Graphics: The Risk On Environment

Rampaging bulls set some milestones last night…

The US S&P 500 hits the highest level since 2007

Nasdaq at an 11 year

Volatility Index at 5-year lows

Cost to insure debts has fallen on a global scale

Bespoke Invest writes, (chart theirs too)

The average country on the list has seen default risk drop by 16% this year. As shown, Norway currently has the lowest default risk at 27.74 bps, followed by the US at 33.18 bps. Switzerland, Sweden and the UK round out the top five in terms of the lowest CDS prices. All five of these countries have seen default risk drop by more than 30% so far in 2012.

This is certainly not about a Goldilocks economy (not to hot, not too cold, but moderating growth)…

Chart from Zero Hedge

…but of markets being manipulated by central banks.

This represents the salient opiating impact from the initial round of money printing by global central banks. Put differently, this is the boom phase of a boom bust cycle. These has also been the partial fulfillment of my expectations

Global CDS Update: The Risk ON Environment

One substantial driver of the direction of interest rates would be the financial market’s perception of credit risks as measured on the credit standings of each nation.

The fierce start of the year rally seen in equity markets have likewise mirrored the actions in Credit Default Swap (CDS) markets

Writes Bespoke Invest (charts their too)

every country except one (Portugal) has seen its default risk decline in 2012. European countries have mostly seen the biggest drops in default risk, with Belgium leading the way with a drop of 31.6%. Greece -- while it still has by far the highest default risk -- has seen its default risk fall the third most in 2012 with a decline of 25.5%. (France ranks second at -25.7%.) The US currently has the lowest default risk out of all the countries shown by a wide margin.

Additional observations

The concerted accelerated massive credit easing programs undertaken by central banks of developed economies has so far soothed or bought off unsustainable debt concerns. Much of the deluge of liquidity apparently has diffused into the global equity and commodity markets through intensified yield chasing actions by market participants.

The easing environment has been complimented by central banks of emerging markets whom has been mostly slashing interest rates too.

The global financial markets have been heavily politicized and greatly relies on sustained central bank support. Given the heavy dependence on central bank steroids, we should expect sharp volatilities in both directions for the marketplace.

I wouldn’t read through the current façade as lasting. That’s because central banks would need further rationalization to pursue current policies. And the only pretext to do more of the same is to see markets undergo spasms anew.

I wouldn’t also interpret the low default risk of the US as sustainable. The US Federal Reserve has been expanding their balance sheet and has been running massive fiscal deficits which means current sanguine conditions are artificial and manipulated and most likely related to the coming US presidential elections.

One interesting observation is that ASEAN CDS are on the lower half of the table and has shown resiliency compared to many major emerging markets contemporaries and even to some developed economies (e.g. France).

If you are counting on a potential ‘decoupling’ by ASEAN relative to developed economies, the CDS markets will likely be the first area to emit such signals. So far, the CDS markets has been manifesting the same dynamics driving other financial markets--the rising tide lifts (almost) all boats.

Phisix-ASEAN Bourses Diverge from Global Market Turmoil

Markets have been exposing the farcical nature of politics—the popular belief that the fundamental laws of economics can sustainably be controlled or manipulated by edicts or by fiats or by legal mandates. Thus, I don’t see any validity to the expression which says that “markets are being forced to come to grips with a distressing reality” in describing what’s been happening today. Europe’s debt crisis has been manifesting on the dynamics where markets have been compelling politicians to act. It isn’t the markets that have been detached from reality; instead it has been the vastly skewing influence of politics in the marketplace.

And it would be serious mistake to simply gloss over the motives of politicians and presume that, along with their allies, they would docilely submit to market forces. The political class along with their economic clients have benefited immensely from the incumbent political institutions, organized along the 20^th century vertical top-bottom framework, will likely continue to fight to maintain their entitlements through the preservation of the system.

And such transition would be surrounded by intense volatilities in the marketplace and in the political realm as evidenced today.

It’s not a question of simply reading past performance (current economic figures) and projecting them into the future as the mainstream does. Many who see the world as operating in a prism of the 2008 paradigm or the Japan stagnation or the Great Depression of the 1930s will most likely be mistaken, as consistently proven in the recent past.

Instead, it is the question of how politicians along with their respective bureaucratic leaders will react in the face of the continuing unfolding crisis and the possible ramifications thereof that would matter most in forecasting the path of price trends in financial markets.

Divergences as Emerging Theme

Divergence seems to be an emerging theme.

One would need just to see how equity markets have been reflecting on the emerging signs of divergences, instead of a contemporaneous convergence during periods of market stresses such as in the crisis of 2008.

Below is the weekly performance of the select major equity markets.

While reflecting signs of weakness, Asian equity markets have not been as buffeted in the scale of her Western counterparts.

To consider, globalization has been increasing the correlations of equity markets.

Asian equity markets (ex-Japan) since 1995 has been exhibiting growing interdependence with global markets[1].

Given today’s deepening of globalization trend, Asian equity markets have become more sensitive to developments of the world. And this is why the argument for a decoupling may not be persuasive.

However my thesis has been that—market divergences or relative asset pricing may likely persists for as long as the world doesn’t succumb to a vortex of liquidity contraction or from a global recession which may also manifest the same symptom.

Yet signs of seminal diversity in equity market performance seem even more apparent from a wider timeframe.

The year-to-date performance of select global benchmarks as seen below.

While the European debt crisis has substantially battered the region’s equity markets where the current bear markets—shown by Germany and France could exhibit signs of forthcoming recession, the expected ripple or ‘contagion’ effects from this crisis seems to have been limited, thus far.

Again the ASEAN-4 and the US S&P 500 appear to sizably deviate from the Eurozone. Japan’s gloomy performance may partly be attributed to dour global sentiment but mostly to the first quarter triple whammy natural disaster. Meanwhile, the weak state of China’s equity markets could be a manifestation of either a cyclical slowdown or a bubble bust, which so far has yet to be established.

It is important to note that we cannot discount a shock from happening given the current circumstances. However as I have repeatedly been pointing out, the fundamental difference of the market’s outcome (from that of 2008 or from Japan’s lost decade) will be determined by prospective policy actions.

Monetization and Debt Profiling

Part of the aberration in market pricing can be attributed to the market’s differentiation of credit risks by specific nations.

The fascinating table above from Bespoke Invest[2] signifies an updated tale of the tape of credit risks, where the cost to insure debt of 44 nations via credit default swaps (CDS) has materially surged in the Eurozone led by Greece and Portugal (see bottom portion of the table) whom has surpassed the former laggard socialist Venezuela.

The Eurozone’s crisis has even dragged AAA credit rating France whose costs of insurance have skyrocketed by 142% year-to-date and which has even topped the ASEAN-4. France has now been ‘riskier’ than the Philippines and the ASEAN.

Meanwhile the US continues to exhibit strength or outperformance amidst rising concerns over global credit risks, which has hardly dented on her CDS premiums. This comes in spite of the recent S&P downgrade.

But the above table doesn’t tell the entire story though.

The reason for the current Euro crisis and the relative ‘safe US credit standing’ has largely been due to the debt maturity profile.

Much of the refinancing needs of Italy and the rest of the crisis affected PIIGS have been current or due in near term (top chart[3]).

Meanwhile US debt maturity profile has been farther out of the curve[4].

Nevertheless, sovereign liabilities of the US continue to balloon.

This November, US debts have soared passed 100% of GDP[5] which adds the US in the company[6] of prospective deadbeats.

The major reason why US the hasn’t suffered the same fate as that of the European PIIGS is that the US Federal Reserve has been monetizing her US debts, something which the Keynesians and the Chartalists have been raving about. The implication is that the US, as the world’s premier foreign currency reserve, is virtually immune to laws of economics. For them, money printing allows the US government to spend at will, which hardly will stoke any risks of inflation. Thus, the aversion to discuss any hyperinflation parallels of Weimar Germany or of Zimbabwe.

Yet the seeds towards the destruction of the US dollar have already been sown, the US Federal Reserve has reportedly outpaced China as the largest owner of US debt[7]. This means that the US has principally been relying on money printing by the Fed to finance her present liabilities.

This also shows the absurdity of the idea that the US Federal Reserve won’t commit to additional quantitative easing (QE) measures, as argued by some.

The US is faced with extremely challenging circumstances of pronounced weakness in many parts of the global economy that could intensify the risks of another recession, in an environment where national (US) saving rates has on a deepening slump[8], the worsening insolvency crisis at the Eurozone area that will extrapolate to reduced access to private financing and a possible contagion from a distressed banking sector[9].

True, US bond yields have been drifting in near record lows. However this hasn’t been a sign of systemic deflation (yes oil prices is just under $100, gold at under $1,700), instead low yields have been representative of policies targeted at manipulating the yield curve and of the temporal haven currency reserve status of the US dollar[10].

To add US CPI inflation has been climbing which in October was at the 3.5% rate and has been above the 1914-2010 average at 3.38%[11]. To consider, US CPI construct has vastly been skewed towards housing[12] which doesn’t accurately signal the real rates.

Yet the shortfall of financing US debts will be reinforced by the ongoing ‘slowdown’ in China whom has been resorting to her own whack-a-mole or piecemeal approach in applying bailouts[13]. And this also should apply to other emerging markets as well.

So far, the appetite to finance US debts by foreign central banks has been drying up[14].

Also the current crisis in the Euro area will postulate an environment of an even tighter competition with the US, the EU and other governments, as well as, other private entities wanting to access to savings from private sector.

Of course a no QE scenario for the FED will only happen if Bernanke and the rest of the FOMC will experience the epiphany of letting the markets clear.

But I would say that the odds for such an event to happen will proximate ZERO.

Central Bank Activism

For as long as the rates of inflation remains suppressed, politicians and their bureaucrats will use the current opportunities to test the limits of controlling and manipulating of the markets.

Thus any proclamations to impose self-discipline should be seen with cynicism.

For instance, the once defiant Germans, who have strongly been opposing the European Central Bank’s (ECB) role as ‘lender of last resort’, appear to be gradually acceding to pressures[15] for the ECB to aggressively backstop the Euro in the name of fiscal integration or union.

In reality, today’s signs of divergences seem to be driven by idiosyncratic liquidity conditions of each nation—where asset prices appear to be priced depending on relative systemic exposure on debt combined with the prospective impact of loose monetary conditions to their respective markets and the economy. These, aside from the transmission effects from policies set by the US Federal Reserve.

Thus in considering the above, the low leverage of ASEAN 4 makes them more receptive to the present boom bust policies.

Yet what sets the today’s markets apart from the 2008, Japan’s stagnation and or the Great Depression has been the central bank activism which as I have been reiterating has been navigating on uncharted treacherous waters.

Artificially manipulated interest rate together with money printing results to relative pricing of assets, which all comprises the inflation cycle.

Bottom line: I think the boom phase for the Phisix ASEAN markets, despite the turbulence in the EU, remains intact, barring any unforeseen events.

---

[1] Worldbank.org Navigating Turbulence, Sustaining Growth WORLD BANK EAST ASIA AND PACIFIC ECONOMIC UPDATE 2011, VOLUME 2

[2] Bespokeinvest.com Global Sovereign Credit Default Swap Prices, November 25, 2011

[3] Macleod Alasdair Watch out for maturing debt, November 19, 2011

[4] Merk Axel, Operation Twist a Primer for QE3? , Merk Funds, October 4, 2011

[5] See US Debt Passes $15 Trillion or Over 100% of GDP, November 17, 2011

[6] Galland David Monetary Madness – Is the US Monetary System on the Verge of Collapse? , October 18, 2011, Daily Reckoning

[7] CNSNews.com Fed Now Largest Owner of U.S. Gov’t Debt—Surpassing China, November 16, 2011

[8] Bloomberg.com U.S. Economy Grew Less Than Forecast on Inventories, November 22, 2011 SFGate.com

[9] See The US Banking Sector’s Dependence on Bernanke’s QEs, October 5, 2011

[10] See Market Crash Confirms Some of My Thesis on Gold and Decoupling, October 2, 2011

[11] Tradingeconomics.com United States Inflation Rate

[12] See US CPI Inflation’s Smoke and Mirror Statistics May 18, 2011

[13] See China Expands Bailout Measures, Reduces Reserve Requirements for Select Financial Firms, November 24, 2011

[14] Vuk, Vedran Are Foreign Banks Losing Confidence in US Treasuries? October 17, 2011 Casey Research

[15] See Will the European Central Bank Relent to Political Pressures to Increase Debt Monetization? November 26, 2011

Updated Ranking of Global Credit Default Risks

Consistent with my earlier post, FT’s James Mackintosh: US Credit Risk Greater Than Indonesia, Bespoke Invest has updated tables of the 5-year Credit Default Swaps (CDS) reflecting on default risks of 60 countries.

On a year-to-date basis, Greece has the highest default risk while the US has seen a hefty nearly 20% increase.

Major ASEAN nations have also seen an uptick in default risks with Thailand registering as the worst performer.

Meanwhile major European economies posted most of the improvements over the same period.

But it’s a different view when seen from the ranking in terms of CDS prices.

The biggest improvements seen among European nations have been as consequence to the previous actions, where the nations affected by the PIIGS crisis have led to a contagion as seen with the prior price surges.

And almost along the lines of Newton’s second law of motion, where for every action there is an equal and opposite reaction, the previous steep increases has prompted for equally substantial declines.

What this seems to suggest is that the Greece crisis appears to be isolated for now.

And Europe's performance can be measured relative to the major ASEAN economies. While CDS prices of the ASEAN contemporaries did suffer some deterioration, in the context of prices, ASEAN CDS remains below the levels compared to the prices of nations affected by the PIIGS crisis.

So the above only reveals of the degree of price volatility or the rapid changes in the market’s perception of credit risks.

As Bespoke notes,

The countries that investors believe are least at risk of default are currently Norway, Sweden, Finland, and Denmark. The US used to be the least at risk of default, but CDS prices here have ticked up 20% so far in 2011. US default risk is still low relative to the rest of the world, but any tick higher is something we don't want to see.

Credit rankings can shift swiftly and meaningfully. All these depend on the policies adapted.

So far, the practice to inflate debt has subdued default risk concerns on some the major economies as the US. However, the law of the late economist Herb Stein should apply “If something cannot go on forever, it will stop”.

Is Japan At A Risk of Debt Default?

When tragic events hit, some people have the habit to resort to sensationalist babble.

They read one bad event as a trigger to even more untoward events.

Such thinking represents more of personal bias rather than a reflection of actual events.

For instance, some have argued that Japan faces a risk of a fiscal crisis following today’s catastrophic earthquake-tsunami.

While there may be some grain of truth to this, this view essentially ignores the option of having markets forces help in the recovery process and the role and the actions of Bank of Japan.

So far the markets have priced some concerns over Japan’s liabilities.

According to Bespoke Invest, (graphs and tables from Bespoke too)

At the moment, it costs $95 per year to insure $10,000 worth of Japanese sovereign debt for five years. As shown in the table of CDS prices below, Japan remains at the low end of default risk compared to other countries around the globe. With the resilient country fighting to get back on track, investors don't appear to be worried about Japan having financial problems.

Bottom line: There are concerns over Japan’s debt conditions alright, but this seems far far far away from real risks of default yet.

In other words, despite the uptick in Japan’s default risk, the Philippines still has higher CDS premium or that the Philippines is seen as more susceptible to a default than Japan.

I am not saying that Japan isn’t vulnerable. I am saying that concerns up to this moment represents more of exaggeration than what is being reflected on the marketplace.

Let me add that what appears to be hounding the markets are the uncertainty of the possible escalation of the meltdown of Japan’s nuclear reactors. Once news reveal of the containment of the problem, you can expect these string of bearish news to gradually get discounted.

Global Debt Concerns Overwhelmed by Liquidity

Here is a nice update on sovereign default risk prices from Bespoke Invest

They write,

default risk has fallen the most for Japan, China, Australia, Chile, and South Korea since July 2nd. It has risen for just four countries -- Egypt, Portugal, Ireland, and the US. Yep, the US has seen default risk rise 15.7% since the start of July, even as the equity market has performed well. Germany has the lowest default risk of all the countries shown.

Of the four high-risk states highlighted, Illinois currently has the highest default risk at 275 bps, followed closely by California at 269 bps. New York and New Jersey are both just above 200 bps.

Flushed with liquidity, most of the world has seen a decline in concerns over debt as measured by their respective credit ratings.

However, we seem to be seeing a different scenario in the US, where creeping default risk concerns have coincided with buoyant equity market.

It’s quite obvious that massive interventions (and expectations thereof) in the financial markets have distorted market signals.

Yet, how much government interventions can keep up with this “sweet spot” mode would something to behold about, most especially that liquidity flows have began to permeate into the commodity markets.

Eventually something has to give.

For the meantime, party on.

Credit Default Risk: From PIIGS To The 4 US States

Four US states, particularly California, Illinois, New Jersey, and New York, has been in a race with the European "PIIGS" in terms of credit risks or default risk as measured by CDS (Credit Default Risk).

As Bespoke Invest notes,

``All four states are closer to the top of the list than the bottom in terms of default risk. As noted earlier, Illinois has the highest default risk at 368.6 bps. The state sits between Dubai and Bulgaria. California ranks second out of the four at 352.9 bps, while New York and New Jersey are both right around the 290 bp level. Illinois and California are both at higher risk than Portugal, while all four are in a worse situation than Spain. In terms of year-to-date change, Illinois default risk is up 117%, New York and New Jersey are both up about 87%, and California is up 35%."

The difference is that the European PIIGS constitute about 18% of EU's GDP while the US contemporary is about 29% of the US GDP. Incidentally, the 4 states are among the biggest (in terms of share of GDP): California (ranked 1st), New York (3rd), Illinois (5th) and New Jersey (8th).

Yet financial markets seem to be singing contrasting tunes which seem inconsistent: jump in the Euro, firming CDS of 4 US states while new lows in 10 year US treasury yields. If there is a shift in concerns towards the 4 US states then treasuries yields are suppose to go higher.

I'd like to add that the gap between the PIIGS and the US-4 relative to the ASEAN-4 led by Indonesia and the Philippines seems to have widened. This partly explains the signs of 'decoupling'.

Selling In May, The Greek "Contagion" Panic In Perspective

We will try to put into perspective last night's panic which was supposedly triggered by concerns over a Greek contagion.

The chart below from Bespoke shows of the Credit Default Swap (CDS) prices or the cost of insuring debt, as of last night.

Bespoke decries the exaggeration in the news, "While CDS prices are higher today for countries like Greece, Portugal, Spain, and Italy, they were just as high late last week prior to declining quite a bit yesterday on news of the Greek bailout. Basically default risk today is right back where it was late last week and not "blowing out" to higher levels."


It's true that the PIIGS led by Greece has seen a rebound in CDS prices to indicate renewed concerns over sovereign issues in spite of the bailout, but they remain below their previous highs and have NOT reached the level of Argentina and Venezuela levels for now.

Again from Bespoke, ``Greece 5-year CDS is at 737 basis points today. Prior to the bailout it was above 800 bps. Venezuela and Argentina still have higher default risk than Greece. Portugal CDS is at 355.4 bps today, up from 275 bps yesterday, but still below the 380 bps it was at last week. Spain is probably the most worrisome country on the list at 208 bps, since it has a much bigger economy than any of the other countries at similar default risk levels. And Italy has jumped up to 164 bps today, which is more than double the next closest G-7 country."

The interesting part is, despite the so-called contagion spurred selloffs, CDS prices in the US and the UK have barely budged! In short, the selling frenzy could be media "exaggerations" and market sentiment feeding into each other more than a real "contagion" related dynamic.


We see parallel developments in the US treasury market. US 10 year yields have fallen (alternatively bond prices rallied) as stock markets retrenched. This implies more of "fear" than sovereign related concerns as both the CDS and treasury markets suggests.

Yet despite the spike in the VIX "fear" index, the US S&P seems more resilient relative to the similar episode last February-meaning that while the VIX have climbed about three quarters of the VIX high in Feb, the decline in the S&P have been relatively less.

Importantly while both the Euro benchmark (STOX50E) and the S&P fell nearly by the same degree last February, today, the S&P appears to outperform the Eurozone by falling less.

So even if the month of May could be partially validating the maxim, sell in May and go away, it isn't clear that this is the start of THE major inflection point. It looks more like a reprieve following the string of gains with Greece as serving as a rallying point for the current market action- of course, until proven otherwise.