The T Report: The “Nothing is Fixed” Rally and What to Make of Spain
The “Nothing is Fixed” rally continues to annoy most people. Just like last week, the refrains that nothing is fixed and nothing can be done are ringing out loud and clear, and once again markets have faded from overnight highs.
While the “Nothing is Fixed” rally is only possible because of government intervention and the fact that the “Everything is Broken” sell-off took the markets too low.
Much of the bad news that caused the “Everything is Broken” sell-off that took S&P from 1,402 on May 1st to 1,278 on June 1st have started to be addressed. The economic data globally continues to be weak. That is dangerous. A near term Greek Exit looks less likely, the problems at JPM seems isolated, contained, and largely over.
The “right” price for the market remains elusive and volatility will continue until the markets determine the extent of government and central bank intervention. A few good things have happened, and in general the tone has indicated a willingness to do more. Without more programs and details on existing programs, the markets will fade, but for at least a few days, a steep sell-off is unlikely until the policy makers provide a strong sense of their ability to do anything more.
If EU policy makers have learned the lessons of Sisyphus and the Fed decides to act rather than trying to catch a falling knife then look for another strong end to the week. In the meantime be concerned about the weakness, but don’t overreact as it seems that “fading the rally” and saying “nothing is fixed” has replaced much of the cheerleading the market is usually exposed to.
What to do about Spanish Bond Yields
Bond yields in general and Spanish bond yields in particular are once again a focus for the markets. German bunds and U.S. treasuries are marginally better, while French bonds are marginally weaker. There has been a “flight” to quality from earlier levels overnight, but largely back to almost unchanged.
Spanish bond yields are a complete disaster. The 10 year is at 7.1% which is 25 bps on the day. The curve is flattening as well with 5 year yields up 38 bps. 2 year Spanish bonds are back to 5.25%. These hit a low of 2.14% back on March 1. The day after the LTRO “carry” trade front running was done.
The 10 year is at new highs but the 2 year actually traded above 6% in November. We can talk about the “point of no return” all we want, but with central bank intervention it can be turned around, but they have clearly reached levels that are not sustainable for long as Spain can’t afford the cost of rolling over debt at these levels.
There are no natural buyers of Spanish debt. The sell-off can continue until either Spanish banks raise capital and are happy to use some of that capital to support new bond purchases or the EU steps in and buys. Above 7% we may start seeing some buying from some big total return bond funds as these yields seemed to entice at least one of them (Blackrock) last time they got this high, but the reality is that the slide can continue until something at the policy maker level is done.
Somewhat bizarrely, the consequences of the slide don’t seem that devastating to markets overall. Maybe it is because the banks now hold most of the debt and most of that is held in non mark to market accounts? Banks will have to post some additional collateral on the LTRO loans that they used, both to meet the increased “initial” margin brought on by the downgrades to BBB+ or below by all rating agencies, and “variation” margin against the price declines. Not good as it sucks in more collateral from banks that have funding issues, but with the willingness of the ECB to accept corporate loans as collateral, it isn’t as devastating as some make it out to be.
If Europe “needs” a catalyst to act, surely this is it? Other than t-bills, Spain will have difficulty tapping the markets, and even if they do, the yields quickly become too onerous to pay and will make any deficit management virtually impossible. This doesn’t happen immediately, but any time Spain has to issue debt and lock in these higher yields, the problem feeds on itself.
Eurobonds aren’t happening, but with all the tools at their disposal, the EU could drive these yields a lot tighter if they chose to. Especially since the tradable “free float” of Spanish bonds is relatively small.
At some point either risk assets will get driven down with Spain, or the EU will decide that it is in their best interest to stop it now. The dominos are lined up and letting Spain hit the wall, will trigger Italy, and then eventually Belgium, France, and Germany itself.