Citi On The Two Latest European Deus Ex Machinas: The Improbable Swiss Franc Peg Rumor And The Impossible Eurobond Initiative

Tyler Durden's picture

Today's two, and two only, upside catalysts for this recent nano-volume breakout rally are the expectations of a Eurobond announcement following tomorrow's nth Merkel+Sark summit. Another expectation is that the SNB will announce any.second.now that it will peg the SNB, an event made virtually impossible as the whole purpose of the recent media PR campaign was to telegraph to the market what the SNB would like to happen, but what will actually not happen in reality (contrary to popular opinion, central banks, when actually doing instead of manipulating, act in total surprise, not in confirmation of leaked rumors). After all why be on the hook for more billions in losses when just spreading rumors achieves the same effect... however briefly. So for those just waiting for tomorrow's headlines which will have no mention of a Eurobond (at least until the next EUR rout), and for the imminent resurgence in the CHF once the market tires of being manipulated by a still completely helpless Philipp Hildebrand, here is Citi's take on both the very much improbable peg and the Eurobond news, which we believe will not happen until the Eurozone is officially on the verge of collapse as that is the very last round in the ECB's bazooka.

From Citi's Steven Englaner:

Discussion of a CHF peg appears to be the flavor de jour today.

 

Price action in the run-up to a peg should not be taken as a guide to how the currency will behave afterwards. If investors think that the peg will be established above spot, they have no incentive to buy CHF until the peg is established -- any buyer of CHF in the run-up is bound to take a loss at least temporarily once buying and selling occurs at the newly established peg. Therefore, in advance of the peg, EURCHF should  run up effortlessly to the expected level of the peg.

 

That easy run-up does not tell you anything about how credible and successful the peg will be. Once the peg is set, any EURCHF seller will have a more attractive level from which to sell, with CBs providing liquidity on the other side. And if the EUR comes under pressure because of risk aversion or sovereign debt concerns, selling EURCHF at the peg level becomes almost a one-way bet, at which point the commitment of the SNB (possibly along with the ECB) will be tested.

 

The odds of success would be much higher, if the peg was accompanied by some sort of hefty tax on foreign deposits or something similar to make challenging the peg more painful. If the peg is set above market and the EUR comes under pressure, investors will basically face a choice of buying attractive CHF or unattractive EUR at the peg -- it is pretty clear what they will choose. Adding an additional cost factor to buying CHF will balance the odds if there is a negative EUR shock.

And from Citi's Valentin Marinov on those mythical Eurobonds:

EUR started the week generally supported as market participants focused on the upcoming meeting between German Chancellor Merkel and French President Sarkozy. Investors will be looking for indications that France and Germany are moving closer to issuing common bonds as measure of last resort in dealing with the euro area debt crisis. The risk to the latest EURUSD rally is that the meeting could disappoint those looking for quick resolution of the euro zone funding problems. 

 

Recent headlines seem to suggest that the German officials in particular are still largely reluctant to embrace the idea of euro bonds as a way out of the crisis. According to Germany’s Finance Minister Schaeuble, the common bonds will require further fiscal integration which will involve ceding SOME national fiscal sovereignty for the countries involved. One concern that the German officials seem to have is that removing the country-specific funding costs would remove the incentive for fiscal austerity at any cost needed to solve the funding problems on a sustainable basis. German government was also quoted today as saying that the euro bonds will not be on the agenda of tomorrow’s meeting between Merkel and Sarkozy. 

 

Even with the above considerations in mind, there seems to be little alternatives to euro bonds when it comes to finding a solution to ease the euro zone contagion on a sustainable basis. Some analysts argue that the combination of (much) larger EFSF facility and continuing aggressive ECB bond purchases could provide a respite for the solvent Tier 2 euro zone countries. Yet, the prospect for larger EFSF facility will not guarantee lower funding costs for Spain and Italy. What is more, Citi economists argue that a potential increase of the euro zone bailout fund in excess of the currently proposed EUR 440bn may result in rating downgrades for both France and the EFSF. We suspect that, with growth prospects in the fiscally weak European countries likely to remain less encouraging for now, a larger EFSF facility may fail to sustainably reduce sovereign debt risks. In turn, the need for more comprehensive solution which would address the issue of the bond market fragmentation of the euro zone could come to the fore again. 

 

We think that the outlook for EUR will continue to be characterized by ‘a binary outcome’ going forward. On the one hand, indications that the euro zone politicians are working towards the eventual implementation of euro bonds should be euro supportive as these will reduce further the tail risk of euro zone break-up. In this regard, signals from Merkel and Sarkozy tomorrow that the implementation of euro bonds will depend on the degree of fiscal integration in the euro area ahead and that they are willing to propose steps towards closer integration could be seen as largely supportive for the single currency.

 

On the other hand, if Merkel and Sarkozy rule out euro bonds in favor of temporary fixes (increasing further the size of the EFSF) tomorrow, this is unlikely to support the single currency in our view. Importantly, if the latter outcome coincides with more economic underperformance in the euro zone member states, the chances for further large-scale ECB bond market interventions could increase and add to the headwinds for the single currency. Needless to say, if the reluctance of the euro zone politicians perseveres in coming months, growing tail risks could push EUR lower still across the board

Bottom line: fade this volume vapor rally.