View: EUR problems to linger, volatility good for RV bond plays, US to outperform
It is interesting how people still feel the need to believe that the start of each year is a clean sheet, particularly markets. More relevant should perhaps be the level of the New Year’s Day hangover – now compounding those lingering from the past few years’ excesses – in trying to assess how this year will play out. It is rather unfortunate that the main story is still the most obvious by a country mile, Europe. It is far more fun to drum up a list of potential surprises, or in the post Taleb world ‘Black Swans’, which will catch markets by surprise. It still may be true with an increasingly stressed Iran (fate of regional ally Syria being a key factor here), a possible soft patch or not in China and the more important year-end risk emanating from the end of the trusty Mayan Calendar which any stockpile of guns and tinned tuna can’t save one from. But the real stresses will emanate from the Eurozone which despite all of those repeated breakthroughs remains in turmoil.
While to us it seems clear what the problem is – insolvency – governments and the EU itself still seem to believe that it is more a matter of rebuilding confidence, particularly that of fiscal sustainability. Unfortunately the debate on how to manage this has been one dimensional and Germanic in nature thus far forcing futile austerity packages upon everyone from Greece right up the ratings scale to France. This medicine might be fine for the usual business cycle recession. But this is not one. Scant attention has been paid to growth measures, key to stabilising debt ratios, with the structural reforms that might help raise productivity often being the first steps jettisoned by governments. Instead so called temporary tax hikes and quickly formulated spending cuts underpin fiscal consolidation, dampening demand and auguring in recession or maybe depression.
One only has to look towards debt trap Greece to see how such policy initiatives exacerbate the initial problems. Of course it’s fairly easy to criticise this example given that tax evasion seems to be more firmly embedded in Greek hearts than the Olympics (the fact that hosting an Olympiad often leaves one impoverished can’t be coincidence!) but the prescribed mix of aggressive fiscal measures and (in)voluntary debt restructuring which will still leave Greece with debt levels of 120% of GDP if (unachievable) targets are met is laughable. As one Greek government spokesman noted this morning, if the current bailout fails they will have to leave the euro. Greek depositors are clear on the risks having been voting with their feet to months in what is a slow motion bank run – and one that could quicken at any moment. We’d bet Merkozy et al. will view this latest comment as another negotiating tactic. Their own stance will of course be that leaving will condemn any country to a future back in the stone-age. We’ll come back to this specific subject in another note.
A bust Greece is the most immediate problem although that is by far the sole concern. Portugal looks to be following closely in Athenain steps while recent austerity measures in Spain and Italy will inevitably draw those economies into recession with France and its AAA rating not far behind. One additional risk we think is worth flagging is Hungary. In fact it could be the pick of EU members to be the first forced into something disorderly. The government in Budapest is developing an authoritarian tinge having already nationalised private pensions and is currently staging a soft coup to disgorge the NBH of its independence. The US has been vocal in its criticism, a band of journalists have been on hunger strike since early December complaining of censorship and Ministers appear hostile to IMF/EU conditions. The old problem of FX debt may yet turn toxic too with the forint nudging record lows vs. the EUR. Given that liabilities are largely held by foreign banks this creates room for a nasty surprise, a risk for Austrian institutions in particular. PLN/HUF longs could be a way to play this; Poland has its problems but, as round one of the financial crisis proved, is more resilient than most with a nice mix of competitiveness and domestic demand. We’d also be more optimistic on the zloty should risk appetite improve whereas Hungary’s problems should prove more lasting.
We’d bet Germany turns out to be more resilient than some expect; thanks in part to our view of a weaker Euro allowing the country’s export machine to grab further market share from its uncompetitive peers even if global growth as a whole slows. This trend should be helped along by both a more accommodative ECB, which is likely to continue to deny money printing while continuing to do so and cutting rates further. We also remain optimistic on the dollar, rate differentials helping what should be relative outperformance in economic terms too – a view the December ISM figures support, not to mention the Chicago and Milwaukee PMI figures already released – and of course its status as the world’s reserve currency looks a little safer.
Looking at the euro chart we’ve seen not an unsubstantial decline since those October highs perhaps but looking at the blocks fundamentals a much larger adjustment is still needed to help temper the recession/depression risks stalking club-Med. Selling rallies should remain the play based around a core short using swings in positioning to take the most out of declines. For now this pair has held the Jan 2011 lows (1.2870ish) and looks to have some room to test back towards and possibly through 1.3200 in the short-term as shorts are squeezed on New Year enthusiasm and technical break of the downtrend form those October peaks. But medium-term accounts should hold on through this and look to add if the opportunity to sell in the mid 1.30’s comes up. Resistance remains the 200-DMA. We’d expect to see EUR/USD sub 1.1500 at some point this year and a move towards parity is by no means an unreasonable target if you also buy into a cyclical dollar upswing.
Eurozone trials and tribulations should also keep volatility elevated in the bond markets creating more opportunities for the relative value accounts, although given how liquidity can evaporate as stresses pile up one might need to be rather nimble. Bunds will remain the region’s ultimate safe haven even if we see setbacks form time to time as the failed auction on November 23rd proved. But the real risk looks set to remain in France and Spain (which could flare up again) with Belgium, Austria close behind. We’d look to use any narrowing of spreads between these credits and bunds to look at wideners, depending of course on the immediate news flow. From past experience these markets are still slow to grasp both political and macro developments. The ECB may provide another source of movement. Italy is likely to see similar swings although given where yields are currently trading perhaps have less attractive credentials from a trading perspective. Greece of course is history although might end the year as a distressed debt play.
Good luck for 2012.
- Five reasons the world won’t end in 2012 (csmonitor.com)
View: France next in the firing line. Stocks, EUR should also feel the pain
Berlusconi or no Berlusconi, Italy looks in dire straits. The immediate focus is on blowing out bond spreads as the remaining liquidity in BTP’s evaporates, sending 10-year yields jumping through the 7.0% level (the 4.75% Sep 2021 bond trading 7.23% as we type). Recent buying from the ECB has just provided investors with liquidity to exit rather than helping shore up confidence in the market. But even before these death throws the picture for Italy was bleak; confidence measures have been in free fall for months and the decline in the purchasing managers’ indices has signalled recession since the summer. Average growth of barely 0.6% since 2000 highlights the fragility of the situation; recessions having the potential to play havoc with finely balanced debt dynamics.
Whether the immediate crisis is one of solvency or confidence is academic now (although those in Berlin, Paris and Brussels still probably don’t see it that way). It looks increasingly probable that Italy will be frozen out of debt markets, certainly at levels that are needed to fulfil its financing needs without blowing a huge hole in the budget and in turn triggering greater pressure from core governments and markets to enact aggressive austerity. Such steps would exacerbate growth pressures of course and one only has to glance towards Greece and Portugal to see how this would eventually play out. The Treasury needs to rollover a further EUR37bn debt by year-end, which by the looks of it the ECB will find itself reluctantly on the hook for, and for 2012 rollovers alone are just shy of EUR307bn. It’s no wonder that the EFSF (ratified at EUR440bn, plans to leverage it to EUR1trn are not really workable without pledges of more capital from the core) already looks like a relic.
There had been hope that the removal of Berlusconi would provide some breathing space but politics is fractured in Italy meaning the prospect of a strong government emerging out of the turmoil is slim, especially given the usual core/ECB prescription of ever more demanding austerity measures in return for aid/support. The IMF – whose arrival looks imminent – would have similar demands. We struggle to see what could really stabilise the situation now, to us it looks as if Eurozone politicians have past the point of no return, Italy (and the world’s third largest bond market) was too big to fail and the consequences will be pronounced and lasting.
BTP’s are likely to remain untradeable as this all plays out, but there still looks to be good trading opportunities elsewhere, in particular in French sovereign paper, contagion leaving its treasured AAA rating ever more exposed and with it the creditworthiness of the whole bailout mechanism. While Sarkozy announced a raft of new budget measures totalling EUR65bn over five years on Monday to shore up confidence, which should pull the deficit back to the 3% of GDP Maastricht threshold by 2013. Given the perilous state of the French banking sector though (which has nearly EUR500bn exposure to Italy, BIS Q2 stats) pressures won’t abate. We still like spread wideners vs. bunds to capitalise on this noting that 12-months ago Italian spreads were not too dissimilar to where French spreads vs. Germany lie today. From current levels of 146bps a push towards 200bps (bunds steady and OAT’s continuing to retrace back to the March/April yield highs) is a reasonable first objective. There is clearly more room for a significant spike higher if the crisis continues to snowball than for conditions to normalise.
Outside of bonds European markets have sold off for the past two sessions but overall have been rather resilient to this crisis specifically; the rally we saw in the region’s stock indices throughout October the most notable peculiarity although euro strength is not that far behind. Indeed, just based on macro trends and the probability of recession in the region we continue to expect that stocks will trade at much lower levels, favouring our sell rallies call, and the single currency itself needs adjust back to a price that would fit more closely with a broader rebalancing, certainly sub EUR/USD1.20 and probably closer to parity.
- ECB Issues Ultimatum To Italy, Threatens To Halt Bond Purchases (zerohedge.com)
- Italian Bond Yields Pass Key 7% Level (online.wsj.com)
- Goldman Sachs On Italy: “What’s Next” (zerohedge.com)
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)
ECB buying may have helped temper Italian and Spanish yields this week but looking at Eurozone debt dynamics more closely it’s clear there are still serious stresses at work. France has been a clear underperformer throughout; bond spreads to similarly rated Germany are now nearing 90bps vs. an average of around 30bps over the past four years while CDS spreads also continue to trend higher (see chart below). Pressure increased following S&P’s downgraded the US on August 5th amid market speculation France could be the next AAA to have its top rating rescinded – although all three of the ratings agencies have affirmed France’s status since. Nonetheless it seems the market wants more clarity on how the government intends to cut its budget deficit, viewing current growth assumptions as optimistic.
Of course the bigger weight on France is the debt crisis not ratings speculation. The ECB’s expansion of its bond purchase programme may have stabilised Italian and Spanish markets for now but still fails to tackle the underlying problems of solvency – which the regions politicians continue to baulk at. Similarly the extent of the ECB’s expanded role is not fully clear; we doubt that it is willing to monetise the debts of the peripheral credits (any bond losses would force a recapitalisation, one method of shifting capital from the core to periphery), expecting the EFSF to step in once its expanded mandate is ratified by individual parliaments. But even then the EUR440bn that this mechanism has to deploy pails into insignificance compared to the EUR1.8trn of debt Italy has outstanding let alone when factoring in Spain and the initial debtor trio. The market then will continue to look for angles to express their concerns.
Over the longer-term a forced fiscal union (another way to enact the north to south transfers needed to stabilise the currency block) should be bad for bunds as German austerity/credibility is diluted, but this saga looks like it has some distance to run until we reach the point where the Teutonic credit is permanently compromised. In the interim bunds will remain the regions safest safe haven asset.
We maintain our view that we’ll see sub 2.00% bund yields before the final end-game. Already futures are within touching distance of the August 2010 high at 134.73 (RX1) which is the immediate resistance market now. An upside break to test the psychological 2.00% level in the cash would target a rally to around 136.50 in the Sep future based on the current 3.25% July 2021 benchmark bond (DV01 approx 11.5 ticks per bps). Current volatility however means we should see large price swings before we hit here. Looking at the chart there is nothing substantial support wise between the current 134.39 price and 132.22/35. Nonetheless longs make a lot of sense both from a technical and fundamental standpoint and any sizeable dip should be viewed as an opportunity to add.
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