Yesterday we presented Goldman's first 3 Top Trades for 2013 [22]as they come out, while also noting Goldman's recent disfatuation (sic) with gold [23]. Today, we present Goldman's 4th Top Trade for 2013, which is, drumroll, to go long Spanish Government Bonds, specifically, the 5 year, which should be bought at a current yield of 4.30%. with a target of 3.50% and a stop loss of 5.50%. This reco comes out after the SPGB complex has already enjoyed unprecedented gains - but not driven by economic improvement, far from it - but merely on the vaporware threat of ECB OMT intervention. Of course, once the "threat of intervention" moves to "fact of intervention", everything will promptly unwind as it always does (QE was far more potent as a stock boost when it was merely a daily threat: the market's peak not incidentally occurred the day after Bernanke dropped his entire load: one simply can't move beyond infinity). And with Spain's massive bond buying cliff in Q1 2013, the days its bailout could be postponed are coming to an end.
So to summarize Goldman's posture heading into 2013: very bullish and optimistic (just as it was in December 2010 when we called them out [24], and months before Goldman was forced to admit [25]it was dead wrong - as it will be this time again), while the Fed has to grow its balance sheet by $1 trillion and as the world is rapidly moving not only into a recession but with tax rates set to increase across the developed world scale. As a result, Goldman is furiously selling to clients (who are buying these up as per the Top Trades) such derivative instruments as Spanish Government Bonds, while urgently buying (clients are selling) gold. Because remember: every "Top Trade" from Goldman has two parties, and Goldman's flow-prop desk is always on the other side.
Full note from Goldman's recently promoted partner (in Goldman you make partner when you make lots of money for the firm) Fransceco Garzarelli:
Top Trade #4: Long Spanish Sovereign Bonds
- Today’s Daily reveals our fourth Top Trade recommendation for 2013: Go long benchmark 5-year Spanish Government Bonds...
- ....at the current yield of 4.30% with a target of 3.50% and stops on a close above 5.50%.
- The expected un-levered total return on the trade is about 8% on a 1-year investment horizon.
- Around two-thirds of the expected return is provided by coupon and roll-down.
- For a more conservative expression of the trade, we recommend that investors ‘cover’ long exposure in Spanish sovereign bonds with CDS on the Kingdom of Spain.
- A more ‘aggressive’ implementation of the Top Trade involves leveraging the view along the duration (longer maturities) or credit dimensions (regional debt).
- If the Spanish government adopts a reactive approach in asking for external financial assistance to the ESM….
- ….SPGBs may fall in price before eventually rallying on ECB interventions.
1. Overview
US data published yesterday were marginally better than expected, with the ISM non-manufacturing index for November up to 54.7, against a consensus of 53.5. The details of the report were generally solid, except for the weakening in the employment sub-component. The ADP employment report recorded a 118K gain in private employment. ADP estimates that Hurricane Sandy reduced the print by 86k. We maintain our +75K forecast for November payrolls, to be released on December 8.
Overnight, the Central Bank of New Zealand (RBNZ) left the policy rate unchanged at 2.5% in line with our view and the consensus. In response to recent weak data, the RBNZ has downgraded its near-term growth and inflation forecasts. However, the statement made it clear that the RBNZ is focusing on the medium term, and was more hawkish that we anticipated. We continue to see only a gradual tightening cycle, with the first hike from 1Q2014.
Today, the European Central Bank and the Bank of England hold their monthly policy meetings. In line with consensus, we do not expect changes to the policy rates or to the unconventional policy measures of the two central banks. In terms of data, Q3 Euro area GDP will be released this morning. We expect a -0.1% quarterly contraction in real terms. In the US, initial jobless claims will offer more information on the impact of Hurricane Sandy on the economic outlook for the near term.
Finally, a GS client survey of expectations for the upcoming Fed moves reveals that the majority of the 266 respondents expect Fed bond purchases to continue at a pace of US$85bn per month through the end of 2013, but project purchases to continue through early-2015 at a reduced pace of $50bn per month. As to the market impact, investors appear to be very polarized between those who think the extension of QE will steepen the curve (in the 5-year to 30-year maturities), and those who expect a flattening. The 5-to-7-year maturity bucket will remain pivotal. In our opinion, the term premium beyond 2015 (3-year forward) is too depressed: the forwards price 50bp hikes per annum in both 2016 and 2017.
2. Introducing our Fourth Top Trade Recommendation for 2013
Our baseline macroeconomic projections for 2013 feature: (i) another year of ultra-low rate policy by the major central banks, and purchases of government bonds by the Fed, the ECB and the BoJ; and (ii) further progress by the fiscal authorities in reducing ‘tail risks’ to economic growth (e.g., the ‘fiscal cliff’ in the US, funding segmentation in EMU).
Mapping these characteristics of the forecast set into financial asset prices we conclude that: (i) low (and slowly rising) benchmark government yields will depress expected returns in publicly traded pro-cyclical securities, such as credit and stocks, and (ii) deeper direct interventions by central banks in asset markets will mitigate return variance.
It is in this broad context that we introduce today the fourth of our Top Trade recommendations for 2013: long Spanish 5-year benchmark government bonds, looking for an 8% unlevered annualized return, following a (very volatile) 5% return in the year to date. As with our recommendation to go long US High Yield, we expect returns to come primarily from coupon and roll-down rather than from price appreciation.
3. Long Benchmark 5-year Spanish Government Bonds, Yield Target 3.5%, Expected Return 8%
On November 20, we initiated a recommendation to go long Spanish vs. Italian 5-year government bonds, opened at 99bp, with an initial target of 40bp and a stop on a close above 130bp. The trade is currently at 96bp, reflecting a decline of about 40bp in both 5-year Spanish and Italian yields. We now recommend dropping the short Italy leg of the trade and would position outright long of 5-year Spanish Government Bonds at the current yield of 4.30% with a target of 3.50% and stops on a close above 5.50%.
Although this trade may appear to clash with our central expectation of a further contraction in Spain’s real GDP in the first half of next year, its rationale rests on the following points:
- According to our valuation metrics and our economic projections for 2013, the yield differential between Spanish and German government bonds is around 1 standard deviation too high (or 40bp-60bp) in maturities between 3- and 10-years. It is important to note that the econometric framework from which these valuations are derived incorporates a ‘trend’ variable, which could switch from representing a headwind into a tailwind in 2013. Further, our estimates do not account for the potentially virtuous loopback effect between lower borrowing costs and economic/fiscal performance.
- The Spanish government needs to fund roughly EUR230-260bn next year, half of which through its SPGB bond program (about the same as in 2012). Our central assumption is that around a fifth of the borrowing requirement will be met by the ESM through long-term loans or participation in syndicated deals (for reference, the maximum Spain can draw under an Enhanced Conditions Credit Line is around EUR100bn). The ESM funds are likely to be pari passu to existing debt, mitigating concerns over subordination. The ECB’s open market interventions through the Outright Monetary Transactions framework in maturities up to 3-years should help to subdue return volatility - which is key to re-attracting long-term foreign investors to the market .
- European policymakers have shown a preference for allocating capital losses on legacy assets held by Spanish regional banks onto existing bank creditors rather than saddling the government with more contingent liabilities. The prospective transformation of Euro area official sector loans to support bank recapitalizations into bank equity will work in the same direction.
Using a 1-year investment horizon, the expected un-levered total return on the trade is in the region of 8%, around two-thirds of which provided by coupon and roll-down.
4. Variations on the Theme
Investors concurring with our fundamental analysis but looking for a more conservative expression of the trade can consider ‘covering’ long exposure in Spanish sovereign bonds with CDS. As we argued on November 8 (see: Global Markets Daily, ‘Can the EMU Sovereign Bonds-CDS Basis Normalize?’), Spanish 5- and 10-year bond yields are on average 250bp over the corresponding maturity EUR-denominated sovereign CDS on the Kingdom of Spain. We expect this ‘basis’ to gradually normalize.
A more ‘aggressive’ implementation of the Top Trade involves leveraging the view along the duration or credit dimensions:
- The term structure of Spanish yields is very steep compared with that in the ‘core’ EMU countries, particularly in maturities between 1-year and 5-years. This is the segment of the yield curve where we expect the biggest spread compression in an environment of low policy rates. Alongside ‘maturity habitat’ considerations, this is the reason why we have decided to express the trade recommendation in the 5-year sector. Extending the maturity of the position could potentially result in a larger capital appreciation. For example, a 30-year Spanish bond trades in the low 80s, or a yield close to 6%. Going by our estimates for German yields and spread changes, we could potentially see Spanish bonds at this maturity trading at most with a 5% y-t-m by end 2013, resulting in returns between 15% and 20%. The risk to this strategy resides in the uncertainties surrounding possible shifts in seniority following the introduction of bonds carrying collective action clauses. And, more broadly, developments in the structure of European sovereign debt altogether, as discussions on a European Debt Redemption Fund progress.
- At the sub-national level, Spanish regional government bonds also offer an interesting risk-reward opportunity. The Regional Liquidity Fund (Fondo de Liquidez Autonómica , or FLA) set up by Spain’s central authorities in mid-2012 currently assists with the deficit funding and refinancing needs of 9 autonomous communities (out of a total of 17), including three of the main regions that have tapped international bond markets (Andalucia, Catalunya and Valencia). Regions borrow from the FLA at 30bp over the Kingdom’s cost of funds in exchange for fiscal conditionality. Such explicit support, now extended into 2013, substantially reduces short-term funding shortfall concerns and improves the regions’ overall credit quality. For reference, the Community of Madrid, which has retained market access, currently borrows at levels of around 250bp over 5-year SGGPs. Investors should however consider that liquidity in this segment of the market is low.
5. Risks to the Trade Recommendation
We have recommended being long Spain at the local price lows in November, and admittedly the entry point is currently no longer as attractive. Nevertheless, if our assumptions on the broader investment landscape are anywhere close to the mark, relatively high coupons in a liquid government bond market potentially backstopped by the ECB should be in demand.
The main risks to the trade revolve around the difficulties the Spanish authorities could encounter placing government bonds in the issuance-heavy first quarter of 2013, especially amid ongoing economic uncertainty. Should the Spanish authorities adopt a ‘reactive’ approach in asking for external financial assistance (i.e., applying for an Enhanced Conditions Credit Line from the ESM), SPGBs may fall in price before eventually rallying back on ECB’s interventions. A downgrade by one of the CRAs to below Investment Grade could amplify these pressures (Spain is currently rated Baa3, BBB minus, BBB by Moody’s, S&P and Fitch respectively).
Whilst these are important considerations, we are of the view that such a scenario of spread widening in Q1 2013 is now the consensus. According to anecdotal information, positioning in Spanish bonds outside Spain is generally light, especially compared with that on Italian BTPs (foreigners currently hold 20% of the stock of Spanish debt, from a peak of 60% before the crisis). For reference, Spain’s weight in 3-5-year benchmark EUR government bond portfolios is around 12%.
We have set a stop loss on the trade at 5.5%; on a 1-year holding horizon this would erase returns from ‘carry’.