Gold returning to its roots today

Today gold is behaving in a more traditional fashion, moving in the opposite direction from copper. With copper viewed as a "risk" asset and gold a "defensive" asset, the two should generally trade with a negative correlation.

Gold and copper futures (Source: Bloomberg)

This is quite a contrast to the recent price action, with gold trading more like an industrial metal, driving gold-to-copper correlation to its highs.

120 day gold - copper correlation

It's not at all clear if today's action indicates the beginning of a reversal in this trend. The decoupling of the two metals should make gold more attractive again as a "safe haven" investment, providing a real hedge to a risk portfolio (of equities and commodities).

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The increase in triparty repo usage and other developments in the repo markets

There is still a misperception in the media that only the CDS market can afford significant amounts of leverage to risk takers. Tremendous leverage is in fact available via repo, a market far larger than CDS. The media often misses the fact that MF Global failed because of repo based leverage. And by the way so did Lehman and Bear Stearns and Merrill Lynch - all failed because they could not roll their repo loans. That's why repo markets are of critical importance to the financial system and need to be well understood by policy makers. It's amazing that a typical US politician knows more about the Kandahar Province in Afghanistan than what a repo transaction is.

Data on repo markets is difficult to come by. Recent report from Fitch sheds some light on the latest developments in that market. Repo haircut (initial margin) - a key measure to track in these markets - obviously depends on the type of collateral. According to the report, treasuries tend to have a 2% haircut these days, while corporate bonds are 5%. That's 20 to 1 leverage. Haircuts for high yield bonds are higher (15-25%) and equities haircuts are around 50%, but vary with the volatility in the market. (There are other ways to leverage equities such as total return swaps.) Just for illustration, the diagram below shows how repo leverage can force asset sales if haircuts are increased from say 5% to 10%. Increasing haircuts is all it took to put MF Global out of business.

One recent development in the repo market has been the return of structured credit such as RMBS securities as collateral in repo transactions. Three years ago leveraging structured credit bonds in the repo market was impossible.

Source: Fitch Ratings

The biggest development has been the recent growth in triparty repo market. To begin with, here is a diagram of a triparty repo transaction (a number of readers have asked to see how this process works.)

Source: Fitch Ratings

Triparty repo eliminates counterparty risk that exists in a bilateral repo transaction. As concerns about counterparty risk increased in 2011 with fears of US banks' exposure to the Eurozone, the usage of triparty repo rose.

Source: Fitch Ratings

The repo market continues to dominate short term funding in the banking sector in Europe, with unsecured interbank funding basically dead across the Eurozone. Also with new derivatives regulation pushing CDS into central counterparties (clearinghouse), repo based leverage becomes an even more attractive way to put on risk. Following such developments in the repo markets will be increasingly important to understanding the health of the financial system.

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Unsecured EU bank paper is expected to have zero recovery

The spread between senior and subordinated credits of EU financial firms is now off the peak reached in the second half of last year, but remains elevated.  This spread can be seen in the CDS markets by comparing the senior and sub EU financials iBOXX CDS indices (chart below).

Sub to senior EU financials iBOXX CDS spread

This spread indicates that senior unsecured bank bonds are substantially lower credit risk than the bank subordinated paper. Such differentiation makes sense in the context of corporate debt markets, but Barclays Capital argues that it's utter nonsense when it comes to the EU banking sector.

Barclays Research believes that recovery in the case of a default is close to zero for any unsecured EU bank paper, whether it is senior or subordinated. Therefore the market shouldn't differentiate materially between the two. Here is why:

1. The rapid rise in secured borrowing in the Eurozone and increased issuance of covered bonds will end up encumbering the bulk of banking institutions' assets, leaving little recovery value for unsecured creditors.

Barclays:  In Europe, secured borrowings continue to increase, with funding from the European Central Bank soaring, most notably through the recent 3y LTRO, and outstanding covered bonds continuing to climb. We estimate that approximately €4.5tn of high-quality assets at European banks are now encumbered to support covered bonds and central bank borrowings, reducing their availability for unsecured creditors in liquidation.

2. The new regulation in Europe will permit bank regulators to effect a "bail-in". The regulators will be able to inject capital below the secured debt, heavily subordinating any unsecured paper.

Barclays:  Orderly liquidation frameworks, which have been adopted in countries such as the U.S., U.K., Germany, Spain, and Denmark and are to be proposed across Europe, give regulators the ability to haircut bondholders while preserving other creditors, effectively subordinating unsecured bonds.

The diagram below illustrates how unsecured lenders who are ordinarily pari passu with the bank's depositors and general creditors become subordinated in a bail-in.

Bail-in illustration (Barclays Capital)

This means that in an event of a bank failure there is little recovery value for all of bank unsecured paper and there will be little difference between senior and subordinated unsecured bank bonds. Therefore the market is mispricing the relative credit risk between the two types of bonds. According to Barclays there should be little spread between the two.

Barclays: Under most legal frameworks, senior debt and non-deferrable subordinated debt (lower tier 2) effectively have the same probability of default. In these situations the difference in spread should be explained by a lower recovery assumption in liquidation for subordinated bonds compared with senior bonds. If senior bond recovery assumptions approach 0%, then there is no justification for senior bonds to trade tighter than subordinated bonds.

As market participants come to terms with these issues, the market for unsecured bank paper diminishes dramatically and spreads between unsecured senior and subordinated paper should tighten. On the other hand secured bond,s which the market views as having imbedded protection against a bail-in, are fast becoming the primary source of longer term bank financing.

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The housing market duality

With the backdrop of extreme weakness in the US housing market through the end of 2011, the trend of divergence between the distressed and the non-distressed housing markets continues.

Source: Capital Economics

CoreLogic's latest data show new lows for the US housing market in 2011 with a worrisome downward trend. The non-distressed market however seems to have stabilized. This market duality should continue through 2012 as new inventory of distressed homes enters the market. The hope is that ultimately the non-distressed component will provide support to the overall market.

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The TARGET2 imbalances reference guide

For some reason the subject of Eurozone's TARGET2 imbalances continues to be of great interest to many. We keep getting numerous e-mails requesting more information on the topic. The paper included below can serve as a reference on TARGET2 imbalances and hopefully will answer a number of readers' questions.

The key to understanding this issue is to look at this "truck purchase" example in the paper and follow how it impacts the national central bank balance sheets.

In this example the Greek central bank has to reduce "base money" while Bundesbank increases "base money" - effectively "transferring" cash from the Greek banking system to the German banking system (to pay for the truck). Simultaneously Bundesbank now has a future claim on the ECB while the ECB has a claim on the Greek central bank (effectively to reverse the "cash transfer" in the future). With significant periphery trade deficits, these claims have grown quite large.

Impact on central bank balance sheets with a cross-border transaction

The concern around TARGET2 imbalances is that central banks owe a great deal of money to each other via the ECB and should a nation drop out of the Eurozone, these liabilities may not be met. The ECB may then have to take a large loss. A mechanism for a nation's exit from the euro area was never developed.

But one question that few have asked on this topic is what is the net impact on base money in Germany vs. the periphery. Clearly this base money imbalance (table above) will also create uneven money stock and significant liquidity tightening in the periphery vs. Germany.

For example if a corporation in Panama (with bank account at a Panamanian bank), a nation that uses US dollars, by some miracle transferred half a trillion dollars into a bank in the US, the Fed would view it as an unplanned QE and would sterilize it by reducing its balance sheet (selling some bonds). But there is no equivalent capability at Bundesbank. Instead Bundesbank relies on "voluntary" sterilization as German banks with all the new deposits are reducing their net central bank borrowing (for example Deutschebank did not even participate in the LTRO program.)  The periphery central banks on the other hand are sterilizing their reduction in base money by lending into their banking system - see the blue text in the above table.

By the same process the collateral held at Bundesbank is decreasing, while the same at the periphery central banks is rising. The collateral therefore is concentrated in the German banking system (banks get it back when they repay their central bank loans) and is trapped at the periphery central banks (who take it in when lending to their banks) - exactly where it is not needed.

One concern is that base money would start growing rapidly in Germany when banks stop reducing their central bank borrowings. If trade deficits continue to widen, this becomes an equivalent of a QE in Germany and potentially a tightening in the periphery - exactly the opposite effect of what's required. If this were China, the central bank would simply issue a note and force German banks to buy it in order to soak up the excess liquidity. However, there doesn't seem to be a legal mechanism in the Eurozone to address this issue.

For further information on the topic, take a look at this paper by Hans-Werner Sinn and Timo Wollmershaeuser. It's a great reference.

TARGET2 Imbalances Paper

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Continuing jobless claims at the highs of previous recessions

A lower "continuing US jobless claims" number today is welcome news. We may be seeing signs of employment stabilization. But let's take a step back and look at a slightly longer time period.

Continuing Jobless Claims SA (Bloomberg)

We are now at the highs of the previous two recessions. And that doesn't include all the people who are "rolling off" - no longer qualify for benefits. When it comes to US employment picture, we've got a long way to go...

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Tightening lending standards vary materially across the Eurozone

As capital becomes more scarce for banking institutions in the Eurozone and balance sheets become constrained, the tightening of credit to the "real economy" accelerates. The lending standards that banks impose to provide credit to companies are becoming considerably stricter.

FT: A European Central Bank survey on Wednesday showed the eurozone debt crisis has triggered a severe credit squeeze across the region with banks imposing significantly harsher loan terms on businesses and consumers. Demand for mortgages and loans to fund corporate investment was also falling sharply, the survey showed.

But not all the Eurozone nations are impacted in the same manner. One would think that the differences in lending standards is defined by the divide between the "core" and the "periphery" nations. But that's not exactly the case. The divide is between nations with stronger banking institutions and the weaker ones. French financial institutions, in spite of being part of the Eurozone core, have been weakened dramatically by the crisis and are therefore tightening loan terms. Germany on the other hand is not impacted while Italy is in bad shape. The chart below shows how lending standards depend on nations' banking system strength.

Source: JPMorgan Economic Research

There is a reason the ECB is going all out to provide funding with unprecedented terms/amounts to the banking system - they are trying to arrest these tightening lending conditions. The liquidity should help, but the damage has already been done to the Eurozone's corporations and consequently to jobs and the area's economic growth.

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Occupy this - PBGC getting ready to take on AMR

A fight to prevent another bailout in the US is on. No, not the banks or autos or insurance companies. It's a fight over the bailout of AMR's employee pension. This is not news - we've discussed this issue back in November. What's new today is that Pension Benefit Guaranty Corporation - PBGC (the taxpayer) wants to step in to prevent the pension bailout that AMR will likely attempt as part of its bankruptcy strategy.

Joshua Gotbaum

NYT: While American [Airlines] has not said it intends to force the government to take over its pension plans, Joshua Gotbaum, director of the Pension Benefit Guaranty Corporation, said he was hoping to get out in front of any such move by the airline. The agency is already operating with a $23 billion deficit and has said it would bear an additional $9 billion loss if American terminated all four of its employees’ plans, which cover 130,000 people.

One thing to keep in mind is that legally AMR can indeed dump the pension. It is a subordinated liability of the firm and without the US taxpayer support, the pension beneficiaries could find themselves in line behind the AMR bond holders in a bankruptcy court. Obviously AMR has a reputational and labor problems if it proceeds. The most likely scenario however is that the firm will trade keeping the pension in return for union concessions on pay and benefits.

So where are all the Occupy AMR these days? 

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Copper inventories shift from LME to SHFE

Exchange held global copper inventories have declined modestly as a potential indication of improved global demand. In particular the focus has been on a substantial decrease in copper inventories at the London Metal Exchange (LME).

Reuters: Copper inventories in London Metal Exchange warehouses have dropped to a 13-month low, and more declines are seen likely as a pick-up in U.S. demand and concerns about a market deficit outweigh a slowdown in buying from top consumer China.

But the LME inventory numbers are not telling us the full story. The Shanghai Futures Exchange (SHFE) has become a major player in the global metals markets. As the LME inventories declined, the SHFE inventories increased, keeping the overall global inventory fairly steady in the last few months (a modest decline from the November levels.)  COMEX (CMX) inventories stayed relatively constant.

Copper inventories
Thousand metric tonnes (source: JPMorgan)

These days relying on the LME inventory numbers alone as demand indicators is no longer sufficient. 

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ISM Prices Paid trend is inconsistent with long-term rates

A relatively obscure gauge of inflation (in terms of mass media coverage) had an unexpected uptick today. The Institute for Supply Management (ISM) Report on Business Prices Paid Index came in about 11% higher than expected (55.5 vs. 50). The index is defined as follows: "The ISM index includes prices paid for all purchases including import purchases and purchases of food and energy excluding crude oil"

The unprecedented accommodation by the Fed and some stability in emerging markets economies will continue to push prices up. Of course the Fed has a 2% inflation target these days, so they are fine letting some inflation filter through. But what does that mean for longer term rates?

This chart compares the 10-year treasury yield (orange) with the Prices Paid Index (white). The divergence in trends is clear. As prices recover relatively quickly from the October lows, treasury yields at these levels are not sustainable.

ISM Report on Business Prices Paid Index vs. 10y treasury yield (Bloomberg)

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