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Financial crisis indicators and safe haven assets

How to measure the intensity of the current financial and economic crisis? Regular monitoring of a number of economic and financial indicators helps answering this question and better understanding the materialization of panic behavior and portfolio reallocations in the markets.

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I am often asked if the economic and financial crisis we are experiencing gain or lose in intensity; oddly, on the other side no one asks me again when and how are we going to exit from these crises looking like we have incorporated a culture of the crisis . It is true that it is unique and unprecedented and that traditional solutions with the economic policy are ineffective regarding the lack of confidence with respect to finance and the mismatch in financial markets (paralyzed interbank market and weak sovereign debt market also paralyzed in the Euro zone)

So it is important to follow a number of economic and financial indicators (statistics, valuation of financial instruments, market parameters) daily, weekly or, where applicable, each month to see where we stand about the intensity level of this crisis. These indicators should allow us to measure

  • shortcomings in the functioning of financial markets (such as paralysis of the interbank market and liquidity crisis)
  • The high risk aversion of market participants
  • Fear, Panic or mimicry

These indicators can be grouped into two main themes: assessment of the liquidity crisis in the banking system, the level of risk aversion and the importance of portfolios reallocation towards assets judged rightly or wrongly safe

INDICATORS FOR MEASURING THE INTENSITY LEVEL OF THE LIQUIDITY CRISIS

I prefer four very different indicators that allow me to objectively assess the degree of intensity of the liquidity crisis

- 1/ the overnight banks deposits to the ECB: 250 to 300 billion Euros every day in the current environment against a high of 340 billion Euros in September 2008 when Lehman goes bankrupt but against levels of 20 to 40 billion in the period of normal functioning of the money market. Everyone will understand that the higher these deposits, the more they reflect significant dysfunction in the interbank market, banks prefer keeping their liquidity in the central bank rather than lending to each other or financing the economy.

the higher the overnight banks deposits to the ECB, the more they reflect significant dysfunction in the interbank market
Mory Doré

- 2/ the spread or difference between 3-month Euribor and 3 months Eonia swap. Just a technical bracket : Eonia rate is representative of the interbank overnight money flow between financial institutions and the 3 months Eonia swap is an off-balance sheet financial instrument (and therefore do not consume the bank liquidity) that allows transforming a debt or a short-term investment in a fixed-rate debt into a debt or a short-term investment in a variable rate, ie indexed by EONIA. Why monitoring this indicator is important (I do it every morning) ? Well, we understand intuitively that the higher the spread, or difference, the more it reflects tight liquidity conditions, in effect, changes in the 3 months EONIA swap are disconnected from the context of bank liquidity when in fact the level of 3-month Euribor is related to the supply and demand on the 3-month interbank exchanges. So the higher the liquidity crisis intensity, the stronger the tensions on the Euribor interbank rate relative to the swap. In times of normal operation of the money market, the spread is around 15bp (0.15%) and now the spread revolves 80bp.

The higher the liquidity crisis intensity, the stronger the tensions on the Euribor interbank rate relative to the swap
Mory Doré

- 3/ Euribor against USD Libor basis swaps. This type of instrument is used to exchange financing conditions in €uro against financing conditions in USD. Under normal circumstances, the basis swap must be worth around zero because it means that the cost of liquidity in a given maturity of loans in Euros is similar to that of borrowing in dollars (For example a European bank will borrow over a year in Euro at 12-month Euribor + 0.20% or over a year in USD at 12 months USD Libor +0.20%). But today, the one-year € / USD basis swap is around -50 bp, reflecting the difficulties of European banks to obtain liquidity in USD across the Atlantic. Refinancing to a year in Euro at Euribor 12 months + 0.20% swapped in USD becomes refinancing to a year in USD at 12 months USD Libor +0.70%.

Under normal circumstances, the basis swap must be worth around zero. Today, one-year basis € / USD swap is around -50 bp, reflecting the difficulties of European banks to obtain liquidity in USD
Mory Doré

- 4/ ECB action and the LTRO weight (long-term refinancing operations) compared to the MRO (main refinancing operations). Since March 2008, the bulk of liquidity allocated to European banks each month during the ECB open market operations has averaged around 565 billion Euros. With a very abnormal distribution as 152 billion are in the normal refinancing operations with 1 week maturity (MRO) and 413 billion are in the operations of extraordinary repurchase agreement from 1 to 12 months (LTRO). That means a MRO / LTRO distribution of about 27% -73%, whereas historically from 1999 to 2007 for normal functioning of the money market in the euro zone, this MRO / LTRO distribution was approximately 90% -10%! !

The MRO / LTRO distribution is about 27% -73%, whereas historically from 1999 to 2007 for normal functioning of the money market in the euro zone, this distribution was approximately 90% -10%
Mory Doré

INDICATORS FOR MEASURING RISK AVERSION DEGREE AND THE IMPORTANCE OF FLIGHT TO ASSETS JUDGED RIGHTLY OR WRONGLY RISK FREE

- 1/ It is necessary to monitor the VIX, rightly called the fear index. This index is a barometer of US equity market volatility. From a technical point of view, it is calculated by averaging the volatilities on the main options exercise price (CALL) and sell (puts) on the S & P 500. The higher the level of volatility, the more fear and risk aversion rise in the markets and a high degree of pessimism on different themes: microeconomic fears regarding corporate profits; macroeconomic fears regarding global recession, fears of systemic risks (bank defaults, sovereign defaults ...)

The higher the VIX, the more fear and risk aversion rise in the markets and a high degree of pessimism
Mory Doré

- 2/ One of the best measures of risk aversion is to observe the spread between 3-month interbank market rate (Libor USD in the United States, 3-month Euribor in the euro zone) and the level of 3 months treasury bills in these areas (3 months Treasury Bill in the United States, three months Bubill in Germany, 3 Months BTF in France). it is Now called the gap between interbank rate and the rate of Treasury bills the TED spread (short causing the market to US Treasury and Eurodollar). Monitoring of this indicator is doubly relevant market: the higher the spread, as now, the more it means not only that the tensions in the interbank market are strong but also that investors favor Treasuries as a safe haven

The higher the TED spread, the greater the tensions in the interbank market are strong and stronger is the preference of investors for Treasuries as a safe haven
Mory Doré

- 3/ Another way to judge the risk aversion degree (we could also have considered this measure as an indicator for assessing the liquidity crisis) is to observe the level of banks performance in financial markets : both in their stock prices (and thus their earnings outlook) and the level of bank CDS (and thus their solvency outlook)

CONSEQUENCES WITH ASSETS REALLOCATION TO TEMPORARY SAFE HAVEN ASSETS

Monitoring these parameters and indicators can be used, with rigor and discipline to take trading positions and opportunistic investment on relatively short time horizons (day, week, fortnight, month ...)

Any spread widening of Euribor / Eonia swap, € / USD basis swap, Ted-Spread or any strong increase in the VIX will lead to panic behaviors and temporary portfolios reallocation in the markets. That’s why we speak of temporary safe haven assets

- Foreign exchange market

In the foreign exchange market, the Swiss franc (before pegging to the euro on the levels of 1.20 from 09.06.2011) and the yen during these episodes tend to appreciate sharply. This is due to the investors memory linking risk aversion to the unwinding of carry trades initiated between 2004 and 2007 at the expense of CHF and JPY. We remember that at the time the absence of risk aversion led to the game as follows: loans of CHF and JPY at very low rates, sales of these currencies against USD and other high-yielding currencies to capture an immediate positive cost of carry; the return of risk aversion led hedge funds engaged in the carry trade with large losses to unwind their positions by short selling heavily the major currencies against the JPY and CHF, this happened violently back in 2008 and 2009 and today, rightly or wrongly, any renewed risk aversion is often synonymous with appreciation of the JPY and CHF. It’s a little absurd because investors fly to these currencies only in relation to memory effects.

Renewed risk aversion is often synonymous with appreciation of the JPY and CHF. This is a little absurd because investors seek shelters in these currencies only from memory effects
Mory Doré

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- US fixed income markets

In the US fixed income markets, there is not just refuge in government bonds in the short term, there are also massive refuge on long-term U.S. loans State with the underlying idea that there are the most liquid assets in the world and then tradable when needed in case of severe liquidity crisis in financial markets. it is absurd, since these investments in USD denominated assets totally ignore the weakness of the US economic fundamentals or concerns about the current situation of public finances. One remembers, for example, that the downgrading of the US paper by Standard & Poors in August 2011 provoked a strong risk aversion among investors around the world and, instead of selling for fundamental reasons US government bonds, on the contrary they had sought shelters in this asset class.

The flight to US government bonds is absurd, since these investments in USD denominated assets totally ignore the weakness of the US economic fundamentals or concerns about the situation of the US public finances
Mory Doré

- Euro Zone

In the euro zone, there is in these periods of risk aversion, refuge for investors to long-term public debt of the "core" Europe and especially to the 10 years German Bund at the expense of peripheral debts, even when it is not exclusively linked to the periphery sovereign debt crisis.

IN THE MEDIUM TERM, WE SHOULD EXPECT A REALLOCATION TO CONSTANT SAFE HAVEN ASSETS WITH THE REVENGE OF REAL ASSETS

Beware, there will be sooner or later limits for investment in government securities only for risk aversion reasons. Other refuges less overvalued shelters will take over: Gold again and again (despite its strong bull path and especially because as a real asset, there can be no bubble); corporate securities with sound fundamentals; inflation linked assets, distressed and tangible assets backed securities with renewed interest, or emerging markets asset (sovereign, corporate, equity)

The only real question nowadays is how to allocate between real assets and financial assets
Mory Doré

In general, we still believe that real assets will take revenge and efficient perform for good reasons: excessive monetization ; inflation fears (especially the economic developments in emerging markets will eventually transform the excess liquidity to sharp increases in the prices of goods and services and not just increase the prices of some financial assets); prolonged period of negative real interest rates.

On the other hand, the profitability outlook for long-term financial assets will remain low: lack of strong growth (the public and private debt can no longer artificially support growth); need to recapitalize states and banks ; non-economic phenomena : risk aversion and regulatory and prudential rules forcing them to underweight financial assets

Mory Doré , November 2011

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