Smart Money Is Not Stupid (Or Is It?)

The first week of January is often a positive one for risky assets as investors return from their holidays. The pattern looked like it was going to be repeated this week, when spreads tightened on Tuesday, the first full day of trading in 2011. But the credit markets went into reverse on Wednesday. Something doesn’t smell right. The Markit iTraxx SovX Western Europe index soared to a new record wide level of 220 bp’s by Friday’s close, and the peripheral names ended all at,  or near, unprecedented marks.

“It seems likely that there are real fundamental reasons why credit has underperformed this week.”

Gavan Nolan


The senior financials index  broke through 200 basis points on Friday as the investors adjusted to the new reality – that senior debt is no longer sacrosanct. Equities have become accustomed to being wiped out by bailouts, hence the paper had little impact on bank stocks, according to Markit Credit Research. The equity markets are still up on the week, though they have given back some gains Friday.

However:

“It should be pointed out that haircuts under the proposal are a last resort and would not apply to existing bank debt currently in issue,” credit analyst Gavan Nolan at Markit writes in his weekly wrap-up.

But according to Nolan is it likely that this will create a split in the senior bank debt market between outstanding bonds and the new bail-in bonds if and when the plans are implemented. (Probably 2013-2014).

It could also raise the cost of senior unsecured bonds, possibly creating an incentive to issue more covered bonds.

Well, my guess is that the market participants is smelling a rat, and to me that is a sign that fundamentals still rules.  Even if it do not look like it does sometimes. Hopefully, the experienced traders are aware of the fact that a market can stay irrational longer than they can stay solvent.

And it might seem irrational that problems in private financial institutions at the moment, making new funding more difficult and more expensive,  is having a severe impact on the funding of national governments.

But it does.

Spreads in banks based in the euro zone’s periphery continue to hit record levels, particularly those institutions perceived to have weak capital bases, and the turmoil in the bank credit market had a “knock-on effect on sovereign spreads,” Nolan writes.

“Investors are aware that any bail-in mechanism won’t remove the systemic risk surrounding the banking industry, particularly in the near-term.”

You bet they are!

Nor does is seem rational that the stock market is going up while the credit market is going down.

But it does.

Gavan Nolan raises the question if it’s technical or fundamental factors that cause the credit/equity decoupling?

His answer is; probably a combination of both.

“Anecdotal evidence suggests that liquidity in the credit markets is somewhat thin, particularly in single names. Some investors may be deciding to sit out the volatility at this early state in the year, and dealers are reluctant to take on positions going into the weekend,” he writes.

But there has been considerable activity in the indices. (Click here for more details).

“It seems likely that there are real fundamental reasons why credit has underperformed this week,” Nolan concludes.

I’m not quite sure if that is a good thing or a bad thing – probably a combination of both…

Anyway – the perhaps most important publication of the week was the EU consultation paper on bank bailouts.

Newspaper reports emerged on Wednesday suggesting that the EU is planning a framework that will include the possibility of senior bank bondholders sharing the burden of future bailouts.

This led to the Markit iTraxx Senior Financials index threatening to breach the 200 bp’s level for the first time since June 2010.

“The EU paper duly appeared late on Thursday, and the predictable widening effect on spreads followed.”

The Markit iTraxx SovX Western Europe index soared to a new record wide level of 220 bp’s by Friday’s close, and the peripheral names were all at or near unprecedented marks.

But the banking burden isn’t the only force driving sovereign spreads wider:

  • Spain, Italy and Portugal are all due to tap the capital markets for funds next week, commencing what will be a busy period for government issuance.
  • Portugal’s 6-month T-bill auction earlier this week was less than impressive, with yields nearly double that of the previous auction in September.
  • The ECB has been buying Portuguese government debt for the first time this year, and it would be no surprise to see it continue its interventions next week.

Conclution: It seems like the Mr. Ben Bernanke‘s favorite expression “unusual uncertainty” will be valid for at least another year.

PS:

When it come to the co-called “smart money,” I did a Google picture search of the term.

The result was a disturbingly number of Paris Hilton photos.

Now, if that’s supposed to be an illustration of smart money, then God help us all!

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