In recent days, CDS that have previously been tightly correlated have continued to drift apart. This differentiation is probably a main factor in allowing 'risk asset' players to continue their single-minded focus on 'QE 2', this is to say the second big round of money printing threatened by the Fed.


To this it must be noted that market participants are on the one hand  acting in a perfectly rational manner by preempting the Fed and discounting the arrival of more helicopter money in advance (especially since it has been telegraphed so clearly be now that the Fed has almost no choice but to deliver), but on the other hand they are actually making it more difficult for the Fed to actually go through with a big 'shock and awe' style monetization program.


Hoenig Continues to Resist

How can the Fed possibly do that with commodity and stock prices soaring, the dollar in free-fall and gold making new highs daily? It has now been suggested that in all likelihood the announcement will promise a program that can be 'adapted to the economy's needs'. Its alleged needs, that is.

We hold with the lone FOMC dissenter Thomas Hoenig that more money printing can only be counterproductive. We urge you to consider his arguments carefully, as they amount to a clear indictment of the bubble blowing of the Greenspan era. In his recent speech on the matter (pdf), which we encourage readers to read, Hoenig disagrees with the Keynesian view that 'we are all dead in the long run' from the outset – the title of his speech is 'The Federal Reserve's Mandate: Long Run'.

Furthermore, Hoenig shows that he is well aware of the 'leakage effect' of the Fed's policy – its policy decisions do not only affect the territory of the United States after all – they have an effect on the whole world. In this recognition of the Fed's wider responsibilities Hoenig is quite alone; he also stands alone with his demand to raise the administered interest rate instead of continuing to pretend that the cost of capital should be zero. He explicitly and critically mentions the malinvestments and distortions created by the loose monetary policy implemented during the post Nasdaq bubble recession.

Now, we of course believe there should not be a central monetary planning agency at all.  Hoenig's modest demand to raise the Federal Funds target rate to 1% is no doubt preferable to 'ZIRP', but similar to every other member of the FOMC, he can not possibly know what interest rate is the 'correct' one that properly reflects the social rate of time preference.

Nevertheless we salute his efforts to be a voice of reason and restraint at the Fed,  his courage in condemning the kinds of policies that have brought about the bubble and subsequent bust and his willingness to consider the long run and global effects of the Fed's policy decisions. If we have to have central bankers, they should ideally all be like him. Alas, for now he remains the 'lone ranger'.


News from Ireland

Coming back to the troubled sovereigns in the euro area, Ireland continues to be in the news. First finance minister Brian Lenihan repeated his assurances that 'Ireland can cut its deficits', mentioning in the process that there are no holy cows in its budget that can reasonably expect to remain unmolested.


Lenihan will next month lay out his plan to narrow the deficit to 3 percent of gross domestic product by the end of 2014. The shortfall will be around 32 percent of GDP in 2010, due to a one-time “spike” from bank bailout costs, the government has said.

“We’ve looked at our welfare bill, our pension bill,” Lenihan said in an interview in New York on Bloomberg Television’s “In Business” with Margaret Brennan today. “All these areas have to be looked at.”


Cutting the deficit from a 'one time' 32% of GDP to just 3% in four short years will take some doing. No wonder 'all areas will be looked at'.

The real bomb-shell came today, and finally it appears as though Ireland has realized that the pain needs to be shared. As the FT reports:


Ireland has opened the door to a renegotiation with senior bondholders of its two nationalised banks despite previously opposing any such move for fear of drawing the wrath of creditors around the world.”


Say what?


“Brian Lenihan, Ireland’s finance minister, told the Financial Times while on a roadshow in New York that he still opposed senior debtholders having to accept any losses as part of the €50bn (£43.7bn) bail-out announced two weeks ago . But if Anglo Irish Bank and Irish Nationwide building society wanted to enter into “amicable discussions” with senior debtholders he would back the talks. “


'Amicable discussions'? So he's still opposed, but not really opposed anymore, to bondholders taking a hit. As far as we understand free market capitalism, bond holders are taking a voluntary risk. Why on earth should they be totally immune to haircuts, with tax payers getting the shaft? It was high time that Lenihan, resp. the Irish government realized this. After all, there is a very real danger that the whole country will land in insolvency.

As the FT further reports, the problem is a layered one: the same investors that hold the senior debt of the insolvent Irish banks are thought to also be the major investors in Irish sovereign debt. Thus the government's reluctance to let them bite the bullet.


“Can there be discussions between banks and senior bondholders for mutual advantage? Of course there can be . . . [I would encourage them] if it is for mutual advantage, yes,” he said.

The treatment of senior bondholders is seen as crucial for Ireland, with Mr Lenihan reluctant to impose losses when many of the same investors also hold Irish government debt.

However, the fact that taxpayers are having to foot most of the burden of the bail-out has caused public anger.

Ireland is legislating to impose “burden-sharing” on the junior debtholders – who are further down the capital structure than senior holders and so suffer losses earlier – in both banks, which will mean they have to accept losses on the bonds. But Mr Lenihan, who met dozens of investors after talks with the International Monetary Fund in Washington, was emphatic that the law would not deal with senior bondholders “under any circumstances”.

Typically, a voluntary negotiation with senior debtholders would involve swapping short-dated bonds for longer-dated ones to help ease financial strain. It is done on a voluntary basis to ensure that it does not constitute a default for products such as credit default swaps. Even though the two banks are state-owned, Mr Lenihan insisted any decision was for Anglo Irish and Irish Nationwide themselves. “I am a little concerned by the concept of negotiations. Anglo Irish Bank is being run on commercial lines, not political ones and they have to make commercial decisions.”


From the above it also becomes clear that the CDS market is on the government's mind as well. We wonder who the sellers of this CDS insurance are, and what assurances they were given, and by whom? We have a feeling this issue will be revisited at some point. In any event, we wish the Irish banks luck in the upcoming 'amicable discussions' with their bondholders. The Irish people deserve a break.

On to the charts:


1. CDS


5 year CDS on Ireland's sovereign debt and the senior debt of the two state-owned insolvent Irish banks (Anglo Irish and Bank of Ireland) as well as on Japan's sovereign debt (prices in basis points, color-coded). For readers who wonder why we include Japan, we do that because we think it should be watched – it is pure coincidence that we are putting it on the same chart. Irish CDS still in consolidation mode at elevated levels – click for higher resolution.



5 year CDS on the remaining 'PIGS' (Portugal, Italy, Greece, Spain) – a slight uptick after the recent softening – click for higher resolution.




5 year CDS on Eastern Europeans (Romania, Croatia, Hungary) and Austria. Here you can see how the markets have begun to differentiate – these all continue to trend lower for now. The contagion effect is no longer as obvious as it once was – click for higher resolution.



The Markit SovX Index of CDS on 19 Western European sovereigns – a slight uptick from a support zone after the recent pullback – click for higher resolution.



2. Euro Basis Swaps

– generally still improving


3 month euro basis swap – still in the recent consolidation zone – click for higher resolution.



One year euro basis swaps – also near the upper end of the recent range – click for higher resolution.



The 5 year swaps look best at the moment, reaching their best level since April – click for higher resolution.



Charts by: Bloomberg



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