A New EU? Does Nein mean Nein?
Guest post by Peter Tchir.
Is it a New EU?
Of the major players coming into June 2011, almost none are left. Attrition and elections have taken care of most of the major players. In fact, you could make a case that Merkel is really the only major player still in the same position.
I think this is important particularly for the ECB. Draghi has now had time to establish himself in his role, and get comfortable with the people at the ECB, the various central banks, and the politicians. He entered the role with a bang – a rate cut, more symbolic than anything, at this first meeting and then began the LTRO’s.
Since then, his efforts to get Spanish and Italian bond yields down have been thwarted by the markets and a deteriorating economic situation. He wants yields low and looks like he is prepared to stretch his powers to fulfill the mandate of “transmission of economic policies”.
How far is he willing to stretch? How much can he do based on that “transmission” mandate? That is the question and we need to get answers, but more and more, it looks like he is prepared to be aggressive. It may not be a completely new EU, but it has changed a lot in a year, and the ECB does look to be a new ECB.
Nein to Nein!
Germany looks more and more isolated in their refusal to play nice and even there it is becoming clear that not everyone is against the idea of money printing and aggressive actions. On top of that, Germany is “only” 25% of the EU economy. It is the single largest economy, but France, Spain, and Italy combined are much larger. Germany plays an important role, but it cannot make decisions unilaterally. Germany could in theory walk away from the EU, but the German “elites” more than anyone seem committed to trying to hold the Eurozone together. They are stubborn and have a deep seated fear of somehow once again being the ones that cause Europe to splinter.
Their voice, while important, is diminishing, and for many of them, they are looking for ways to save face as they backtrack from 2 years of causing problems. Assuming Nein means Nein is likely to be wrong in this case.
The Immediate Problems that the ECB CAN Address
Currency exit and forced redenomination has to be taken off the front pages of the newspapers. I have not seen a single paper that walks through how redenomination would work in practice. There are 100’s that talk about an event, and then a future where the currency adjustment “restores equilibrium” or some such nonsense, but they gloss over how you get to that stage. The reality is that you don’t. Not easily and possibly never. The uncertainty created will cause business to die. To die quickly and violently as no one will want any part of cross border commerce while currencies and laws are in a state of flux. This isn’t just for the weak countries. Germany will see problems as well as they face political backlash from the rest of Europe and from a strong currency. A lack of energy resources makes this reversion to old currencies and devaluation even more problematic.
While currency redenomination risk remains on the front burner, business will be slow to engage in big new projects and the risk of bank runs remains high.
Any policy that provides funds direct from the ECB to weak countries, such as the plan floated this weekend, would immediately reduce the risk of redenomination. The ECB would become the center of a tangled web, so intricate and complete it would be hard to visualize how to untangle. So the ECB CAN take redenomination risk of the table.
Budget problems in Spain and Italy need to be fixed. The ECB cannot do much to fix the overall budgets of Spain and Italy, but it CAN help. Both countries have seen cost of new money increase dramatically and are paying rates far above the ECB’s target rate for banks. That adds to the annual budget deficit as that higher interest rate cost affects current year payments. It takes time for these higher rates to influence the overall cost, but we are well over a year into the crisis and if Spain and Italy had been able to refinance all that debt 2% cheaper, it would be having an impact. The circular nature of this is vicious as well. The more Spain and Italy have to pay to refinance debt, the bigger their current deficits, and the lower their credit quality, causing rates to go higher. This is the “transmission” element the ECB is focusing on. The ECB wants (in fact needs) Spain and Italy to have low rates, and needs to find a way to get them. It will reduce current deficits and future projected deficits.
An ECB plan to support countries would take away roll risk, so not only would the countries that need money the most, be able to get it at rates in line with overall policy, but they could spend less time on how to raise money in the bond market, and more time on how to fix their economies and budgets. So the ECB program can help the budgets, it will take time, but it is real, and will also allow countries to focus on things other than bond auctions.
Constraints in both Will and Way
Throughout the crisis there have been concerns about whether the EU had the will or the way to fix the problem. Much of the conversation revolves around the “way” they can fix it. Do they have the tools? Do the treaties allow them to do what is necessary? The reality is that the “way” argument was to hide the fact that Europe didn’t have the “will” to fix things.
Now it looks like Europe might have the “will” to fix things. That Europe is finally willing to engage in a wholesale effort to support the periphery. If Europe is willing to do that, they can find ways. EFSF, while lacking in many respects, isn’t insignificant. The ECB, while constrained by its mandate, seems to have some flexibility, especially if they decide they want to push the envelope. A lack of will has been a bigger impediment to success than a lack of way, so this psychological change is important.
It is also useful to point out that so far the term “bailout” has been applied very loosely. Germany, for example has delivered very little cash to any of the countries. It has guaranteed debt that was used for the countries or supported IMF and ECB efforts to funnel money to the countries, but very little German cash has found its way to the countries as part of “bailouts”. On top of that, all nations that have received “bailout” money have continued to pay that money back. There has not been a single default on any money lent as part of the “bailouts” so Germany is actually profiting from this so far (ignoring the cheap rates they are also benefitting from).
The image of German’s dumping money on these nations just isn’t correct. So far, Germany has acted more like Rumpelstiltskin and demanded a high price for their loan, rather than as some sort of charity act that the term “bailout” implies.
Even though I believe the will is now much stronger, and there is a way, they will be careful not to be “reckless” and will embark on programs that are easier to sell internally.
What Trades Should do Well?
I like Spanish and Italian bonds, but only with maturities of less than 5 years. I think that the ECB will focus on the primary market and the short end of the curve. I think they will make money available in the 2 year range. It is long enough to offer real support, but short enough that the political opposition will be lower. I don’t exactly agree with the theory that 2 year risk is so much less than 5 year or 10 year in the case of Spain or Italy, but politicians tend to. Politicians often have a simplistic view and will take comfort in that the next 2 years are “foreseeable” and 5 years and out isn’t. It’s not true, since they can’t seem to anticipate anything 3 months out, but that is what they believe. They can be convinced to lend short term rather than long term.
I would go out as much as 5 years because any such program will be in place for awhile so even if loans are only for 2 years, there will be a window during which they are available. That will support the 5 year point. The 5 year point is also aided by bad CDS shorts and is in the comfort zone of banks.
The threat of subordination will keep the curve extremely steep. Even if the program were to be “senior unsecured” and pari passu with other debt, there would be doubt in the minds of investors. There should be concern that if things don’t work out, that non public holders would once again (like Greece) bear the brunt of the initial restructuring. So the curve should be steep as it prices in risk that any program goes away AND that bonds not part of the program would be subordinated. The ECB needs to ensure that countries have access to cheap money, but they don’t need to support the secondary market, and they don’t need to lend to countries for long term (it would be good if they did, but it isn’t necessary for the ECB’s objectives to get accomplished).
Spanish and Italian stocks, Bank stocks, and bank CDS. The best analogy I can think of is that this is like an earthquake and the “damage” will be greatest around the epicenter. So if the ECB launches on a new program, the epicenter of the earthquakes will be in Italy and Spain. The closer to the center the more benefit. Italian and Spanish banks are sitting right on the fault line and will benefit the most from this action. Companies in these countries should also see a rebound. Banks outside these countries will benefit more than companies. In many ways, the rest of the world has decoupled from the problems (DAX is up 20% YTD), but banks have been held back more than other companies because of how interconnected the global banking system is. This would extend as far as U.S. banks.
Credit Default Swaps. I continue to believe that CDS can go tighter. It will be led by bank CDS, but will be helped along as shorts capitulate. CDS has become the last bastion of “cheap shorts”. Too many investors are short, some whose primary knowledge of CDS came from reading “The Big Short”. I continue to see a lack of interest in bank hedging, and if “real money” ever decides to stop chasing the same silly bonds to the same silly yields and sells CDS instead, the gap will be ferocious. CDS spreads aren’t at the tights of the year yet, and have been stubborn these past few days (tighter, but grudgingly so). High yield bond and leveraged loans should continue to do well, but at this stage, high quality, BB type paper should be traded with a rate hedge.
Short German, French, and EFSF bonds. As the realization that your bunds aren’t about to get converted into Deutschemarks any time soon hits, these will look expensive. As EFSF is called upon to use up its remaining capacity, the supply will add to pressure to this particular entity, above and beyond the pressure on German and French yields. While I would be uncomfortable owning 10 year bonds in Spain and Italy, getting short 10 year bonds in Germany, France, and EFSF seems fine. The subordination argument that makes 10 year scary on the one side doesn’t directly translate to making it appealing on the other.
US stocks are the “dirtiest shirt” and far from the epicenter. The US has largely decoupled. We are about to start facing our own problems, and the campaign format that we will face them in, is particularly troubling. We rally because everyone in China is going to buy a iPhone despite evidence that China is having much bigger trouble than access to iPhone. US stocks will go along with the global rally, but I expect them to lag.
China. Tempting, but I’m not comfortable yet. Japan, maybe? I am working on forming a better opinion here, but suspect they will outperform the U.S. market on European action, but still underperform Europe itself.
Short, nervous, and rebalancing.
I shifted from being long to finally having gotten short on Friday. I don’t like that position right now. I will be shifting back to a more positive position. I think I will be between small short and small long, with longs continuing to focus on Spain, Italy, banks, and the credit positions mentioned above. Shorts will become more common and will be focused on U.S. markets. It is hard to be long Spain here after a 20% run from the lows, but I find that I gag less when looking at that, than other options for being long.
On the option front, I have started buying S&P September puts. I will look at increasing that position once I’m out of more of my short, but will continue to be patient as I think we will see a move higher in index values and see a drop in the cost of vol.
I will definitely be taking this morning’s fade as a chance to take off shorts and get back to a long bias.