Morgan Stanley On Europe: "We're Getting Worried"

Tyler Durden's picture

We have noted the similarities between the current risk rally and previous years but Morgan Stanley's Laurence Mutkin is "getting worried" that investors expect the second half of this year to be different (and consistently bullish). Much of the current risk-on rally around the world was sparked by Draghi's "whatever it takes" moment theoretically reducing the downside tail-risk in Europe. Well, systemic risk in Europe is now at recent lows...

and just as in 1H12 and 1H 11, core yields are rising notably, peripheral spreads compressing, money-market curves are steepening, and 2s5s10s cheapening.


Of course, he notes, 2013 is different from previous years (OMT for example) but much rests on how ECB's Draghi responds to the recent (LTRO-repayment-driven) rise in EONIA forwards. Albert Einstein reportedly said that insanity is doing the same thing over and over again and expecting different results. Applying that to the European bond market - for the third time running, the year has opened well but it would be insane to expect a different outcome (than the typically bearish reversion) this time?


Via Morgan Stanley, low could Core 2-year yields go? Shockingly, we think they could retrace nearly all the recent sell-off, under the conditions that

  • (1) banks' weekly 3y LTRO repayments fall to near zero (even if the first repayment of the February tranche at end-Feb is as big as the first repayment of the December tranche last week); and
  • (2) systemic sovereign stresses re-assert themselves; and/or 
  • (3) president Draghi forcefully states that the ECB will prevent a sharp rise in EONIA.

In the near term, therefore, much depends on how ECB president Draghi responds to the recent rise in EONIA forwards at next week’s Press Conference. Our economists doubt he’ll lean heavily against the rise in rates, but we hope he'll avoid the mistake his predecessor made in blithely characterizing the rise in EONIAs after the 1y LTROs’ expiry in 2010 as being no more than evidence of the improving health of the banks.


An End to the Rally?

Peripheral spread has tightened considerably since the OMT announcement. We have argued that the “magic” of the OMT has reduced tail risk events and hence bought time for peripheral countries’ economies to stablise and recover. This has been the case: yields have fallen and market confidence risen, leading to encouraging signs:

  • Converging current account balances in core-peripheral
  • Improving funding conditions for the banking system, evident in LTRO repayments; peripheral deposit flows stablised; and Target 2 balances and foreign ownership of Spanish and Italian government bonds showed signs of improvement

However, do the signs of improvement warrant further tightening? The answer is less certain than it was three months ago in our view. Given the level of peripheral spreads, the risk of a reversal is rising, due to a few critical factors:

  • Rising funding cost because of LTRO repayments: The larger than expected initial LTRO repayment has taken the markets by surprise and led to a rise in the money market rates and short-end core rates. Despite its possibly being a sign of a stronger banking system, the rising funding costs directly reduce the carry and attractiveness of owning peripheral bonds, in particular relative to Germany given rising German yields. 
  • End of further easing in a fragile recovery: With a seemingly stronger banking system and funding markets, ECB’s rhetoric became less dovish than markets expected in the January meeting. However, the weaker parts of the banking system as well as peripheral sovereigns are still relying on low funding costs to aid any further recovery.

    If the end of further easing is signaled and priced in by the markets, the fragile recovery could be dampened fairly quickly, given the rise in funding costs. So far we have already seen a small tick up in the Monetary Transmission Index for Spain. 

  • Valuation: Both Spain and Italy spreads versus Germany have tightened close to or through the lows reached following the 3yr LTROs. Despite the market’s acknowledgement that the OMT is a more credible backstop, valuations are less appealing now: Italy is overvalued and Spain is close to fair value.

  • Debt sustainability prospects for peripheral sovereigns have already worsened slightly this year, due to the combination of a stronger euro and higher absolute yield levels. 0-5y Spain and Italy yields are +30bp vs January’s lows; and our FX strategists estimate that the euro’s recent rally has made it some 5% and 12% overvalued for Spain and Italy respectively  – an additional drag on nominal growth prospects. As yet, this deterioration in the outlook for debt dynamics has been pretty negligible. But if core rates push higher and take peripherals with them, the market could focus more on debt sustainability again.

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deKevelioc's picture

Cure for a strong euro?  Begin the meme of the terrible euro, again.

Ghordius's picture

+1 send in the terrible clowns

dunce's picture

Nothing seems to get recycled as much as "this time it is different". Usually what they are referring to is political attempts to repeal the laws of economics as explained by the Austrian school of thought by legislation. The only thing that changes is their explanations for their latest failure.

SilverMoneyBags's picture

Same old story, same old outcome. Things would be better by now globally, if we had taken a different approach years ago.

helping_friendly_book's picture

Please look at this to explain why the people in North America are being abuse by the "chosen ones"

This news clip is from FOX news so I can say it is right wing.

if you watch the whole video you will be appalled by the truth.

I never thought I would ever claim a Fox news segment as the most honest reporting I have ever seen.

Bloomberg will not allow me to post this video.

the truth watch if you dare

It seems Bloomberg news hires disqus to censor their comment section.

Please feel free to go to any Bloomberg article and post this news report produced by FOX news.

I think disqus is paid by the piece, meaning they are paid a set amount for every censor of a comment.

I propose we break Bloomberg by posting this video, which is red pill stuff, on every article produced on


Volaille de Bresse's picture

"Europe's toast.

We all know that.

Yet nothing seems to happen.

I don't get it."


Me neither... I often walk the financial district of Paris and at lunchtime you see these scums... I mean traders on the sidewalks happy as as pigs in shit! Looks like business is good for them. They frown a bit when I tell them they should be hung with barbed wire (a rope would be too sweet) but apart from this... la vie est belle for them!

buzzsaw99's picture

The only thing MS execs worry about is their next bonus.

falak pema's picture

every time MS gets worried, its good news for the people.

Atomizer's picture

Morgun Stanlwee On Eulope: "We'le Getting Wollied" -Hahahahaaaa


Sony must launch the Flexible Full Color Paper Screen, begin licensing agreements.

The Future of communication or not!

Connect the dots.. ;)