As I Warned Yesterday, It Appears the Market Is Calling the Europeans Bluff – It’s Now Put Up Or Get Put Down

Reggie Middleton's picture

Yesterday I commented on the folly of promising big money to throw at
a myriad variety of highly indebted nation without a central authority
to enforce the structural change needed to actually cure the problems
that created the need for the monies in the first place. See  The
EU Has Set Up An Oppurtunistic Entry Point for Shorts Instead of
Expressly Offering a Solution to the Pan-European Sovereign Debt
and What
We Know About the Pan European Bailout Thus Far.
The primary flaw,
by far, that I perceive in this most grand of grand bailout schemes is
that it is just that – a bailout, not a solution. Methinks the market is
about to call the EU on their bluff pretty much along the same lines
that I espoused above. For those subscribers who follow my belief that
the ECB and EU leaders are making one of the largest policy blunders of
modern times, this may be an opportunity to set up a short position that
makes the Lehman Brothers’ debacle look like a day rally. All
subscribers are welcome to download our latest File Icon Euro Bank Sovereign Debt Exposure Preview.
A more verbose summary will be released for pro and institutional
subscribers shortly. Reference the following articles in this early
morning edition of Bloomberg:

Erases Gains as Optimism Cools; Stocks, Commodities Fall on China CPI

May 11 (Bloomberg) — The euro lost
all of yesterday’s gains on concern the almost $1 trillion lending plan
to bail out indebted nations in Europe will fail to avert a slowdown in
the region. Asian stocks, copper and U.S. index futures fell after
China’s inflation rate accelerated to an 18-month high.

The euro, after yesterday
strengthening as much as 2.7 percent against the dollar, traded 0.3
percent weaker than last week’s closing level as of 1:45 p.m. in Tokyo.
Asia Pacific Index
dropped 0.7 percent to 119.29 as declines in
mining companies and Japan’s banks countered positive earnings news from
corporations including Sony Corp. Standard & Poor’s 500 Index
futures lost 0.6 percent, following the biggest jump in U.S. stocks
since March 2009.

“Markets realized quickly that this
crisis won’t be cured by adding liquidity, no matter how big it is,”
said Toshihiko
, head of trading for currencies and financial products at
Mitsubishi UFJ Trust & Banking Corp. in Tokyo. “The structural
problems of the euro zone will persist. I’m not surprised at all the
euro is losing strength again.”

Greece may have its credit rating
lowered to junk within the next month, Moody’s Investors Service said
yesterday, citing the country’s “dismal” economic prospects. The
European Central Bank’s decision to buy government bonds, a move
designed to help reduce financing costs for countries including Greece,
poses “significant stability risks,” council member Axel

Inflation Accelerates as Loans Surge, Property Prices Rise by Record

– I led my Pan-European Debt Crisis series with a piece on
China macro for it is quite possible that a China bubble burst may be
the straw that breaks the European camels back. See Can
China Control the “Side-Effects” of its Stimulus-Led Growth? Let’s
Look at the Facts

May 11 (Bloomberg) — China’s inflation
accelerated, bank lending exceeded estimates and property prices jumped
by a record, increasing pressure on the government to raise interest
rates and let the currency appreciate.

Consumer prices rose 2.8 percent in
April from a year earlier, the fastest pace in 18 months, and property
prices jumped 12.8 percent, the statistics bureau said in statements
today. New
of 774 billion yuan ($113 billion), announced by the central
bank, was more than any of 24 economists forecast.

Asian stocks pared gains on concern
that Chinese officials will move to cool the fastest-growing major
economy, while yuan forwards rose. China’s top priority should be
preventing excessive increases in asset prices and liquidity after
Europe’s almost $1 trillion loan package reduced the risk of another
global slump, central bank adviser Li
said yesterday.

“Price pressures have been building
throughout the economy, strengthening the case for higher interest rates
and a stronger yuan,” said Brian
, a Hong Kong-based strategist at Royal Bank of Canada.
“China is at risk of overheating, with spot fires breaking out in
various parts of the economy.”

… The MSCI Asia Pacific Index
reversed a gain of as much as 0.7 percent after the China reports, to
trade 0.5 percent lower at 119.55 as of 12:03 p.m. Hong Kong time.
Non-deliverable yuan forwards rose 0.2 percent, indicating that the
government will scrap a peg to the dollar and let the currency gain 2.4
percent in the next year. The increase in consumer prices compared with
2.4 percent in March and the 2.7 percent median estimate of 30
economists surveyed by Bloomberg News. Producer
jumped 6.8 percent, also topping estimates, today’s release
from the statistics bureau showed. The jump in property prices in 70
cities was the biggest since data began in 2005, defying a government
crackdown on speculation that intensified last month.

Swaps, Libor Spreads Show Doubts Over Europe Bailout: Credit Markets

May 11 (Bloomberg) — Money markets and the cost
of protecting bank bonds from losses show investors are concerned the
almost $1 trillion rescue plan announced by European leaders may not be
enough to contain the region’s sovereign debt crisis.
Markit iTraxx Financial Index of credit-default swaps on 20 European
banks was last at 130.5 basis points compared to 100.25 basis points for
the Markit iTraxx Europe Index of 125 investment-grade companies, a
benchmark it traded an average 10 basis points below for three years,
according to CMA DataVision. The three-month Libor-OIS spread, which
widens as banks’ willingness to lend decreases, advanced to 19.17 basis
points from 18.92 yesterday and 6 on March 15.

The loan package for debt-laden
nations including Greece is part of an attempt to stem a decline in the
euro, which fell to a 14-month low last week, and stave off a sovereign
default that would threaten recovery from the worst global recession
since the 1930s. Banks’
potential losses stemming from the crisis are under scrutiny by
investors concerned financial institutions are owed too much by Europe’s
most-indebted countries
. [Look above for our latest take on this. Shorting into
European bank strength is the Reggie Contrarian Trade of the Day!

“Sovereign risk hasn’t gone away in
the slightest,” said Jim
, head of fundamental strategy in London for Deutsche Bank AG,
Germany’s biggest bank. “What this package has done is massively
reduced the tail risk in European markets without necessarily changing
the medium- to long-term dynamics of financial markets.”

Investor ‘Euphoria’ … Elsewhere in
credit markets, the extra yield investors demand to own corporate debt
instead of government securities fell 8 basis points to 169 basis
points, or 1.69 percentage point, after soaring 28 basis points last
week, according to Bank of America Merrill Lynch’s Global Broad Market
Corporate Index. It peaked at 511 basis points on March 30, 2009, and
dropped to as low as 142 on April 21. Average yields fell 0.5 basis
point to 4 percent.

The cost of protecting Asia-Pacific
bonds from default rose today as investor “euphoria” at the European
measures abated, according to Fumihito
, head of Japan credit research for UBS AG in Tokyo.

The Markit iTraxx Asia index of
credit-default swaps on 50 investment-grade borrowers outside Japan
climbed 3 basis points to 108 as of 11:27 a.m. in Singapore, Royal Bank
of Scotland Group Plc prices show. It declined 28 basis points
yesterday, according to CMA, after European Union finance chiefs agreed
to offer as much as 750 billion euros ($956 billion), including
International Monetary Fund backing, to countries facing deep budget
deficits and flagging investor confidence.

Europe Sovereigns… The European
Central Bank also said it will buy government and private debt. Credit
swaps on Greece tumbled 329.5 basis points to 586, the biggest decline
since March 2005, according to CMA. The swaps are still up from 364 on
April 12. Contracts on Portugal, which were 152 basis points four weeks
ago, dropped 170 to 255. Spain, which declined 65.5 to 173 yesterday, is
48 basis points higher than April 12. Italy, which fell 68.5 to 157
yesterday, was 124 basis points two weeks ago. “Maybe Greece won’t
default in the near term or even the medium term, but the debt hasn’t
gone away,” said John
, head of credit at Gartmore Investments in London. “Budget
deficits still need to be cut for the debt to be paid down.” Credit
swaps pay the buyer face value if a borrower fails to meet its
obligations, and prices decline as perceptions of creditworthiness
improve. A basis point equals $1,000 annually on a contract protecting
$10 million of debt.

Libor Rates… The three-month London
interbank offered rate in dollars, the rate banks pay for loans, fell to
42.1 basis points from 42.8 on May 7. The rate climbed 8.2 basis points
last week, the biggest increase
since October 2008, a month after Lehman Brothers Holdings Inc.’s
bankruptcy filing.

The difference between it and the
overnight indexed swap rate, the so-called Libor-OIS spread, climbed
yesterday even after the rescue announcement. Predictions for the spread
in the months ahead, based on contracts
trading in the forwards market, or so-called FRA/OIS spreads, are for
26.5 basis points by June, down from 38 on May 7 and still almost twice
the 14.5 basis points from two weeks ago, according to UBS AG data.

“People will remain somewhat on
edge,” said David
, a London-based strategist at CreditSights Inc. “There are
still a lot of hurdles to overcome before we get settled back to where
we were a month and a half to two months ago.”

The European bailout may unravel if
countries fail to meet austerity targets under terms of the loan
package, Watts wrote with strategist Louise
in a note to clients yesterday..

“You now have moral hazard at a
sovereign level and investors should still be wary of the whole
situation,” said Gartmore’s Anderson. “There are record deficits in just
about every country in Western Europe and something ultimately needs to
be done about them.”

Recovery Proves Short-Lived on Interest Rates, ECB’s Bond-

May 11 (Bloomberg) — Europe’s $1
trillion plan to rescue the region’s debt-laden governments may fail to
reverse the euro’s worst start to a year since 2000 amid bets the
central bank will keep interest rates at a record low for longer.

The currency surged by as much as 2.7
percent against the dollar yesterday before paring that gain, and
closing up 0.3 percent to $1.2787 in New York. It will probably decline
toward $1.20, according to UBS AG and Barclays Plc, ranked by Euromoney
Institutional Investor Plc as the world’s second- and third- largest
currency traders. Schneider Foreign Exchange, the third- most-accurate
forecaster of the euro against the dollar in the first quarter, also cut
its prediction.

Traders are betting the currency will
resume its decline as Europe’s economic recovery trails behind that in
the U.S., prompting the European Central Bank to keep its main
refinancing rate at 1 percent this year while the Federal Reserve starts
raising rates. The ECB’s decision to buy bonds may prompt investors to
question its independence and demand “a higher risk or credibility
premium,” Kenneth
, a senior market economist at Lloyds Banking Group Plc in
London, wrote in a client note.

“The cost of securing the future of
the euro is proving to be extremely high, as can be seen by the size of
the package, and there are a lot of long-term negative implications
attached,” said Ian
, a senior currency strategist at BNP Paribas in London.
While the rescue package “may provide some very near-term support for
the euro” it “doesn’t have an impact on the longer-term outlook,” he

The euro fell 0.5 percent to $1.2722
as of 6:36 a.m. in London, from yesterday in New York, and dropped 1.1
percent to trade at 117.99 yen. Europe’s common currency is
“endangered,” John
, who helps oversee $7.5 billion as chairman of New
York-based FX Concepts Inc., manager of the world’s largest currency
hedge fund, said in a Bloomberg Television interview. “The problem has
been found out. The king has no clothes.”

The 16-nation euro slumped 11 percent
since Jan. 1, its worst start since the year after its introduction, on
concern the debt crisis in countries from Greece to Portugal will slow
the region’s economic recovery and prompt the ECB to buy assets while
the Fed is exiting its own emergency measures.

‘Temporary Rally’… The currency
surged yesterday after governments pledged to make 440 billion euros
($562 billion) available as part of the package, with 60 billion euros
more from the European Union’s budget and as much as 250 billion euros
from the International
Monetary Fund
. It jumped 4.4 percent versus the yen in the two days
through yesterday, the biggest advance since November 2008. The gains
won’t be sustained, said Mansoor
, Singapore-based global head of currency strategy at
UBS, forecasting a “temporary rally” toward $1.35 before a drop. “The
euro will definitely hit what we call its long-term fair value at $1.20
and it may easily overshoot that if difficulties in Europe persist,” he
said. “The policy mix in Europe is becoming very unfavorable to the

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