Guest Post: The Market Is Up, So Investors Are Bullish; And Why Eurobonds Won't Work

From Peter Tchir of TF Market Advisors

The Market Is Up, So Investors Are Bullish

There is always an element of price action driving investment decisions, but today it seems to have hit unprecedented levels.  The relief is palpable.  People are getting bullish again, but so many of the bullish comments seem to start with the fact that stocks are up today.  There were some investors who were happily long coming into this week, there were even some who were short at the start of last week and turned into bulls at some time last week (hats off to them).  What is bizarre is how many people who were nervous longs last week, suddenly feel comfortable.  If stocks were down 5% would they still be so bullish? 

What is driving the bullishness?  Stock prices being up, really does seem to be the biggest driver.  We are seeing short squeezes in the most liquid asset classes, particularly those used as hedges - CDX indices, BAC CDS, Gold, beaten down ETF's like XLF.  Italian and Spanish bond yields are unchanged to a tiny bit higher.  That should be watched.  Some IG new issues are in the market and are being priced at a large concession to existing bonds.  That will put pressure on the real market.  With some core real markets not responding as well as some of the hedge markets, I am not convinced the rally will remain persistent, and since so much of bullish sentiment is coming from the rally, that could turn negative quickly.

The ECB purchases are another positive on the market.  The ECB looks like they used 22 billion euro rather than 15 billion.  I guess it shows commitment that they spent more than people realized, but I think we need to look at the ECB purchases more closely.  They moved the yields in Spain and Italy by over 1% pretty much across the entire curve.  2.2 trillion of debt repriced 100 bps tighter (or 2.5% or so in price terms) because the ECB bought around 20 billion eur of bonds.  The ECB wasn't strictly limited to purchasing bonds of those 2 countries, so the money also positively impacted yields in other countries.  That is a big bang for the buck (or euro).  I am trying to figure out what the move means.  If the entire increase in yields that led to the intervention had occurred on similar volumes, than I would be more comfortable downplaying the entire market's concern about Italy and Spain.  It doesn't sound like volumes on the way down were that low.  Low, yes, but not that low.  So maybe this move tighter was totally artificial.  Hedge funds and bank trading desks just got out of the way of the ECB.  No one decided to fight it and just pulled offers to see how high the ECB would reach.  Some hedge funds may have even anticipated or bet on another round of aggressive ECB action and been long this debt.  Understanding how positive the ECB action was, or how little it really changed is a key to the next big move.  I am becoming convinced that the big move was largely artificial and can reverse quickly once the ECB steps back.  I'm also becoming convinced that to get further decreases in yield from here, the ECB would need to spend a lot more money.

Eurobonds will not work.  I wrote about that earlier today, and believe any strength attributed to that possibility should be immediately sold.  Rather than grasping at the hope that Europe will create a new financing mechanism involving much more co-operation, investors would be better off biting their nails and being concerned that not all countries will ratify the already proposed EFSF2 "solution". 

The short selling relief ban has probably already played out since not everyone got on board.  All that it will have accomplished is make it harder for the market to spike higher on squeezes, and likely fall further and faster on any down move.

I've heard a lot of investors say the market over reacted and too much negativity was priced in.  Well, I think that it is hard to tell what is priced in.  So many people are hedged and wedged, it is not clear what view they are expressing, and whether they are expressing their view in the right market - ie, bonds, cds, equities, commodities.  It will take some time for investors to organize themselves, but if data continues weak like today, we will find out that not all the bad news is priced in.  S&P futures hit a low of about 1076 last week. They hit a high of 1196 today and were at 1193 when I started writing.  So we have rebounded 11% from the lows.  Maybe we have taken back a lot of the over reaction here at 1190.


And from earlier, here is Tchir explaining why Eurobonds won't work:


Eurobonds, What Yield?  What Rating?   

In the latest round of throwing spaghetti against the wall to see what sticks, chatter about Eurobonds has greatly increased.  The immediate response from the markets, of course, is to stabilize.  Like so many of the other programs announced, I doubt that a Eurobond in the real world would achieve as much as people in the political world think it would.  But before deciding if it would accomplish much, let’s try and figure out how it would be priced or how it would be rated.

Some entity has to issue the Eurobonds and there has to be some source of money to pay for the Eurobonds.  I realize it might seem naïve to start thinking about how Eurobond obligations will be repaid, but I still cling to a world where potential lenders care about little things like getting repaid. 

Most sovereign issuers are able to raise debt because they can use taxes to pay off that debt in the future.  At least that is how it works in theory, though right now, the only way most countries are paying their current obligations, is by issuing more debt.  In any case, there is no chance that some European Issuing Entity is going to be given any form of taxing authority in the near term to raise money.

So the Eurobonds are going to be backed by either transfer payments from the member countries or from guarantees.  In either case, the amount of support will have to be defined.  Each country will have to be assigned a portion of the debt it has to repay or guarantee.  The EFSF uses “over guarantees” to effectively put the entire burden on the highest rated countries.  That over guarantee concept, where the AAA countries fully guarantee any EFSF bonds issued was almost cute when total issuance was going to be less than €275 billion.  It became a little more disconcerting with total potential EFSF issuance at €440 billion.  It is getting downright scary for Germany with talk about further increases in size, and some doubt about France’s ability to maintain its AAA rating.

I think Eurobonds will have to rely on a more traditional structure.  That is especially true, if Eurobond proceeds are going to be available to all countries.  There seem to be 2 ways to structure the Eurobond transfer payments/coverage. 

The first methodology, and “fair” way would be for countries to provide support in direct relation to how much of the proceeds they will use.  So if a country intends to use 10% of the money raised by Eurobond sales, then they would be responsible for paying back 10% of the issue.  This seems totally reasonable to me, but ultimately doesn’t accomplish much.  If it is the weakest countries, those having the most difficulty accessing the capital markets, then what benefit does the Eurobond construct provide?  The Eurobond would be rated based on the weighted average rating, and it should price based on the weighted average yields the countries could get independently.  A simple example helps illustrate this.   Assume the Eurobond was 50% Germany and 50% Italy.  10 year bonds of those countries currently trade at 2.3% and 5% respectively. They are rated AAA and Aa2 on –ve watch.  If they issued a bond where 50% was going to be repaid by Germany and 50% by Italy, the rating would likely be Aa2[i].   If Germany is not on the hook to pay more than their stated percentage, then this deal should price right around the average yield, so 3.7%.  In the end all the Eurobond would do is transfer interest costs from the weak countries to the strong.  Germany would pay 3.7% in interest rather than 2.3% they could achieve on their own.  Italy is happy to pay 3.7% instead of 5%.  How much of this would the German people be willing to take?  They will see that some portion of their taxes are used by the Government for things Germany wants to do,  some is used to pay interest on their own debt, and some is used to pay to subsidize Italian rates.  This version was simplified as it had only 2 countries, but the concept is the same for the Eurozone as a whole.  If the guarantees or transfer payments for Eurobonds are based on the way the proceeds are allocated, it does nothing to change the average cost of debt in Europe, it just shifts more onto the countries that pay less than the average.  Financial markets might be happy with that, the recipients of the subsidized interest payments would be happy, but what about the countries doing the subsidy?  Maybe they can convince their citizens that keeping the weaker countries afloat is good business and the small cost to the taxpayers is worth it.  Maybe they can convince them of that, but I think it is getting harder and harder.

What about a method where the guarantees or transfer payments are based on GDP or some other measure?  That would have the benefit of putting the rating and yields more firmly on the shoulders of the strong countries.  It would achieve a better rating and better yield than a method that is based on who will get the money.  German GDP is about 1.6 times that of Italy.  So let’s say Germany will provide 60% of the backstop and Italy 40%.  The rating might make it up to Aa1, and the yield should now be 3.4% since Germany is having a bigger impact.  That is all great, but what to do with the money.  Italy actually has 1.3 times as much debt outstanding as Germany (€1.6 trillion vs €1.2 trillion).  Should Italy be able to use 55% of the proceeds even though they only guaranteed 40% of the repayment?  Not only does that increase the subsidy that Germany is taking on, it means that Germany is taking on real credit exposure to Italy.  If Italy borrowed 55% of the money (in line with their debt outstanding vs German debt outstanding) and wasn’t able (or willing) to repay, what would happen?  Eurobond investors would lose on the 40% that was backed by Italy, but would look to Germany for the repayment of the other 60%.  Germany is now not only subsidizing Italy’s funding cost, they are taking on more risk.  A solution where the Eurobond is backed based on the GDP of countries would trade the best. It would have the highest rating and the lowest cost of issuance.  The markets would love it!  But why would the top countries take on the burden of subsidizing the other countries AND take their credit risk?  Again, this is a simplified example, but the problems remain the same if done for the entire Euro zone.  In fact, if there is already concern about France’s ability to retain its AAA rating, this will only make those concerns more realistic as France would be increasing its average cost of funds, and be taking on direct exposure to the weak members.

I’m not even sure that the Eurobond solution sounds great on paper, but it will not look good when implemented.  I just don’t see how the top countries will agree to this.  The risk they are taking on would continue to grow and would move beyond their control.  At some point, and this may be the point, they will say Nein, or Non, or Nee, or Pfft. 

Any rally initiated by more talk of Eurobonds should be faded.  It just cannot happen in a meaningful way in my opinion.  They will not be able to convince Germany and the Netherlands to agree to it.  It is getting too big for Germany and the Dutch seem to be getting more reluctant by the day to open their liquidity dykes for the benefit of other countries.  And France, well, they may agree, but that would really call into question their AAA status.



[i] The negative outlook would be incorporated in the rating process.  Also, the rating agencies calculate “average” ratings in a way that lower ratings have more impact than they would in a simple average calculation.