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Operation Twist Aftermath

A few more words regarding the "Operation Twist" aftermath: we want to once again stress a point we touched upon yesterday, namely that the merry pranksters at the Fed have failed to consider a number of points when they decided to embark on their newest experiment.

One of these is that insurance companies, pension funds and banks are now faced with lower "risk-free" long term yields. This upsets the actuarial calculations pension funds and insurers base their contracts on and means that existing commitments will eat into their profit potential, while new commitments will have to reflect the lower yield landscape, meaning that the expected payouts to their new clients will decline. This in turn means that people will be even more inclined to increase their precautionary saving and cash balances, increasing the deflationary undertow of the private sector deleveraging cycle. This effect is ultimately salutary, as it is a countervailing force to the capital malinvestment that artificially lowered interest rates tend to produce. It is however almost certainly not what the central bankers wanted to achieve. Banks meanwhile will record large accounting profits on the increase in the market value of their treasury bond holdings, but their ability to squeeze profits from such holdings in the future has declined commensurately, as the steep yield curve has provided them with a considerable source of income.

It is important to consider again what we pointed out yesterday: experience shows that in the fiat money system, a steepening yield curve is associated with inflationary growth, rising asset prices and growing economic confidence. A flattening yield curve is associated with the opposite: growing deflationary psychology, falling asset prices and a decline in economic confidence. In other words, the reaction of the markets to "OT" was perfectly logical, although it has presumably "puzzled" the helicopter pilot once again.

The Banking Crisis

Standard & Poors has cut the ratings of seven large Italian banks, putting them on the same slippery slope the French banks find themselves on. This is to say, many counterparties will halt or reduce their trading in certain items with these banks, wholesale funding sources will dry up, while large depositors are likely to pull their deposits and move to places perceived to be safer at this time. In short, the "institutional bank run" is now going to engulf Italy's banking system more fully. We expect ECB funding to Italy's banks to soar as a result. According to RTE News:

“Standard & Poor's tonight downgraded seven Italian banks after dropping Italy's sovereign rating to A/A-1 two days previously.

The long-term ratings of Mediobanca, Findomestic, Intesa Sanpaolo and their units Banca Imi, Cassa Risparmio Bologna and Biis were downgraded to A from A+. Their short-term ratings remain unchanged at A-1.The rating of BNL was reduced to A+/A-1-.

Unicredit, Italy's biggest bank, escaped a ratings downgrade for the moment but was put on negative outlook.

Standard & Poor's on Monday downgraded Italy's sovereign debt rating, citing economic, fiscal and political weaknesses.”

(emphasis added)

On Wednesday, the credit ratings of Bank of America (NYSE:BAC) , Citigroup and Wells Fargo were downgraded by Moody"s on the grounds that these banks are no longer considered "fail-proof" due to an alleged change in policy (really?). This of course means that they are now also subject to the risks we discussed above. Ironically, Moody's noted in its report that the "contagion risk" between banks has declined – just as the downgrades it has dispensed once again increase contagion risk! BAC's share price promptly collapsed to a new low, more than eradicating the "Buffett bounce," which we rightly denounced as a typical bear market "hopium bounce" at the time.


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The "hopium bounce" in BAC after Warren Buffett's investment in the company has been given back in its entirety.

The big French banks meanwhile are forced by the tense funding situation to vastly shrink their bloated balance sheets. This means there is a wave of "distress selling" in the offing, while these banks will concurrently turn into "zombies" with regards to new lending. Note here that euro-area banks provide some $1.6 trillion in lending to Asia, so the fact that they are now shrinking their balance sheets will redound on credit availability around the world.

As Bloomberg reports:

BNP Paribas SA and Societe Generale SA, France’s two largest banks, are trimming about 300 billion euros ($405 billion) off their balance sheets as Europe’s deepening debt crisis threatens to make them too big to save.

At the end of March, French financial firms had $672 billion in public and private debt in Greece, Portugal, Ireland, Italy and Spain, according to Basel, Switzerland-based Bank for International Settlements. That’s the biggest exposure to the euro-area’s troubled countries and almost a third more than German lenders. The four largest French banks have 5.9 trillion euros in total assets, including loans and bond holdings, or about three times France’s gross domestic product.

“The banks are entering a slimming cure, which is forced by the sovereign crisis,” said Jerome Forneris, who helps manage $10 billion, including the two French lenders, at Banque Martin Maurel in Marseille, France. Rather than tap the market for capital, BNP Paribas and Societe Generale are seeking to free up a combined 10 billion euros through asset cuts and disposals. Paris-based BNP Paribas plans to cut $82 billion of corporate- and investment-banking assets, while Societe Generale may exit businesses such as aircraft and real-estate finance in the U.S.

The banks have been forced to act after concerns about their sovereign debt holdings made funds reluctant to lend to them, crimping liquidity options. At the end of 2010, France’s three largest banks had at least 500 billion euros of short-term and interbank funding rolling over within three months or less, according to a Barclays Capital note dated Sept. 7.

“If liquidity conditions worsen, their size and the weight of their trading books would make it more problematic for the government to replicate a rescue like in 2008,” said Christophe Nijdam, an analyst at AlphaValue in Paris. France provided about 20 billion euros to bolster capital levels at its largest banks after Lehman Brothers Holdings Inc.’s September 2008 bankruptcy. President Nicolas Sarkozy also set up a 320 billion-euro fund to guarantee bank debt. “If guarantees had to be put in place again like in 2008, it would represent close to 20 percent of GDP,” Nijdam said. With French public debt set to rise to almost 90 percent of GDP in 2012, it would “be more problematic today,” he said. [no s***, Sherlock, ed.]

Credit markets signal a squeeze at French banks, with increased risk of default. Credit-default swaps on BNP Paribas have almost tripled to 292 basis points from 110 in July, according to CMA. Contracts on Credit Agricole SA have climbed to 297 from 130, while those for Societe Generale have surged to 399 from 128.”

Not surprisingly, the market concerns about these banks continue to percolate, although the banks themselves continue to sotto voce deny that they are in any kind of trouble. In other news, they also have a certain bridge in Brooklyn that's up for sale.

These problems are a major reason to expect some sort of concerted intervention measures soon. The upcoming G-20 meeting may well be used to lay the groundwork for such a coordinated intervention.


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The Eurostoxx bank index. The selling pressure in European bank stocks has been unrelenting.

Another noteworthy development in this context was a rumor – in our view a credible one – that the Fed is about to cut the interest rate on its foreign exchange swaps with the ECB and other central banks. This will relieve some of the pressures that the current "penalty rate" exerts on banks required to access this type of funding, but it is of course the exact opposite of what was once considered prudent policy in times of financial stress. The WSJ reports:

“With global financial markets under pressure, you can bet central bankers, at least those in Washington, would like to do something about it. Their toolbox is getting a little bare, but there may be some tinkering they can do. From IFR, via Russ Certo at Gleacher & Co., comes the suggestion that they might cut the rate they charge for dollar swap lines to Europe:

The Fed currently charges 100bps over OIS on the 7-day dollar operations and this is what will also be charged once the 3-month operations get underway. For some this is too high and thus it is understandable that there are rumors now circulating that the Fed will cut the rate on FX swap lines to Europe. These swap lines act as a ceiling but clearly the ceiling is too far away to have a material impact unless the market clearly considers you as a bad credit. We have seen a rewidening of the 3mth EUR currency basis swap back to the highs of this year as well as a widening of USD Libor/OIS spread (Dec IMM) suggesting that such an action from the Fed cannot be ruled out.”

It's a good bet that this isn't going to end the budding recession, but as far as the willingness of central bankers to "tinker" goes, we would certainly think it likely that this move is on the agenda.

Recession Signals Proliferate

Another important development on the fundamental front was the growing evidence that a globally synchronized recession has begun. China's HSBC "flash PMI" was once again in contraction territory, clocking in at a lower than expected 49.4. However, the importance of the data was once again downplayed by economists, which is a very good reason to be extremely concerned. The markets in any case didn't wait long to deliver their verdict. Industrial commodities and "commodity currencies" both plummeted again. In some currencies there has been a veritable bloodbath, such as e.g. the South African Rand (this is however great for SA's gold producers; the decline in the Rand since mid August is the equivalent of a $430 rally in the gold price to them).


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The South African Rand as a proxy for "commodity currencies": the recent move deserves to be called a crash by now. Ironically, it is a great boon for SA's commodity producers, especially its gold producers.

Then European flash PMI data came out, and they were even worse than expected as well. For the first time in two years, the euro-area as a whole has slid back into contraction. The highlights according to Markit were:

Flash Eurozone PMI Composite Output Index(1) at 49.2 (50.7 in August). Lowest since July 2009.


Flash Eurozone Services PMI Activity Index( at 49.1 (51.5 in August). Lowest since July 2009.


Flash Eurozone Manufacturing PMI at 48.4 (49.0 in August). Lowest since August 2009.


Flash Eurozone Manufacturing PMI Output Index at 49.5 (48.9 in August). 2-month high.

The euro area periphery remains mired in a depression and now the "core" is weakening quite fast as well. Below are two charts illustrating the PMI since 1999.


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Euro area PMI and GDP since 1999. A new recession has very likely begun.


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Euro area PMI, core vs. periphery. The periphery continues to be the downside leader, but the core is now playing catch-up.

The complete report from Markit can be downloaded here (pdf). We would note to the above that the news backdrop has become so bad that some sort of relief is probably close. As you will see further below, the panic in credit markets has reached astonishing proportions by now. We don't believe the decline in asset prices is over yet, but it is a good bet that any improvement in the fundamental backdrop would be greeted with a rally that relieves some of the current oversold conditions.


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The weakness in PMI data has put enormous pressure on the price of copper and other industrial commodities. The recent plunge has further increased the divergence between copper and the S&P 500 index. Our warning on Monday that copper was perilously perched has proven to have been rather timely.

What Traders Must Be Aware Of

Amidst the continuing carnage in the world's stock markets, more and more divergences are lately appearing between the markets of different countries, as well the sub-sectors within these markets. In spite of the fact that both inter and intra-market correlations have generally increased to hitherto unheard of levels (this is to say, unheard of in the post WW2 era – the phenomenon was well established in a previous era few of today's investors have personal experience with, namely the 1929-1949 secular bear market), there are several notable divergences developing in the stock market that have a historical record of appearing near short term lows.

The reasons to give these divergences some thought here are the following:

  1. The evidence that short term bearish sentiment is getting closer to "capitulation levels" is growing. Note however that we are not quite there yet.
  2. Short term cycle turning points (the average of an unweighted amalgamation of several somewhat esoteric time cycle methodologies – to be taken with a big grain of salt) are scheduled to appear in late September and mid October. Whether they will coincide with short term highs or short term lows is of course unknowable, but it may be good to keep an eye on whether price extremes are becoming evident near these dates.
  3. Policymakers must be getting increasingly desperate in the face of the carnage in euro area credit markets and stock markets around the world. The institutional bank run developing in Europe is an extremely serious development in this context. The easiest way of creating relief would be an announcement of concerted action that ultimately aims to increase asset prices. We expect something of the sort to be in the offing soon.

We should add to the above that so far, the divergences between e.g. euro area and Asian/U.S. stock markets have meant little. In fact, all they have so far meant was that the weaker markets have become leading indicators of the stronger ones. The same may hold true for the divergences we will highlight below, but it is nonetheless important not to forget that they normally represent an early warning sign of an upcoming low. Of course a few days can make a very big difference in terms of the price level at which said low will be established. We would also note, if the support from the August lows in the S&P 500 index should hold or only be slightly undercut before leading to a bounce, then we would expect this support to be decisively breached in the next wave down after the bounce has played out.

The most important divergence is the recently growing relative strength of the NDX vs. the SPX and the NYA index. A chart of the NDX-SPX ratio illustrates this:


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The ratio of the NDX to the SPX has recently increased very notably. This growing divergence between the stronger tech sector and the weaker broader market is a medium term bullish sign. While the wave of selling may continue in the short term as the crisis in euro-land plays out, this indicates that a low of some importance is close in time, albeit probably not yet in price.

In a similar vein, the broader NYA index has already broken decisively below its August lows, while the SPX has not:


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The NYA vs. the SPX (green line at the bottom of the chart). The NYA is either in a third wave or a fifth wave down. If the former, then it is without a doubt leading the SPX. If the latter, then it is beginning to create a potentially bullish divergence.

Please note, we are not trying to turn prematurely bullish here. There are still a great many reasons to expect more pressure on asset prices to ensue. The crisis situation in Europe remains unresolved and as we noted above, near term sentiment indicators have not yet reached the extremes we are likely to see at a true wash-out low. As you will see below, the panic in euro area credit markets continues in relentless fashion. The above is merely a heads-up: traders and investors must not lose sight of the developments depicted above. They are in the class of "early warning signs" that deserve to be paid close attention to.

Euro Area Credit Market Charts

Below is our usual collection of charts of CDS spreads, bond yields, euro basis swaps and a few other charts. Prices in basis points, with both prices and price scales color-coded where applicable.

These charts continue to look just terrible and we note that our expectations as to how the triangles in many CDS charts would resolve have now turned out to be correct.


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5 year CDS on Portugal, Italy, Greece and Spain – once again, new highs are being made (with the exception of the CDS on Greece which remain slightly below their record highs of last week).


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5 year CDS on Ireland, France, Belgium and Japan – the move in CDS on France and Japan are in our opinion extremely worrisome.


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5 year CDS on Bulgaria, Croatia, Hungary and Austria – we have clear breakouts to the upside now from the bullish triangles we have highlighted over recent weeks.


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5 year CDS on Latvia, Lithuania, Slovenia and Slovakia – the same is true of these. Massive breakouts to new highs.


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5 year CDS on Romania, Poland, Slovakia and Estonia – ditto.


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5 year CDS on Saudi Arabia, Bahrain, Morocco and Turkey – more dramatic moves higher.


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5 year CDS on Germany, the U.S. and the Markit SovX index of CDS on 19 Western European sovereigns. Another new high for Germany and the SovX, and now CDS on US debt are beginning to rise as well, as there is once again trouble with the debt ceiling.


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10 year government bond yields of Italy and Austria, U.K. Gilts and the Greek 2 year note. Heavy buying by the ECB has lowered Italian yields on Thursday.


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Three month, one year and five year euro basis swaps – the "euro-doom" trio shows that funding pressures remain front and center for euro area banks.


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Our proprietary index of 5 year CDS on euro-area bank debt. Please note that we have now altered the composition of this index. The new constituents are: BBVA (NYSE:BBVA), Banca Monte dei Paschi di Siena (OTCPK:BMDPY), Societe Generale (OTCPK:SCGLF), BNP Paribas (OTC:BNOBF), Deutsche Bank (NYSE:DB), UBS (NYSE:UBS), Intesa Sanpaolo (OTCPK:IITOF) and Unicredito (OTC:UNCIF). The addition of UBS has lowered the overall index value slightly.


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5 year CDS on Australia's "Big Four" banks – another breakout, and they are now back at their 2008/9 highs. As we have said for many months, we expected funding troubles to eventually strike the banks down under, and CDS spreads to blow out. Here we are.


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The SPX and the AUD-JPY cross rate. A few days ago we remarked on the bearish divergence between the two – now they are confirming each other.

Charts by: Bloomberg, StockCharts.com

Source: Update On Financial Markets And The Banking Crisis In Europe