Monday June 26

Stock prices rose fractionally today as rates rallied. The S&P 500 and the Dow Jones each rose less than 0.1% to 2,439 and 21,409 respectively. Economic data today showed that durable goods orders fell 1.1% last month compared to estimates which called for just a 0.6% decline. This continues the recurring pattern of poor economic data that is missing expectations, which hurts the chances that the Fed will continue to hike rates as hawkishly as expected. In Europe shares benefitted from an EUR 17bn bailout of Italian banks on behalf of the Italian government. The 2 year Treasury yield fell 2bp to 1.33%. The 10 year Treasury yield was unchanged at 2.14%. Accordingly 2yr vs 10yr bull steepened to 0.81%. USD rose 0.1% against EUR to $1.1180. USD rose 0.5% against JPY to Y111.85. Oil prices rose today after a heavy selloff last week. Brent crude oil rose 0.6% to $45.83 while WTI finished up at $43.43.

The bank rescue in Italy is raising some questions on the relationship between the government and private sector. Veneto Banca and Banca Popolare di Vicenza are being liquidated instead of going through Europe’s normal resolution process. The big winner in this deal is Italian bank Intesa. Intesa will assume ownership of the good assets of the two failing banks along with an EUR 4.8bn cash subsidy. That subsidy will go towards making sure the capital ratio is unchanged by the acquisition as well as other costs associated with the process. Intesa also received billions of dollars in guarantees that will go towards backing potential legal and other risks. The reason these bankruptcies didn’t go through the normal resolution process was because it was deemed the failure wouldn’t be a threat to financial stability. However many analysts and industry participants thought that going through the resolution process itself would have posed a risk to financial stability since losses on senior bondholders would have been imposed, which could have sparked a broader selloff. Rules state that in order for a bank to go through the resolution process losses have to be imposed on 8% of liabilities, which in the case of the failing banks would have meant some senior bondholders. Now investors can use that threshold and precedent set here to better estimate how other bank failures in Italy might go.

The bank stress testing process is set to get less stringent for banks. There are currently two portions of the annual stress tests. The quantitative element which determines whether a bank would be able to follow through with its proposed capital plans and withstand a severe economic downturn without having its capital dip below key levels. The qualitative portion of the tests have proved to be trickier for banks. Banks such as Citi, Deutsche Bank, and Santander have failed the qualitative element of the tests in recent years, which is embarrassing from an investor and public relations standpoint. Only one company since the financial crisis has missed the test for quantitative reasons. The fact that regulators also call out failing firms publicly seems a bit ironic. The whole point of stress tests is to ensure financial stability. If regulators publicly censure banks that miss stress tests, it could hypothetically create panic for that bank if the situation was bad enough. Going forward the tests might only probe the quantitative portion of the test, which would mean a lot more transparency and clarity for bank managers and investors as well. Stress testing is also set to ease for smaller banks, as there is a risk that those firms could overinvest and overspend to meet requirements.

Recent events in bond markets are suggesting that investor demand for debt from Chinese issuers may be getting close to full. As interest rates in China have risen this year and interest rates in the US have fallen, companies in China have issued an increasing amount of bonds denominated in dollars. Year to date Chinese issuers have already sold around $90bn in debt, which is close to the entire total for last year and already eclipses the 2015 year total. The largest Chinese property developer China Evergrande which carries a single B rating last week issued $6.6bn in bonds which is the largest ever high yield issuance from a Chinese company. The bonds carried a coupon of 8.75%, and they are already trading below face value which is abnormal so soon after issuance. That suggests that investors who were allocated bonds have been selling shortly after receiving them. That could be a sign of them receiving more bonds than they wanted. For this particular issuance the company increased the size significantly on the last minute, which could have resulted in investors receiving far more bonds than they wanted given that investors oftentimes bid for more bonds than they want since they rarely receive full allocations. There is also signs of investor concerns that Chinese issuers are simply issuing as much debt as markets can absorb in the current environment irrespective of need or credit conditions. That would be bearish for Chinese high yield corporate bonds.

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Monday June 26

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