The Bank Of England Sends In The Cavalry

Summary

• The combined firepower of the Bank of England and the European Central Bank has compressed the yields on both corporate and sovereign debt to historic lows across the developed world.
• The compression has resulted in the 10-year benchmark notes of Spain and Italy falling 550 basis points and 421 basis points below that of the 10-year Treasury note.
• The 30-year gilt has returned 53% capital gains for the year.

Who says central banks lack the firepower to force borrowing costs down any further across the developed world? To the surprise of investors, observers and economists alike, the Bank of England (BOE) has coordinated with the on-going European Central Bank (ECB) large-scale purchase program (LSAP) to do exactly that: The spread on the 10-year Bund with Italy in the immediate aftermath of the Brexit vote stood at 1,549 basis points (b/p). At yesterday's market close (10 Aug) that spread had compressed to 1,187 basis points-a drop of 363 b/p. Meanwhile, the rally in gilts has exceeded extraordinary, with the 30-year gilt almost halving since the 23 June British referendum to 1.06% at yesterday's market close. On the price side, the 30-year gilt has returned 53% on the year-in capital gains.

Figure 1: 10-year Sovereign Debt Spreads Post-Brexit

Country	24 June	10 August	Spread vs Germany 24 June (b/p)	Spread at 10 August (b/p)
Germany	-0.057%	-0.108%
Italy	1.492%	1.079%	1,549	1,187
Spain	1.637%	.950%	1,694	1,058
Portugal	3.087%	2.740%	3,144	2,848
France	0.392%	0.107%	449	215
Netherlands	0.190%	-0.013%	247	121
UK	1.087%	0.531%	1,144	639
US	1.575%	1.506%	1,632	1,608

Click to enlarge

Lest we forget, Italy is a country where recent European Bank Authority (EBA) in conjunction with the Single Supervisor Mechanism (SSM) of the ECB conducted stress tests and found that almost 17% of loans at Italy's biggest banks were non-performing through the end of 2015. The average of non-Italian banks across the EU was just under 5%. Italy was able to arrange a private sector recapitalization of Monte dei Paschi di Siena (OTCPK:BMDPY) the country's third largest lender and the world's oldest functioning bank, which has managed to fail EU stress tests for the past two consecutive years. The private sector recapitalization of MDP very publicly skirted current EU rules around bailing-in the bank's bondholders, over a third of whom happened to be small retail investors who were aggressively sold the bank's debt under the guise of safe, long-term interest bearing investment plays. MDP was the only bank tested whose capital ratio turned negative at -2.4% in the EBA/ECB's worst case scenario test. Underlying Italy's banking woes has been Italy's inability to compete with more industrially efficient north European countries while at the same time being trapped in a currency bloc that did not allow for devaluation on the national level. Thousands of small and medium-sized companies which make up the backbone of the Italian economy have long been hopelessly behind on loan payments or long bankrupt or both, undermining the solvency of both the country's banking and political systems. A constitutional vote scheduled for October dealing with the replacement of the country's dysfunctional legislature with a unicameral parliament which in theory goes a long way toward providing stable parliamentary majorities, could easily go the wrong way in a populist-tinged electoral environment. Rather than a vote to precipitate structural change of the Italian electoral process, the vote could morph into a personal moratorium on Prime Minister Matteo Renzi and his government. Political chaos could ensue and Italy's already teetering banking system could experience Greek-style capital flight. Estimates of upwards to €18 billion in capital will likely be needed to fully recapitalize the Italian banking system. In spite of such economic and political woes, the yield on Italy's 10-year sovereign note is an eye-popping 427 b/p lower than that of comparable US paper.

In Spain, the after-Brexit spread between borrowing costs with Germany came to 1,694 b/p. The spread at yesterday's market close between the two countries' 10-year benchmark had fallen to 1,058 b/p or 636 b/p in the post-Brexit period. It was only in the summer of 2012 that scores of regional savings banks, heavily invested in a property and construction bubble that spectacularly and quickly burst, slid precipitously toward insolvency that abruptly forced Madrid into a €100 billion international bailout of then one of the world's most bloated and inefficient banking systems. Since that time much has changed in the Spanish banking system which has shed more than half of its bank branches and after years in which credit to households and businesses was scant at best, Spain's banking system has emerged as an unexpected tailwind for economic growth rather than the more familiar headwind of recent past. Spanish banks suffer from the negative interest rate environment now in place at the EU level and continue to struggle mightily to cover their capital costs. Of course, the struggle to cover capital costs is a European-wide problem and not unique to Spain as capital continues to flee Europe pursued by negative yields-to more hospitable climes such as the US. Still, this is a country that has wallowed in a political vacuum for seven months without a permanent government after two inclusive elections-with another electoral cycle likely imminent. Spain also blew through its 3% current budget deficit agreement with the European Commission posting a deficit of 5.1% through the end of 2015. This budgetary faux pas could have cost Madrid 0.2% of GDP in fines. Instead, the country was given a 2-year reprieve. And then there is the issue of variable mortgage rates and the setting of mortgage floors by Spanish banks to protect lending margins. The overwhelming majority of Spanish homeowners have variable mortgage contracts, tied to the 12-month Euribor benchmark. The 12-month Euribor rate is a negative 0.048% as of yesterday's (10 August) market close. Last month an advisor opinion of the European Court of Justice (ECJ) sided with Spanish banks saying banks should not be required to fully reimburse borrowers who signed variable mortgage contracts that limited how far their interest payments could fall in relation to the benchmark Euribor rate. In better financial times, Spanish banks first put such floors into place over 10 years ago at levels of 2.5% to 3.5%. Some banks that have done away with such floors, many in response to local anger, maintain floors that hover around 0.8%. The preliminary advisor decision of the ECJ caused bank stock to soar as millions of euros hang on the final decision which is expected by the end of the year. Meanwhile, Spain's borrowing costs at the 10-year level are 556 b/p lower than comparable US paper.

The BOE took an unexpectedly aggressive stance against the possibility of economic uncertainty and likely downturn as investors continue to assess the impact of the Brexit vote. In a unanimous vote (4 August) the Monetary Policy Committee (MPC) voted to cut the Bank's primary lending rate to 0.25%-the lowest such rate in the Bank's 322-year history. The unanimity splintered 6-3 on further stimulus programs: £170 billion in asset buying with a target of £435 billion; £60 billion in corporate bond purchases and a £100 billion lending program for banks.

The BOE's corporate buying program surprised markets. The ECB moved into the corporate space when sovereign debt configurations started to become scarce, particularly in Germany where capital contributions to EU budgets are the highest and current government policy initiatives to balance the budget has severely limited government debt auctions. The BOE move into corporate bond issues comes right out of the starting block. The average yield on US investment grade corporate paper through the end of 2015 was 3.67%, according to Barclay's data. On the eve of the BOE announcement that average yield had fallen to 2.85%. While the BOE intends to buy sterling-denominated corporate debt, subsidiaries of US-based companies come into play creating the age-old dilemma of private versus public policy motives. US companies lead the world in issuing debt to finance share buy-back and enhanced dividend payout programs-initiatives that fly in the face of BOE intentions of spurring growth in the greater economy.

Of course, what is on display in the much distorted bond markets of today is not the historical importance of underlying fundamentals such as inflation and economic growth of places like Spain and Italy. Such research has been shoved unceremoniously aside by the rip-roaring appetite of fixed income investors and the voracious demand from central banks throughout the developed world for long-date bonds-almost at any price. The dynamic goes a long way toward explaining why investors would buy debt issues, now estimated at $12.6 trillion carrying negative yields worldwide-that are guaranteed to lose money if held to maturity. The dynamic also goes a long way toward offering an explanation as to why long-term debt yields in Spain and Italy, among other countries, are at all-time lows.

The combined large-scale asset purchasing plans of the BOE and the ECB create unprecedented opportunities in sovereign debt and currencies across the European economic landscape as investors react more to uncertainty than to central banks' inability to foster either inflation or economic growth.

• The pound, at $1.3676 on the 24th of June has fallen 5.39% to a mid-day $1.2939 (12 August) against the US dollar. The pound has fallen 2.90% since the 3rd of August, which was the eve of the BOE announcement of its stimulus package. Shorting Currency Shares Pound Sterling Trust (FXB) is a play on the falling market value of the pound which will continue to decline for the duration of the BOE asset purchasing program.
• Shorting the 30-year gilt is likely the play of the year. Already returning 53% of capital gains for the year, the percentage gain will likely grow as availability in the secondary market is outstripped by BOE demand, almost irrespective of price. These price-side gains are clearly unsustainable.
• The path of the yen is much more difficult to predict in the absence of a move by the Federal Reserve on the federal funds rate. The yen's market close on the eve of the Brexit vote was $106.15 to the dollar. A day after the vote the yen had strengthened to $102.20 to the dollar, a 3.72% move in an eight hour period. The yen's move on the BOE announcement was slight, closing at $102.24 on the 3rd of August, strengthening to $101.22 on the 4th of August. At mid-day (12 August) the yen stands at $101.02 to the dollar. The probability of a rate increase in December continues to grow, currently at 22%. The yen stood largely fast due the Abe government's announcement of a ¥28.1 trillion stimulus program that pre-empted the BOE by two days. The package includes a fiscal component that would necessitate the government to finance the ¥1.7 trillion infrastructural component, prompting the biggest uptick in long-term Japanese government yields in three years. Recent survey research is signaling that the impact of negative interest rates is having a perverse impact of causing business and households to save rather than to spend cash.
• The Dollar Index (DXY) continues to benefit from the economic disarray of Britain as well as the euro-zone. On the eve of the Brexit vote the Dollar Index stood at a reading of 93.21, rising to a reading of 95.54 when the results of the Brexit vote were made public. On the eve of the BOE announcement, DXY stood at a reading of 95.55, increasing only slightly to 95.79 at market close on the 4th of August. The dollar has since strengthened slightly to a mid-day reading of 95.60 (12 August), but still down from a high of 99.53 on the 29th of January. Long bets on US Treasuries continue to be in play and can be captured by iPath US Treasury 10-year (DTYL) as the attractiveness of dollar-based assets and Treasuries remains at magnet-strength to international capital flows escaping historically low yields across the developed world.
• The 10-year German Bund slipped negative on the 15th of July and has remained in negative territory ever since. At its current yield of -0.106% mid-day (12 August), the paper is still eligible for the ECB asset purchasing program however German paper on the secondary market remains scarce due to the government's balance budget policies which has limited auctions of new debt. The Deutsche Bank German Bund Futures (BUNL) has soared as a result of the scarcity, with a return of over 83% on the year. The ECB asset purchase program is currently scheduled to run through March of 2017.
• The Swiss franc (FXF), the Swedish Krona (FXS) and the Danish krone are currencies from EU member states outside the euro-bloc. Each of these countries has set overnight deposit rates in negative territory to prevent euro-zone capital flight from overwhelming their respective financial systems. While the ECB continues its asset purchasing program which is scheduled to run through March 2017, each country in its own way acts as a safe-harbor for euro-zone based investors. Each of these currencies are overvalued as a result presenting ample shorting possibilities, particularly as the ECB program comes to an end in the early spring.
• Without a move on the federal funds rate, the euro will likely trade in a narrowly defined range for the foreseeable future. The euro started the year at $1.0861 to the dollar and has strengthened slightly to $1.1168 mid-day (12 August). The euro high for the year was on the 2nd of May when it hit $1.1535 to the dollar and its low was early in the year when it hit $1.0781 on the 6th of January. The euro lost 2.35% to the dollar on the Brexit vote but barely moved on the BOE stimulus announcement on the 4th of August. Shorting the euro (Currency Shares Euro Trust (FXE)) in anticipation of a Federal Reserve move on interest rates is in play, with the likelihood of such a Fed move coming out of its December FOMC meeting looking stronger as the year progresses.
• The CBOE VIX, the so-called "fear index" remains far below its long-term average of just below a reading of 20, down 44.49% for the year. The Index spiked on the 24th of June hitting its second highest peak of the year at 25.76-a spike of 44.33% on the result of the Brexit vote. Since then, the Index has fallen steadily to its current low. A long play on the VIX comes via Velocity Shares (TVIX) or Proshares Ultra (UVXY).

The lag-time on data assessing the impact of the Brexit vote will continue to flow in as the year progresses. Clearly the BOE decided not to wait for more conformation of an economic slowdown that anecdotally is proving overwhelming. From the loss of passports to sell securities into the EU from the London bases of myriad international banks to the loss of EU infrastructural funding through the European Investment Bank, the UK economy is poised to come out all the poorer as a result of its vote to leave the EU. The time-lag on the confirming data is likely already in grasp and the BOE is not taking any chances on getting it wrong.

Disclosure: I am/we are long BUNL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.