View: Spain ‘worries’ totally predictable, PM Rajoy’s delaying tactics all part of the game
Watching the Eurozone crisis unfold is a bit like sitting down to watch a few Road Runner cartoons, we all know Wylie Coyote is going to run over a cliff at some point we just don’t know what sort of pain and suffering he’ll go through first and the particular shape he’ll form when he hits the bottom. In these terms one could well compare the market to a four year old, deriving endless surprise, dare we say enjoyment, from what is a tried and tested formula. And so we find ourselves with panicked headlines from Spain once again with the usual media tarts rolled out with a new damning indictment on why the project is doomed, a scenario as predictable as any of those classic cartoons.
Full report below…
View: OMT helpful, but not unexpected. Should temper Fed doves demands for easing
While the crux of what the ECB was working on was well flagged in advance of Thursday’s policy meeting thanks to the usual ‘official’ leaks there seems to have been enough doubters to trigger a very positive market response to the official unveiling of its new bond purchasing plan. It is perhaps partly down to timing; we didn’t actually expect such explicit detail until the German Constitutional Court had dealt with the ESM issue and the fact that there was not any immediate pressure to finalise a strategy thanks to effective verbal support over the summer was another reason to pursue things in the usual Eurozone timeframe, i.e slowly. Furthermore the hostility of the Bundesbank to debt monetisation, as they see it, was (and still is) problematic. It appears Draghi just accepted that this wasn’t something that could be resolved with Weidmann clearly the sole dissenter when the board came round to voting. Another factor might be worth mentioning is the proximity to the FOMC meeting from which the market also expects support, admittedly aimed at addressing growth rather than solvency/survival of the Euro. We’d normally have expected some buck passing to the more proactive Fed, although in this instance the opposite might be true, more on that later.
Full report below…
View: ECB must step up to the plate to stabilise crisis
Prospects for technocrat governments in Italy and Greece seem to have created a glimmer of hope, a rather curios reaction given the multitude at problems facing the new leadership in these troubled periphery states. While the exit of Berlusconi certainly warrants feelings of euphoria – rarely do democracies have to suffer from such morally corrupt leadership for so long – the exit of Greece’s Papandreou doesn’t really shift the balance, after all he was something of a technocrat figure anyway. Replacing him with a slightly better qualified one won’t have a marked effect on the country’s long-term fate (death by debt trap). Similarly the problems facing Italy goes far beyond a delusional leader, politics is likely to remain fractured and the economy is already heading towards recession; further steps to tighten fiscal policy will merely reinforce these pressures and erode confidence á la Portugal and Greece. Italy is no Ireland.
Recent bond market price action confirms this. The overshoot in Italian yields last week may have been triggered by LCH Clearnet raising its margin requirements but the mild recovery since, aside from patches of short covering, has been a function of defensive and sometimes aggressive ECB buying rather than any vote of confidence in a new government and optimism the administration will be able to take meaningful reform measures. Real investors continue to vote with their feet, unwilling to give Italy the benefit of doubt, having already suffered ignominy in Greece where they are now being asked to take a ‘voluntary’ 50% haircut (which will no doubt rise at the next bailout) vs. a zero write down for official lenders. Such balance is unworkable longer-term in our view and certainly based on projections that leave Greece’s debt to GDP ratio at 120% after restructuring and the austerity programme.
Contagion to Germany’s AAA rated peers is equally noteworthy. France in particular is in the firing line with the quickly revoked ‘downgrade’ from S&P’s (we’re not quite sure what type of technical issue not only send out a downgrade but also writes the covering letter) seen by many as merely the shape of things to come. Looking at spreads to bunds France’s AAA charade has already gone, trading at 175bps over 10-year German paper (and that’s 15bps tighter this morning thanks to the ECB) still some 29bps wider than when we recommended selling France back on Nov 9th (http://wp.me/p1G1Fr-j3). While ECB activity will keep things volatile the path of least resistance is clear. Earlier victim Spain is also back in the firing line with penal levels of unemployment making austerity all the more difficult to enact and growth flat-lining even before the latest flare up. Elections later this month add a further mist to proceedings.
We’re inclined to pin the blame on this spread on the German’s. Not only do they remain rigorously committed to the one dimensional austerity driven solution, which simply can’t work in Greece and given the Italian economic trajectory is an equally dangerous endeavour there, but are also remain vehemently opposed to allowing the ECB to cushion the blow by becoming the lender of last resort. Such hostility to ECB money printing may have its roots in the hyperinflation of the Weimar Republic (and we all know where that led) but economic conditions are somewhat different in 2011 to the 1920’s and there is also ‘form’ as to how such monetisation might impact thanks to quantitative easing programme enacted in the US and UK. To suggest that by allowing the ECB a broader mandate could lead to a similar outcome is simply disingenuous. Of course the German’s still do not see it this way. Nor do they appear (or want) to understand the difficult in enacting round after round of aggressive austerity in the countries in the firing line. It’s always easier to prescribe than administer.
A good dose of pragmatism is needed, growth is vital to stabilise debt dynamics which appears to have been largely overlooked when conjuring up the bailout programmes. Austerity may have a similar impact on a multi-year (decade) timeframe and avoid the moral hazard element that is proving so hard to sell to core electorates, but it is unrealistic to think markets will be willing to move on with a solution that leaves the periphery in a quasi-depression –it will simply lead to more contagion. Nor do we believe countries affected will have pain thresholds high enough to tolerate such narrowly focused solutions. In fact the most likely consequence of technocrats administering German medicine is that it fractures whatever flimsy consensus remains, significantly increasing the chance of a disorderly end to euro membership for some states or even the death of the entire project.
With realistic compromises there is still room to put in place structures to end financing pressures, speed up structural reform and ease pain of austerity and therefore downside risks to growth (or recession!). Reforms need to be focused at a structural level rather than on immediate slash and burn budget consolidation. Measures including raising retirement ages, means testing entitlements and reducing red tape for business would all provide significant medium-term benefits. Tax reform should also feature heavily. A weaker euro also has a critical role to play in helping temper the pain of adjustment (see our note of November 9th http://wp.me/p1G1Fr-jd). Most importantly now though is the influence of the ECB. It is the only institution that has the resources to provide the necessary liquidity, enabling it to retake the initiative lost to markets. Despite its protestations this might actually already be happening, by being forced into aggressive purchases of Italian debt (which the new Monti government will at least ensure it continues to do) the ECB will find it increasingly difficult to sterilise its interventions. It had hoped it would be let off the hook as an enlarged EFSF came on line but plans to leverage this fund have unravelled as quickly as they were announced and the EUR1trn size muted is still insufficient. This leaves the ECB with little option but to reluctantly purchase debt of those struggling to fund in the market.
It would be ironic if Europe blindly walked into a solution having walked into so many traps eyes wide open.
View: Is a Greek bank run top of the ‘what happens next’ list?
Shy of a miracle it’s difficult to see how the fallout from Greece PM Georgios Papandreou’s referendum pledge can be contained. Even if his own party opt to eject him to try and limit collateral damage or he falls in the looming confidence vote he has also promised it will be difficult to put a genie like this back in the bottle. The ruling PASOK government has offered this to the public and we’d imagine there would be a marked reaction if this was stolen back. The damage has been done.
The key question should now be where this leads to in the short-term. Markets are fretting over a government collapse and what this means for the recently agreed bailout, given the vocal criticism of the PM within PASOK today this looks a viable outcome. Equally relevant is how this development impacts the broader EU debt crisis solution; would a disorderly Greek default wipe out the flimsy firewall the EFSF provides for Italy at al., even the new improved version? But there are more immediate risks in our mind at the local level that the market does not appear to be considering yet, namely the prospect of an old school (perhaps not that old remembering Northern Rock) run on the banks.
Local deposits have been eroding at pace for many months (there are plenty of stories of Greek cash buyers in the London housing market trying to protect their cash assets) but faced with years of even more intensive austerity and thereafter a still unworkable debt burden (120% of GDP if the new bailout is to be believed) this pace can only increase. The flip side now appears to be a ‘no’ vote and effective bankruptcy, not to mention the obvious implications that would have for Euro membership., one would have to be deluded to keep any sizeable deposits in local banks, no matter how strong one’s sense of national pride or fondness for the drachma might be.
In fact sending money offshore offers depositors sizeable upside and zero downside. Such a scenario however would only reward those with first mover advantage, solvency would quickly evaporate and take Greece to its pain threshold far more rapidly than any political evolution. This would inevitably force the ECB into the hot seat but whether active intervention from Frankfurt would be enough to halt the snowball is a question we’d rather not see tested.
- Greek Referendum Is On (zerohedge.com)
- THE BIGGEST BOMBSHELL OF ALL: Greek PM Papandreou Has Gone Rogue (businessinsider.com)
View: Greek debt burden not sustainable at 120% of GDP, growth more vital than ever
After much haggling and no doubt some bashing of heads behind closed doors Eurozone leaders have finally settled upon a ‘solution’ the debt crisis that has been plaguing markets for the past year or so, agreeing to increase the voluntary haircut (helping avoid one criteria for a credit event) on Greek debt from the paltry 21% agreed back in July to 50% while plans have also been approved to increase the notional size of the EFSF (gearing its EUR440bn to EUR1trn) and finally to recapitalise the banking sector.
Markets have responded positively to the apparent breakthrough (Eurostoxx 50 up 4.2% and the DAX +4.0% approaching lunch), but as ever the devil is in the detail. What grabs our attention immediately is the rather worrying statement that the Greek deal should bring the debt to GDP ratio down to 120% of GDP by the end of 2012. A staggering number based on a 50% write down for private bond holders and hardly a route to debt sustainability given the pressures the economy remains under. Some of the underpinnings of the deal appear particularly optimistic, such as a further EUR15bn increase in the already elevated EUR50bn the government will have to raise from its privatisation programme. It is easy to be cynical in these matters, nonetheless we don’t think the package can create the necessary conditions for growth which is vital to stabilise the terrible debt dynamics. It looks reasonable to expect further write downs if the official lenders are not willing to take a haircut on their commitments too. Private investors’ hands should at least be strengthened by this in a next round, even if in the first instance the cost is expensive.
As for the EFSF, expanding the facility was critical. By the looks of things the fund will effectively provide some form of insurance protection to bond holders although how this will actually fits together is vague, it looks like the technical details are still being worked on. On paper the increase looks to be enough but given the questions over the Greek element of the deal, it might not in six months’ time. Equally interesting is how Eurozone leaders broached the subject of bank recapitalisation. Rather than any official action the banks will have to raise capital themselves (EUR106bn in total) so that core tier 1 capital ratios reach 9% which ought to have interesting implications for credit going forward, details of which are here http://tinyurl.com/6gww5fl.
Overall its clear progress has been made but whether this marks a clear break with the past is uncertain. Fine details are largely absent as it typical for European summits and we’re not convinced the steps are aggressive enough to draw a line under the issue. There are plenty of risks, questions remain over Portuguese solvency and Italy is still in precarious territory due to its huge financing needs and political dynamics. From a market perspective we think a lot of this good news is priced in. Of course there is room for the euro and equities to rally in the first instance as some money had been taken off the table ahead of the summit. But we think as the plan is digested some caution will creep back in, investors likely to be wary of execution risk as ever. The reaction of Greek bond yields might be telling, the 10-year is still trading around 35c to the EUR which even we can work out is more than a 50% implied haircut. Selling into the EUR/USD rally looks a natural way to play it from our perspective. There still remains little room for shocks even with an enlarged EFSF. Growth trends across the block are worrying with recession risks elevated, without growth solvency issues can only creep back in.
View: Bund chart still signalling rally reversal, stay short while above 1.96%
Investors have taken a more constructive view of European leaders of late, feeling they have finally seen the light and will take the necessary measures to form a credible firewall around both Greece and the wider sovereign debt problems infecting the Eurozone. Steadier markets however seem to be having their usual effect, allowing politicians to return to the long standing game of brinkmanship. The gulf between France and Germany – or the core of the core if you like – will remain the focal point.
Both sides appear to agree that the EUR440bn EFSF must have more resources and banks recapitalised to limit contagion of a Greek restructuring, but discussions on how this should be executed are as ever fractious. France is in increasingly dire straits with its stuttering economy and an increasing hole in its bank’s balance sheets (we hark back to the mid when Credit Lyonnais was pushed close to bankruptcy and their Paris HQ conveniently burnt down along with much of the incriminating documentation), not exactly the strongest hand and one not lost on the bond market, see chart above. The German leadership on the other hand is under intense pressure to spread the cost burden of an enlarged bailout fund (to whom we’re not sure), with voters and the courts limiting Merkel’s room for manoeuvre.
The impact on the bund has been notable this week with yields retracing from resistance at 2.250% tagged on Monday, sliding all the way back to 1.985% before steadying. But shorts shouldn’t be tempted to bail out just yet despite this reversal. Technically this price action looks very much corrective; the base that has formed on the chart over the course of September is still the more substantial force. We’d expect to see the market trade in this higher 2.03-2.25/27% range into this weekend’s Eurozone talks and certainly not trouble the important 1.96% line above which the mood is bearish, i.e a bias towards higher yields. The ultimate aim is for a push towards 2.37% in the first instance, again while we hold 1.96%. From a risk reward perspective current bund levels look attractive for new entrants.
While German officials have been blunt in stating that markets should not expect a clean resolution to the crisis from this summit, we expect to see progress which should be enough to prevent any meaningful reversal in (improved market) sentiment, hope no doubt shifting to the next G20 meet in November. As we noted back on the 10th October (http://wp.me/p1G1Fr-ec) the overwhelming pessimism that has swept markets in recent weeks does indicate a good chunk of pain is priced in (bund yields fell in excess of 180bps April through to September). Another interpretation of bearish bund price action might be that Germany is on the point of accepting it will have to shoulder the principle liability of resolving the Eurozone crisis and as such credit risk ought to rise. Those that disagree with our directional ideas might be better placed being short EUR rather than long bunds.
- French bond blow-out, chart du jour (ftalphaville.ft.com)
View: Sell the EUR/USD rally, but be ready to fold if 1.3834/37 weekly line falls
Improvement in risk appetite over the past seven days is notable. Stocks have bounced aggressively; battered commodities have managed to put in a decent bounce as have the higher yielding currencies such as AUD and BRL. And that other proxy measure of risk has also mirrored this, the DXY pulling back sharply from 38 week highs touched on October 4th at 79.83, helped along by a strong bounce in EUR/USD which has taken this pair back from the 1.3146 low to the 1.3800 area or up around 5% – rather painful for EUR bears like ourselves but not quite yet a game changing move.
There have been a number of forces at work, firstly expectations for a US recession have been pared back thanks to a string of better numbers (we’d note the market was already adjusting to this prior to last Friday’s payrolls report which if you look at closely is not as encouraging as the headline rate implied) and there has been a growing expectation that European politicians have woken up to what needs to be done to stem contagion risk from Greece, promises of bank recapitalisation are critical in our mind although an emerging consensus for leveraging the EFSF is equally key. On top of these we also had dovish FOMC minutes which showed there was still some support for QE3 type steps if measures taken proved insufficient to bolster growth, never nice to hear if you are a dollar bull.
Looking at the FX crosses, EUR/USD’s reversal has been aggressive, helped along by bearish positioning and the move to pick up risk again as the market adjusted to better news flow. Whether such gains are warranted on a fundamental basis is highly questionable. Although the Eurozone debt crisis may be nearing its end game the saga has inflicted substantial damage on confidence across the region, austerity policies will continue to sap growth in club Med and in core Europea growth has also stalled – before the debt crisis really took grip too. So recession is still the most probable outcome for the block and the case for the ECB to unwind earlier tightening remains compelling.
Technically the picture remains medium-term bearish too, a close above EUR/USD1.3834/37 on the weekly chart – which incidentally is also the 50% Fib line of the August/October sell off – is needed to shut off lower targets and from a daily perspective the 1.3950/1.4060 (200-DMA) area above here should prove tough to crack too. Indeed, our view remains bearish for the EUR on a multi-week timeframe (sub 1.30) and we’d only abandon this view if we can hold back above that weekly pivot or if the Dollar index (DXY) fails to hold support at 76.45/50 which would suggest the recent break here was a false dawn. Shorter-term break traders might prefer to look for a fresh swing lower rather than attempting to pick the top of this move given momentum and the broader improvement in risk appetite to which EUR/USD is well correlated too. In this regard support at 1.3680/90 is the first area to watch; a swing through here would have room to run to the lower 1.35’s in the first instance.
- EUR Shorts Flee The Overcrowded Burning Theater In Disorderly, Multiple-File Exodus (zerohedge.com)
- ForexLive US wrap: EUR stalls at key retracement (forexlive.com)
View: Bund profit taking could push market back to 2.09/11%
After tagging a new intra-day low at 1.68% on Tuesday Bunds have reversed, ending yesterday’s session just shy of 1.80% and pushing on towards 1.85% in Wednesday trading. There are a number of forces at work with speculation that the Chinese might take a more proactive role in the European debt crisis (despite rather contrary comments from PM Wen Jaibao at the World Economic Summit in Dalian where he emphasised fiscal and monetary responsibility) and perhaps more importantly the return of ‘Eurobonds’ – courtesy of European Commission President Jose Manuel Barroso – to the messy debt debate which follows on from comments from Chancellor Merkel yesterday that the EU would take whatever steps necessary to avert a disorderly Greek default. Sarkozy is also on the case (talk being he can charm Merkel into agreement which his recent track record adds credence to!), following intense pressure on the French banking system.
In light of recent bund gains some profit taking looks sensible. But this should be a corrective wave. We don’t think we’re quite at a watershed moment in terms of European consciousness – the usual routine appears to be happening again, namely that the crisis flares up forcing policy makers into fresh promises which in turn calms markets allowing politicians to revert back to their normal posturing between EU and local influences. No ‘definitive’ statement can alter the fact that Greece is in a debt trap, only hard cash from Germany can and that doesn’t look forthcoming.
Technically the corrective case looks strong. The market failed to hold below the 1.75% marker for two consecutive days which we identified as the first objective in our September 5th update and price action is also pointing to a more pronounced bounce in yields. Ultimately lower yields do look reachable, 1.55% being the more significant lower target. But before we get here there should be a notable retracement, the 1.94% line being the first level to reach ahead of 2.00/03% and the more important 2.09/11% area. A break of this and 2.26/27% would come back into play. Given room on the upside the risk reward from holding onto longs are rather asymmetric. In fact, looking at some of our indicators we’re not that far from a short-term sell signal on perhaps a 5-10 day timeframe.
- End game approaches for Greek crisis (marketwatch.com)
View: Bunds still the only viable defensive play, 1.55% yields beckoning
We’ve been bullish bunds since the start of the summer on expectations the Eurozone crisis will get worse before it gets better. Unfortunately for those living in the region this prognosis was spot on, and there is still looks no end in sight with glaring splits within the block clear for all to see. To make matters worse the breadth of problems continue to grow with each new euro bailout plan proving too little too late – exposing the flawed political structure of the EMU project as much as those of the single currency itself. Indeed, the Greek bailout proposed back on July 21st looks doomed to fail even before it’s off the ground; not that its structure was all that viable in the first place. The ECB meanwhile has been forced into buying Spanish and Italian debt to prevent a total freezing up of these two key markets as investors voted with their feet, exposing its vocal independence as something of a fraud (not a criticism unique to the ECB we’d add).
Last weekend’s State elections in Germany have further complicated the already chaotic situation. Defeat of Angela Merkel’s coalition block in her own State – despite heavy campaigning by her personally – can be attributed directly to her mishandling of the crisis in the eyes of voters. Given that Federal elections are due next year the concept of Germany pushing for any form of consensus based solution looks more and more improbable. Self-preservation will become the goal.
Politics aside, economic pressures are spreading with a clear deterioration in conditions across the block in July and August following from an already disappointing Q2 GDP performance. If powerhouse Germany is faltering what hope is there for those being forced into further austerity. Of course it is easy to say growth should be the priority – the truth is the crisis is now so mature that even this is no longer a viable strategy – after all who would lend to enable these governments to pursue growth policies. So it’s back to that question of which countries are already insolvent and which are guilty by association and of those which can still escape. 12-months ago this would have been a fairly straightforward question but now the shades of grey continue to spread and with it the ultimate cost (see chart above).
As the death throws play out (it may take a while yet) perceived safe haven assets will continue to find buyers – forced or otherwise – with bunds set to be the principle beneficiary. We anticipated sub 2.00% bund yields in are article of August 3rd, the weight of demand though has already seen yields gap below here. The next target level on a cash basis is 1.75% but the principle draw should be 1.55%. Looking at the political and economic realities this looks easy to justify, factoring in uncertainty/panic over the future of the entire euro project even more straightforward.
In futures terms, pushing on from already record highs, the psychological draw is the 140.00 level (RX1), above there lies strong weekly resistance currently at 140.24 (rising approx. 10 ticks per wk) which looks a more robust target. Higher projection levels from the weekly continuation chart point to as high as 145.03 by year-end but we’d expect to see a decent retracement before a leg towards here, even if this is just due to increasing volatility/panic and the political reactions these trigger (reform of the EFSF and more touting of ‘Eurobonds’ potential triggers). The first decent initial support area comes in at 136.18/26 on the daily chart now although we’d need to see 133.88 fail to confirm any more permanent top is in place and expect buyers, if given the opportunity, to use such dips to continue to accumulate.
We mentioned on Friday in our payrolls article we like curve flatteners in the US and the same logic also applies to the German curve although the market is a little further down the line here. But given the deflationary policy mix at work in the Eurozone and ECB’s (lack of) tolerance for aggressive monetary policy the foundations for the flattener are even better.
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