'It Is Impossible To Hedge That Risk': One Bank's Public Service Announcement

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Includes: ADRU, DBEU, DBEZ, DEZU, EEA, EPV, EURL, EZU, FEEU, FEP, FEU, FEUZ, FEZ, FIEE, FIEU, GSEU, HEDJ, HEZU, HFEZ, HFXE, HGEU, IEUR, IEV, PTEU, RFEU, SBEU, UPV, VGK
by: The Heisenberg

Summary

I'm going to tell you some things I bet you weren't aware of.

Do you know what "impossible" is?

"Impossible" is when you need to liquidate €410 billion in corporate bonds at once.

Not even central banks can backstop what may be coming in April.

Show of hands: Who's tired of hearing the phrase "mispriced political risk?"

See there? I just anticipated someone's derisive comment. Apologies to whomever got their criticism frontrun.

To be honest, even I'm tired of hearing myself talk about the market's refusal to price in risk from Europe's upcoming trio of elections.

I mean, yeah, Europe's multiple trials by ballot box fire are the most important scheduled (and I emphasize "scheduled" because invariably, the most important events are the ones that aren't scheduled) geopolitical events of 2017, but after a while you just kind of come to accept the fact that the market is terrible at pricing the tails until a black swan actually lands, at which point it's obviously too late. That's a sad state of affairs, because after all, markets are supposed to be "discounting mechanisms"... but such is life.

All of that said, I'm still intrigued by how Europe is trading around the French elections. That intrigue has morphed into a veritable obsession over the past week. And believe me, I'm not the only one who's obsessed. Have a look at the results of BofAML's most recent global fund manager survey:

(Chart: BofAML)

As I noted on Wednesday morning, the most amusing thing about that chart is that "bond market crash" is a distant third place. That's how worried money managers are about the French elections.

And it's not difficult to understand why. Remember, it's not just French public debt that would be redenominated in the event Marine Le Pen were to win and take the country out of the EMU (and I say that like a default on public debt wouldn't be a big deal - it would, in fact, be the largest sovereign default in the history of the world).

I implore you, please read and internalize the following from a BofAML note out Wednesday (my highlights):

The sheer quantum of French IG debt means that the French elections are of systemic importance for the credit market. There is currently €410bn of French IG debt, more than the amount of IG bank bonds that existed at the start of '07. What has caused France to become such a dominant part of the IG market (23%)? In part, German credits' defensiveness. From 2011 to 2014, German credits deleveraged materially, shrinking the stock of German bonds by a third, and thus magnifying the growth of French credit. But in a world where "the street" is smaller, hedging such vast sums of French risk becomes virtually impossible. Even if the ECB bought only French corporates going forward, we estimate it would take them 25 weeks to help investors shift their bonds.

Think about that for a minute. French investment grade debt accounts for nearly a quarter of BofAML's € IG credit index.

Recall how I'm always talking about banks' unwillingness to inventory bonds in the post-crisis environment, and how I'm always harping on the "cost of balance sheet." That's a huge concern for investment grade corporate credit (and high yield, of course). The bottom line is, it can't be sold in a pinch. How many times have I said that? I understand how hard that is for some folks (especially those who own corporate bond ETFs) to come to terms with, but it's the reality.

In other words, the conundrum of French corporate debt in a redenomination event represents my "crowded theatre" credit analogy taken to its logical extreme. Here's BofAML:

With a much reduced "street", relative to Lehman times, simply selling French bonds of this magnitude feels close to impossible.

It doesn't get much clearer than that.

Well, what about the ECB? Can't they backstop this? After all, they do buy corporate debt now.

The answer to the "Can't they backstop this?" question is: "No." Again, we go to BofAML:

Even if the ECB - the newest buyer of credit risk - was to buy only French credit going forward, we estimate that it would take them at least 25 weeks to help investors shift all of their non-financial bonds.

You might be asking yourself how it came to be that French corporate debt comprises a quarter of the entire € IG credit market. The simple answer is German deleveraging. Have a look:

(Chart: BofAML)

Damned German conservatism. Go figure.

Anyway, what you've hopefully surmised from the above is that if French debt is that large of a percentage of € IG, it stands to reason that if spreads on that debt blow out as the market begins to price in election risk, the impact that spread widening will have at the index level will be magnified by the extent to which French credits have come to dominate index composition.

Putting the pieces together here, remember I said on Wednesday morning that iTraxx Main was trading awfully tight considering the widening spread between French sovereign debt and German sovereign debt? Well, guess what iTraxx Main is. It's an index tied to € IG corporate credit.

So, the situation is as follows:

  • French debt makes up an outsized percentage of the total € IG credit market.
  • Spreads on that market have not priced in French election risk to the extent sovereign yields have.
  • French corporate credit is relatively rich compared to OATs in terms of how election is risk is priced.

What do you think that portends for € IG credit as a whole?

Well, I'll tell you. It suggests that: i) iTraxx Main should be tracking the OAT-bund spread pretty closely, and ii) if it is, you should expect € IG spreads to widen materially as the French election gets closer, assuming Marine Le Pen's chances of winning remain at current levels.

Let's go to BofAML one last time (my highlights):

French elections continue to garner much of the credit market's attention. Although 1st round elections are still 10 weeks away, the credit market has gravitated towards using OATs as a barometer for spreads. Chart 7 shows the 1m rolling correlation between iTraxx Main spreads and 10yr OAT-Bund spreads, using 1min data intervals. Note the correlation has risen consistently since the start of the year and touched a record (92%) shortly after the start of the month.

There is still 10w to go to the first round of the French Presidential elections. While spreads have weakened over the last few weeks on concerns around the outcome, there has also been enough short covering taking place to keep iTraxx Main in a relatively tight range thus far.

As chart 10 shows, French credits have so far seen a widening of only 5% (from 124bp to 130bp) which would put their performance at a bit less than the fallout from the US elections, but much less than what was seen for Italian credits last year.

See how this all fits together?

Specifically, it suggests you should bet on French corporate credit spreads widening, but I'm going to go out on a limb here and assume that's not a viable option for most readers.

Instead, I suggest what you take away from this is that I don't talk about things for no reason. When I talk about something like the risk that corporate bonds can't be sold in a crisis, or when I continually assert that there are very real implications for the entire global financial system attached to the French elections thanks to knock-on credit risk, I'm not "fear-mongering" hoping to make a few bucks on the infinitesimal chance that one of my articles spooks people enough to boost some amateurish Put position I'm not telling you about.

Rather, I'm telling you these things because, honestly (and I'm nothing if not a straight shooter), I know what I'm talking about, which is why you'll notice a correlation between the themes I discuss and the research that's subsequently produced by the people who actually run these markets.

So keep that in mind, and remember, when you hear someone like Credit Agricole's deputy CEO Xavier Musca tell you they "have no contingency plan" for a Marine Le Pen victory, they are either lying or conveying the fact that, as BofAML points out, it's literally impossible to craft a "contingency plan" for an event as disruptive as a French redenomination.

Either way, it doesn't bode well.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.