Commentary and weekly watch by Doug Noland
There were important developments last week on the liquidity analysis front. Tuesday's release of the Federal Open Market Committee (FOMC) minutes (March 13 meeting) threw chilled water on market expectations for near-term additional quantitative easing. In Europe, Wednesday's auction of Spanish 10-year bonds disappointed increasingly nervous markets. Demand for Spain's debt has waned. This is a serious issue for a country suffering from deep recession, a troubled banking sector and ongoing borrowing requirements. Even from a bearish perspective, one would have expected the massive liquidity operations by the European Central Bank (ECB) to have bought Spain more than just a few short months.
It's the nature of inflationism that once commenced the "money
printing" just becomes incredibly difficult to stop. Over the years, US and global markets have been conditioned to expect policy measures that ensure ongoing marketplace liquidity support. The ECB's US$1.3 trillion Long-term Refinancing Operations (LTRO) liquidity facilities coupled with concerted global central bank liquidity measures were a game changer for global risk markets. Rapidly escalating de-risking/de-leveraging dynamics were stopped dead in their tracks.
From my analytical framework, the key issue these days boils down to a fundamental question: did policy measures commence a new bullish liquidity cycle for global risk markets? Or, instead, did these interventions only foment a period of upside market dislocation and instability with attendant susceptibility to disappointment?
Many were quick to downplay the markets' poor reception to the FOMC minutes. Only a "couple" committee members saw the potential need for additional quantitative easing, down from the "few" at the previous meeting. It is clear that the majority of committee members see no need for additional stimulus, although the markets the previous week were excited by chairman Ben Bernanke's dovishness. The marketplace is less than appreciative of the steady chorus of mixed messages from various central bankers.
Yet the markets do believe that Bernanke retains a keen desire for additional stimulus, in spite of heightened internal and external pressures. Last week's data will embolden the doves, if not the bulls. And the markets remain quite confident that the Fed chairman will move quickly to bolster the markets in the event of a return of market instability (the "Bernanke put"). This market perception inflates the market values of equities, bonds and risk assets more generally.
However, the markets last week clearly turned more sensitive to potential liquidity risks. In Europe, the markets took a meaningful step back toward instability. Spain's 10-year yields jumped 41 basis points (bps) to 5.74% (high since January 10), and the country's two-year yields jumped 46 bps to 2.93% (high since January 24).
Credit default swap (CDS) prices for Spain's sovereign debt jumped 27 bps this week to 464 bps, the high since last November. Worryingly, Spanish bank CDS prices spiked significantly higher. Italian 10-year yields jumped 34 bps this week to 5.44%, the high since February 24. Italian CDS surged 21 to 418 bps (two-week gain of 38 bps).
It is worth noting that Italian CDS traded at 127 bps one year ago; at that time Spain CDS was trading near 200 bps. Elsewhere in Europe, Belgium CDS rose 12 bps (245), France gained 10 bps (179), and Portugal jumped 26 bps (1,103). The new Greek 10-year bond saw its yield surge 96 bps this week to 21.50%, with a three-week gain of 372 bps.
And while policymaking plays a profound role in shaping market perceptions, my analytical framework recognizes the global leveraged speculating community as the marginal source of marketplace liquidity.
When the speculators are building positions and adding leverage, the markets enjoy self-reinforcing higher prices, bullish sentiment and liquidity abundance. The markets do, however, remain acutely vulnerable to any serious move to pare back risk/leverage. We saw again last year how quickly seemingly robust global markets can falter and succumb to self-reinforcing liquidation and illiquidity.
Two articles this week from the Financial Times (Sam Jones) shed some interesting light on speculator activities: "Hedge Funds Make Most of Assymetric Risks," and "ECB Liquidity Fuels High Stakes Hedging." "The European Central Bank's moves to boost liquidity in the Eurozone are powering big returns for the high-stakes hedge fund strategy made notorious by the collapse of Long Term Capital Management more than a decade ago: relative value bond arbitrage." Super.
From Sam Jones' FT article:
Across the eurozone, and beyond, hedge fund managers are now pointing to "significant" pricing anomalies on a scale not seen since 2008. A huge rally in credit has seen spreads tighten to pre-Lehman lows. The reason for most hedge funds is clear. For all of its protestations to the contrary, the European Central Bank's longer-term refinancing operation is having as profound an effect on markets as quantitative easing. "The Fed and the Bank of England were early and significant proponents of QE; the ECB has only recently begun," Michael Hintze, the founder of the $11bn credit hedge fund manager CQS wrote… "The thinly disguised QE move by the ECB - LTRO - still has further scope for expansion," he said. "The LTRO was a game changer,' says Suki Mann, a strategist at Societe Generale. "We have seen the mother of all rallies in the first quarter - the third best quarter for credit ever." It was a question of buying risk, says Mr Mann - "the higher the beta the better."
At long last, the markets have assumed, the ECB fell in line with the Federal Reserve and Bank of England. And once the risk market rally took off, there was intense pressure throughout the marketplace to participate. The bears were run over and the cautious were forced reluctantly to jump aboard.
Exceptionally strong markets then bolstered the view that the LTRO had fundamentally changed the liquidity and risk backdrop. In this liquidity-induced euphoria, a fallacy took hold that Europe was well on the way to actually resolving its debt crisis.
There is support for the view that the unlimited nature of the LTRO was ill-conceived; that the ECB lost control as the liquidity facilities ballooned to unimaginable dimensions. But perhaps, instead of the beginning of something - might the LTRO actually prove to be something more akin to the beginning of the end? Rather than the ECB finally succumbing to the Fed's inflationist policy doctrine, might the LTRO spur the Bundesbank (and others) to take a harder line with liquidity operations?
Whether one examines the LTRO or the Fed's QE programs, the scope of these market interventions has become staggering. Resulting market distortions have been commensurate. The whirlwind of speculation has turned too unwieldy. And with the LTRO having incited powerful forces of re-risking and re-leveraging, European markets have actually become increasingly vulnerable to an abrupt deterioration in the liquidity backdrop.
The euro was hit for 1.8% last week. German bunds rallied, with spreads to other European borrowers widening meaningfully. The so-called "relative value bond arbitrage" and other leveraged strategies might have had a rough go of it. The Italian 10-year yield to bund spread widened 41 bps this week to 371 bps (9-wk high). The Spain to German yield spread widened 47 bps to 401 bps (wide since November). The French to bund spread widened 16 bps to the widest level since January 19. European equities performed poorly. Germany's DAX dropped 2.5%, reducing its year-to-date gain to 14.9%. Spanish stocks were hit for 4.5% (down 10.6% y-t-d) and Italian stocks were smacked for 5.0% (up 0.8% y-t-d).
The week brought important confirmation for the thesis of heightened European market vulnerability. There's a strong case that an important market inflection point has been reached in Europe. Once de-risking/de-leveraging dynamics commence in earnest they generally persist. Contagion effects build momentum. And last week global markets also appeared increasingly vulnerable. But how this might play out in US markets is less clear.
There was a certain amount of intrigue heading into Friday's US payroll data, not the least of which was that most markets were closed for the holiday. Many thought somewhat disappointing data would support Bernanke's case for QE3, in the process bolstering the flagging "risk on" trade. Others, including myself, believed US equities would prefer stronger data, employment growth that would support the "US as relatively best performer" thesis.
But at 120,000, the increase in nonfarm payrolls was the weakest reading since October (112,000) and below even the pessimistic estimates. Bonds surged on the news, as S&P 500 futures sank more than 1%. The dollar retreated somewhat on the news, although the currencies were mixed overall.
Friday accounted for much of last week's decline in 10-year Treasury yields. Fixed income spreads were generally resilient in the face of heightened European stress and resulting pressure on global risk markets. If Friday's Treasury rally is sustained Monday, it will be interesting to monitor various credit spreads (many credit instruments did not trade Friday).
There is growing market chatter regarding huge positions in various credit indices being traded by major market operators (including JPMorgan). I would tend to see such a backdrop raising the odds of market fireworks if the reemergence of European debt stress provokes a bout of general risk aversion. With markets poised for a weak Monday open, those positioned aggressively "risk on" had a long weekend to contemplate an increasingly unsettled backdrop.
US stocks were lower for the week, although they significantly outperformed Europe and most global bourses. While Friday's data don't help the cause, it's too early to dismiss the possibility that US equities have been anointed "best game in town" by the sophisticated market operators. At the same time, I see added support for the view that much of the global leveraged speculating community is operating with "weak hands".
When markets head south - albeit Spanish stocks and bonds, commodities or gold equities - there's intense pressure to liquidate positions and cut losses. At the same time, our bubble markets have a history of trying to ignore European developments. At the minimum, it is at this point reasonable to presume that the recent halcyon period for global risk markets is winding down....