion Rescue Package – NYTimes.com.

Now I’ve heard that most of this is in the form of guarantees, which to me are about useful as a poopy-flavored lollipop.  The loans that are available could be used to roll the debt that these countries have at what I’m sure are concessionary rates, but what will that accomplish?  It simply masks that credit conditions in the Eurozone are getting worse, not better.  Call it a supra-sovereign Enron scheme, if you will.

The real piece that was needed in this mess wasn’t even provided by the EU.  It was provided by the other central banks.  From the Federal Reserve (emphasis mine):

In response to the re-emergence of strains in U.S. dollar short-term funding markets in Europe, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing the re-establishment of temporary U.S. dollar liquidity swap facilities. These facilities are designed to help improve liquidity conditions in U.S. dollar funding markets and to prevent the spread of strains to other markets and financial centers. The Bank of Japan will be considering similar measures soon. Central banks will continue to work together closely as needed to address pressures in funding markets.

via FRB: Press Release–Federal Reserve, European Central Bank, Bank of Canada, Bank of England, and Swiss National Bank announce re-establishment of temporary U.S. dollar liquidity swap facilities–May 9, 2010.

This shows that the crisis has morphed beyond taking a stand on a sovereign debt issue.  This is now a currency and financial system issue with banks in Europe not wanting to fund counterparties in Euros.  That’s why my post on Euro Libor to dollar Libor spreads was key.  That’s the issue that needs to be focused and you can’t fix it by throwing Euros at the problem.  Nobody wants them.

But Japan did follow suit, which inspired me to write this haiku:

So there you have it…

This mess is now everyone’s mess because central bankers failed elementary school science.

Quick Update on Euro-land Curves

I published a 3 pager on Scribd earlier that just showed some snapshots of Euro-land funding curves.  I’m re-posting it here:

View this document on Scribd

Not only have we not seen a change in the shape of the curve, but for the past several months the entire curve was compressing.  All rates were headed lower.  Only now are they starting to show signs of  reverting back to where they were earlier in the year.  The curves haven’t even made it back to the levels of last year.

So what does this mean?  It means none of this matters to European banks until it does.  Don’t know what that means?  Read this.