French Toast

The title of this brief post does not refer to the disgustingly sugary culinary monstrosity of the same name, but rather to both the precarious state of the French economy/banking system/government and the trade idea that we’re going to illustrate here, the recipe of which also includes an important German ingredient.

This is in our opinion an excellent trade, not only because it has the potential to deliver significant gains, but more importantly because of the exceedingly tiny amount of risk that it entails: it is a lesson in asymmetrical investing.

So without further ado here is this brilliant idea: sell short an amount X of French OATs against an equivalent amount of German Bunds (i.e. buy 100€ of Bunds for every 100€ of OATs sold). This basically removes interest-rate risk from the equation (so that we don’t have to correctly forecast whether rates are going to rise or fall) and leaves only country-specific risk on the table, the idea being to sell the higher risk bond against the lower risk one, in the expectation of a re-pricing of the two that better reflects the real risk differential, currently suppressed by the various alphabet-soup policies of the ECB (such as LTRO and OMT) as well as the supportive buying of overleveraged French banks.

What’s so interesting about this trade? At the time of writing, the spread between the yields of the two bonds is a paltry 53bps (that is: the French 10yr bond yields 0.53% more than the equivalent German security).

Now we don’t know about you, dear readers, but we regard the possibility of French Bonds yielding less than German ones as quite remote, to put it mildly. Even yield parity seems to us to be extremely unlikely. Yet, let’s consider this as our worst-case scenario: all that it entails is a risk of 53bps, practically nothing (in our own risk analysis, we objectively consider the likelihood of the spread going as low as 25bps). On the other hand towards the end of 2011, during the height of the European crisis, the spread reached a high slightly above 200bps: is that feat repeatable? Of course it is! We would actually wager that it’s likely to be exceeded, for the reasons we’re going to enumerate in the next section. So, the extremely pessimistic scenario has us losing 53bps and a moderately optimistic one has us gaining 100/150bps, all this without having to take a stance on the direction of the underlying market (interest rates): not bad it seems!

The only caveat is that since the 2011 rout ended OATs have shown the tendency to trade as a safe haven rather than as risk-on securities like BTPs and so far there is no indication that this may be about to change (although these phenomena tend to occur quite abruptly and without advance notice). As such, the prudent speculator might want to wait for definitive confirmation before committing to the position (i.e. he may decide to act only if and when OATs prices start to diverge from Bund prices, thus leaving some money on the table, but lowering his chance of failure and shortening his waiting time). Another option, that we’re also currently weighting, could be to sell a mix of OATs and BTPs, the latter offering lower risk but also a more uncertain return and the former offering exactly the opposite (i.e. a higher potential return, but also greater losses should the current calm that permeates the markets continue: the current spread stands at around 260bps and under such a scenario it could easily go to 150bps or lower).

We won’t make any specific remarks about Germany, apart from the following: the country is far from being a sanctuary of fiscal rectitude and a refuge for free-market enthusiasts. It is simply further removed from the edge of the abyss than its neighbours (a big plus is that it does not have a real estate bubble, although one is incipient).

The French Connection

1. Government Finances

As of the end of 2012, the French Government sports a 4.8% budget deficit and a 90.2% debt-to-GDP ratio. It has also forecasted a 3.7% deficit for the current year: we let our readers ponder on the likelihood of that target being reached (in our opinion chances are slim to none and slim is out of town). Now, these do not seem particularly comforting numbers, especially when one considers that a serious recession can significantly worsen the budget picture, by simultaneously lowering tax revenues and increasing expenditures. As we shall see below, there’s also the very real possibility that French banks will require a massive bailout, further increasing the public debt and actually bringing it to a completely unsustainable level. And of course the fact that the French Government is run by a bunch of twats (the wonderful definition of this word being: “a man who is a stupid incompetent fool”) who think that economic success ought to be punished doesn’t help: see “The Economy” section below. A final remark: public spending already accounts for roughly 57% of French GDP.

2. The Banks & The Housing Bubble

The French banking system’s total assets are more than 400% of French GDP, with the largest three banks, BNP Paribas, Crédit Agricole and Société Générale (mind you: there’s the guillotine ready for those foolish enough to get even a single accent mark wrong), accounting for a whopping 240%. This should drive home the point that there’s no way the French Government could possibly “save” its banks if they were to run into serious trouble (doesn’t mean it won’t try, though). French banks are also highly leveraged (this is true of most European banks, with the German ones topping the list) with assets-to-equity ratios routinely around 30/40, they have large exposure to OTC derivatives and they’re allowed to assign a 0% risk-weighting to French OATs, allowing them to buy gobs of them entirely with funny money (i.e. with pure leverage) and thus linking their fate even more to that of the state. The last point means that they could provide support to OATs prices for a while, but it also means that the whole exercise is destined to end in tears (see Greece, Spain and to a lesser extent, at least so far, Italy), as two drunks try to hold each other up.

The catalyst that may ignite a banking crisis in the country is of course the bursting of the huge real estate bubble that has now reached historical proportions (for a discussion on the French Housing Bubble, please see our recent post on the topic) and to which French banks are heavily exposed as is “de rigueur” to be, with very high Loan-to-Value ratios to boot (loans with LTV ratios of 100% or more were common at the height of the bubble). You can archive the following words, uttered by Oudea in June of 2012, under the tag “Famous last words”: “Societe Generale SA (GLE.FR) Chief Executive Frederic Oudea said Wednesday that French banks were not exposed to the type of real estate bubbles that have caused other major banking crises. Speaking on French radio, Mr Oudea, who also serves as president of the French Banking Federation, said that "major banking crises come from real estate bubbles," citing the U.S., Ireland and Spain. "The very good news for France is that... there has not been the same real estate bubble [in the country]," he said.” Very good news indeed, at least for short sellers!

3. The Economy

The French economy is suffering from a serious recession. A combination of counterproductive economic policies (that include not allowing loss-making enterprises to restructure by firing workers), stifling regulations and bureaucratic requirements, ever-rising taxes and huge malinvestments engendered by the mispricing of capital due to the ECB’s interest rate manipulations all but guarantees that France is in for the bust of a lifetime.

Let’s see some data: GDP is contracting at a quarterly pace of 0.2% and has been basically flat since late 2011; the unemployment rate stands at 10.6% and growing; PMI readings are dismal, both for the manufacturing and services sectors, and retail sales aren’t faring much better (here, here, here and here the links to the latest Markit press releases, which also provide a bit of perspective); industrial production keeps on declining at a worrisome pace and has been in contraction since the beginning of 2012; both business and consumer confidence are in the basement, with the latter now being lower than at the height of the 2008 financial crisis; car registrations are also at multi decade low (another sign of the bursting of the bubble). We could go on and on and on, but we think you get the picture!

As such, we’re not surprised to see that loan-loss provisions are starting to rise at major French banks, as businesses and households face increasing financial difficulties and as the economic crisis favours and accelerates the bursting of the RE bubble. In fact, we expect to see more and more of the above, as the crisis gathers pace and starts to impact more directly the banks’ balance sheets.

The rather depressing chart of France QoQ % GDP growth (or lack thereof), via Tradingeconomics.

France’s unemployment rate: notice the troubling trend. Courtesy of Tradingeconomics.

The tragic chart of France’s % change in industrial production, again via Tradingeconomics.

A long-term chart of business confidence: not very inspiring. Thanks to Tradingeconomics.

This chart is even more depressing: it shows consumer confidence at an new all-time low, via 

Tradingeconomics.

Conclusion

There’s no doubt in our mind that France is headed towards a meaningful crisis, that moreover appears to have already begun. The question is whether this event will engender a re-pricing of its sovereign debt or whether the bland reassurances of Super Mario will prove to be enough in preventing “contagion”. Our personal answer to this question is that we’re in for a quite wild ride in French OATs, but in any case the very low level of risk of this prospective trade makes it very appealing in our opinion, as the cost of being wrong is almost non-existent. We obviously encourage our readers to do their own research on the matter: caveat emptor!

A Brief Note on the Yen

We’re currently busy writing our second post, which will focus on the Japanese Yen. We can by no means be certain that the recent bout of selling has exhausted itself, but as we’ve stated we like to establish a position when we think that the long term potential of the trade trumps its short-term risks. Hence we’re buyers here. As to why this is the case, please find below a brief summary of the salient points, on which we’ll elaborate further during the course of our next post, which we expect to go live early next week.

Interesting Fundamentals

Inflation as properly defined (an increase in the supply of money and money substitutes) has been relatively tame in Japan, particularly when compared to the rates of growth achieved by the Federal Reserve and the ECB. This gives our bullishness a solid basis, at least until the Bank of Japan continues to refrain from implementing the “bold” (read reckless and ruinous) policies invoked by Abe (our contention, backed by actual facts, is that so far nothing meaningful has really happened: traders just think it has). When it comes to the next BoJ Monetary Policy Meeting, it seems to us that the market has likely discounted at least both an increase in the size of the asset-purchase program and the adoption of a 2% “inflation” (we use the term here in its common fallacious meaning) target. Imagine what could happen if they were going to disappoint… Even if the BoJ were to implement both, we think we could still witness a “sell the news” event. As for the long-term soundness of the trade, it’d need to be re-evaluated in light of the Meeting’s decisions, keeping in mind that one thing is to “adopt a 2% inflation target”  and another one is to actively print money at a high enough rate to achieve the Yen’s devaluation (keep in mind that it’s not so easy to outprint Bernanke). Moreover, we harbour more than a few doubts about the desirability of a weakening Yen (and the accompanying rising interest rates) and we suspect that these are shared by quite a few Japanese, including some powerful business leaders who could make their voices heard at the LDP’s headquarters (the fact is, if Abe is not a complete fool, like for example Hollande is, he’ll quickly reach the same conclusion without the need for any outside help).

Two different and somewhat interrelated catalysts

We suspect that in recent times there has been a resurgence of the infamous carry-trade, particularly in favour of what we like to call bubble currencies (the Aussie dollar is chief amongst them). This has likely been driven by the desperate and very risky hunt for yield, which has also produced the already mentioned collapse in the spread of risky bonds vs. treasuries [Ed. Note: we can personally attest to this fact, as we’ve witnessed many European banks peddle Aussie bonds of questionable quality to unsuspecting customers. This is moreover confirmed by the worryingly high 80% of Australian government bonds and 70% of corporate bonds currently owned by foreigners.].

The Japanese hold a massive 3.3 trillion $ in net overseas assets (of which roughly 1.3 trillion $ are foreign exchange reserves, whilst the rest is in the hands of the private sector), more than 50% of their annual GDP. What if they suddenly repatriate some of them (maybe because of a scary bear market in equities or a resurgence of the European debt crisis or a deepening recession at home)? We mention here en passant that Japanese holdings of Australian and New Zealand bonds are rather large in both absolute and relative terms. This, coupled with the very real possibility of a sudden bursting of the Australian bubble and a few other considerations, makes us think that the best way to play the Yen is via the AUD/JPY and NZD/JPY crosses. A careful accumulation of long-dated put options might prove to be a savvy speculation, as they could allow the owner to withstand any further upside there might be left in these crosses whilst at the same time limiting his losses to a predetermined amount in case the BoJ really goes nuclear.

Extremely oversold readings and one-sided Sentiment

The USD/JPY cross has not been so stretched above its 200-day simple moving average since at least 2005. This combines with many other measures and indicators into an extreme technical picture rarely seen and almost always destined to revert spectacularly. Countless pundits and self-appointed experts with a dubious track-record have been all over the news predicting nothing less than the total collapse of the Yen. Sentiment on the currency lies at multi-year (probably all-time) lows. There are also signs that Japanese investors have recently increased their exposure to foreign equities (mainly American ones): as they tend to be rather risk-averse, this may indicate an extreme degree of complacency in the markets and act as a contrary signal for stocks (reference our post on equities as well), which could in turn activate on of our hypothesized catalysts.

How Bull Markets end

We will also go through a brief list of the phenomena that usually accompany the end of secular bull runs, with the purpose of showing that none of them are currently present in this case. We’ll use Apple as a recent example of how such moves tend to end (although it’s important to note that not all of them reach the same mind-boggling extremes).

Conclusion

We are bullish on the Yen and we’re actively buying it. We cannot rule out further weakness (and in particular a test of the 90 zone against the USD), but we consider the risk/reward proposition to be good enough for us. Readers should always remember the importance of doing their own analysis and of proper position sizing and risk management strategies.