Trigger-happy central banks spark bond euphoria

 The recovery in Europe has been electric since the European Central Bank opened the floodgates in December. Photo: PA

"The credit market's on fire," said Suki Mann at Societe Generale. "We have seen a massive grab for yield. The mood is so good that even if Greece were to default it would probably make no difference."

The average borrowing cost for high-grade US companies has dropped to 3.52pc, just shy of all-time lows. American firms took advantage of the hunt for safe yield to raise $70bn (£44bn) last week alone, led by McDonald's and IBM.

The recovery in Europe has been electric since the European Central Bank (ECB) opened the floodgates in December, lending banks €489bn (£410bn) at 1pc for three years, with more to come later this month.

Europe saw the biggest one-month compression in high-grade debt yields in January since records began, excluding the V-shaped rebound after the 2008 crash. Telecom Italia's yields have dropped 180 basis points this year.

"The ECB was the game-changer. A lot of this money seems to have gone into corporate bonds and it makes sense because non-financial corporates are the strongest in history with big cash reserves and very defensive balance sheets," he said.

Data from Deloitte shows large companies have amassed record cash reserves on both sides of the Atlantic, with British non-financial firms sitting on £731bn, and US corporations holding $1.73 trillion in cash.

"High-grade companies like Google, Caterpillar, and the German auto-makers are now better credits than most governments," said Marc Ostwald at Monument Securities.

Spain's energy group Repsol can borrow for five years at 3.55pc, undercutting the Spanish state at 3.75pc. American companies cannot beat the US Treasury at 0.82pc but the gap has narrowed. Five-year yields for both Procter & Gamble and Caterpillar are 2.1pc, while GE is at 2.24pc.

Mr Ostwald said the world's central banks have eliminated most of the risk, promising to keep interest rates near zero for at least two years, even if the latest rush into junk bond segment of the market and is looking "overcooked".

Stephen Jen from SLJ Macro Partners said the double blast of a "trigger-happy Fed" and an activist ECB has transformed the outlook for global assets this spring. "All investors should respect the rule 'don't fight the Fed'. A new rule is 'don't fight the ECB'. Certainly the market should not fight the Fed and the ECB at the same time," he said.

Andrew Roberts, credit chief at RBS, said companies' ultra-cautious stance and their aversion to a fresh blitz of debt-drived takeovers makes them an alluring place to park money. These "super-corporates" have decoupled from eurozone woes. "The credit default swaps on Siemens, Carrefour, and Nestle hardly moved during the sovereign debt crisis last year," he said.

Bank bonds are the great exception to Europe's credit rally. The side-effect of the ECB's lending blitz is that the bank has gobbled up collateral. Since the ECB has first claim on this, the process reduces ordinary "unsecured" bondholders to ever lower ranking – affecting €2.6 trillion in European bank debt.

Holders of senior bank bonds are being relegated to junior status. "Banks are pledging more and more of their assets to the ECB: for unsecured bondholders, it all adds up to structural subordination," said John Raymond from CreditSights.

The risk is this could back-fire if banks over-indulge at the next ECB tender, borrowing a further €1 trillion or more. For now the party is in full swing.

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Relax, central banks can still save us

Even if Europe and America slide back into recession with fiscal deficits already dangerously stretched and interest rates on the floor, financial authorities still have the means to prevent a spiral into debt-deflation.

Whether they have nerve to use those means if necessary, and whether they can overcome deep rifts to act in unison and with overwhelming force, is another matter. It would help if China and other reserve powers stopped sniping from their clay towers. They will suffer just as badly, or worse, if the damn breaks.

Perhaps oddly, I am not as uber-bearish as some at this juncture. It is far from clear to me that the US is crashing into a second slump. While the Philly Fed’s manufacturing index for August was catastrophic at minus 30.7, it is a twitchy index.

Paul Dales at Capital Economics says it flashed false warnings in 1995 and 1998. The US Conference Board’s leading indicators are more reliable. They are signalling sluggish growth.

Andrew Haldane, the Bank of England’s financial stability chief, says global banks have raised equity by $500bn since the bubble burst. They have slashed assets by $3 trillion, and halved leverage ratios from 40:1 to a long-run average of 20:1. “UK and US banks’ cash ratios are at their highest levels for several decades,” he said.

Citizens and firms on both sides of the Atlantic are running a “financial surplus” near 2.5pc of GDP, compared to a 1pc deficit five in 2006. US companies are sitting on $2 trillion in cash. The West is better cushioned this time.

There is much wreckage left, of course. A quarter of US mortgages are under water. A shadow inventory of unsold homes must still be cleared. Detox will be long and painful.

Yet it no longer makes sense to talk of a US housing bubble. The price to incomes ratio has halved to three, among the world’s lowest. Cleveland, Detroit, Cincinnati, and Atlanta are down to 2.4.

But let us concede - as a 'Gedanken Expirement' - that arch-bears are right to fear a full-blown global slump. Are we powerless?

The US cannot easily crank up fiscal stimulus with a deficit already at 10.8pc of GDP (IMF estimate). Much as I admire Nobel Laureate Paul Krugman – vindicated in his prediction that US 10-year bond yields would fall to historic lows – he misuses history to argue that spending on the scale of World War Two could safely lift America out of slump.

Yes, the US pushed public debt above 120pc of GDP to defeat Hitler, and Britain topped 200pc defeating Napoleon. Both countries marched on to greatness, but in each case they were the world’s paramount industrial power.

Who was going to threaten US Treasuries or the dollar in the late 1940s when Germany and Japan were under US occupation, and America accounted for half of global GDP?

Military demobilisation allowed an instant cut in the US budget deficit. Today the rot is structural, a failure to stop health care and ageing costs spiralling out of control.

So with fiscal policy exhausted, the burden must fall on monetary policy. Here we have barely begun to use our atomic arsenal even at zero rates. As Milton Friedman taught us – though nobody in Frankfurt -- it is a fallacy to think that low rates are loose. Zero can be extremely tight.

That may be the case now with US Treasury yields signalling deflation and M2 velocity collapsing as it did pre-Lehman.

To those who argue that the Fed is pushing on the proverbial string, David Beckworth from the University of Texas replies that the Fed showed between 1933 and 1936 that it could deliver blistering growth of 8pc a year despite debt deleveraging in the rest of the economy.

My own view is that Ben Bernanke has strayed from classic Friedman policy, blunting the effect of his two rounds of QE. Under his doctrine of “credit easing” he has steered bond purchases to banks. This has limited effect on the quantity of money.

A Friedmanite would argue that Bernanke has barely tried monetary stimulus. Yet he has greatly eroded his political capital in the process, especially by arguing that the purpose of QE2 was to push up inflation and help Wall Street. These were tone deaf justifications. “Treasonous” is the verdict of Governor Rick Perry of Texas. That was to be expected, but it does complicate matters.

The eurozone obviously needs looser money. M3 broad money is stagnant and real M1 deposits have turned negative, even in Germany and Holland. Real M1 is contracting at an alarming pace in Italy. EMU growth has wilted, five countries are spinning towards default, and the banking system is seizing up. This cries out for a change of course, yet the European Central Bank is still tightening.

The ECB’s Jean-Claude Trichet said “we do not do QE”. Indeed, Germany forbids it. Not only has the Bundesbank forgotten that the Bruning deflation of 1931 destroyed Weimar - not the hyperinflation of 1923 - it is imposing its policy blunder on the whole currency bloc. The visible result of piling monetary contraction on top of fiscal contraction is to push the Club Med over the edge.

The lesson of 2008-2010 is that further QE by the Fed alone risks a dollar slide and a further global crisis. A successful monetary blitz - if required - would need joint action by all major central banks in concert, including the ECB with no 'ifs’, 'buts’, and hostile body language. Some $6 trillion would suffice, or 10pc of global GDP.

We are not there yet. The August squall may pass. US growth may surprise, and China may avoid a hard landing. For all our squabbling, we still live in a benign world where ships and capital move freely and leaders talk to each other.

Remember what the world looked like when Franklin Roosevelt moved into the White House in March 1933 and shut down the US banking system.

The front page of the New York Times on his first Monday in office announced: "Hitler Bloc Wins A Reich Majority, Rules Prussia"; "Japanese Push On In Fierce Fighting, China Closes Wall, Nanking Admits Defeat"; "City Scrip To Replace Currency"; "President Takes Steps Under Sweeping Law of War Time"; "Prison For Gold Hoarders".

That was a serious situation.

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Europe unveils sweeping plans to govern reckless banks

 'Banks will fail in the future and must be able to do so without bringing down the whole financial system' Photo: EPA

The European Commission’s "Framework for Bank Recovery and Resolution" draws on Scandinavia’s hard-line approach during their banking crises in the early 1990s. The goal is to end the pattern of moral hazard and mispricing of risk that generated Europe’s debt woes.

"Banks will fail in the future and must be able to do so without bringing down the whole financial system," said Michel Barnier, the internal market commissioner Mr Barnier’s consultation paper will lead to a "legislative proposal for a harmonized EU regime" as soon as this summer, with an insolvency structure in place by 2012.

The final phase will be the creation of a European Resolution Authority by 2014, adding a fourth pillar to the EU’s new architecture of financial regulation. EU "authorities" typically have their own permanent staff and powers to override national bodies.

The document said regulators should be given "statutory power" to write down senior bank debt, by any amount necessary, or to convert debt into equity. "Such a power would only apply to new debt (or existing debt contracts renewed or rolled over) after entry into force of the power."

Worries over the exact shape of the bondholder haircuts caused credit default swaps on senior European bank debt to rise sharply earlier in the day, with the Markit iTraxx Senior Financials index rising 16 basis points to 196.

Spanish and Italian banks were hit hard, among them Banco Santander, with some lenders in the eurozone periphery at even higher levels than during Europe's so-called "Lehman moment" last May.

The jitters spread to sovereign debt as well. The CDS on Portugal rose 25 points to 525, Ireland rose 18 to 630, Belgium rose 17 to 240, and Spain rose 13 to 350.

The EU plan would apply to all classes of senior debt, with authorities given leeway to act on a case-by-case basis, depending on systemic risk. Some trade creditors and counterparties in swaps and derivatives contracts may be shielded under specific circumstances.

There would be a strict ranking of creditors. "Equity should be wiped out before any debt is written down, and subbordinated debt should be written down completely before senior debt holders bear any losses," said the document. Bonds would be bound by contracts giving the authorities power to impose losses once a "trigger" is activated.

The plans allow oversight bodies to place a "permanent presence" of inspectors in the offices of suspect banks, adopting a scheme already pioneered by Spain’s central bank. There will be annual stress tests, geared to shocks of "low probability but high impact".

Regulators will be able to order bank boards to fire directors, desist from any activity, reduce leverage, sell off assets, or restructure debt.

In extreme cases, they will have pre-emptive powers to take over the entire bank and decapitate top management, perhaps when Tier I capital ratios fall below an fixed level. Stronger banks will be required to help cover the costs of failure by weaker peers, creating a further buffer between the financial industry and the taxpayer.

Mr Barnier, a former French foreign minister and Savoyard ski enthusiast, has worked closely with the authorities in the UK, where similar plans are already under way. Britain is the first of the big EU states to introduce a resolution mechanism.

There were widespread concerns a year ago that Mr Barnier would pursue a "French agenda" to cut the City of London down to size, but he has since won plaudits as a man who genuinely wishes to bolster Europe’s leading financial hub – though on a sounder footing. Jonathan Faull, his right-hand man as director-general, is a British EU official of free-market views.

The concern for bondholders is that the screws may be tightened further as Germany and other states alter the text to alleviate populist pressures at home, or that the decision to seize banks and impose haircuts will become politicized. It is unlikely that either EU ministers or the European Parliament would go so far as to penalise existing debt, which might be construed as retroactive. The legal complications would be enormous.

Mr Barnier has to walk a fine line, doing enough to deter moral hazard without going so far as to cause investor flight from EMU bond markets. His paper says that creditors should be treated fairly, with scrupulous consistency, and in conformity with European rights law. But at the same time, the document recognises that it is hardly healthy if funding costs in Europe are held down "artificially".

Much grief might have been avoided if the EU had created this machinery long ago, before launching monetary union.

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Traders bet £ 2. 7bn against before banks of the report of the CVI

Part-nationalised Lloyds and Royal Bank of Scotland have fewer shares available to borrow, but there is still a short position that could be as much as ?47m on ?13m on RBS and Lloyds.

The equivalent of 1. the market value of Barclays £ 36 5.3 68pc is "on loan, mainly to cover short positions, in accordance with the data Explorer." The market value of the HSBC £ 118. 5bn, 1. 17pc or. 38bn £ 1 is ready while the figure is 1. 68pc or £ 40 m at Standard Chartered.

Partly nationalized Lloyds and Royal Bank of Scotland have fewer shares available to borrow, but there is still a short position that could be as much as 47 million pounds on the Lloyds and 13 m £ on RBS.

Barclays is more at risk of developing recommendations for the CVI, according to analysts and investors. On a note of 25 possible outcomes, designed by Goldman Sachs, Barclays is to be worst affected by the proposals of the Sir John Vickers ranging from capital requirements higher than the more radical division of sale retail and investment banking services.

Lloyds is then followed by RBS, HSBC and Standard Chartered, according to Goldman.

Separately, Morgan Stanley found that 58pc of investors believe that the shares of Barclays will be the hardest hit of all the banks of the United Kingdom.

Evolution believes an "increase in the funding of the costs seems inevitable" with its analysts saying: "for example, Barclays Capital was around £ billion of debt wholesale - if BarCap financing costs would increase by saying 100 basis for this raisonl points'impact could be £ billion after tax""they have added."

Lloyds Banking Group stands to lose the most if the ICB is trying to reduce the dominance of the big four banks on the retail market. While few expect the commission to require the cancellation of the merger of the HBOS-Lloyds, the Group may be forced to sell part of its branches. Morgan Stanley analysts said that the sale of 1,000 branches can cost Lloyds as 17pc of profits before taxes.

Deutsche Bank, said: "we expect a bold document with disposals and other remaining on the table." Morgan Stanley said he expected the report "most severe and demanding that the final result."

The ICB should offer a degree of "elsewhere" - a change in structure to limit the responsibilities of the British Government for the losses overseas.

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Banks and commodities drag FTSE 100 into red

Banks were the biggest laggards as an effective stake sale by a key Abu Dhabi investor in Barclays helped send its shares down 2.5pc.

Abu Dhabi exercised 131.6m warrants in the bank, equivalent to a 1.1 pc stake, and simultaneously entered into a hedging arrangement with Nomura, it said in a statement after Thursday's close.

Energy stocks were also languishing as crude prices fell by $1.30. BP shares fell 0.9 pc. Miners retreated after early gains as nerves set in ahead of the payrolls data. Rio Tinto lost 0.7 pc while silver miner Fresnillo fell 4.6 pc.

By midday, the FTSE 100 was 47.82 points lower at 5614.50, after it closed 0.3pc lower on Thursday on a wave of placings and block trades, signalling that some investors reckon the market has reached its peak.

On Thursday, Kazakhmys was the worst performer after broker Credit Suisse sold 9.35m shares – 1.75pc of the company – on behalf of the Orleans Trade & Investment Corporation (OTIC). Vladimir Ni, a non-executive director of Kazakhmys who died in the summer, had transferred 9.35m shares to OTIC.

Lloyd's of London insurer Catlin also dipped 16½ to 325p as Morgan Stanley placed 14m shares – around 3.9pc of the company – at 325p. Traders reckon the seller and buyer were long-only instiutions.

Thursday's deals follow a string of other share sales earlier in the week. Harbinger Capital sold a 14pc of its stake in Inmarsat, down 7½ to 636½p, while Vladimir Kim, chairman of Kazakhmys, disposed of 11pc of his shareholding in the mining giant to the Kazakh government, pocketing nearly $1.3bn in the process.

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Banks and commodities drag FTSE 100 into red

Banks were the biggest laggards as an effective stake sale by a key Abu Dhabi investor in Barclays helped send its shares down 2.5pc.

Abu Dhabi exercised 131.6m warrants in the bank, equivalent to a 1.1 pc stake, and simultaneously entered into a hedging arrangement with Nomura, it said in a statement after Thursday's close.

Energy stocks were also languishing as crude prices fell by $1.30. BP shares fell 0.9 pc. Miners retreated after early gains as nerves set in ahead of the payrolls data. Rio Tinto lost 0.7 pc while silver miner Fresnillo fell 4.6 pc.

By midday, the FTSE 100 was 47.82 points lower at 5614.50, after it closed 0.3pc lower on Thursday on a wave of placings and block trades, signalling that some investors reckon the market has reached its peak.

On Thursday, Kazakhmys was the worst performer after broker Credit Suisse sold 9.35m shares – 1.75pc of the company – on behalf of the Orleans Trade & Investment Corporation (OTIC). Vladimir Ni, a non-executive director of Kazakhmys who died in the summer, had transferred 9.35m shares to OTIC.

Lloyd's of London insurer Catlin also dipped 16½ to 325p as Morgan Stanley placed 14m shares – around 3.9pc of the company – at 325p. Traders reckon the seller and buyer were long-only instiutions.

Thursday's deals follow a string of other share sales earlier in the week. Harbinger Capital sold a 14pc of its stake in Inmarsat, down 7½ to 636½p, while Vladimir Kim, chairman of Kazakhmys, disposed of 11pc of his shareholding in the mining giant to the Kazakh government, pocketing nearly $1.3bn in the process.

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