Knight Capital's European Macro Notes - Why the Rally?
From Brian Yelvington of Knight Capital
Europe: The rally over the last few days has been driven by quite a few seemingly bullish headlines and one CDS scare. It seems every player that has gotten active in the space over the past couple months now has no interest in being long protection. Many of the ideas being bandied about are part of the normal process of working through such a large and difficult situation. We maintain our belief that the ultimate solution here will be one that involves a central treasury and central fiscal framework. Merkel’s “Pact for Competitiveness” provides a nice first step, but has no central treasury function and no real way to enforce the fiscal discipline portion of the suggestions – in short, it looks a lot like the Maastricht Criteria, but more fleshed out with respect to imbalances at the taxation and labor levels. The markets are pricing as if Germany and France are categorically on the hook already. Though we believe in that endgame, we do not believe the time is now for that to be priced in. With elections in Ireland and Germany coming up within the next two months (along with a slew of debt coming due), the markets will have a chance to see what the voters think. Democracies can make this messy.
The talk regarding the EFSF having the potential to buy bonds raises more questions than answers to us. For one, at what price will they be purchased? Banks that hold the sov debt are reticent to sell below par since that would make them realize a loss. The EFSF can ill afford to purchase bonds from banks at par when they are trading in the open market at prices well below that, and such a subsidy does not seem to make economic sense either. The aforementioned voters will soon recognize that this debt purchasing is a transfer and represents taxation on core country’s citizens to support periphery debt. Also, who might sell? The ECB’s program has a scant €76.5B to sell into such a scheme against an aggregate periphery debt load of over €3.2T. Direct issuance is a possibility, but then the EFSF becomes an even bigger CDO performing funding arb – at an unknown cost. With only €440B available, it seems that the funding for only a portion of the periphery would be achieved. Further, the AAA rating on the bond issuance out of the EFSF has a participant element to it. If a country needs funding, it is prohibited from contributing to the facility and whatever it draws comes out of the facility. Would a purchase of a particular country’s bonds by the facility constitute a drawdown per the facility’s rating requirements? It would seem so, though details are sketchy right now. Either way, this would seem to impact the ratings that were so important they took five months to obtain last year.
The most fearful prognostication from the point of view of those who are negative on the peripheral situation is that restructurings could occur that would not trigger CDS. There is no doubt this is possible, but there are more moving parts than first meet the eye. For starters, such restructurings would have to be voluntary and not binding on all holders. This puts the restructuring country in a game of chicken with bondholders. If bondholders hope for a better deal and hold out, then the country has not achieved its goals. Without Collective Action Clauses (CACs), it is going to be hard to get holders in a room and amend debt. We do believe that most of the debt is held by EMU member banks, who might be satisfied with extension so long as they do not have to take a loss, but we note that they are likely the chief purchasers of short dated protection and thus have a bit more incentive not to see the whole CDS protection matrix suddenly become worthless. Pols could also potentially desire an event (that settles near par) in order to shake out the speculators that they blame so heavily for the current malaise.
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