By Martin T., Macronomics
“A complacent satisfaction with present knowledge is the chief bar to the pursuit of knowledge.” - B. H. Liddell Hart
“In mechanics and physics, Hooke’s law of elasticity is an approximation that states that the extension of a spring is in direct proportion with the Load applied to it. Many materials obey this law as long as the load does not exceed the material’s elastic limit. Materials for which Hooke’s law is a useful approximation are known as linear-elastic or “Hookean” materials. Hooke’s law in simple terms says that strain is directly proportional to stress.” - source Wikipedia.
“The CHART OF THE DAY shows the yield on the two-year gilt falling. It reached a record low 0.115 percent today. Similarly-dated Swiss rates dropped to minus 0.44 percent on July 16, with Germany’s and Denmark’s yields sliding to as low as minus 0.074 percent and minus 0.331 percent, respectively, two days ago. Shorter-maturity rates have turned negative for nations perceived as havens from the almost three-year-old debt crisis, which has sent Italian and Spanish yields to euro-era highs and countries including Greece, Ireland and Portugal seeking bailouts. A negative yield means investors who hold the notes to maturity will receive less than they paid to buy them.” - source Bloomberg.
“We think Spain Sovereign CDS will drift wider, indicating increasing default risk perception given:
-Italy’s shrinking budget deficit to -3.9% in 2011 from -4.6% in 2010,
-Spanish unemployment level expected to reach 24.3% in 2012,
-Spanish Prime Minister Mariano Rajoy has decided to side step the 4.4% deficit target for 2012, for 5.8%.”
“The sovereign debt constraint in Italy is that of a stock – a high accumulated indebtedness – rather than a flow due to operational deficits. Accordingly, the arithmetic of sovereign sustainability in Italy is much more sensitive to the ratio of the cost of debt to trend nominal GDP growth than in Spain.”
“Spain’s ten-year yield closed above 7% for only the fourth time in the euro era, as auction costs for two- and five-year issues spiked and bid-to-cover levels fell significantly, further pressuring the ECB for action. The associated impact on its banks and their funding costs drove the Bloomberg Industries Spanish Banks Index (BIERBESC) to fresh lows.” - source Bloomberg.
“In May 2010 the ECB securities market program began, peaking at 219.5 billion euros in March 2012 and recently holding at 211 billion for several months. Two three-year liquidity injections and a June euro area summit release have failed to stabilize yields, which in turn continue to buffet bank stocks and liquidity supply, suggesting new actions are required.” - source Bloomberg.
No wonder our “Flight to quality” picture is displaying “Risk-Off” with Germany’s 10 year Government bond yields falling again towards record low levels at 1.16% and the 5 year CDS spread for Germany well below 100 bps in the process back to March 2012 levels - graph below, source Bloomberg:
As our good credit friend discussed on Friday, in terms of the news flow, nothing has materially changed:
“Latest BIS data confirm that after further writedowns and asset sales, the total exposure of European banks to Greek sovereign bonds and public sector debt fell more than 70% quarter-on-quarter to end-March, and now stands at $6.4 billion. Should Greece exit the euro, resolution of private sector debt and guarantees remain the largest outstanding issue. (Corrects currency.)” - source Bloomberg.
“We’re looking at a situation when people are realizing we’re at a point of debt restructuring and repudiation,” Marc Ostwald, a fixed-income strategist at Monument Securities Ltd. in London, said in an interview today. “It’s cold-hearted reality. The great blag and bluff of the euro zone has always managed to kick the can down the road, but it is no longer a viable strategy. We’re getting to a crunch point.”
“The top panel of the CHART OF THE DAY shows implied volatility on one-year options for the euro versus the U.S. dollar has plunged since last year, when yields on Spanish and Italian debt had surged, sparking speculation the debt crisis was spreading. The middle panel is a gauge of option demand for hedges against extreme moves in the common currency over the next year. The final graph shows demand for puts, which grant the right to sell the euro, relative to calls is the weakest since April. A call allows for purchases of the euro. Game-theory and cost-benefit analysis show Germany is unlikely to agree to issue euro-region bonds, viewed by strategists as important to stemming the crisis, and Italy and Ireland have the most incentive to voluntarily exit the currency bloc, Bank of America said. The so-called Nash equilibrium in a game in which Greece has the choice of adopting austerity or not, and Germany can choose between issuing Eurobonds or not, is no austerity and no euro bonds, the bank’s analysis shows. Game theory is a study of strategic decision-making. A Nash equilibrium, named after John Nash, a Nobel laureate in economic sciences, is a scenario in which no player in a strategic game has an incentive to unilaterally change an action. Bank of America forecasts the euro, at $1.2199 yesterday in New York, will trade at $1.2 at the end of September.” - source Bloomberg.
One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest report is sending us again a clear warning signal indicative of a growing deterioration:
Delays in Terms of Payment as indicated in their May survey published in June have been reported rising by corporate treasurers. Overall +36% of corporate treasurers reported an increase compared to June (+27.8). The record in 2008 was 40%…
According to their latest survey realised early July 2012, the opinion of French treasurers for large corporates cratered in the last two months from -0.7% in May to -19% in July, the most significant drop in two months since this survey exist (first one was December 2005).
According to an article from John Glover from Bloomberg from the 20th of July - Europe’s $180 Billion of Maturities Lifts Swaps: Credit Markets:
The deterioration in speculative-grade European company credit is being worsened by the outlook for economic growth, hence the risk of seeing a spike of defaults, in this low yield, deflationary environment. Lack of growth means lack of unemployment prospects and reduced tax revenues with increasing pressure in cash flows as indicated by the pressure in the terms of payments from the AFTE monthly survey. It is still a game of survival of the fittest. It’s also causing some companies to pay more to raise money or to be taken over when they cannot pay their debt as indicated in the Bloomberg article quoted above:
Consolidation, defaults and restructuring are going to happen no matter what, for struggling corporates, struggling Spanish regions and provinces, as well as struggling countries. We touched on the subject for the European car industry with Peugeot in our last conversation. In similar fashion to our conversations involving shipping (Shipping is a leading deflationary indicator) and air traffic (Air Traffic is a leading deflationary indicator), the auto industry is as well facing a game of survival of the fittest in this current deflationary environment we argued.
The Bloomberg article concluded with the following quote from Andrew Sheet, European Credit Strategist at Morgan Stanley in London:
“If companies “don’t have cash on the balance sheet” they’re “not in a good place”. If a company
generates free cash then it’s in control of its own future.”
So, in relation to our title, in true Hooke’s law fashion, given the “Yield Famine” we are witnessing, we believe our credit “spring-loaded bar mousetrap” has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894).
“If you build a better mousetrap, you will catch better mice.”
George Gobel – American comedian.