Notes From Underground: S&P, The Insider’s Trading Edge

It is startling to think that the S&P downgrades could have any sort of effect on the markets. The sovereign debt markets have been telling those who are attentive that not all countries in the European Union are equal. Several of the GIIPS have had interest rate yields far above those of the German benchmark for almost two years. Even the French 10-year note has widened to 150 BASIS POINTS over the German 10-year BUND during the last six months. DO WE REALLY NEED S&P OR OTHER RATING AGENCIES TO CERTIFY WHAT THE MARKETS HAVE BEEN SAYING?

The media reports the S&P decision as breaking news but the fact is that S&P clients have been given the heads-up long before the SHRILL VOICES OF WHAT PASSES AS JOURNALISM READS IT OFF THE TELEPROMPTER. It was comforting to see the stock indices stage a late rally and show a modicum disregard for what has been obvious to any sophomore finance major.

The most significant outcome will be that QUALITY COLLATERAL will be more valuable as the lower-rated paper will have an increased haircut, causing a greater drain on BANK CAPITAL. For the moment this is seemingly priced into the market. If anything, the eventual outcome will be for the ECB to increase the LTRO as more liquidity is needed to overcome the impact of larger haircuts on sovereign debt. In the quiet holiday markets today the EURO held up fairly well as did the global equity markets.

There was late discussion about the high probability of a GREEK DEFAULT, but with Greek 2-YEAR NOTES yielding more than 140% it seems that this is a foregone conclusion. It is a matter of WHEN. If the Greeks don’t default very soon then it appears that it will wait until after the French election that begin in late April. President Sarkozy, who has suffered a political setback with the French downgrade on Friday, will do all he can to prevent the GREEKS from defaulting, thus causing the French government to nationalize the largest French banks. German and French banks are large holders of Greek debt so any default will be a huge hit to BANK CAPITAL (I suggest reading the paper by Lee Bucheit and G.Mitu Gulati, “How to Restructure Greek Debt”).

Again, Sarkozy will utilize ever tool at his disposal to prevent the French financial sector from taking this hit prior to the elections. The Greeks appear to be aware of Sarkozy’s dilemma and are pressing every advantage they have for a better deal. Rumor has it that a team of Greek officials headed to Washington today for renewed discussions with the IMF. Even though the problem is of course a SOLVENCY ISSUE FOR EUROPEAN SOVEREIGNS AND, BY EXTENSION, BANKS, THE IMMEDIATE EFFECT IS TO FORCE CENTRAL BANKS TO PUMP LIQUIDITY INTO THE GLOBAL SYSTEM TO OFFSET THE EFFECTS OF INCREASED HAIRCUTS.

*** An interesting story that was reported last week in the Financial Times concerned Brazil’s SUGAR GROUP pushing for greater funding to increase sugar production and ramp up ETHANOL PRODUCTION. The U.S. tariffs on Brazilian ethanol imports expired on December 31, same day as the credit for corn-based ethanol production. Experts have argued for years that corn-based ethanol is much less efficient to produce than SUGAR-BASED, but the agricultural/ethanol lobby has been very forceful in providing non-market incentives to produce corn ethanol.

The impact of using corn has led to increase in higher global food prices even though the RENEWABLE FUELS ASSOCIATION has tried to argue that the effect on grain prices has been minimal. The fact is that CORN PRICES have soared as ETHANOL has consumed more of the corn crop than livestock producers. As corn prices have risen, farmers have intelligently substituted corn production from other grain acreage, forcing the cost of all grains higher.

George Bush created this policy of screwing with the FOOD CHAIN and OBAMA has maintained it for three years. However, now the OBAMA ADMINISTRATION is to be APPLAUDED for helping bring an end to this ridiculousness. Playing with FOOD PRODUCTION is always a dangerous road for governments to travel. Let a more efficient producer utilize a much less significant food crop to produce energy.

***Something to consider: Much discussion has taken place about the 500 BILLION EUROS on deposit at the ECB by EUROPEAN BANKS. It seems that the commercial banks in several European countries are having BONDS come due in the next twelve months and are hoarding cash in anticipation of having problems rolling over the BONDS at a reasonable price. The EU BANKS are borrowing from the ECB through the LTRO at 1% and earning 0.25% at the ECB, thus resulting in a negative carry of 75 basis points.

It seems to me that the banks are losing money to insure against redemptions. Insurance is the key and the 75 basis point is actually similar to the fee that U.S. banks pay in FDIC premiums. It must be remembered that Europe does not have an FDIC pool so the action on the part of EU-based banks makes perfect sense. This will be on our radar screens especially as a second round of LTRO takes place in late February.

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6 Responses to “Notes From Underground: S&P, The Insider’s Trading Edge”

  1. arthur Says:

    yra, good points…, what do you think about Yardeni: A double recovery?

  2. Mayank Says:

    Hi Yra,

    Love your blogs. I am new to macro environment and still pretty young to use history as my backdrop. I do want to ask how come we are seeing treasury yield to SPX widening(yield going down while market going up). From what I have learned from academia and recent readings that yield should go up when market rallys but over the last year yield on the 10-year has been going down and still at the lowest level while the SPX is holding on and just touched 1300 mark. If I am not wrong last time we saw that was in 1996 before the russian ruble crises, LTCM blow-up and then dot-com bubble. Are the bond vigilantes not buying the stimulas in Europe and up beat recovery in the US or are they behind the curve.

  3. yra Says:

    Mayank—the relationship is broken because of the role of the FED and other central banks in the QE programs.Also,the need for good collateral is keeping a bid to high quality sovereign debt—does that make sense.last week I blogged about how the treasury market is broken because of the fed and it is driving the bond vigilantes to the sidelines as last year was not a good year for the BOND BEARS

  4. yra Says:

    Arthur:I am in the balance sheet recession camp and am by nature an austrain in that i believe that credit cycles are very powerful forces.The U.S. economy will continue to subject to fits and starts of all kinds—Yardeni is looking for more growth but at this point I am waiting to see what occurs in Europe–money is printed but balance sheets are shrinking

  5. arthur Says:

    very hepful. Your blog is better than HBS!

  6. Mayank Says:

    Thank you Yra, really appreciate the clarification.

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