The T Report: Overdone?

Posted by on Oct 18, 2012 in Uncategorized | No Comments

CDS Lagging for First Time in Awhile

Yesterday in particular was a huge outperformance for CDS. Spanish bonds were more than 30 bps tighter across the board. That lead to a major squeeze in all the CDS indices.

Yet this morning, SNR FINS in Europe is 5 wider, MAIN is 3 wider, and even IG19 is back to 91 from a low of 89.25 yesterday. IG19 is back to about 4 bps rich to fair value, another sign that yesterday’s capitulation lower was driven by pain and fast money rather than specific credit selection.

On the bond side, Spain has been able to eke out small gains so far, but Italian bonds are definitely weak, particularly the front end.

What will the “bailout” rate be?

It seems a certainty that Spain will ask for and receive a bailout package. The “conditionality” will be a key issue. How onerous will the terms meet and what will the ongoing tests be? If the tests are strict and quarterly, Spain may not receive much money at all. I think the terms will be far less draconian than for Greece but tough enough that the market will be uncertain about the longevity of the program.

Asides from the conditionality, what will the rate be? Amazingly, there seems to be very little conjecture on that. Knowing that Spain will get a credit line and that the ECB will initiate OMT is great, but at some point the rate matters. It certainly matters for Spanish bonds.

If they follow the IMF’s own rules, then the all-in rate should be around 2.5% to 3.00% for 2 years. The loan would be for 5 years and charge the SDR borrowing cost plus 2% for the first 2 years, switching to SDR rate + 3% after year 2. There is a 0.25% facility fee, and some 0.5% flat fee (hard to tell if that is annual). So that is how I am coming to that pricing.

The OMT is designed to ensure that the ECB’s rate policy “transmits” to countries. What does the ECB consider a “fair” transmission rate that needs to be supported? In theory it could be as low as the overnight rate they set, but even the ECB will want some form of “curve”. So they wouldn’t support 2 year Spanish debt at the overnight rate. Then the ECB does seem to want to “punish” countries for a lack of a better word, or at least not appear overly aggressive. I find it hard to imagine the ECB buying up 2 year Spanish notes at 2%. In fact, I find it hard to imagine the ECB buying Spanish bonds at yields lower than the line of credit. I cannot see the ECB letting Spanish 2 year bonds get to 4%. Even 3.5% seems high given what the ECB is trying to achieve. 3% seems like a reasonable intervention target. It would be a low rate by historical standards, but high enough that the ECB wouldn’t have to buy all €150 billion of Spanish bonds maturing by the end of 2014 (this ignores t-bills which have been successfully rolled even for Greece).

So with the Spanish 2 year at 2.7%, the market may even be ahead of itself. I think that even if a full program is announced, the support is likely to be at a yield of 2.5% to 3% so much of the value is priced into the bond market. The equity market may well be in la la land given the chances of the bailout doing anything for the economy. The continued slow progress in bank recap is a big concern for the economy.

Finally, as a rule of thumb, assume that the ECB will become senior if the plan doesn’t work. They can say what they want, but if trouble hits, the ECB will likely pull another Greece situation and suddenly own new CUSIPS with favorable treatment. I think that will keep the curve steep as investors will be reluctant to buy bonds the ECB isn’t (longer than 3 years) on the chance that the whole plan goes pear shaped.

Unemployment Claims and Housing

Today we will either get confirmation that last week’s claims numbers were affected by some data issues, or that there has been a huge drop-off in firings. I can’t wait to read Jack Welch’s tweet on the subject in either case. I think we a spike back to the trend level of 360k to 370k for the current week with upward revisions to last week’s. If last week’s does get revised up to above 360k, expect some market weakness, and a lot of headscratching.

The housing starts and permits numbers always strike me as confusing. An industry that notoriously overbuilds and overestimates demand just started a lot of new homes. It seems like it was only last month people were still complaining about the overhang of unsold homes. It was encouraging o see such a spike, as clearly it indicates some confidence at the homebuilder level and should result in jobs and if bank stocks were weak or the S&P was below 1,400 it would be reason to be encouraged. Up here, I think you can afford to take a wait and see attitude.

IBM and Intel Don’t Know What They Are Talking About

I remain convinced that CEO’s have no more insight into the macro environment 6 months out than any of us. In some cases, maybe even less. They put out their earnings guidance based on extrapolation of trends more than anything. They know the next quarter pretty well. Two quarters out they can already see the signs, but beyond that, their guess is as good as ours. Do they know if China will have a hard or soft landing for example? No. So I take their guidance with a grain of salt, but I think the market may have been overly complacent about the message IBM and Intel gave.

Breaking Up is Hard to Do

The enthusiasm with which the market has reacted to Pandit resigning from Citi is a bit curious. Suddenly it is apparently easy to split up Citi and unlock the value. I think it is easier speculated than done.