Despite a green showing in European equity indices this morning (aside from Spain that is) - as they shrug off the dismal China/Aussie data overnight in the incessant belief that bad is good and worse is better - there is a bid in a number of the major AAA safe-haven assets in Europe. Swiss 2Y rates are dropping notably this morning, German and Danish 2Y rates are stable to dropping, and Dutch and Finnish rates remain extremely low. It seems that between Merkel's comments this morning and the following big three unanswered questions - it's not all risk-on in Europe, and expectations for a squeeze in EURUSD - with net shorts at 2012 lows and USD longs basically neutral - seem exaggerated for now.
2Y Swiss rates are dropping notably again today - to one month lows - and the rest of the major AAAs are stable to trending lower in the last few days...
USD longs have been reduced to an aggregate 'flat'...
and EUR positioning is near its most long...
Via SocGen; The Big Three Questions
How will the ECB address seniority? This is probably the thorniest question out there. If the ECB is senior - as was the case in Greek PSI - then investors will discount higher loss given default for new programme countries. If the ECB is not senior, it may be in danger of breaching Article 123, which prohibits it from funding governments.
We see several solutions.
- Only purchase T-bills: The ECB could focus its purchases on T-bills, which are typically kept outside debt restructuring. That would effectively keep the ECB senior, but would also up loss given default on peripheral sovereign bonds.
- Ask the EFSF/ESM: The EFSF/ESM could offer the ECB credit protection. That would protect the ECB and avoid conflicts with Article 123, but it would send us right back to spring 2012 when new concerns on EFSF/ESM capacity emerged.
- Article 123 loophole: A loophole is found so that the ECB can take losses in the event of a sovereign debt restructuring, offsetting such losses against gains elsewhere. This is the most attractive in terms of returning stability to the peripheral bond markets, but also the most challenging from the vantage point of the Treaty, the Bundesbank and German public opinion.
MARKET ISSUES: Believe me, markets will give the ECB's answer to seniority very close scrutiny indeed.
When will Spain request assistance? It no longer seems a question of if, but when for Spain. Last week, Catalonia requested €5bn from the €18bn government liquidly fund and thus joins Valencia (€4.5bn) and Murcia (€0.3bn) in requesting assistance. The fear is that €18bn will not be enough and this at a time where the Spanish sovereign still faces punitive market yields and the economy is in recession. Chancellor Merkel is due to meet Prime Minster Rajoy on Thursday. Rajoy has said he wants to see the details of the ECB's bond buying plan before deciding on a request for additional aid. He also believes that Spain needs no new conditions to receive bail-out. We agree, but delivering on the targets will require more in what is proving an uphill battle.
Spain may, however, be asked to do more on privatisation, set tougher controls on the autonomous regions and face the embarrassment of the IMF joining the programme oversight. Quality of oversight is also one of the ECB's concerns and we expect them to push for IMF participation.
MARKET ISSUES: Summing up on the euro area debt crisis, the issues remain the same;
- the periphery faces an uphill battle to meet targets that few private forecasters (including ourselves) expect can be reached,
- the EFSF/ESM is still too small with Spain and Italy combined facing around €800bn of funding needs over the coming three years and
- while the ECB can be helpful, it alone is not enough.
Is the German Constitutional court ruling only preliminary? On 12 September, the Court will decide whether to place a temporary injunction on the ESM legislation passed by the Bundestag. If the Court decides against an injunction, the German President can sign the ESM Treaty. Even if the Court at a later date were to find against the ESM, Germany would not be able to retract as this is an international Treaty. The language of the ruling will be important offering insight on hurdles to future risk sharing. If the Court - contrary to expectations - decides to place an injunction, that would place the ESM in limbo until a final ruling is rendered.
MARKET ISSUES: The EFSF (after Spain's bank package) has around €150bn of spare lending capacity. Once ESM become operational, this increased to €400bn. It is likely to need more.
Source: Bloomberg, Citi, SocGen