Mind Boggling Performance in Spanish and Italian Bonds
Spanish 2 year yields are at 3.39%, or 50 bps better on the day. There is ZERO liquidity, but even then it is almost unbelievable that on July 24th, these bonds were yielding 6.77%. That is a massive change. It is completely dependent on Draghi supporting them. Without clear indications that Spain will ask for help and the ECB will provide the help, this won’t last. But so far, all indications are that Europe has had a change of heart. Even in Germany, the dissent, while still there, is coming more and more from second and third tier players, rather than key figures.
Even the 5 year point is interesting. Italy and Ireland (yes Ireland is back) have stopped gapping tighter, but are grinding away and now yield 4.87% and 5.50% respectively. Spain remains a star with the yield down to 5.39% which is 36 bps better on the day, and Portugal, of all places, is now yielding “only” 9.4%.
Outright shorts ARE getting killed. Whether you are short bonds or CDS the pain is palpable. The “smart trade” which was allegedly to play the curve from a flattener is also getting crushed as the rally is definitely steepening the curves.
At these yields a lot of any potential upside is gone, especially for the front end. Until plans are known, I would not be adding risk in Spanish and Italian bonds, and would cut some front end exposure. While the long end remains tempting to add, the risk that it is “orphaned” in any ECB short date focused plan is high.
We are hitting some “round” numbers on some U.S. indices in particular. The S&P 500 is pushing up against 1,400. IG18 is pushing down against 100. IG in particular seems to struggle to break through big number like 100, and can lag, but once it goes through, it tends to make a sharp move lower. I’m not sure why the “round” number phenomenon is so pronounced in IG, except that unlike S&P, which is an index made of individual stocks, CDS is individual CDS made up of an index. The basis is down to a tolerable 3 bps, so the index isn’t as extended as in the past. IG18 may struggle with 100, and S&P may struggle with 1,400, but look for a quick gap if they are broken.
Away from “round number” resistance, many risk assets are near their highs of their recent ranges. U.S. stocks, most notably seem to be bumping up to levels that are hard to break through. So are many European stock and CDS indices. It will take some strength to plug through those levels and while my gut is to fade this rally in expectations that they fail, I think we will actually see many assets push through their resistance and gap higher. I continue to like European Stocks, particularly Spanish and Italian as they have the most ability to gap a lot higher if they beat the resistance. They are the beneficiaries of the change of attitude in Europe (assuming there is one). Banks should also be able to do well, though the LIBOR overhang remains an issue.
Debt on Debt and Green Shoots
I’ve already read a lot of comments about how “piling on debt” won’t help. That is true but it is also a little inaccurate. If Spain has debt that is maturing, rolling that debt into new debt is not “adding to the debt pile”. Rolling debt occurs, and what the ECB would hopefully do is not only reduce the risk of a failed auction, but dramatically drive the cost lower. That is good. The longer and cheaper the financing provided by the ECB (or EU) the better for Spain.
As Spain and others have to issue debt to cover shortfalls, that is new debt. That is bad and is adding debt on top of debt, but even here, getting access to cheap funds is better than not having that access. Also, the amount of new debt is relatively small to the portion of debt rolling over, so be careful about getting to negative about piling debt on.
Replacing high cost debt with cheaper debt and reducing risk of a failed auction to zero would be positive and most of the debt was getting rolled anyways so it isn’t “piling on new debt”.
Not quite as frequently cited is the argument about what happens when the ECB or EFSF or whoever is providing loans runs out of money. A valid question, but without much effort and even without the ESM, this can go on for months. With a bit of effort and the ESM, you can push this at least a year or more. So the real bet, is if Europe can buy 6 months, can the economies show enough signs of stopping the decline, that investors get excited about the prospect of future growth?
Post Lehman Credit Investing
One little stat I found interesting is buried in IG11. This was the IG CDS index that would have rolled on September 20th 2008. It was delayed until October 2nd. This 125 name, investment grade index, created at the time of Lehman has had 1 default and that was CIT. Maybe I’m overly mesmerized by this statistic, but selling protection on Investment Grade credit at the height of the crisis has been a home run trade. Only 1 default. The spread at launch was 266 bps. The coupon was 150 bps. The current spread is 55 bps and the duration is minimal.
Even IG9, the index of JPM Whale fame, has only had 4 Credit Events so far.
I’m not sure it says much, other than, in my opinion, that people tend to underestimate how easy it is to avoid default, especially when you have aggressive central bankers.
Vacation and Client Visits
Over the next couple of weeks I will be travelling and seeing clients so the T Report may not come out at the usual time and may be missed a couple of days. You know how to reach me, and if anything changes in my view I will update.
For now I remain long, but a bit cautious as we have had such a big run. I think U.S. CDS has incredible room to tighten and offers even better value than bonds. I like Spain and Italy, both stocks and bonds, but am small as these remain high beta. Banks should do well. The LIBOR hangover is still there, but with Europe possibly getting fixed and CDS doing better and housing showing signs of improvement, the banking sector should outperform, and the reality that LIBOR lawsuits will be complex and take a long time also helps on banks. I will be out of any S&P by 1,410 and likely to be short by 1,425, if not sooner.