Is the Correction Over?

Below is our customary update of credit market charts: CDS on various sovereign debtors and banks, bond yields, euro basis swaps and a few other charts. Charts and price scales are color coded (readers should keep the different price scales in mind when assessing 4-in-1 charts). Where necessary we have provided a legend for the color coding below the charts. Prices are as of Monday's close.

The 'Draghi effect' has worn off a little bit, as many CDS and bond yields in the euro area and the markets most closely correlated with it (CEE and Mid East) have begun to bounce slightly after the ECB-induced across-the-board retreat. The month of September is coming closer and with it, uncertainty will no doubt increase. Spain is not likely to go forward with a bailout application before the German constitutional court has delivered its verdict on the ESM ratification (currently scheduled for September 12). The outcome of the court's deliberations is most likely going to be some sort of compromise – we doubt it will torpedo the ESM –  but it seems likely that the ESM's funding and use will be bound to conditions so as to avoid any collision with Germany's constitution and the European treaties. The fact that the court takes so much time to debate the issue is of course a direct result of the deteriorating social mood in the euro area, and the verdict is likely to reflect it as well.


Capital Flight from Europe Widens, no 'Obvious End to Crisis' in Sight

PIMCO's Thomas Kressin has spotted a 'new dimension' to the euro area's debt  crisis, namely that capital is now flowing out from the euro area as a whole (as  opposed to merely moving from the periphery to the core). This comes not entirely unexpected, as companies and investors all over the world are making prepararation for a break-up of the 'irreversible' euro.

As we have pointed out previously, these preparations actually make an eventual break-up more likely, as e.g. banks are 'renationalizing' their lending and asset bases. The cross-border interbank lending market has simply died in many cases, and has been replaced by funding from the ECB, which ranges from LTRO's to ELA. If this trend continues – and there is so far nothing that indicates it won't – it will make it easier for nations under strain to break away from the currency union and return to a nationally controlled currency.

BoE chairman Mervyn King has chimed in with another gloomy assessment as well, noting that there is 'no obvious end to the crisis in sight'. We don't agree with him very often, but in this case we do.

Readers should keep in mind that with the economic downturn spreading inward to the euro-area's core, the political difficulties of the implementing the bailout policy continue to mount.

There is already considerable push-back to the recent announcements of ECB chief Draghi in evidence, with the latest addition provided by the Belgian Central Bank governor Luc Coene, who is dismissing sovereign bond buying by the ECB as 'making no sense', as it would 'only serve to weaken the ECB and do nothing to solve the underlying issues of competitiveness'. Once again we  agree. Coene even thinks that the exercise could end up with the ECB holding the bulk of the sovereign debt of Italy and Spain. In a similar vein, Finland's prime minister Jyrki Katainen has reiterated his country's rejection of bond buying by the ECB or providing the ESM with a banking license. As Katainen correctly remarks, 'there are no simple tricks to resolve the crisis'.

Financial market participants are of course for the most part in the 'there actually is a simple trick' camp – with the trick consisting of money printing on a grand scale. They have been trained like Pavlov's dogs by the seeming success of this method elsewhere, primarily in the US and the UK, where government bond markets have actually prospered in spite of soaring public debt and truly monumental money printing exercises. This view has the distinct disadvantage of being very short-sighted and simplistic, but it is fairly typical for the financial markets to embrace such a view.

As long as nothing bad happens on account of a specific policy,  it is simply assumed that nothing bad ever will happen. It is a bit like selling CDS on Greece's sovereign debt in 2007 at 40 basis points, arguing that 'yes, Greece has an allegedly unsustainable and way too large public debt, but the markets are obviously not worried about it' – as though that actually proved something.

This line of thought should actually be christened the 'Krugman argument', as Paul Krugman argues at every opportunity that the US government should liberally add to its $15 trillion debt pile simply because yields on treasury debt are currently so low.

Admittedly we don't see a trigger for US bond yields to rise much either at the moment,  but we do know that it is not going to be possible to accelerate the current rate of debt growth even further without suffering consequences eventually. The markets are always calm about these things until they no longer are – and then the situation tends to become pear-shaped very quickly. This is then what is referred to as a 'non-linear event', which usually comes with all sorts of superlatives attached to it. It is after all in the nature of the current monetary and financial system to create cycles and price moves of extremely large amplitude. The widespread belief, so often expressed by Krugman and others, that control over a printing press means the government can spend as much as it likes without ever having to say sorry is touchingly naïve and extremely dangerous at the same time.

How did Spanish economist Pedro Schwartz put it? 'Often Nobel Prize Winners are tempted to pontificate on matters that are outside of the specialty in which they have excelled.'



Krugman on the receiving end of a few well-deserved barbs courtesy of Spanish economist Pedro Schwartz.



5 year CDS on Portugal, Italy, Greece and Spain – click chart for better resolution.



5 year CDS on France, Belgium, Ireland and Japan – click chart for better resolution.



5 year CDS on Bulgaria, Croatia, Hungary and Austria – click chart for better resolution.



5 year CDS on Romania, Poland, the Ukraine and Estonia – click chart for better resolution.



5 year CDS on Germany (white line) , the US (orange line) and the Markit SovX Index of CDS on 19 Western European sovereigns (yellow line) – click chart for better resolution.



5 year CDS on Morocco, Turkey, Saudi Arabia and Bahrain – click chart for better resolution.



Three month, one year, three year and five year euro basis swaps – click chart for better resolution.



Our proprietary unweighted index of 5 year CDS on the senior debt of eight major European banks (BBVA, Banca Monte dei Paschi di Siena, Societe Generale, BNP Paribas, Deutsche Bank, UBS, Intesa Sanpaolo and Unicredito – white line), compared to 5 year CDS on the senior debt of Goldman Sachs (orange), Morgan Stanley  (red), Citigroup (green) and Credit Suisse (yellow) – click chart for better resolution.



10 year government bond yields of Italy (generic bid price, generic gross yield is at 5.94%), Greece, Portugal and Spain – click chart for better resolution.



Austria's 10 year yield (green), UK gilts yield (yellow), Ireland's 9 year yield (white) and the price of the Greek 2 year note (orange, yield prior to PSI break). Not much movement yet in 'safe haven' bond yields – click chart for better resolution.



10 year government bond yield of Spain, weekly candlestick chart. The trend remains up – click chart for better resolution.



5 year CDS on Australia's 'Big Four' banks – declining in line with the recent 'risk on' backdrop, but it is notable that the 2009-2010 lows remain elusive – click chart for better resolution.




Spain's 2 year government bond yield over the past several trading days (hourly candles) – backing up by 64 basis points in five days, to 4.14% – click chart for better resolution.



Inflation expectations in the US (orange line), euro area (white line) and the gold price (yellow line) – click chart for better resolution.



A Bloomberg Briefs chart of price changes in non-ferrous metal prices in China over the past year. This nicely illustrates the effect the weakening growth rate of China's economy has on raw materials prices – click chart for better resolution.



Charts by: Bloomberg, BigCharts



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4 Responses to “European Credit Markets – No ‘Obvious End to Crisis’”

  • JasonEmery:

    “as Paul Krugman argues at every opportunity that the US government should liberally add to its $15 trillion debt pile simply because yields on treasury debt are currently so low.”

    I don’t view Krugman as being significantly different from Romney, Obama, Ryan, Bernanke, Tea Party types, etc. What they all have in common is a lack of knowledge (or disdain for) the Ludwig Von Mises principal of bubble deflation. The only conceivable soft landing is to invent a time machine and go back in time and prevent the bubble from forming.

    What we need to do is prepare for a very significant contraction in inflation adjusted GDP. I would suggest a 2nd constitutional convention where we invite all of creditors, including current and future social security and medicare beneficiaries, to renegotiate our debt and unfunded liabilities in a manner that causes the least amount of disruption.

    Since our debt plus unfunded liability pile is increasing by $6 trillion per YEAR, or 40% of GDP, using GAAP accounting, I don’t see how anyone can say that hyper inflation is not already here, right now.

  • kycattle:

    Thank pater for the priceless link to that debate. The krugman response is both hilarious and frightening. He clearly cannot learn anything that he doesn’t have to and as long as he’s paid to have those opinions he’s unlikely to change them. He’ll be paid to have them until the whole world is in tatters again and likely by that time his Keynsian long run will have arrived. If one is religious it is easy to believe that there is a special seat in hell being warmed for him and his patrons as we speak.

    Otherwise it’s simply more evidence that real yields will remain firmly negative for as long as the fonancial system can handle it. Once that period ends the strife over what remsins of the worlds

    • kycattle:

      Sorry – smartphone trouble

      … Once that period ends the strife over whats left of the worlds remaining resources will be all that is left. It is too bad that all the evidence points to a complete repeat of thr great depression including war on the same scale. Those who can’t learn from history are doomed to repeat it they say. Some will do better than orhers but nobody really wins on average when this happens.

      Thanks for your eloquent, insightful and humorous writing.


    Dear PT

    It is wonderful to see Paul Krugman being lambasted. He has been celebrating the losses of individuals such as Kyle Bass for sometime for his bets against ‘safe havens’ such as Japan.

    What is particularly dangerous about Krugman is that his inductive logic bias is based upon short term data. His basic argument is that no major currency has been taken to the cleaners recently – therefore it is risk free to play chicken with the bond market.

    It is particularly infuriating because, he, like Keynes, is held up as a bastion of common sense by politicians who desperately want to believe in the tooth fairy.

    Sadly, by the time they realize that he is wrong it will be far, far too late.


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