Spain held their first bond auction of 2013 last week and it went very well, seeing buyers come in attracted to the bond's superior yields even though it is an investment, on its surface, that carries a lot of potential risk. Many of the bond traders involved know Spain's fundamentals are awful - youth unemployment above 50%, GDP contracting, government budget deficit of 8% of GDP, etc. - but are trapped in a kind of reverse Skinner's experiment where pressing the buy button induces a high as opposed to pain.
The OMT Legacy
This is the legacy of the ECB's OMT and the Draghi Put. OMT stands for Outright Monetary Transactions and it is, in effect, an open-ended unlimited promise by the ECB to buy the sovereign bonds up to 3 years from maturity of any Euro member nation that asks for a bailout. The keys to the OMT are that the country must ask to be bailed out and when they do so, submit to the restructuring plan demanded by the ECB. The bond-buying will, in theory, be sterilized, resulting in no overall expansion of the ECB's balance sheet.
The mere presence of the OMT creates a false sense of security in the sovereign debt of those members of the Euro-zone that are functionally insolvent. The Draghi Put is another way of saying that R* for European Sovereign Debt is approaching zero and without the OMT it was far higher than that.
R* is the default risk premium for a debt instrument used in valuation models like the Black-Scholes equation. U.S. and Japanese government debt both carry an R*=0 because both central banks have the power to make good the coupon value of any security the U.S. or Japanese treasuries issue. They may pay you back in currency not worth electrons used to store the ledger entries, but you'll get paid in full. The real problem overhanging the Euro for most of 2012 was this lack of a guarantee.
(click to enlarge)Since the Euro (FXE) bottomed on July 24th and Draghi had his Clint Eastwood moment with the bond vigilantes, telling them not to short the Euro, U.S. Treasuries (USTs) and Japanese Government Bonds (JGBs) have both risen in price as capital leaked back into the Euro and Euro-zone debt as the arbitrage between PIIGS debt yields, and USTs and JGBs became too attractive to ignore. After that all tha, what was needed was the announcement of a facility that raised the ECB near the level of the Fed and Bank of Japan in terms of power. The fundamental shift in capital was on. R*, for high yield Spanish and Italian debt was now essentially zero. It's a risk-free bond buying party, folks.
What's good for the Fed is now good for the ECB.
The Threat is More Powerful Than the Gun Itself
The important point here is that Draghi was in a superior position to the Fed to make such a bold move with the markets. He knew the Germans would demand controls over the process; ensuring that the Euro-zone project stays functionally more solvent than its competitors. One of the key conditions to getting a bailout will be the sovereigns pledging their gold reserves as collateral for a bailout, for example. He also knew that, combined, the entire Euro-zone has 20+% more Gold (AMEX:GLD) than the U.S. and an overall smaller funding/future liabilities problem than the Fed. The magnitude of the budget shortfall in Washington, Social Security, Medicare, state pension funds and bankrupt municipalities dwarfs the ECB's problems. Now that the fiscal cliff has been resolved and the lack of solution inherently inflationary for the Dollar, the ECB's position is even stronger.
So, Draghi says, "Make My Day" and the bond vigilantes do. They start buying Spanish and Italian debt, and the crisis is pushed farther out into the future. Ultimately, he has their gold reserves as collateral to make the threat stick. The ECB loves a rising gold price in this phase of the currency war; it improves the backing of debt that is being issued at ever lower coupons. This makes it possible for Spain to roll over debt this year at lower rates-- the same way Japan did last year. Gold becomes an ever bigger portion of the ECB's balance sheet and allows them to divest foreign currency reserves beyond what is needed to settle international trade. This is the long game that the ECB. has been playing.
So, when the ECB. held rates constant this week after the market was expecting them to be lowered and the Spanish and Italian bond auctions were rousing successes -- both countries selling short-term debt at far lower yields than they did at their previous auctions- the Euro jumped, the Dollar tanked versus every currency except the Yen and Brent Crude and Copper (CPER) threatened major upside breakouts of multi-month formations.
Come on Down for the Big Win
The S&P 500 (SPY) ended the week at 1472.05, following through on last week's breakout high. If this holds through the month, a test of the all-time high at 1550 is very likely. Looking at the inflation markers for this week, we have the following signals:
Week of 1/7 to 1/11/2013
Spanish 10 yr Yield
US 10 Yr Yield
US 10 Yr TIPS Yield
The Euro blasted back over $1.33 with its highest weekly close since the week of 3/26/2012 -- the week that the Greek CAC ruling and ISDA's decision against it being a default occurred; laying to bed the idea that a naked CDS is anything other than a speculative bet. Gold and other commodities sold off on Friday after pushing up to resistance levels but failed to hold gains, even though markers for the day were all inflationary. While they were up for the week, Brent crude (BNO) did not follow along with Gold, Silver and the Euro, suggesting that the move down in Brent was overdone on Friday with TIPS yields dropping and the 5/30 spread widening - which is correlated with higher Gold.
The breakouts in the Euro and S&P 500 are very significant. They signal mounting inflation as the EURUSD pair rises and equities are bid up with newly-created credit (See this week's statistics for reference, here). As I explained in my last article, if U.S. inflation is indeed incipient then the Euro, Gold, Silver (SLV) and Brent will all move together in a broad sense. I would be expecting a rebound in Brent this week.
U.S. Treasuries will continue to levitate on QE bond buying and the prisoner's dilemma that bond traders have been facing for years will persist. They are now repeating that behavior with Spanish and Italian bonds. They know they are playing with fire but at this point the fire doesn't seem to burn. If anything, they are being rewarded for playing Draghi's game. The higher the Euro rises versus the Dollar the thicker their skin will get, the stronger the Draghi Put will be and the harder it will be for the Fed to protect U.S. Treasuries and corporate bonds against the tide of selling. We're beginning to see a wave of selling from various U.S. Treasury ETFs. The iShares Barclays 3-7 Year Treasury Bond ETF (EI) has seen more than $1 billion in redemptions since the Presidential election, for example.
The question, of course, is how far down can Spanish yields be pushed under these circumstances? The spreads with German Bunds are still at historic levels, so there is little danger of the situation topping in the immediate future.
This week I'm looking for upside breakouts of these levels to confirm the moves in the S&P 500 and the Euro:
- Gold closes above this past week's high of $1678.75
- Silver closes above the $31.03 high from two weeks ago
- Brent closes above $113 per barrel
- Copper closes above $3.72 per pound
If most of these things happen I would be more comfortable with the call of that the Fed is getting what they want, higher CPI inflation incoming, because the market will, across the board, be forecasting it.