The short-end of the Spanish curve is collapsing rapidly, and at last check was tighter by nearly 70 bps even with the 10 Year essentially unchanged, for one simple reason: more hope and prayer. This time we have completely unconfirmed and unverified talk that either the ECB will hold another conference, or that Spain will finally request a full blown bailout. Neither is likely to happen, certainly not on a Friday. In other words, the rapid steepening of the curve on more "talking" will not last. What will however, is increasingly negative sentiment toward the longer end of peripheral country bond curves. To wit, here comes JPM recommending a new short position in Spanish 10 Years. Below is the full text of JPM's Gianluca Sanford saying to short the Spanish 10 Year until it touched 7.75%. Why 7.75%? Because that is the level at which Rajoy will have no choice but to demand a bailout. The irony is that the market, by frontrunning politicians, continues to make the required political decision impossible - welcome to the new normal. Paradoxically, only after the market has fully abandoned hope, can the desired outcome happen. But it will take the broken market a few more weeks to figure this out.
Mario Draghi disappointed markets at the ECB press conference on Thursday. After his bold comments in London last week led many investors, including ourselves, to expect the imminent re-start of the SMP purchase program, Draghi failed to announce any new immediate measures. Rather, he announced that:
- Any SMP bond purchases require that the country in question formally requests EFSF/ESM bond-buying support.
- This request needs to have the appropriate conditionality negotiated, and go through the normal approval processes (Eurogroup finance ministers / parliamentary approvals where required).
- Only in the context of a formal EFSF/ESM bond-buying program will the ECB consider SMP purchases for a given country. Steps (1) and (2) are necessary but not sufficient conditions to re-start SMP.
Separately, Draghi stated that a) steps will be taken to address investors’ concerns about official-sector seniority, although we are doubtful that this can be done in a credible manner, and b) future SMP purchases would focus on the “shorter part of the yield curve”. In general, details were short and Draghi mainly promised that the “modalities” would be “concretized” over the next few weeks. Other options remain on the table (such as loosening of collateral restrictions, lowering of collateral haircuts, LTROs etc.) but there is significant uncertainty over timing and effectiveness of these other measures.
Clearly, Draghi’s statements were negative for markets, as they indicate that no SMP support will be forthcoming in the near-term. First, the ECB imposed clear conditions on ECB support (and again, note that seeking EFSF/ESM support is necessary but not sufficient). Second, although we think that Spain could theoretically formalize and negotiate a bond-buying request over a relatively short time period (e.g. 1-2 weeks), we do not think Spain is willing to do so anytime in the next few weeks. For instance, Spain’s next bond auction is on 6 September, suggesting little short-term funding pressure; Spain next auctions T-bills on 21 August. Third, note that if Italy were to seek bond purchases from the EFSF/ESM, or Spain were to seek a much larger intervention than the €30-40bn we have previously discussed, it would take much longer to negotiate with political leaders (on the timeframe of months).
Thus, in the absence of the prospect of near-term SMP intervention, we recommend re-entering shorts in 10Y Spain. We target a 10Y yield level of 7.75%, vs. current levels of 7.12%. Spain reached 7.75% on an intra-day basis in late July, and was trading near this level prior to Draghi’s comments last week (Exhibit 1).
We also recommend closing our 2s/4s Spanish curve flatteners. Draghi’s statement that any future SMP purchases will focus on the short end of the yield curve, will likely focus yield pressure on the long end of peripheral yield curves. Thus we recommend exiting this trade at a loss.