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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.
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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.
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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.
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Hopes that there might be some consensus evolving on Greek debt appears to have evaporated with European bond yields seeing savage moves on Monday. Bunds fell up to 20bps as investors sought out save haven assets. At the same time Spanish 10-year yields hit a post crisis high of 6.00% (up 35bps on the day) and Italian bonds – which have proved less sensitive to such stories throughout much of the crisis – were slammed 42bps higher to end the day around 5.68%.
The recent performance of BTP’s is worrying on numerous levels. Italy is obviously critical to the EUR project, its economy being around 45% larger than Spain. We don’t think Italian solvency is the ‘killer’ issue; if we got as far as that it probably means Greece, Portugal, Ireland and more notably Spain have already gone. What it does is weaken the German driven austerity solution and instead increase pressure to create a swift and effective mechanism (to default) to deal with the debt problem permanently – hence cracks in the French driven plan to voluntarily roll over Greek debt.
Extreme volatility looks set to remain the order of the day for the European bond markets (keep an eye on those ratings agencies, desperate not to be behind the curve on this one!), the euro should also face further heat. Indeed the range break in EUR/USD today leaves the 200-DMA @ 1.3900 exposed; through here the next stop would be 1.3650/60. Bears should feel comfortable as long as we stay sub 1.4220/50. As we noted on July 5th EUR/JPY looks as good a way of playing this theme. Throughout much of the last 12-months the yen has been as much a beneficiary during broader risk off moves, and with the EUR in the firing line this time it looks well placed to continue to outperform. Like EUR/USD we also saw a EUR/JPY range break today, the initial objective of which should be a drive towards 110.56 or close to seven big figures below where we were on the 5th. We have also seen sell signals generated from some of the longer-term moving averages. There is some scope for a short-term bounce but 113.42/60 should provide a solid ceiling from here.
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News flow weighing on the equity market mood on Wednesday morning with not only Moody’s decision to slash Portugal’s debt rating into junk territory last night but also another rate hike from the PBOC rekindling China slowdown fears encouraging profit taking. The e-mini S&P (ES1) futures have ticked down close to 7pts since the close as a consequence, hitting the 1,330.00 marker thus far, a touch above the first intra-day support level at 1,328.00. A crack here should see the faster money look to take the pair down in the direction of the more important 1,319.00/1,313.00 zone where there is some further intra-day support protecting the 100 and 55-DMA’s at the lower end of this band. Our daily indicators suggest the market is by no means overbought however, let alone signalling a more meaningful top is in place, so our preference for buying weakness remains. As we noted last week bulls shouldn’t be too ruffled whilst the market holds above 1,301 and we’d be surprised if the market can slide as far as that this week.
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EUR/JPY has had a modest pullback after the late June rally stalled at 117.80 resistance. The range traders should be encouraged by this with the base of the recent trading range down at 113.50/114.09 (200-DMA) compared to current levels around 116.96, which is pretty close to a three to one risk reward ratio for a short. While there aren’t any particularly compelling sell signals popping up on our daily indicators yet the hourly charts do hint at downside pressure.
On the fundamental side the Japanese are obviously keen to see a weaker yen but intervention prospects look rather slim currently. We’d probably need to see USD/JPY to make a decent run through 80.00 to prompt further BoJ buying. Equity gains are probably the greater risk for EUR/JPY bears, keeping pressure on the principle funding currencies (JPY/USD/GBP) where the policy stances are markedly divergent from the ECB’s. While we’re bullish equities on a multi week time frame after the strong gains of last week some consolidation wouldn’t be surprising which in turn would allow the EUR to drift lower in the short-term. Eurozone debt problems are rarely off the front pages too, underlined by this evening’s decision to cut Portugal’s debt rating to junk (Ba2) which ought to counter another (probable) ECB rate hike on Thursday.
Against this backdrop any run back towards EUR/JPY117.20 should be viewed opportunistically, working a stop on a close above 117.80. Shorts should add if 115.80/90 falls with a 114.30 target.
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