European Credit Is Wider And Entering A New Phase Of Risk Aversion

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Includes: DIA, HYG, IWM, JNK, LQD, SPY
by: Peter Tchir

The CDS Indices are wider today and, in many cases, hitting new highs for the year. SOVX is 10 wider, trading at 320. Main, the investment grade index, is 11 wider, trading at 176. Its previous high was 170 back when the SPX was close to 1100. Finally, the Senior Financials CDS Index is over 265, which is 20 wider on the day and is wider than at any other time throughout the entire financial crisis. SocGen (OTCPK:SCGLF) stock price is at a multi-year low and approaching March 2009 levels. Deutsche Bank (NYSE:DB) is doing much better than its immediate post Lehman price, but is now down close to 40% on the year.

The Greek 1 year bond is at 61 now. That is down 10 points in 2 weeks, and is a clear sign that Greek default is being priced by the bond market and mark-to-market accounts. That makes sense as the IMF seems to be more contentious than before, there is growing public disagreement between the various countries, and the staunch support of Germany is becoming more questionable, as their economy stagnates and their leader is losing public support.

The fact that people remain hopeful of eurobonds saving the day is just a clear indication of how little risk of default, the market is pricing in. The eurobonds seem unlikely at the best of times and virtually impossible in this stressful, fragmented, and more and more insular market.

While adding fuel to the fire, it is worth noting that Italian 10 year bond yields are back to almost 5.5% after being driven below 5% on some actual ECB purchases and the threat of more purchases. Spain is doing a little better, but like virtually all its previous attempts, all the ECB open market purchases seem to have done is stabilize the markets briefly, with no lasting impact, and to saddle the ECB balance sheet with more mark to market losses.

I think we are entering a new crucial phase in the problems in Europe as quarter end reports will drive a notional reduction. During parts of 2007 and 2008, CEOs of banks and other financial institutions did not want to show any exposure to sub-prime, or to certain banks, or to leveraged loans, etc. The CEOs in particular were convinced that they needed to show ZERO net exposure to the asset classes most in question. As part of the “window dressing”, their risk management departments were told to be short and told to reduce notional exposures. It was no longer just an economic decision it had become a "what's best for the share price" decision. The reality is that making money is best for the share price, but that notion gets thrown out the window once CEOs panic. I believe we are there, and there are some real repercussions from that.

The main problem is that we will see credit curves flatten and possibly invert. As short dated paper to the current "culprits" (sovereigns and financials) matures, the lenders will not want to roll over the positions. This will create pressure at the short end of the curve, normally a relatively safe haven. We are seeing that in Greek bonds as the short end sells off; it also shows up in OIS where that rate increases.

The banks that are late to the hedging party, and it seems like there are a lot of them, will be reluctant to lock in losses on longer dated assets. Due to the duration, those losses are now large, so they will sell shorter dated assets or buy protection on a shorter maturity in order to show that they have taken notional exposure down, but have some chance of not locking in losses (losses the accrual accounting banks haven't even recognized). As investors see curves flatten or invert, they will get concerned, and will sell stock. This may take some time, but if I'm correct and we are entering the first real quarter end where every bank is going to want to show minimal notional or "jump to default" risk on PIIGS and Banks, this can happen.

It also means that we are less likely to see a relief rally in credit, particularly in the cash market until October. The hedges are now as much for reporting purposes as economic purposes, which means these institutions will stubbornly keep themselves hedged to the level deemed appropriate by the boss until October.

Disclosure: I am short SPY. My positions are actively managed and may change.