From Goldman's Francesco Garzarelli. Lots of conflict of interest comedy. Some good ideas.
- The European Financial Stabilization Mechanism backstops EMU public finances without distorting incentives.
- The focus now turns to budgetary plans by individual countries, and the new rules on fiscal coordination.
- The ECB’s ‘interventions’ in sovereign bonds have so far targeted the smaller, weaker credits.
- Secondary trading in Spanish and Italian government bonds is slowly ailing; over time, this should help financial risk subside.
- The dispersion of EMU sovereign spreads will remain wide going forward, reflecting greater differentiation across fiscal positions.
- EMU GDP-weighted 5-yr government yield is now 2.4%, comparable to the US, and roughly 80% of Emu public debt is held within the Euro area (relative to only 52% in the US)
Investors continue to discuss the European Financial Stabilization Mechanism (EFSM) announced over the weekend. Below are some more thoughts on this policy initiative, the ECB’s interventions and market reactions. Our comments here expand on those we presented earlier in the week, and during a joint webcast with Erik Nielsen on Monday. Spain announced further fiscal adjustment plans today, aiming to front-load its deficit reduction, while the European Commission will unveil its proposals for reforming the fiscal coordination arrangement within the monetary union. Both are very important for the medium-term direction of EMU spread markets.
Broader markets have benefited from strong activity data across the main regions, as Fiona Lake reviewed in yesterday’s comment. This morning, German GDP came in slightly higher than expected at +0.2% quarter-on-quarter, while France’s rose only 0.1%, lower than consensus. The Italian number is not out yet. Based on the partial breakdown so far available, exports appear to continue to lead the upswing, while investment spending is lagging. Pan-Eurozone GDP, available later this morning, should print +0.3% qoq.
Yesterday we recommended initiating a long position in the German DAX index at 5,937.16 for a target of 6,550 and stops on a close below 5,650. This trade ties into our view that ‘core Europe’ will benefit from the loosening of financial conditions, particularly in Germany, and from ongoing strong export growth towards Asia. Kamakshya Trivedi runs through this view in the latest issue of Tradewinds. In spite of the widening in country spreads, at 2.4% the GDP-weighted European 5-yr government rate is now the lowest since the start of the credit crisis in 2007, and close to its US counterpart. We are recommending short positions in 10-yr Germany against 10-yr US Treasuries for a target of 40bp, now 59bp.
Last night, David Cameron was sworn in as UK Prime Minister. His Conservative party will govern in coalition with the Liberal Democrats. Sterling is now back to last Friday’s levels against the Euro, and the trend is towards appreciation. We continue recommending long positions with a target of 0.83. The spread between 10-yr Gilts and corresponding maturity SONIA is relatively stable at 60bp. Later this morning the Bank of England will present its latest Inflation Report, followed by a press conference.
2. What to Watch
There are several market indicators we are monitoring particularly closely to gauge whether tensions in Europe are subsiding or not. Three in particular seem to us particularly important at this juncture:
(i) The average bid-ask spread on benchmark issues traded on the electronic MTS platform. After the dislocations in Euro-area government bonds witnessed last week, the market has become more two-way on Italy. Liquidity is slowly improving in Spain, whereas demand and supply remain distant in Portugal, Ireland and Greece, in spite of the ECB’s heavy open-market interventions in these credits. Our understanding is that the ECB will remain involved in the secondary government bond market until their functionality has been restored (more on the ECB’s actions below).
(ii) The 5-yr senior financial Euro CDS (iTraxx). Financial risk has increased in light of the deep cross-country exposures of EMU banks. The Financial senior CDS index has already compressed significantly since the announcement of the measures on the weekend, but still remains at elevated levels relative to the start of the year. Going forward we expect senior financial CDS, bank equities, and SOVX (sovereign risk) to co-move closely until sovereign tensions remain in focus.
(iii) The 3-mth Dollar LIBOR-OIS forward differential. Using the third rolling contract on IMM dates (currently Dec-10), the spread has widened to 35bp, from a 20bp since last September. This indicator tells us about risk appetite (desire to hold Dollars), and counterparty risk (European banks tend to fund their Dollars in the morning, when LIBOR fixes). In the view of some, the fixed charge for Dollars at the Fed/ECB swap lines at 1 week maturity (around 100bp over OIS) could be a factor preventing the Libor-OIS differential from declining. Our view is that the abundance of Dollar excess liquidity will over time encourage spreads to compress.
3. Further Thoughts on the EFSM and Sovereign Spreads
Some commentators, especially in the US, have drawn analogies between the EFSM and the TARP. These are ill-founded, in our view. Firstly, the European Financial Stabilization Mechanism (EFSM) does not entail additional funding by the Euro area. A further key difference is that the mechanism requires countries to apply for the funds and comply with a set of fiscal conditions to obtain them as targets are met. As such, it reinforces market discipline rather than creates ‘moral hazard’. The mechanism involves:
1. A facility, run by the European Commission, providing financing of up to EUR 60bn to EMU countries that have entered joint EU/IMF adjustment programs. The facility will probably remain in place permanently. The funds will be disbursed as and when conditions are met, on terms and conditions ‘similar to the IMF’s’. It is unclear, although improbable, that the facility will ever be fully pre-funded. As is the case for the existing balance of payment assistance program to EU non Euro area members, the Commission is likely to raise funds in markets by issuing Eurobonds backed by resources in the EU budget when a contingency occurs. The bonds would be super-senior, operating under a ‘joint and several’ guarantee (meaning that a claimant may pursue an obligation against any one party). The latest 9-yr EU bond trades close to Libor flat, and through corresponding maturity EIB and KFW paper.
2. An SPV backed by pro-rata guarantees from participating EMU states (possibly with some contributions from Sweden and Poland) providing an extra funding of up EUR 440bn. This scheme will be in place for three years. Although this has not been confirmed yet, the vehicle will presumably raise funds directly in the marketplace, allowing scalability. The funding offered to Greece was instead raised by each country domestically, creating problems for countries such as Ireland and Portugal, where the cost of funds had increased. For reference, using ECB capital shares for all the 16 EMU members, including Greece, a simple blended cost of funds is currently 1.3% at the 2-yr maturity and 2.4% at the 5-yr. The cost of funds would be presumably higher, since some of the credit risk of the distressed sovereign would be transferred to the lenders. Given the pro-rata arrangement, all members’ domestic issuance would cheapen. The structure will need parliamentary approvals, but these should be secured in coming weeks by the main contributors.
3. Co-financing by the IMF. The fund does not pre-commit capital, but it has publicly stated that it is ready to contribute up to EUR 250bn in this scheme.
Lending would come from a combination of these three channels (it is not for the borrower to pick between them). As stated before, these facilities represent a very substantial fiscal backstop for EMU countries that may undergo budgetary restructuring under a joint EU/IMF program. Crucially, unlike for Greece, the conditional funding commitment has been politically agreed well ahead of any new contingency. Erik Nielsen calculates that the EUR 500bn would be sufficient to take Spain, Portugal and Ireland out of the market for a couple of years, if they were ever to enter an adjustment program. The support scheme represents an important mutual risk-sharing mechanism, subject to conditionality set by the IMF and the Eurozone institutions.
Leaving Greece aside, the key question should now turn back to whether EMU countries currently under the spotlight, including Spain, Portugal and Ireland, will need to access these facilities or not. Our central case is that these sovereigns will not require non-commercial help. In this respect, there are today two important things to watch. Firstly, the Spanish government has just outlined additional budgetary measures agreed with the opposition aimed at a more front-loaded adjustment. Secondly, the European Commission will put forth its proposal for the reform of the Growth and Stability Pact, which governs the fiscal coordination among EMU members. It is widely expected that both the preventive and the dissuasive arms of the pact will be strengthened relative to their current version in place since March 2005 (see: http://ec.europa.eu/economy_finance/sgp/index_en.htm).
Coming to the ECB, the purchase of government bonds is not ‘quantitative easing’. The latter is aimed at increasing the money supply (a liability of the central bank) and spurring credit creation when policy rates are at zero. There is already excess liquidity in the European banking system, and the ECB provides longer-term funding ‘on tap’ through its LTROs. The central bank has instead embarked on something akin to intervention in the FX markets, to correct the overshooting seen in the last few weeks. The operations will be ‘sterilized’, presumably through the regular refinancing operations.
Peripheral spreads have narrowed to roughly where we expected on Sunday. Spain is now at 145bp over Germany at the 2-yr maturity, from 237bp, while 2-yr Italy trades at 107bp over, from 181bp on Friday. We see further room for compression, with Spain likely hovering around 100bp and Italy at 80bp. A bigger compression awaits more clarity on budgetary dynamics and growth. We continue to prefer Italy over Spain. Greece closed at 626bp over Germany from 1779bp on Friday, and Portugal closed at 160bp over Germany yesterday. Both credits have been targeted by the ECB, and the market is not two-way. The spread between Spain and Portugal is now too narrow.
Going forward, we think that the intra-EMU dispersion of sovereign spreads will remain wide. This reflects an increase in the standard deviation of debt-to-GDP ratios back to levels last seen in the mid-1990s, before EMU started.