Please, click here to read this article in pdf format: march-11-2010
In the past days, the world seems to have embarked on to another leg of a rally, with equities trying to set the stage for higher highs. Volume is reduced though and you may ask yourselves why we are not as bullish as we were last year, after all the evidence in favor of a nascent recovery. Is it because the recovery is weak? Is it because unemployment remains high? Is it because consumer spending looks low? No, no, no…We wrote before anyone, back at the beginning of 2009, that we expected unemployment to be high and that we did not expect any growth, but agony.
The main reason we were bullish then was that the stimulus programs, the quantitative easing was well underway. That is no longer the case. Is that all? Should we no longer be bullish just because stimulus programs are unwound? No, there is another element to it. The same countries that claim to be unwinding these programs are running unsustainable fiscal deficits and absolutely no serious and credible action is taken. That, to us, is enough to worry. Are we short the markets? No, we were stopped weeks ago, because we can no longer take the pain of even a 1.5% loss…

Consistent with this sentiment, some analysts deem the credit (not yield) curve in investment grade space (CDX IG13 index) to currently be to steep in the front end, suggesting that the implicit default rate is too high. What is the analysis based on? Simple, descriptive statistics, going back to 1970. We wonder what period in history, back to 1970, was ever similar to the outlook we’re facing? When was there monetary coordination? When did the world fall since 1970 into a liquidity crisis with stimulus programs of the size and geographic reach seen today? Furthermore, we ask ourselves how is it that so much research is currently being done on the defaults outlook, without anyone taking a closer look at the maturities concentration the world faces in high yield, between 2013 and 2015? When did a scenario of so close a maturity front together with increasing interest rates not demand a steep credit curve? Hence our not so bullish stance here, as discussed above.

On another topic, we are finally seeing some long overdue concern of politicians on sovereign credit default swaps. Particularly in Europe. As we wrote on March 1st (refer: www.sibileau.com/martin/2010/03/01 ): “…politicians focus on the greedy side of those who trade these swaps, which is really idiotic, because these derivatives represent a huge boost to systemic risk, even if they were traded for the most morally justifiable reasons…”. Regulators are wrong in seeking to prohibit these instruments, blaming them for their problems to issue debt. By the same token, regulators are ignoring the true problem of these contracts, which is the fact that any counterparty selling them does so on leverage. If a sovereign in Europe or the US was to fall, the implicit guarantees that these institutions selling sovereign credit default swaps have would be worthless and they would be undercapitalized, at exactly the same time everyone rushes to the liquidity door.

Finally, we refer to our previous letter, where we challenged the notion of Canadian markets strength based on commodities performance or even growth expectations. As you can see in the charts below (source: Bloomberg), the exodus to Canada is a process that started long before Parliament discussed the 2010 budget last week. It began in November, and took off in earnest with the Dubai credit event. The Canadian “thesis” worked against the Australian dollar, a commodity currency which has increased policy rates (below left) and extremely steadily vs. the Euro (below right). The foreign exchange market never lies.