10 December 2014: China Rubs Salt Into Weak Oil Wound


China's Securities Depository Corporation announced (CSDC) Tuesday that they would no longer accept non AAA-rated corporate debt securities as collateral in repurchase transactions, essentially raising the cost of short term collateralized borrowing in the private sector. AAA-rated corporate debt securities to be pledged as collateral must also originate from AA-rated issuers. The CSDC aims to improve the dexterity of short term borrowing albeit at higher borrowing costs by creating a mandatory preference for up-in-quality securities; to better prepare its financial and private sectors against any untoward financial circumstances. This also comes on the back of the heels of the Cabinet's decree to clear lower quality debt including the local government financial vehicles (LGFVs) from the repo market. Given that more than 1trn Yuan of outstanding corporate bonds are now deposited at the CSDC, analysts estimate that around 500bn Yuan of those securities would then be ineligible for repo dealing.

Apart from tightening collateral rules, the PBoC also fixed the Yuan higher as it tried to clam down on excessive risk taking in the local equity and corporate debt markets. The results were not as encouraging as the intentions of the PBoC were. The Shanghai Composite saw its largest 5.6% daily decline in more than 5 years as money rotated out of Chinese equities and into the the safety of safe haven assets like Treasuries. Chinese IG and HY credit both saw spreads widening significantly and this carried over to American trading. Interest rate swaps have been propelled higher while corporate debt sold off strongly. The Yuan saw its largest drop against the greenback since late 2008 despite the PBoC bidding efforts. Overall, there was a net outflow of capital from the Chinese financial markets as even bond yields on Chinese government debt rose significantly.

China has hinted rather overtly it wants to drastically reduce leverage in its stock and bond markets, and is partially working on this goal by tightening monetary policy through indirect tools; fixing Yuan higher and raising collateral standards and reducing availability.


Japan also saw a weaker than expected revision to its 3Q14 GDP figures Monday, ascertaining fears that Japan has officially slipped back into its fourth technical recession in 5 years, echoing the market's consensus for continued QQE by the BoJ and possibly even further measures to stave off the next leg of its deflationary spiral. Although lower oil prices would be a tailwind for the Japanese economy overall, the marginal benefit on Japanese corporates' bottomlines would still not be able to offset the structural and cyclical weaknesses in its real economy. The weak Yen continues to put pressure on import costs, especially that of energy in the form of natural gas. Unless oil prices continue their decline towards $50, it remains unlikely that Japan would experience any material benefit.


Crude oil continues its stumble with North Sea Brent breaking $65 for the first time since 2009 while WTI printed a $60 handle as OPEC confirms that demand in 2015 will be the weakest in 12 years. This comes on the back of Iran's opinion that oil could see $40 if the current discord between OPEC members continues. The historic rout in oil prices worldwide has also led to adverse negative feedback in energy intensive economies; notably Venezuela and Nigeria, with CDS spreads indicating a 80% likelihood of default for the former. In America, HY debt across the energy sector has been diverging lower from its equity counterpart. However as hopes of a rebound in energy prices and CAPEX diminishes, the latter is expected to snap back to its less sanguine cousin.

The Russian Ruble is almost 50% lower against the Dollar since the start of this year, mainly due to financial sanctions and isolationists treatments imposed on the Kremlin. The recent weakness in the Ruble though, has been attributed almost entirely to declining energy prices, as Russia is Europe's largest energy exporter.

The current phase in crude oil hallmarks a new paradigm in its process of price discovery where supply becomes less price elastic, as evident on the reluctance on OPEC's majority consensus on not to reduce production instead allowing prices to settle in an equilibrium, and demand is forecast to remain sluggish due to a cyclical downturn in global growth. This new paradigm probably entails oil prices that are sticky to the lower end.


Over in Europe, a crisis seems to be unavoidable as Germany and France are bickering over the press media, with the Chancellor criticizing her French counterpart on his management of France's fiscal problems, stoking Euroskeptic sentiments throughout the currency bloc. Adding fuel to the fire is Greece calling for a snap presidential election next week raising the specter of a parliamentary dissolution, which again gives rise to Euroskeptism and fueling the already worrying trend of anti-reform and anti-austerity. More importantly, this sows the seeds for a Grexit (Greek-exit, a term popular amongst market players in 2012) and breeds further fear that the radical Syriza party could gain the upper hand in a possible new parliament.

The ASE (Athens Stocks Exchange Index) is now down over 18% from the highs on Monday while yields on the 3Y GGB have surged to 9.35%; this is 75bps higher than that of the 10Y GGB, meaning an inverted yield curve. GREXIT has once again spread contagion fears across the periphery where Portuguese, Italian, and Spanish bond spreads have all started to inch wider. German Bunds and US Treasuries remain bid as the rotation remains obvious.

Last week, Italy's long term credit rating was downgraded by S&P to a mere notch above junk status. Many believe that the ECB will be forced to conduct sovereign QE, rather than the covered bond purchases now, and it seems market participants are already or have already priced in this possibility by initiating pairs trading positions speculating on convergences and divergences across the European sovereign debt market.