Back from the spiritual cleanse and I chatted with Mr. Santelli today about volatility as the prairie fires of global politics causes great angst and HEADWINDS for markets. There was nothing new for readers of Notes From Underground as we have weighed and measured many of the issues plaguing the global markets. In this post, I want to call attention to a couple of pieces that appeared in the press Monday night and Tuesday morning. The front page of Tuesday’s Financial Times had a story, “Deutsche Received Special Treatment In The EU Stress Tests Via ECB Concession.”
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Everything that I blogged about last night appeared on the financial markets’ radar screens today. The non-issue of Deutsche Bank suddenly became an issue as investors became worried about the collateral that they were holding at Deutsche Bank. It was not “locusts” that caused the market to become concerned about Deutsche’s solvency but rather depositors and prime brokerage accounts that feared for their capital. Compounding the DB story was the rise of the price to hedge against a Deutsche Bank default, as well as the infamous COCO bonds that many European banks issued in an effort to enhance their capital ratios in deference to the Basel rules. You could purchase some of the Deutsche COCOs today for an effective yield of 12.7% but if the COCO bondholders are bailed-in, the COCOs will cease paying interest and the DEBT will be automatically converted to equity, thus further diluting existing shareholders.
The reverberations from Merkel’s Boner will be systemic in nature. The more I think about the ridiculousness of Chancellor Merkel’s ill-advised comment about not financially supporting Deutsche Bank, the greater my fear of a cataclysmic credit event. According to a recent Zero hedge piece, DB has many trillions of derivatives on its books. Yes, it is notional value but as we learned with Lehman notional value is irrelevant when counterparties to Deutsche’s SWAPS and other credit derivatives demand their collateral back. In today’s shadow banking environment, the rehypothecation of credit through securitized instruments compounds the problems of a default or bankruptcy.
It seems that 108 years is enough time to pass to relive history. For those who are not sports fans, Merkle’s Boner is a famous mistake made by New York player Fred Merkel, who didn’t touch second base and was called out erasing the “fact” that the New York Giants had beaten the Chicago Cubs. The major GAFFE led to the Cubs beating the Giants and the CUBS moving to the World Series where they defeated the Detroit Tigers for their last World Series championship only 108 years ago.
It is hard to believe that NOTES FROM UNDERGROUND is approaching its 1,000 blog post. Many of the themes touched in my analysis have had an echo effect. Certain themes have continued to provide trading opportunities over and over. 1. The European financial crisis; 2. The Fed’s destruction of the bond market; 3. The ECB‘s destruction of European sovereign debt markets in an effort to preserve the Maastricht strait jacket. 4. Russian geo-political moves on a timely basis to affect Putin’s desire for an increased role for Moscow on the world stage; 5. Japanese desires to fabricate an inflationary backdrop to ease the burden of debt overhang; 6. Too much or too little growth in the emerging market economies; 7. China’s desire too have an enlarged impact on the global financial system in fact and fiction; and oh so many more.
Today, President Mario Draghi guided the ECB Board to a status quo decision on the monetary policy of the EU. In yesterday’s NOTES, I opined that when Merkel and Draghi met in Berlin last Friday it was to receive the blessing from the Empress of Europe for a renewed effort at monetary stimulus. Chancellor Merkel was reticent to fan the flames of the AfD and other parties disillusioned with the present state of Germany’s position in the EU. The repression of German savers in an effort to bail out the European financial system is a below the surface issue for voters who are protesting in the streets against the ill-advised policy of a million refugees. Before Draghi can embark on more QE or some other unconventional monetary tool, GERMANY MUST BE SUPPORTIVE.
In a weekend of very little financial news the biggest story becomes the announcement by Deutsche Bank that its plans to raise 8 BILLION EUROS ($11 BILLION) in new capital to shore up its balance sheet. (Deutsche Bank closed near its 50-week on Friday at $42.17.) I have had many calls and e-mails about the impact from this news. My response to all has been to wait to see how Deutsche Bank trades tomorrow to see if this is a buy the fact opportunity. It is no secret that DB is the most highly leveraged of all the major global banks so a capital infusion is not a surprise event as Europe undergoes ECB-mandated stress tests. The bottom line is that the DB news will have little impact upon the EURO currency or the BUND market. If Deutsche Bank had failed the upcoming stress tests that would’ve been a major news event. Eight billion euros to shore up its balance sheet is a mere ounce of prevention.
The pundits have been pontificating about the low valuations of European financial stocks–based on correlations to other developed-market financials–and proclaiming it’s time to purchase the “undervalued.” Why, this is the greatest no-brainer since sub-prime debt and Orange County Treasurer Robert Citron buying very risky inverse floaters prior to 1994 (sarcasm intended). The only problem with the pundits pushing European bank stocks is the following chart of Deutsche Bank. There is a great disconnect between the huge U.S. banks and Deutsche Bank. Even more significant is that the massive Swiss Banks (UBS and Credit Suisse) are holding their rallies despite settling with financial regulators in many different markets. What is wrong with the crown jewel of Europe and Germany?
It is a similar problem for the large Japanese banks, which have been underperforming the Nikkei rally and the euphoria about the success of ABENOMICS. If Japan is on the road to some inflation and increased economic activity, the banks are supremely undervalued and efficient market theory maintains that it can’t be so. It appears that there is a major disconnect between reality and perception. The Japanese banks OUGHT TO BE outperforming all the global financials because of the aggressive action they have taken to offload their hoard of JGBs. Japanese banks are acting rationally by selling off a potential depreciating asset to the market’s largest buyer: the BOJ. According to a Bloomberg article by Finbarr Flynn and Monami Yui from January 31, Sumitomo Mitsui cut its JGB holdings by 56 percent.
If Abenomics is ultimately successful, why would any investor want to hold bonds that will be a negative yield as inflation levels rise? BUT IF BANKS LIKE SUMITOMO are raising cash by selling JGBs what are they doing with the cash? If the Japanese economy was indeed growing, domestic loans should be rising. Flynn and Yui report that domestic loans increased by only 4.3 percent last year. Also, Tokyo-based Moody’s analyst Graem Knowd notes: “Banks need to rebalance their portfolios away from JGBs. It it turns out that Abenomics hasn’t worked and only ended up leaving Japan with a bigger pile of debt” and a “doomsday scenario for JGBs isn’t a zero probability scenario.” Again, if the banks are invoking the correct policy, why has the market failed to raise their equity valuations. (I am buying some of the banks on a very slow and correction only basis–in my opinion this is a low risk valuation relative to the pricing of other global equities.)
Bringing more focus to the efforts of the Japanese banks to rebalance their assets away from JGBs is the recent discussions taking place in Japan over the issue of the Government Pension Investment Fund (GPIF). The Japanese public pension fund has 1.26 TRILLION DOLLARS in assets and targets a very conservative style of investment. Currently, the GPIF invests 60 percent in JGBs and 12 percent in Japanese equities, according to a March 5 Reuters article. Prime Minister Abe’s government is “… pressing the GPIF to buy more stocks and invest relatively less in bonds to generate higher returns for Japan’s fast-greying population.” The issue of maintaining a decent rate of return on its national pension will be a challenge for the administrators of the fund. If not JGBs, what will be the most efficient mix of assets? Regardless, the Japanese banks are pressing ahead and dumping questionable assets on the major buyer of last resort, the BOJ.
The theme of banks continues through an article from March 7 piece in the International Financing Review by Gore and Whittall, “Eurozone Banks’ Sovereign Exposure Hits New High.” This is a very serious issue for it creates the potential for an adverse feedback loop that can bring the European economy to a depression. “Banks in the region now hold about 1.75 trillion euros in government debt, equivalent to 5.7 percent of their assets, and the highest relative exposure since 2006, according to ECB data. In Italy and Spain, roughly one in every 10 euros in the entire banking system is now on loan to governments.” The Eurozone banks are loading up with sovereign bonds because under the Basel rules sovereign debt is deemed a “riskless” asset and therefore banks need not to hold reserves to protect sovereigns in case of a stress event.
Let’s remember that it was only 18 months ago that the European bond markets were under great strain and President Draghi announced that the ECB would do “whatever it takes” to secure the European sovereign debt market as well as the Euro currency itself. As the article goes on to say, “Banks’ holdings of government bonds have risen by 355 billion euros–or about 25 percent–since the liquidity injections in 2011 and early 2012. Banks in fiscally weak countries have increased their purchases the most, with Italian, Portuguese and Spanish banks increasing their holdings by 62%, 52% and 45%, respectively.” Look at the chart of Deutsche Bank again and one gets the sense of a negative feedback loop in full development, which should raise a yellow caution flag. Now, how about those sanctions on Russia?
It is very easy to fall prey to the German view of the European debt crisis: Blame the profligate PIIGS for living beyond their means and borrowing to support a lifestyle based on leisure. There is of course great truth to this but it was the Northern European banks that lent the money in a ready fashion. The GERMAN and DUTCH current account surpluses had to be lent somewhere and with the Chinese and Japanese monopolizing the profligate lifestyles of the Americans, Germany turned to their European comrades. Belonging to the EURO and, thus, ECB zone of finance, Commerzbank, Deutsche Bank, Rabobank and SocGen all felt comfortable buying the AAA debt of Spain and Italy and of course the three little PIGs.
As the news came out on Friday morning, the headline reported that the unemployment rate dropped to 8.6% from 9%–at first glance, the rate looked like 98.6 on the economic thermometer. The analysts are still arguing over the meaning of this data, but for traders and investors the real outcome is meaningless. It may lead to foreign investors purchasing U.S. equities as America is seen to be a relatively stronger economy, especially when compared with the EUROPEAN CREDIT-STRESSED environment.
Click on the image to watch me and Rick discuss market volatility