Monday, July 30th, 2012
Goldman’s ex-employee Mario Draghi is in a box: he knows he has to do something, but he also knows his options are very limited politically and financially. Yet he has no choice but to escalate and must surprise markets with a forceful intervention as per his words last week or else. What does that leave him? Well, according to Goldman’s Huw Pill, nothing short of pulling a BOJ and announcing on Thursday that he will proceed with monetization of private assets, an event which so far only the Bank of Japan has publicly engaged in, and one which will confirm the world’s relentless Japanization. From Pill: “Given the (to us) surprisingly bold tone of Mr. Draghi’s comments last week, we nevertheless think a new initiative may well be in the offing. We have argued in the past that the next step in the escalation of the ECB response would be outright purchases of private assets. Acting in this direction on Thursday would represent a significant event. We forecast the announcement of measures to permit NCBs to purchase private-sector assets under their own risk to implement ‘credit easing’, within a general framework approved by the Governing Council. This would allow purchases of unsecured bank debt and corporate debt, enabling NCBs to ease private-sector financial conditions where such support is most needed.” Why would the ECB do this: “A natural objection to outright purchases of assets issued by the private sector is that they involve the assumption of too much credit risk by the ECB. But substantial risk is already assumed via credit operations.” In other words, the only thing better than a little global central banker put is a whole lot global central banker put, and when every central planner is now all in, there is no longer any downside to putting in even more taxpayer risk on the table. Or so the thinking goes.
Of course, a rational person may wonder: why would the ECB, which a week ago was arguing for impairing senior debt, suddenly go ahead and monetize not only senior but subordinated debt. And one step further, one may also wonder if this is merely the latest iteration of a Goldman call that should be faded. Because if so, the market is in for a rude awakening. Alternatively, if Draghi does go the full Shirakawa, expect merely a brief LTRO-type response higher, to be followed by yet another major swoon lower as the drug addict demands more, more, more, only that more no longer exists with each succeesive asset dilution iteration.
We forecast that the ECB will permit NCB purchases of private sector assets
ECB President Draghi’s comments in London last week have raised market expectations that important new measures will be announced by the Governing Council on Thursday (August 2).
Were the Spanish government to request support from the EFSF ahead of Thursday’s meeting and accept the implied conditionality, we would expect the ECB to offer significant support to sovereigns, including through outright ECB purchases of government debt via the SMP. This would mark a significant acceleration and intensification of what we have previously forecast. However, our base case is that events will not move so quickly: the Spanish government is pre-funded through October and, according to the latest reports, an immediate Spanish request to the EFSF is unlikely. We do not expect the ECB to move unilaterally: we view explicit and concrete political support for its actions via EFSF conditionality as a prerequisite for an extension of support to the sovereign markets.
The ECB therefore risks disappointing heightened expectations. Bringing forward measures to ease private-sector financing conditions in the periphery is a likely response. Well-flagged possibilities in this regard include a further easing of collateral eligibility standards and new longer-tenor refinancing operations. But precisely because these measures have been anticipated, they are unlikely to satisfy the market expectations raised by Mr. Draghi’s comments. And we would in any case view the effectiveness of such measures as questionable, given the segmentation of financial markets and dysfunctionality of financial systems in the periphery.
Given the (to us) surprisingly bold tone of Mr. Draghi’s comments last week, we nevertheless think a new initiative may well be in the offing. We have argued in the past that the next step in the escalation of the ECB response would be outright purchases of private assets. Acting in this direction on Thursday would represent a significant event. We forecast the announcement of measures to permit NCBs to purchase private-sector assets under their own risk to implement ‘credit easing’, within a general framework approved by the Governing Council. This would allow purchases of unsecured bank debt and corporate debt, enabling NCBs to ease private-sector financial conditions where such support is most needed. Progress in centralising banking supervision at the ECB would facilitate such support for the banking sector.
1.Market tensions continue to mount in the Euro area, in an environment of ongoing macroeconomic weakness.
2.Thursday’s comments by ECB President Draghi in London have raised expectations that the ECB will resume purchases of peripheral sovereign debt via its Securities Markets Programme (SMP). Peripheral markets have rallied as a result.
3.Anything short of an announcement of such a resumption at next week’s ECB Governing Council meeting risks disappointing markets. Indeed, expectations have been raised further on reports that a package of additional measures (interest rate cuts, new liquidity operations) is being prepared in parallel for the August 2 ECB monetary policy meeting.
4.Thus far, we have assumed that the European Financial Stability Facility (EFSF) would be the authorities’ first line of defence in addressing sovereign market tensions. We continue to hold this view. Moreover, we anticipated that the ECB would act in a supportive manner towards sovereign markets should the EFSF take up its responsibility in this regard, for example by offering another longer tenor LTRO operation on a fixed rate / full allotment basis (thereby supporting Euro area banks’ purchase of peripheral sovereign debt). We also continue to hold this view. And recognising the limited capacity of the EFSF / ESM, we have assumed that ultimately the ECB’s balance sheet will need to be mobilised to fund financial support for vulnerable Euro area sovereigns. Our view here is also unchanged.
5.How then to interpret the (to us) surprising boldness of Mr. Draghi’s remarks in London last week? We see them as reflective of an accelerated pace of events, rather than a fundamental change of character. We organise our further analysis around two possible explanations for this acceleration: (a) that Mr. Draghi expects an imminent Spanish request for EFSF support, and therefore foreshadows ECB action as part of a more comprehensive policy response; and (b) that Mr. Draghi’s concerns about contagion and spillovers from sovereign funding tensions in Spain have become more acute.
The Spanish are coming
6.We had been working on the assumption that – with the Spanish sovereign pre-funded for several months yet – we would not see Spanish recourse to the EFSF until the early autumn, as the usual political prevarication prevailed.
7.Mr. Draghi was clearly aware of the market expectations he was creating last week; hence, his comments might suggest he is confident that the Spanish government will turn to the EFSF sooner than that, opening the way for new ECB actions in the coming weeks. Comments from the German and French governments in the aftermath of Mr. Draghi’s remarks, which point to the EFSF as the vehicle for addressing market tensions, would support this view.
8.We continue to doubt the ECB will act ahead of a Spanish request for EFSF support. A unilateral reactivation of SMP purchases of sovereign debt by the ECB in the form seen on past occasions risks being not only ineffective, but even counterproductive – for all the usual reasons:
- As Friday’s statement from the Bundesbank demonstrates, its resistance to central bank purchases of peripheral sovereign debt remains strong. The Bundesbank is not alone. Reigniting discord within the ECB’s decision-making bodies by restarting the SMP threatens to disrupt once again the ECB’s capacity to act on this and other dimensions of policy. And such discord inevitably implies commitment to such interventions is somewhat ambiguous, thereby undermining their effectiveness;
- Given how ECB holdings were treated in the Greek debt restructuring, subordination concerns understandably persist among market participants. Declarations of a willingness to take losses on SMP holdings ring hollow: actions speak louder than words in this context. While the ECB may have the opportunity to demonstrate such willingness sooner rather than later in the Greek context, the effectiveness of unilateral SMP purchases is questionable: they need to encourage rather than deter the natural longer-term holders of peripheral sovereign debt from re-entering this market;
- Above all, were the ECB to restart SMP purchases unilaterally, the incentive for the Spanish government to seek EFSF support – and accept the implied conditionality – would be reduced. An opportunity to hardwire the necessary consolidation, reform and adjustment into the institutional system would be lost. Broadly speaking, we take a positive view of the Spanish government’s policy programme. While we see scope for accelerating and deepening structural reform, if anything we view their envisaged fiscal adjustment as possibly too aggressive. But these measures have not arisen spontaneously: they have come in response to market pressure. For market pressure to be relieved by external financial support, we view the introduction of greater conditionality as crucial to maintain the momentum of adjustment.
- More generally, it has been a long-held ambition of the ECB to ensure governments have explicit financial involvement with regard to peripheral sovereign debt purchases via the EFSF, rather than leaving the ECB to take sole responsibility. And involving the EFSF introduces the necessary formal conditionality and political accountability to the process, which – as last year’s experience in Italy demonstrates – the ECB acting alone lacks.
9.As we have argued in the past, such concerns make us even more sceptical of proposals to cap peripheral sovereign yields or target spreads through an ECB commitment to potentially unlimited SMP purchases of peripheral government debt. Market participants seek the certainty offered by such an unconditional commitment to stabilise yields. Given the multiplicity of uncertainties they face at present, that desire is understandable. But such an unconditional commitment by the ECB renders public budget constraints very soft. Irrespective of their behaviour, governments are able to borrow at the rates pegged by the ECB, serving to create moral hazard and scope for ‘free-riding’ on others’ disciplined behaviour.
10.For the ECB in the current environment, this tension between satisfying markets and constraining government is inescapable. It lies at the heart of the difficult course the ECB has charted throughout the financial crisis. Managing the trade-off entails offering external financial support to governments in return for their acceptance of conditionality. Hence, involvement of the EFSF to provide political legitimacy to that conditionality appears crucial.
11.All this leaves the initiative for triggering the next steps in the hands of the Spanish government. Should a request for EFSF support be forthcoming ahead of or in parallel with the ECB Governing Council meeting next Thursday, it would open the door for the ECB to announce supportive measures on that occasion.
12.As we have said in the past, in parallel with EFSF purchases of Spanish sovereign debt subject to adherence to the conditionality expressed in the required Memorandum of Understanding (MoU), we would expect the ECB to support sovereign markets through a repeat of the longer-tenor LTROs that served this purpose earlier in the year. These fund banks to buy domestic sovereign debt in the primary market (where the ECB is prohibited by the Treaty from operating directly). The latest data reveal greater reluctance on the part of Spanish banks to increase their holdings of sovereign debt, while Italian banks continue to show a willingness to do so. In the former case, some ‘arm twisting’ may be required to ensure demand at sovereign auctions, but with public ownership of the Spanish banking sector on the increase, this should be possible.
13.Moreover, recognising the inadequate capacity of the EFSF in the face of sovereign tensions in Spain and / or Italy, we have argued that ultimately – and probably sooner rather than later –the ECB will be drawn into funding that vehicle. With considerations in the German Constitutional Court delaying the introduction of the EFSF’s permanent (and slightly larger) successor (the European Stability Mechanism, ESM) until at least mid-September, this concern will be particularly acute in the coming weeks.
14.We have always argued that the typical characterisation of how this funding would be provided – giving the EFSF / ESM a banking licence – was an unnecessarily clumsy and provocative route in the face of the well-known institutional and political sensitivities. Admittedly, having the ECB make outright government debt purchases via the SMP in parallel with EFSF / ESM interventions (as envisaged above) is not much (if any) better in this regard, but nevertheless has returned to the discussion. A less controversial scheme, perhaps involving the publicly-owned development banks of the larger Euro area countries, could be found. But these institutional and legal niceties should not detract from the underlying economic reality: one way or another, the ECB’s balance sheet has been and will be mobilised to support sovereign funding. As reflected in the preceding discussion, the crucial question concerns the terms on which this funding is provided.
Addressing contagion (1): Cross-country sovereign spillovers
15.All this assumes that Spain will request EFSF support. Yet German Finance Minister Schaeuble is reported on Saturday as saying a Spanish request for EFSF support is not imminent, as Spain does not face immediate funding problems. And in this Mr. Schaeuble is correct. Having taking advantage of the post-LTRO euphoria in the first quarter, the Spanish government has pre-funded itself, probably through early October. On Spain’s part, there is no urgency to seek external financial support.
16.But Spanish tensions have implications elsewhere. One rationale for immediate ECB action is to contain potential contagion across countries. After all, the introduction of the SMP back in May 2010 stemmed from the concerns that disorder in Greek sovereign markets was dragging down ‘innocent bystanders’ with more modest fundamental problems, simply because of adverse market dynamics. In his London remarks, Mr. Draghi appeared to endorse this line by reviving discussion of the need to re-establish an effective transmission of monetary policy throughout the Euro area.
17.Italy is the most pressing case in this regard. With a primary fiscal surplus, even from its initial high level of sovereign debt the Italian fiscal situation is sustainable – provided that outstanding debt can be rolled over at reasonable rates. But this crucial condition is not met in the current challenging environment. Political pressure is therefore building in Italy: despite accepting the pain of fiscal austerity (and suffering a deep and prolonged recession as a result), Italy has not been rewarded by the markets or by their European partners.
18.In his London comments, Mr. Draghi referred to the impact of ‘convertibility risk’ on interest rates, yields and financial conditions. These remarks are consistent with our own interpretation of recent developments: as the risk of Euro exit has mounted through the crisis, a redenomination risk has become embedded in some asset prices. Uncertain as to what a paper Euro-denominated asset originating from the periphery really represents, foreign investors have been unwilling to hold, still less buy, such assets – and peripheral financial conditions have tightened significantly as a result. Viewing the emergence of this redenomination risk as a systemic problem of which Spanish funding tensions are simply a symptom, one can argue that a systemic solution is required. However well Spain and Italy behave, they are victims of a systemic problem over which they have limited influence.
19.The impact of such systemic considerations could justify ECB actions to contain sovereign spreads. But unfortunately for ECB policy makers, spreads do not come with labels. As we have argued in the past with respect to the distinction between liquidity and solvency risks, a grey area exists between spreads arising from systemic risks and those coming from country-specific economic fundamentals. Attempts to cap sovereign spreads run foul of the dangers expressed above: while they can offset the impact of systemic risks beyond the country’s control, they can also induce free-riding and moral hazard.
20.Conditionality is therefore required. And that leads us back to the role of the EFSF/ ESM in providing the political legitimacy for such conditionality. In the end, the elimination of redenomination risk requires fundamental changes that prompt long-term private holders of sovereign debt back into peripheral markets. Introducing incentive problems makes achievement of that goal harder rather than easier.
Addressing contagion (2): Spillovers from public- to private-sector financing
21.Concerns about spillovers from Spanish sovereign funding tensions not only extend to other countries, but also to the Spanish private sector. Mr. Draghi’s remarks about the impairment of the monetary policy transmission mechanism reflect the extremely difficult financing conditions facing Spanish companies and households, and weak pass-through of official ECB rate cuts to the Spanish real economy. Our own recent analysis of the relationships among official interest rates, bank lending rates and sovereign yields support these concerns. And we have demonstrated that these concerns are not unique to Spain: similar issues arise in Italy and the rest of the periphery.
22.One approach to addressing this problem is to reduce the sovereign spreads that are associated with higher bank funding costs and financial market dislocations. SMP purchases of sovereign debt are a natural vehicle for the ECB to use in that context. But such an approach immediately runs into the problems identified above: the effectiveness of such interventions will be greater the less conditional they are, but the risk of free-riding by the fiscal authorities will be greater.
23.An alternative approach would be to bypass the sovereign spreads and support private-sector financing directly. With its broad and widening definition of collateral eligibility, purchases of bank covered bonds and 3-year LTROs, the ECB has already engaged in variants of this approach, a path now being mimicked by some other central banks. But scope exists to go further.
24.Collateral eligibility could be relaxed again and the haircuts imposed on collateral values reduced. Indeed, the ECB is already engaged in a review of its collateral framework: we anticipate that this will look to remove sovereign credit ratings from the system, in an attempt to eliminate the ‘cliff risk’ inherent in the current system. While the rationale for such a measure may be systemic, it is undoubtedly convenient in the specific circumstances faced by Spain now. And a review of the collateral system offers scope to make more aggressive easing measures elsewhere. Further longer-tenor LTRO operations could be envisaged, out to 5 or 10 years.
25.But, particularly in Spain, the efficacy of such measures is open to question. With the replacement of private unsecured financing with funding from the ECB’s 3-year LTROs against eligible collateral, assets on Spanish bank balance sheets have become encumbered. While bank funding at ECB operations is now cheap and readily available, insufficient free collateral is available to exploit this. Buying covered bonds – as the ECB has done in the past – does not help in this respect (as it also, by nature, involves encumbering bank assets), while changes in collateral eligibility and haircuts have a marginal impact.
26.Outright central bank purchases of unsecured bank debt – something that we have discussed previously – would address this issue. They would support banks’ balance sheet flexibility and facilitate the flow of credit to bank-dependent (and thus credit-starved) small and medium-sized enterprises (SMEs), particularly if marginal incentives were introduced to expand new credit and direct it towards SMEs. Of course, despite the recapitalisation scheme being put in place in Spain, other constraints (notably capital problems) weigh on banks’ ability to lend. And credit demand is weak. So such measures are not a panacea. But in a bank-dependent economy where the traditional interest rate channel of monetary policy transmission is impaired by market segmentation, they may be the most effective tools available. And the prospect of assuming responsibility for banking supervision across the Euro area may make the ECB more willing to act aggressively through the banks.
27.Extending the chain of logic developed above, this would point to the desirability of bypassing not only the sovereign space, but also the banking system by buying corporate debt. Admittedly corporate debt markets in the periphery are underdeveloped. But were the ECB to initiate purchases, issuance would no doubt quickly follow. And financing the larger corporates that are able to issue would improve their working capital position and thereby indirectly ease financing pressures on their SME suppliers as payment periods normalise.
28.A natural objection to outright purchases of assets issued by the private sector is that they involve the assumption of too much credit risk by the ECB. But substantial risk is already assumed via credit operations. And, by their nature, credit easing measures involve the assumption of credit risk. The more aggressive the measure, the greater risk assumed. If – as the macro data suggest – Spain and Italy need substantial stimulus, then imparting that via credit easing means that a lot of risk will need to be taken. And given the present segmented state of Euro area financial markets, for a given willingness to accept risk, it may be preferable to make targeted interventions in the countries and sectors where tensions are most acute – even if this means the risks inherent in any single position is greater.
29.The risk assumed can also be distributed across countries in a politically acceptable manner. As with the risk associated with the national schemes for bringing unrated corporate loans as collateral introduced last December, one could envisage the ECB approving a set of voluntary national private asset programmes proposed by NCBs to reflect their particular circumstances, where the credit risk in those operations remained on the NCB balance sheet. Of course, this would not eliminate the risk faced by Germany and the Bundesbank: to the extent that such purchases create TARGET 2 balances (which is likely to be significant), the Bundesbank would still suffer losses in the event of Euro break-up or a peripheral country exit. But the idiosyncratic risks associated with an individual purchase (or indeed any cyclical or sectoral risk that does not lead to exit) would fall on the peripheral country alone, and not on Germany or other Euro area countries. (Of course, in some respects this is a disadvantage: only the ‘catastrophe risk’ is mutualised, but other forms of risk are concentrated at the national level. Thus the risk sharing benefits of a more integrated financial sector are forgone.)
30.Such a scheme allows NCBs to undertake quasi-fiscal action (since credit easing is a form of public subsidy) and monetise the fiscal consequences (by expanding their balance sheets). NCB purchases of private-sector assets (within a framework overseen by the ECB that leaves the credit risk inherent in such operations lying on the NCB balance sheet) offer scope for surgical interventions targeted to address the most impaired elements of monetary policy transmission, while limiting the potential adverse consequences for incentives (especially of governments). Cosmetically, such measures will add to the impression of a renewed Balkanisation of monetary policy in the Euro area. But, with Euro financial markets deeply segmented, such targeted measures offer a way of managing the consequences of that segmentation for the private sector and real economy while maintaining the pressure for governments to act on fundamentals in a manner that reduces and ultimately eliminates the segmentation over time.
Tags: Bank Debt, Bank Of Japan, Central Planner, Corporate Debt, Credit Operations, Credit Risk, Downside, ECB, Escalation, Goldman, Governing Council, Huw, Japanization, Mario Draghi, Monetization, Private Assets, Rational Person, Substantial Risk, Taxpayer Risk, Whole Lot
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Sunday, July 15th, 2012
Last week the S&P erased 6 days of consecutive losses in 30 minutes of trading on the back of news that JPMorgan lost at least 25% of its average annual Net Income in one epic trade, and stands to make far fewer profits in the future, even as the regulators are about to fire a whole lot of traders for mismarking hundreds of billions in CDS. This was somehow considered “good news.” This being the “new normal” market, where nothing makes sense, and where EUR repatriation as a result of wholesale asset sales by European banks drives stocks higher, we were not too surprised. Sadly, even in the new normal, things eventually have to get back to normal. And that normal will come as corporate earnings are disclosed over not so much over the next 3 weeks, when 77% of the companies in the S&P report Q2 results, but in the 3rd quarter. Why the third quarter? Simple: as Goldman’s David Kostin explains, “consensus now expects year/year EPS growth to accelerate from 0% in 2Q, to 3% in 3Q to 17% in 4Q.” Sorry, but this is not going to happen, and as more and more companies preannounce on the back of the global slowdown which many has seeing US GDP down to 1.3% in Q2, and sliding further in Q3 absent some massive QE program out of the Fed, it is virtually guaranteed that the unchanged Earnings precedent that Q2 will set (and there is a very high probability that Q2 2012 will mark the first YoY drop in earnings since the unwind Great Financial Crisis) will continue into Q3 and likely Q4. Because, sadly there simply is no catalyst that will drive revenues higher, even as margin contraction was already set in.
All of this also means that the only possible driver of S&P growth in Q3 (of which we are already 2 weeks deep into) and Q4 will be multiple expansion. This, however too, will be a disappointment. Again from Kostin:
We believe P/E multiple expansion is unlikely in 2H. Headwinds include the fast-approaching Presidential election, associated policy uncertainty, and the looming “fiscal cliff” that everyone outside the beltway decries but no one in Washington, DC seems willing to seriously address.
Not to mention the debt ceiling which is still on track from making US landfall sometime in the next 3 months.
So while short covering rallies are fast and furious, corporations -that traditional deus ex to justify US “decoupling” – now have only one fate before them: disappointment.
Which leaves the Fed. Sadly, not even the extension of Twist can do anything about the biggest concern that banks are currently facing, namely the accelerated decline in reserves, as a result of the prepayment of Maiden Lane obligations and the gradual drop in FX swaps (at least until the next time Europe needs a Fed-based bail out that is). As can be seen in the chart below, Adjusted Reserves have tumbled to level not seen since December, and then May of 2011, both times when the market was about to turn over if not for global coordinated central bank intervention.
Full note from Goldman:
Our 2012 investment thesis for the US equity market has three pillars: a stagnating economy, static P/E multiple, and minimal earnings growth.
First, weak macro data and three proprietary Goldman Sachs indictors support our view of a lackluster economy. The Goldman Sachs Current Activity Indicator (CAI) shows the US economy growing at an annualized pace of just 1.3%. The three-month moving average of our Earnings Revision Leading Indicator (ERLI) diffusion index, a measure of 29 separate micro-driven industry data points, remains below trend at 41, consistent with a softening of our Global Leading Indicator (GLI). On the macro front, the June ISM report slipped to 49.7, the first sub-50 print in three years.
Second, we believe P/E multiple expansion is unlikely in 2H. Headwinds include the fast-approaching Presidential election, associated policy uncertainty, and the looming “fiscal cliff” that everyone outside the beltway decries but no one in Washington, DC seems willing to seriously address.
The third leg of our three part framework will come into clarity during the next several weeks as firms report 2Q results and offer guidance on business activity for the second-half of 2012. 80% of S&P 500 market cap will report between July 16th and August 3rd. Firms to watch next week include: BAC, C, GE, IBM, JNJ, KO, MSFT, PM, SLB, and VZ.
We expect a modest quarterly earnings miss. A shortfall in sales rather than margins will be the primary culprit. Firms will struggle to meet revenue forecasts given weak global demand and a strong US Dollar. Consensus margin expectations are already flat or negative in most sectors.
Bottom-up consensus currently forecasts flat year/year EPS growth, driven by a 4% increase in sales and a 40 bp fall in margins to 8.9%.
Five sectors are expected to post negative earnings growth in 2Q 2012 compared with 2Q 2011: Energy, Materials, Utilities, Consumer Discretionary and Consumer Staples. Analysts forecast Materials and Energy will both post year/year EPS declines of 12% reflecting the sharp fall in commodity prices during 2Q, with Brent plunging by 16% and copper dropping by 10%. In contrast, Industrials and Information Technology will report EPS growth of 7% and 11%, respectively. Apple (AAPL) will again be a standout performer with year/year sales and EPS growth of 32% and stable margins of 25.6%. Including AAPL, the Tech sector is forecast to deliver sales and EPS growth of 9% and 11%, respectively. Without AAPL, the sector will post revenue and EPS growth of 6% and 7%, respectively.
2Q results will affect the market’s outlook for earnings in 2012 and 2013. Consensus now expects year/year EPS growth to accelerate from 0% in 2Q, to 3% in 3Q to 17% in 4Q. Consensus forecasts full-year EPS growth will double from 7% in 2012 to 14% in 2013. In contrast, we do not forecast a steep 4Q 2012 inflection and anticipate EPS growth climbing from 3% in 2012 to 7% in 2013.
Our full-year 2012 and 2013 S&P 500 EPS forecasts remain $100 and $106. Current bottom-up consensus equals $103 and $117. Consensus 2012 estimate has dropped from $107 in January and from $114 in August 2011.
Earnings season focus points: (1) domestic demand; (2) international weakness; (3) margins; and (4) losses from JP Morgan’s CIO unit.
Our ERLI Diffusion Index suggests US micro data improved in June but the three-month moving average remains below trend at 41. In May, our diffusion index of micro driven, industry-level data points fell to 29, the lowest reading since April 2009 (a reading of 50 implies “trend” growth). However, data rebounded in June producing a slightly above trend reading of 53, with 23 of 29 industry variables increasing at a trend or better pace. Examples include hotel occupancy, rail car loadings, and NY/NJ port activity. If this trend persists, it implies that the micro data points which inform equity analysts’ earnings projections may not be as poor on a near-term basis as an otherwise gloomy macro picture suggests. In contrast, our macro driven Global Leading Indicator of industrial production has been contracting at an accelerating rate for the last three months, which our research has shown augurs poorly for S&P 500 returns.
Margins will once again be source of scrutiny. Margins have stabilized at 8.9% for more than a year after having surged by 300 bp from a cyclical low of 5.9% in 2009. Differing margin forecasts explain 80% of the gap between our top-down EPS estimate and bottom-up consensus for 2012. Consensus expects margins to remain flat during the first three quarters of 2012 before rising sharply starting in 4Q and expanding to 10% by year end 2013. In contrast, we forecast margins will hover around 8.9% for the next two years.
JP Morgan CIO trading losses. This morning JPM reported 2Q EPS of $1.21, 59% above consensus expectations of $0.76. Of course, analysts had cut estimates by 38% since May after the bank disclosed large trading losses in its chief investment office. The JPM CIO losses of $4.4bn reduce 2Q 2012 EPS for the S&P 500 by $0.49. For the Financials sector, year/year EPS growth in 2Q is anticipated to be 8% including JPM and 12% without.
Tags: 2q, 3q, 3rd Quarter, Asset Sales, Consecutive Losses, Contraction, Corporate Earnings, Earnings Season, European Banks, Financial Crisis, Global Slowdown, Goldman, Kostin, Net Income, Nothing Makes Sense, Q3, Q4, Qe, Repatriation, S David
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Thursday, June 14th, 2012
Two months ago, as we were carefully reading the latest Goldman explanation of how the firm had completely missed something Zero Hedge predicted back in January, namely the record warm winter’s impact on skewing seasonal adjustments for payroll data (which has since validated our day 1 of 2012 predication that 2012 will be a carbon-copy replica of 2011, and which has made the comedy value of another Goldman masterpiece, that of Jim O’Neill’s idiotic “2012: Not a Repeat of 2010 or 2011″ soar through the roof) we stumbled upon something we knew was about to get much, much more airplay: Goldman’s quiet and out of place admission that what matters for a country’s central bank is the flow of its purchases, not the stock (another massive economic misconception we have been trying to debunk since the beginning). Recall these words: “…we have found some evidence that at the very long end of the yield curve, where Operation Twist is concentrated, it may be not just the stock of securities held by the Fed but also the ongoing flow of purchases that matters for yields…” This is how we summarized this observation two months ago (pardon the all caps): “UNLESS THE FED IS ACTIVELY ENGAGING IN MONETIZATION AT EVERY GIVEN MOMENT, THE IMPACT FROM EASING DIMINISHES PROGRESSIVELY, ULTIMATELY APPROACHING ZERO AND SUBSEQUENTLY BECOMING NEGATIVE!”
All caps aside, what this means is simple: if it is indeed flow that matters (and it is), then Fed intervention can never stop, period. If the stock of a central banks’ assets is irrelevant, the Fed can have $1 on the left side of the balance sheet or $1 quadrillion: it does not matter – if the market expects the Fed to stop buying assets tomorrow, then the crash is as good as here. That has precisely been the biggest flaw with the Fed-accepted stock model, per which Bernanke can buy up a few trillion in MBS and the stock market will be flat as a frozen lake. Alas, this is increasingly becoming obvious is not the case. Hence flow.
Which is why today, two months later, and a week before Bernanke will almost certainly announce the NEW QE, we were not surprised at all to see that Goldman has actually made the case for flow in the form a of a white paper titled “Flow Effects at the Ultra-Long end of the Curve.”
For monetary theory purists this is equivalent to Martin Luther walking up to the front door of the Marriner Eccles building and nailing his 95 theses: we have now entered the era of the monetary reformation, which incidentally as more and more classical economists follow suit, will throw all of Keynesian and neo-classical economics into a tailspin where virtually every core assumption will have to be reevaluated.
Congratulations economists: in their pursuit of another record year of bonuses at any cost, Goldman just sacrificed your precious voodoo. Because where Goldman goes, everyone else promptly follows.
From Goldman Sachs:
Flow Effects at the Ultra-Long End of the Curve (Shan/Stehn)
- With the scheduled end of the Fed’s twist approaching, market participants are debating the extent to which the end of the Fed’s purchases will affect the yield curve. The “stock view” – which Fed officials and we have generally subscribed to – suggests that markets tend to price in the Fed’s purchases at announcement and then show little responsiveness to the subsequent flow (and end) of purchases. The “flow view,” however, would suggest that yields increase when the twist concludes.
- Using a simple model of the Treasury yield curve, we revisit this issue in today’s daily. Our estimates suggest that the flow effect is negligible for short and intermediate maturities (of less than 20 years) but statistically significant at the ultra-long end of the curve (with maturities of 20+ years). Although the uncertainty is significant, these estimates suggest that – all else equal – the end of the twist will have negligible effects on the short and intermediate part of the curve, but might push up yields at the ultra-long end of the curve by around 5 basis points.
With the scheduled end of the Fed’s twist approaching, market participants are debating the extent to which the end of the Fed’s purchases will affect the yield curve. Economic theory suggests that we need to distinguish between the effects of the announced stock of Fed purchases and the flow of actual purchases. In forward-looking and liquid markets, bond yields should primarily depend on the announced stock of purchases. Therefore, markets should price in the size of the purchase program at announcement and show little response to the subsequent flow of purchases. This means that when the flow of Fed purchases is discontinued—but the size and duration of the Fed’s balance sheet is unchanged—there should be little effect on yields. Empirical evidence has generally reinforced this prediction. Our own work, for example, has confirmed that stock effects dominate flow effects. (See Sven Jari Stehn, “Stocks vs. Flows Revisited: End of QE2 Unlikely To Have Significant Effect on Bond Yields,” US Daily, April 13, 2011.)
Although the “stock view” appears to be a good description of the effects of Fed purchases at the short and intermediate maturities, flows might be more important at the ultra-long end of the Treasury curve. Intuitively, this would fit with the observation of investment habitat – how purchases of 20-30 year bonds are mostly conducted by more heterogeneous investors that are less sensitive to changes in demand and supply in the Treasury market. Consistent with this view, we found tentative evidence for flow effects at the ultra-long end of the curve in earlier work (see US Daily cited above). However, the number of observations was very small and so the estimates were very imprecise.
With more data on hand and the end of the twist in sight, we revisit the issue of flow effects from Fed asset purchases at the long end of the curve in today’s daily.
Following our previous work, we focus not just on one particular point on the yield curve at a time but also explore how the Fed’s purchase program has affected the entire yield curve. Doing so allows us to better separate the effects of economic factors (which affect the entire yield curve) from the Fed purchases (which differ across the yield curve). Making use of the relative movement of yields at different maturities provides more information and should thus provide better identification. (This disaggregated approach is motivated by Stefania D’Amico and Thomas King, “Flow and Stock Effects of Large-Scale Treasury Purchases,” Finance and Economics Discussion Series, Federal Reserve Board, 2010-52.)
Specifically, we construct our model in a number of steps.
First, we use the New York Fed’s Treasury yield curve estimates, which provide coupon-equivalent par yields for maturities between one year and 30 years.
Second, we construct a dataset of daily flows of Treasury purchases from the New York Fed’s website and allocate these into different “maturity buckets.” For example, we match purchases of bonds that have remaining maturity of between 9.5 and 10.5 years with the 10-year bond yield discussed above. Our sample period – which runs from March 2009 through April 2012 – can be divided into three phases: QE1 (March 2009 through October 2010), QE2 (November 2010 through August 2011), and the twist (since September 2011). The distribution of the purchases is shown in Exhibit 1 below.
Third, we control for the announced stock of Treasury purchases. Given our focus on testing for flow effects and the difficulty of identifying the announcement effect at individual maturities, we use a very flexible approach to capture the effect of the stock of purchases on yields. (Specifically, we use an intercept dummy and a linear trend for each maturity bucket in each QE phase.) The advantage of this approach is that we do not have to make a priori assumptions on the magnitude of the stock effect and doing so should raise the bar for finding flow effects. The drawback, of course, is that our model focuses solely on generating a flow estimate and cannot provide an estimate for the magnitude of the stock effect.
Finally, we combine the data on yields and flows with our stock dummy variables to construct a panel model for these thirty maturity buckets with daily data since March 2009. To take into account variations in duration and/or liquidity factors across maturity buckets, we allow the constant in our model to vary across maturities (that is, we include so-called maturity “fixed effects”). And to disentangle the effect of the Fed’s purchases at the different maturity buckets from economic factors that affect yields across the maturity spectrum, we allow the whole yield curve to shift over time (that is, we include so-called “time fixed effects”). In a nutshell, we estimate the following panel regression:
yield = ?*flow + ?*stock+ fixed effects
where the flow variable captures the purchases, the stock variable is given by the dummies described above and the fixed effects represent maturity and time fixed effects as discussed above. If there is a flow effect, then we should find a negative ? in this regression. To explore whether the flow effect differs at different parts of the curve, we allow ? to vary across different maturity buckets. In our baseline specification, we split the yield curve into seven segments (namely, 1-2 years, 3-4, 5-7, 8-10, 11-14, 15-20, and 21-30 years).
Our results are summarized in Exhibit 2 below. (For the full set of details, see Table 1 in the appendix). Our estimates reveal statistically insignificant ? coefficients at the short and intermediate maturities (up to 20 years), but negative and statistically significant estimates of ? at the ultra-long end of the curve (with 21-30 years maturity). In other words, our estimates confirm previous findings that the flow effect is negligible for short and intermediate maturities but significant at the ultra-long end of the curve. In terms of magnitudes, our results suggest that a $1bn purchase at the ultra-long end of the curve (all other things equal) lowers the yield by 3.3bp at that part of the curve.
We performed a few robustness checks. First, we split the regressions for the 1-10 maturities and 11-30 maturities in two regressions to address the concern that the daily time effects are not appropriate when grouping all 30 maturities together in one regression. The results are qualitatively similar: the flow effect at the very long end of the curve remains significant but the size of the effect drops from 3.3 to 2.3bp per $1bn (see Table 1 in the appendix). Second, we omitted the 1-2 years and 1-3 years maturities since the yields of these maturities have effectively been pinned down by the Fed’s guidance language. Again the results are qualitatively unchanged (not shown).
In a final step, we can look at the implication of our estimates for the yield curve should the twist end in June as currently scheduled. As discussed, our model suggests that – all other things equal – we should not expect to see significant effects on the short and intermediate parts of the yield curve. But – again all other things equal – our model would point to an increase in yields at the ultra-long end of the curve. A simple approach to gauging the implied magnitude of this effect is to look at the average monthly purchases at this part of the curve over the last few months and ask by how much yields would move if this dried up. The Fed has purchased around $13bn per month at the ultra-long end of the curve (21-30 years) since the start of the twist. Taking into account that no purchases were actually made at the 21-23 year maturity (see Exhibit 1 above), this comes to an average of around $1.8bn per month in each of the maturity buckets where purchases actually took place. Applying our estimates of the flow effect – the 2.3bp to 3.3bp range per $1bn of purchases – this would imply that an increase in yields at the ultra-long end of the curve of around 5bp.
While we have reasonable confidence in the qualitative conclusion of our analysis – that flows tend to perturb yields only at the ultra-long end of the curve – it is important to keep in mind a number of caveats when interpreting the quantitative implications of our model. First, disentangling the influence of stocks, flows and other variables on the yield curve is a very difficult exercise and the uncertainty is therefore considerable. Second, our estimated magnitudes are only about as large as the average daily volatility of yields over the last three years (around 6bp at the 30-year maturity). Finally, it is important to note that our model’s estimate only refers to the effect of the end of the flow of purchases on yields and does not take into account other factors that might influence yields at the same time. For example, the end of the twist could have a significant effect on the yield curve beyond the analysis presented here if Fed officials deliver something different from what the market is expecting for the June meeting.
Tags: Balance Sheet, Carbon Copy, Central Banks, Goldman, Masterpiece, Mbs, Misconception, Monetization, O Neill, Payroll Data, Predication, Qe, Quadrillion, S Central, Seasonal Adjustments, Stock Market, Stock Model, Warm Winter, What This Means, Yield Curve
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Thursday, June 7th, 2012
In preparation for what we are about to receive from the Charmain of the Fed, may we be truly grateful, Jim Grant offered CNBC’s Maria B the forthright advice last night “prepare for platitudes but watch what they are doing not what they are saying”. The ever outspoken Grant notes that the Fed’s balance sheet has been contracting (unlike Maria’s mainstream perspective); for the past three months the Fed’s balance sheet has contracted at an annualized rate of 10% – even as Fed-head after Fed-head talk up QE and so on. So unless they continue buying securities – since the short-dated positions will continue to roll off – the Fed’s balance sheet will continue to contract and therefore the stimulative effect will fall. Grant does expect QE3 since it is the fun-drug that we have been using for 4 or 5 years and that Bernanke will need little pushing to continue the Grand Manipulation. He ends on a rather interesting note that the Wisconsin win and the potential for an Obama loss in November may be more of a positive driver for stocks since markets begin to revert to a free market once again – we suspect this is not the case given the donors/beneficiaries under Romney’s wing. But rest assured – the bespectacled bear ends on the chilling note that ‘the long-term implications are bad’ for the ongoing manipulation that is now the status quo.
and from Goldman, if there was any doubt of Grant’s comments on the implicit tightening – or inverse flow – as they present the embedded tightening opportunity cost for the Fed it does nothing.
The bottom line here is that if the Fed does nothing then there is an implicit 5-10bps of rate-hike tightening per quarter implicit in the balance sheet roll-down (50bps in next 3 years) – so when considering the Fed’s actions, discount the effect of this automatic tightening before buying the S&P at 2000…
Tags: 3 Years, Amp, Balance Sheet, Beneficiaries, Bernanke, Bottom Line, Charmain, Cnbc, Donors, ETF, ETFs, Fed Head, Gold, Goldman, Jim Grant, Mainstream, Manipulation, Opportunity Cost, Platitudes, Qe, Rate Hike, Term Implications, Three Months
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Tuesday, June 5th, 2012
Earlier today, by way of a simple graphic, the world’s biggest hedge fund, Bridgewater, was kind enough to remind the world just how pointless any debates about Europe’s future viability are if the primary funding conduit: the EFSF/ESM hybrid can not provide the cash needed for even half the combined funding needs of Italy and Spain. Now, Bridgewater strikes at Europe once again, this time redirecting the general attention to where it is long overdue: Italy.
Because while Spain has for months now, ever since the publication of the ‘Ultimate Doomsday Presentation‘ right here in Zero Hedge on April 7, been punished with ever widening bond and CDS spreads, and a local stock market which recently hit a 12 year low, Italy has largely avoided the vigilantes and general bearish scrutiny so far. The main reason for this is the assumption that Italian Banks had loaded up on enough LTRO cash that they had sufficient dry powder to buy up Italian bonds in the primary and, more importantly, the secondary market for at least a few more months. We bold “the assumption” because as Bridgewater calculates, the ‘dry powder’ number is far, far less than conventional wisdom had been expecting. In fact, at negative €48 billion in residual LTRO capital, Italy flat out has no additional cash with which to plug ongoing debt funding needs.
And with that, it is time to wave goodbye to the always wrong conventional wisdom, and to wave in the arrival of the vigilantes, who had been so missed in Milan since the fall of 2011 when they nearly toppled Europe’s fulcrum economy, and only the sacrifice of Silvio Berlusconi prevented an all out catastrophe on November 8, 2011. This time, the token replacement of an unelected token technocrat (and Goldman crony) will no longer appease anyone.
Source: JP Morgan’s Michael Cembalest
Tags: Assumption, Bridgewater, Catastrophe, Conventional Wisdom, Crony, Debates, Doomsday, Efsf, Fulcrum, Gold, Goldman, Hedge Fund, Italian Banks, Jp Morgan, Sacrifice, Scrutiny, Silvio Berlusconi, Stock Market, Strikes, Technocrat, Viability
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Tuesday, June 5th, 2012
Germany remains vehemently opposed to any euro-wide deposit guarantee scheme as the head of the association of savings banks believes it: “would lead to a spreading of risks to the detriment of German financial institutions” and that this would “increase the burden for national protection schemes, which is not in the interest of German banking clients“. Not exactly encouraging and along with the fact that Goldman notes that Germany’s ‘growth plan’ (which includes increasing EIB capital and redirecting existing funds to the periphery) with which it will attempt to bolster its opposition to soaking up more peripheral risk, contains ‘nothing really new in it’. For this reason Goldman is far less sanguine heading into the ECB meetings as they hope for the best and prepare for the worst. They expect Draghi’s forward-looking statements on being ready to act, conditional on events in the periphery, will be the most important headlines but expect him to remain stoic in his position on governments contributing to the solution. Goldman’s view remains that, at least for the time being, the ECB has to play a leading role in stabilising the system (though SMP remains marginalized given its potential to sit outside of the ECB mandate) given that it can operate more quickly and more effectively, given the many political constraints governments face. A genuine long-term solution, however, falls once again in the domain of governments.
German government prepares “growth package”; nothing really new in it. According to news reports, the German government has been working on a list of measures to support growth in the Euro area. The list includes measures such as increasing the European Investment Bank’s capital by around €10 billion and redirecting existing money in EU funds towards the periphery. There seems to be nothing really new on the list and there is no indication that the German government would now be in favour of any large public spending programme. The German government will use this list for its forthcoming discussion with the opposition on the fiscal compact, scheduled for June 13. The government needs the support of the opposition in order to get the fiscal compact through parliament. The opposition has demanded that, in exchange for its support, the government should come up with specific measures to support growth in the periphery.
German banks critical on proposed support measures for peripheral banks. The head of the association of savings banks, Fahrenschon, wrote in an op-ed in FTD that a Euro area wide deposit guarantee “would lead to a spreading of risks to the detriment of German financial institutions” and that this would “increase the burden for national protection schemes, which is not in the interest of German banking clients”. The association of private banks, BdB, at the same time has rejected in a written statement direct financial help for peripheral banks from the EFSF. Such help would be conditional on a restructuring of the banking sector and only national governments would ultimately be in a position to ensure that such conditions were met.
Portuguese government to inject €6.63 billion into banks. Portuguese Finance Minister Gaspar said yesterday that Portugal will use money from its current EU/IMF programme, earmarked for supporting banks, to bolster the capital position of its three biggest banks.
Focus: ECB preview: Hoping for the best, preparing for the worst
Bottom line: We expect the ECB to keep rates on hold this Wednesday and also expect no announcement of further non-standard measures. Further ECB actions are to a great extent conditional on events in the periphery, and on the implication these events will have for the wider Euro area and the financial system. ECB President Draghi is likely to use the press conference as an opportunity to signal that the ECB will in principle stand ready to support the system if needed. However, Draghi is also likely to remind governments forcefully that they must contribute to the solution and that the ECB can only accommodate what in the end is a political process.
Growth outlook (a lot) more uncertain
Growth at the beginning of the year was somewhat stronger than we had expected and the Euro area economy ‘only’ managed to stagnate, after a small decline in economic activity at the end of last year. Stronger than expected numbers out of Germany and Spain – although the Spanish economy still contracted by 0.3%qoq – were the main reason for this, more than offsetting a negative surprise in Italy.
However, the latest monthly indictors coming out of the Euro area suggest that the economy is losing momentum again and our Current Activity Indicator, which uses information up to April, is consistent with a small decline in GDP. The May business surveys imply this downward trajectory continued last month (for more on the outlook see our latest European Views).
In the May introductory statement, the ECB’s Governing Council’s view was that the “latest survey indicators for the euro area highlight prevailing uncertainty. Looking ahead, economic activity is expected to recover gradually over the course of the year”. This outlook, according to the Governing Council, “continues to be subject to downside risks”. We think the June statement will now acknowledge that an easing in economic activity during the summer is likely, but will at the same time still expect an improvement by the end of the year. Thus, we expect “gradual recovery” to remain part of the Governing Council’s main scenario.
We also expect the deterioration seen in the data since March to be reflected in a downward revision of the June staff projections. While a revision to our more pessimistic outlook for Euro area growth of -0.5% for this year seems unlikely, we could see the staff now forecasting – after -0.1% for 2012 in March – a more pronounced weakness in the coming two quarters, leading to an annual growth forecast of around -0.3%.
A downward revision of the 2012 annual figure to around -0.3% would imply that the ECB’s staff expect the current weakness to be temporary, followed by a stabilisation by the end of the year and a return to positive growth in 2013. Next year’s growth forecast of +1.1%, in this scenario, is unlikely to be changed much (GS: +0.4%).
A more significant change in the staff projections would signal a more fundamental reassessment of the current situation, and would also, everything else equal, make further policy easing – including a reduction in rates – more likely.
As far as the inflation outlook is concerned, the May statement saw inflation staying above 2% in 2012, but “over the policy-relevant horizon, we expect price stability to remain in line with price stability” and “risks to the outlook for HICP inflation rates in the coming years are still seen to be broadly balanced”. This risk assessment is unlikely to change, although we could see the Governing Council signaling a small reduction in the underlying inflationary pressures by deleting “still” from the sentence in the statement describing the risk assessment.
The somewhat more benign outlook for inflation should also be reflected in a moderate downward revision of this year’s forecast of 2.4% on the back of weaker growth and lower energy prices (for example, back in March the staff assumed a price for Brent crude oil of US$115 for this year) and a broadly unchanged figure for next year (+1.6%; GS: 2.4% in 2012 and 1.9% in 2013). Again, a more substantial downward revision of inflation would signal a fundamental reassessment of the outlook for the Euro area.
ECB to remain on hold in our base case scenario…
ECB actions remain to a great extent conditional on developments in the periphery at this point, and on the implications these events will have for the wider Euro area and the financial system. Ultimately, it is the implications for the Euro area as a whole that the ECB cares about. Our base scenario foresees a ‘muddling-through’ in Greece, with the newly elected government unlikely to choose an exit from the Euro or implement the EU/IMF programme unconditionally. Meanwhile, it is likely that Spain will eventually have to ask for external financial help to support its banking system. All this is likely to be accompanied by slow progress – mostly consisting of announcements – on deeper policy integration and the building of higher financial firewalls.
We expect the ECB to keep rates on hold in this ‘muddling-through’ scenario. That said, the ECB will stand ready to provide liquidity to banks, as it has in the past, and we expect the ECB to extend the deadline up to which it will operate its current full-allotment regime in its refinancing operations significantly, potentially until the end of the year. Emergency Liquidity Assistance (ELA) should be the main tool through which additional liquidity needs will be met (see our European Daily Comment from May 31 for more details).
President Draghi is likely to be asked during the press conference about the preparations the ECB has made in the event Greece leaves the Euro. While Draghi will probably simply say that the ECB expects Greece to remain part of the Euro area, he may want to use this opportunity to stress the ECB’s willingness to support banks in the event of a liquidity shortfall.
…but would come out in force if needed
We could see the ECB engaging in a wide range of non-standard measures in order to safeguard the system should events turn out to be more disruptive. Liquidity measures such as additional LTROs, possibly beyond 3 years, and a further widening of the collateral framework would be part of the ECB’s response to a sharp rise in tensions on the back of, for example, a disorderly Greek exit from the Euro.
Outright purchases of financial assets are also conceivable in such a scenario. The hurdle for reactivating the SMP seems high at this point and several Governing Council members have been sceptical about whether the SMP would fall within the ECB’s mandate and about the overall effectiveness of the programme. Moreover, with the EFSF now in a position to buy government debt in the secondary market, the ECB is unlikely to be eager to use its balance sheet to stabilise peripheral yields.
The ECB could therefore consider outright purchases in other market segments, including bank debt. But depending on the sharpness of such moves, the SMP may very well be reactivated on short notice.
Political coverage necessary
Implicit or explicit approval by Euro area governments would be required for the ECB to engage in a new round of additional support measures in a disruptive scenario. Whether this support for the ECB would take the form of a common declaration by governments or individual statements is difficult to say. But whatever shape or form such political backing took, it would clearly increase the ECB’s effectiveness in dealing with the situation. Our view remains that, at least for the time being, the ECB has to play a leading role in stabilising the system given that it can operate more quickly and more effectively, given the many political constraints governments face. A genuine long-term solution, however, falls once again in the domain of governments.
Tags: Deposit Guarantee Scheme, Detriment, Draghi, ECB, energy, European Investment Bank, Favour, Financial Institutions, German Government, Gold, Goldman, Governments, Heading, Long Term Solution, Mandate, Measures, Nbsp, Opposition, Periphery, Political Constraints, Savings Banks, Smp
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Tuesday, May 22nd, 2012
With both gold and broader commodity indices down significantly month to date, many investors are asking if they should lower or even remove their commodity exposure. I believe the answer is no.
First, it’s useful to put the recent weakness in perspective. Both gold and a broad basket of commodities are down roughly 10% over the past three months. While the losses represent a significant correction, they are in line with the performance of equity markets over the same time period. Even more importantly, here are three reasons for maintaining a strategic exposure to commodities.
1.) Diversification: Commodities typically behave differently from paper assets like stocks and bonds even as correlations between all risky assets have risen in recent years. In fact, based on historic relationships, it doesn’t take a large allocation to commodities – it typically takes less than 10% – to improve the risk-adjusted returns of a strategic portfolio.
2.) Inflation: Commodities tend to perform best when inflation is rising. As I mentioned last week, while I see little risk of double-digit inflation in the near-term, inflation is not completely dead. Core inflation in the United States is rising at 2.3% year over year, a 3 ½-year high. Given the US fiscal position and the unconventional nature of recent monetary policy, there is a non-trivial risk that we may see more than 2.3% inflation over the next decade. Over the long term, even modest inflation would erode purchasing power. Commodities can offer an effective hedge against this scenario.
3.) Potential tailwind from monetary policy: While commodities have suffered recently, the performance hasn’t been awful. The S&P Goldman Commodities Index is down roughly 5% year to date. Meanwhile, gold was up around 2% through the end of last week, returns that still compare favorably with most equity markets outside of the United States.
One reason for the resilience, as I’ve written before, is that commodities and gold generally benefit when real interest rates are negative. In such a rate environment, there’s no opportunity cost for holding commodities, and commodity returns tend to be higher. At least historically, the level of real interest rates has been far more important to commodity returns than either inflation or the dollar. In fact, over the past twenty years, the variation in real interest rates explains roughly 60% of the variation in the annual return of gold. To the extent the Fed, and most other major central banks, are determined to keep real rates negative for the foreseeable future, we’ll be in an environment supportive of commodities, particularly gold.
To be sure, commodity prices are likely to remain volatile – along with just about every other risky asset – in the near term as investors worry about the potential for a disorderly default by Greece impacting the global economy. However, for investors, especially those currently underweight commodities, now may very well be a good long-term buying opportunity (potential iShares solution: NYSEARCA: IAU).
Past performance does not guarantee future results. Diversification and asset allocation may not protect against market risk.
iShares Gold Trust (“Trust”) has filed a registration statement (including a prospectus) with the SEC for the offering to which this communication relates. Before you invest, you should read the prospectus and other documents the Trust has filed with the SEC for more complete information about the issuer and this offering. You may get these documents for free by visiting www.iShares.com or EDGAR on the SEC website at www.sec.gov. Alternatively, the Trust will arrange to send you the prospectus if you request it by calling toll-free 1-800-474-2737.
Investing involves risk, including possible loss of principal. The iShares Gold Trust (“Trust”) is not an investment company registered under the Investment Company Act of 1940 or a commodity pool for purposes of the Commodity Exchange Act. Shares of the Trust are not subject to the same regulatory requirements as mutual funds. Because shares of the Trust are intended to reflect the price of the gold held by the Trust, the market price of the shares is subject to fluctuations similar to those affecting gold prices. Additionally, shares of the Trust are bought and sold at market price not at net asset value (“NAV”). Brokerage commissions will reduce returns.
Shares of the Trust are intended to reflect, at any given time, the market price of gold owned by the Trust at that time less the Trust’s expenses and liabilities. The price received upon the sale of the shares, which trade at market price, may be more or less than the value of the gold represented by them. If an investor sells the shares at a time when no active market for them exists, such lack of an active market will most likely adversely affect the price received for the shares. For a more complete discussion of the risk factors relative to the Trust, carefully read the prospectus.
Following an investment in shares of the Trust, several factors may have the effect of causing a decline in the prices of gold and a corresponding decline in the price of the shares. Among them: (i) Large sales by the official sector. A significant portion of the aggregate world gold holdings is owned by governments, central banks and related institutions. If one or more of these institutions decides to sell in amounts large enough to cause a decline in world gold prices, the price of the shares will be adversely affected. (ii) A significant increase in gold hedging activity by gold producers. Should there be an increase in the level of hedge activity of gold producing companies, it could cause a decline in world gold prices, adversely affecting the price of the shares. (iii) A significant change in the attitude of speculators and investors towards gold. Should the speculative community take a negative view towards gold, it could cause a decline in world gold prices, negatively impacting the price of the shares.
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Tags: Amp, Commodities, Commodity Indices, Core Inflation, Correlations, Diversification, Fiscal Position, Goldman, Monetary Policy, Nbsp, Paper Assets, Purchasing Power, Resilience, Risk Adjusted Returns, Risky Assets, Same Time Period, Stocks And Bonds, Tailwind, Term Inflation, Three Months
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Monday, May 14th, 2012
Just because it is always amusing to watch the cognitive dissonance in the head of a permabull, here is Jim ‘Soon to be head of the BOE… allegedly’ O’Neill’s latest missive to (what?) GSAM clients. Yes, the same O’Neill who week after week, letter after letter kept on saying that 2012 is nothing like 2011, finally being forced to admit that 2012 is, as we have been saying since January 1, nothing but 2011, as the central planners’ script writers prove painfully worthless at coming up with anything original. That, of course, and that the lifelong ManU fan had to suffer the indignity of interCity rivals picking up the trophy this year after a miraculous come back win against QPR. Oh, the horror…
Is it One of Those May’s Again?
Not another one, surely? It is almost too simple to be true. I have been saying to people all year that we would have a great rally into May. Then, it might be quite a challenge for the Summer and, like clockwork, we could come back in the Autumn to take the markets to fresh highs. I had expected that the S&P would get to the 1470-1480 area before the correction would set in. In this sense, it has happened quicker, because of the fact that “May” started in April, just as it did last year? While I have read a few articles recently trying to dismiss the “May” factor, the evidence is annoyingly persuasive that if the May to October months could just be 6 month holiday periods, and we picked up our investments as though nothing had
changed, the long term annualized return would be notably higher. Of course, it is difficult to find a coherent reason why this occurs so often. And, as some doubters correctly point out, it often doesn’t occur.
Anyhow, as can be seen in the attached chart, the momentum in the S&P has clearly turned lower, but interestingly, we sit just above trend line support (and well above the 200-day moving average). So, this is probably just a correction.
For some of us spoilt Manchester United fans, for the best part of the past 20 years at least, we have been able to take solace with the May issue, because around about this time, we are usually picking up the Premier League Trophy, and often there is a European Champions League Final to be thrown in as well as an FA Cup Final. Alas, this year, the cupboard might be empty and, of course, City could be picking up the League for the first time in 44 years.
Europe. Could it get any Messier?
I went to visit a rather weird play with my wife early last week, and I found myself thinking at one point “This is nearly as screwed up as the Euro Area.” I did warn last weekend that the French, and especially the Greek election, might have some impact this past week. It is quite ironic, as a couple of people pointed out to me given that I am always dismissing Greece’s economic relevance, that I suggested it might be more important in the short term than the French election. I shall discuss the French election issue more below, but given we all knew this was coming for months, and that Hollande won with the majority reasonably similar to the polls, I am not sure what was really new last week on this score (except for the German reaction).
Greek voters appear to now face another election in a few weeks with some simple choices. Do you want to remain in the EMU and stick with the commitments and support that your international allies have generously given you? Or, do you want to recreate the Drachma and run the risk of a massive banking collapse and lots of other unpredictable consequences? Polls appear to suggest the far left is likely to do well, so these questions are pretty real ones. As for the Euro, as I argued last week, it is not entirely clear to me that, once the dust settles, Greece leaving would be material either way. But we shall see.
French Election and Germany.
As I said above, there was not really a lot of new information about Hollande’s plans last week. Therefore, in some ways, it was all discounted. Quite a few contacts of mine suggested that, despite the rhetoric, France under Hollande will not do anything dramatic against the spirit of the Fiscal Compact, although they will push the issue of a supplementary plan for a Growth Pact. And as I reminded many of my colleagues, they are probably more fundamentally “pro Euro” than Sarkozy, which many people seem to have forgotten. Importantly, in this regard, this Administration is another one now in power in Europe that supports a true
Euro bond at the core of a more integrated Europe.
As I found myself thinking as the week wore on, this means that the German elections in the Autumn of 2013 are going to be really important. Anyone who wants to be in a coalition with either the SPD or Greens (or both) is going to have to support the idea also. I suspect Chancellor Merkel will be more than happy to support it. A number of meetings that I coincidentally had this week added to my confidence on this score.
Against this “big picture” background, the most interesting aspect of the French election is how German policymakers responded. Suddenly there is a fresh tone of what I would regard as welcome realism and open mindedness. First of all, Finance Minister Schauble talked about the need for higher German wages, which would help rebalancing within the EM. And a few days later, some Bundesbank officials acknowledged that Germany would probably have to accept inflation above 2 pct for some time. As one of the people I was referring to above put it to me, it would be through “gritted teeth,” but the reality is that they really have no alternative if the EMU is to persist following the shifting ground demanded by European voters. All of this should be good, and it will probably mean that the ECB will be less hawkish as a result.
Tags: Amp, Annualized Return, Autumn, Boe, Central Planners, Cognitive Dissonance, Coherent Reason, Goldman, Holiday Periods, Indignity, January 1, Manu, Missive, Momentum, Moving Average, O Neill, Rally, Rivals, Script Writers, Trend Line
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Wednesday, May 9th, 2012
Because the market sure could do with some humor on this blood red morning, we bring you FX strategist extraordinaire Thomas Stolper, who sadly does not give us the latest fade trade, but decides instead to come clean with pearls as: “On our EUR/$ forecast, last revised in January, we have been both right and wrong.” Surely the “right” part is what he is worried about: after all if Goldman prop (whatever it is called these days) can’t take the other side of the clients’ trades, nobody gets paid. Yet Tommy still gets paid the big bucks: Why? For insights like these: “Cyclical forces and continued fiscal stress account for the lack of a EUR/$ rally…and we see little chance that they resolve themselves near term for EUR/$ higher.” So cutting right to the good stuff: “Our structural, long term thought framework has not changed; we think global macro and flow fundamentals still argue for a weak USD and this theme will likely overwhelm other currency market developments on a one to two year horizon.” We get it: the EURUSD can’t go higher, but the USD is going lower. Mmmk.
From Goldman’s Thomas Stolper
- On our EUR/$ forecast, last revised in January, we have been both right and wrong.
- EUR/$ hasn’t cratered, despite very negative sentiment. On this we have been right.
- But it also hasn’t rallied in line with our past forecasts. On this we have not been right so far.
- Cyclical forces and continued fiscal stress account for the lack of a EUR/$ rally, …
- and we see little chance that they resolve themselves near term for EUR/$ higher.
- Longer-term we retain the view that broad USD weakness will reassert itself.
1. Market update
German industrial production for March announced yesterday surprised positively, attesting to continued solid underlying growth in the German industrial sector. After a brief squeeze higher, EUR/$ spent much of the day cycling around 1.30, as the uncertainty driven by the elections in Greece over the weekend continued to weigh on markets. European equities closed the day down 2-3%, while the SPX was down a more modest 0.8%. Sovereign bonds on the Euro periphery continued to take things in stride, with 10-year yields rising only modestly. This morning, risky assets continued to trade on the backfoot.
Elsewhere, Australia’s 2012-13 budget reinforced our bottom-of-consensus views on economic growth there, suggesting that the weight falls on the RBA to provide some stimulus to the economy as the Government moves to an unprecedented contractionary setting. We continue to expect the RBA to ease interest rates 25bps in June and 25bps in November 2012.
Given the latest round of nail biting over Greece, we today review where we have been right, and where we have been wrong, on our EUR/$ call. In particular, we quantify why EUR/$ has not rallied in line with our past forecasts, and assess the implications going forward.
2. Quantifying the drivers of EUR/$
While our long term EUR/$ views are driven by our structural bearish stance on the USD, ever since the European crisis began we have emphasized that near-medium term EUR/$ swings are primarily driven by three forces: (i) the weak balance of payments of the US vis-a-vis the more balanced picture for the Euro zone; (ii) interest differentials as a proxy for growth and monetary policy divergence between the Euro area and the US; and (iii) a fiscal risk premium, which measures sovereign distress on the Euro periphery.
Now, while most can agree on how to measure the interest differential – we have used 2- or 5-year swap rate differentials in the past – measuring the fiscal risk premium is tricky. What we have done in the past is to try a variety of things. We have used the relative performance of European versus US equity markets (see The Global FX Monthly, January 2012 ), and have also used the cross-currency basis as a measure of bank funding stress. Finally, we have used the GDP-weighted spread on 10-year sovereign bond on the Euro periphery over Germany (see Global Markets Daily: Quantifying the Drivers of EUR/$, Jan 26, 2012). None of these measures is perfect, of course. Our broad point here is simply that the Euro zone crisis has injected a risk premium into EUR/$ where previously there was essentially none, and that this risk premium has been – empirically speaking – roughly as important as the rate differential in explaining EUR/$ moves over the past year or two.
We can use such a framework to decompose the decline in EUR/$ from its peak in 2011 to now, focusing in particular on the roles of the interest differential and the fiscal risk premium in the recent EUR/$ move. For purposes of illustration, we use GDP-weighted Euro periphery 10-year bond spreads over bunds as our proxy for the fiscal risk premium. This exercise shows that – of the 18 big figure drop in EUR/$ between April of last year and now – 8 big figures reflect the interest differential, another 8 big figures reflect the fiscal risk premium, with the balance reflecting other factors we control for like global risk appetite and oil prices. In short, we think cyclical factors, like growth and monetary policy, and the fiscal risk premium have accounted in roughly equal parts for pretty much the entire fall in EUR/$.
In January we revised our EUR/$ forecast to 1.33, 1.38 and 1.45 on a 3-, 6- and 12-month horizon, respectively. The key element of our forecast was near term stability of EUR/$ (in the form of our 3-month forecast, while consensus was for EUR/$ weakness). That said, it has been a long-standing forecast of ours that EUR/$ would rally. For example, in September 2011 we had 3-, 6- and 12-month forecasts of 1.40, 1.45 and 1.50 for EUR/$. We now discuss in greater detail where we have been right and where we have been wrong on EUR/$.
3. Where we have been right and where we have been wrong
The fact that the EUR/$ has not fallen sharply year-to-date and actually rallied since its January low of around 1.26 is where we have been right, in particular since we made our forecast in January against the backdrop of pervasive EUR bearish sentiment. The fact that EUR/$ has held up well has underscored two of our core beliefs: (i) that USD is itself very weak, due to a weak balance of payments (see Global Markets Daily: The Largely Ignored Deterioration in US Flows, Dec 13, 2011 ); and (ii) short EUR positioning that remains large, so that a lot of bad news is already priced in. In these two respects, we have been right.
However, the EUR/$ strength we had been forecasting back in 2011 for 12-months out also has not materialized, and this is where we have not been right so far. Our thinking in the past had been that gradual policy progress and markets becoming comfortable that tail-risk scenarios like a full-scale Euro break-up are not going to happen would ultimately cause the fiscal risk premium to come down, providing EUR/$ with a boost.
What has happened instead is that fiscal consolidation has brought a hit to growth, which has weighed on EUR/$, while offsetting the more marginal benefits from any reductions in the fiscal risk premium. We had thought markets would gradually get used and look beyond the near term muddling through in Europe. Instead, currency markets remain skeptical in regards to fiscal and growth risks on the periphery.
4. Now what?
Our structural, long term thought framework has not changed; we think global macro and flow fundamentals still argue for a weak USD and this theme will likely overwhelm other currency market developments on a one to two year horizon.
At the same time, we have highlighted in our discussion above, the near term path for EUR/$ remains torn between the negative growth impact from fiscal consolidation and ultimately positive effects from a gradually shrinking risk premium. The balance between these two forces in the near term continues to look unclear, in line with our near term forecast for limited EUR/$ upside. Separately, though QE3 in June remains our baseline forecast, this is increasingly a close call, as Jan Hatzius once again flagged yesterday (see US Views: Still Dreary (Hatzius), May 8, 2012), further reducing the potential for EUR/$ top rally in the near term.
Tags: Currency Market, Elections In Greece, Eurusd, Fiscal Stress, Global Macro, Goldman, Good Stuff, Horizon, Humor On, Industrial Sector, Little Chance, Market Developments, Mmmk, Negative Sentiment, Ov, Pearls, Rally, Squeeze, Stolper, Strategist
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Wednesday, March 28th, 2012
Germany’s recent ‘agreement’ to expand Europe’s fire department (as Goldman euphemestically describes the EFSF/ESM firewall) seems to confirm the prevailing policy view that bigger ‘firewalls’ would encourage investors to buy European sovereign debt – since the funding backstop will prevent credit shocks spreading contagiously. However, as Francesco Garzarelli notes today, given the Euro-area’s closed nature (more than 85% of EU sovereign debt is held by its residents) and the increased ‘interconnectedness’ of sovereigns and financials (most debt is now held by the MFIs), the risk of ‘financial fires’ spreading remains high. Due to size limitations (EFSF/ESM totals would not be suggicient to cover the larger markets of Italy and Spain let alone any others), Seniority constraints (as with Greece, the EFSF/ESM will hugely subordinate existing bondholders should action be required, exacerbating rather than mitigating the crisis), and Governance limitations (the existing infrastructure cannot act pre-emptively and so timing – and admission of crisis – could become a limiting factor), it is unlikely that a more sustained realignment of rate differentials (with their macro underpinnings) can occur (especially at the longer-end of the curve). The re-appearance of the Redemption Fund idea (akin to Euro-bonds but without the paperwork) is likely the next step in countering reality.
Section 4 below is the most critical to understanding the pitfalls of the consensus thinking…
1. EFSF Has Helped Contain Tensions in Peripheral Hot spots
The EFSF, which became operational in August 2010, was the first authority empowered to redistribute fiscal resources to support adjustment programs across EMU member states. The Facility has EUR54.5bn in bonds outstanding (including EUR30bn as part of the Greek debt exchange) and EUR8.9bn in bills. Earlier this month, it was authorized to raise a total of EUR241bn. This amount exceeds the aggregate committed capital to the three program countries by roughly EUR50bn, partly to provide for liquidity buffers. By comparison, the amount of bonds outstanding from the European Investment Bank—another supranational issuer—is in the region of EUR405bn.
The EFSF supply replaces the market funding programs (covering amortizations and deficit) for Greece, Portugal and Ireland. Thus, from a flow perspective—and taking into account that most EMU countries are reducing their borrowing requirements—the net supply of EUR government bonds available to private investors is declining.
The stock of Euro area government debt has increased substantially in the wake of the 2008 financial crisis, as has been the case elsewhere. Reflecting a process of ‘mutualization’ of the debt owed by the smaller issuers through the EFSF, the average quality of the pool of investable Euro area securities is progressively being upgraded. The ECB has contributed to this dynamic by removing around EUR200bn-worth of debt from private hands through its Securities Market Program (EUR150bn of which are Italian and Spanish bonds).
The EFSF issuance does not constitute a ‘Eurobond’, defined as a claim backed jointly and severally by the EMU countries. Rather, investors in EFSF securities effectively hold a (credit-enhanced) portfolio of Euro area sovereign issuers, excluding those currently under financial assistance programs. The country allocations of the portfolio map the ECB’s ‘capital key’, which roughly correspond to GDP size. Relative to a bond market capitalization, the capital key over-weights Germany and under-weights Italy.
The EFSF has no paid-in capital, but rather is backed by financial guarantees (amounting to EUR726bn) that exceed the maximum lending capacity of the facility (EUR440bn, corresponding to the sponsorship of the highest rated countries). After the downgrade of France, the weighted average rating of the sovereign guarantors is AA minus, and the weakest constituent (Italy) is rated BBB. EFSF long-term bonds are currently rated AA+ by S&P, and have the highest rating by both Moody’s and Fitch.
The EFSF securities currently span maturities ranging between 3 months and 20 years. They trade below the Euro-swap curve at the short end, and around 100bp above it at the long end. Benchmark 10-yr EFSF bonds currently trade around 10-15bp above the corresponding maturity government bond issued by France—the closest rated core sovereign issuer. EFSF bonds are also broadly aligned with the weighted average funding cost for the facility’s sovereign backers, indicating that the benefits of over-collateralization and the costs of lower liquidity broadly offset each other (the Facility lends on to program countries at funding costs plus operational costs, and the recovery on loans is assumed to be zero by rating agencies). If bond yields move in line with what our valuation work suggests, EFSF securities should increase in value against the Euro-swap curve, and trade tighter in relation to France.
Demand for EFSF bonds from the first issuances has been split as follows: 46% to the Euro area, 33% to Asia and 10% to the UK. Central banks and Sovereign Wealth Funds purchased 38% of the bonds, with banks buying another 29% (see charts on the next page). The share acquired by Euro area financial institutions has progressively increased, as investors in the core countries switch away from low-yielding German Bunds in favor of securities that reflect the sovereign risk syndication being conducted directly through the fiscal schemes and indirectly on the ECB’s balance sheet.
2. Two Ways to Increase Pressure in the Fire Hydrants
Pressures to increase the EFSF’s endowment at the height of the sovereign crisis last year eventually resulted in allowing the Facility to leverage its resources. This has now been crystallized into two Special Purpose Vehicles (SPVs): a European Sovereign Bond Protection Facility and a European Sovereign Bond Investment Facility. The first scheme aims to provide partial risk protection certificates for sovereign bonds (i.e., a ‘first-loss insurance’ scheme). The second is a co-investment fund open to both the private and public sector dedicated to EMU area government bonds.
We assessed the idea of ‘first loss protection’ favorably when it was first circulated last year. The advantages of ‘credit wrapping’ new issuance of government securities are associated with the combination of a credit risk transfer from the guaranteed sovereign to its guarantors (the AAA-rated backers of the EFSF), which, in turn, benefit from a decline in systemic risk; and the reduction in refinancing risk accruing to the previous bond holders, which over time mitigates the potential segmentation of the market.
However, faced with the largely unquantifiable risks stemming from a potential breakup of the monetary union, the scheme has become less appealing to investors. The Protection Facility has other shortcomings too. Based on the rating agencies’ published methodologies, the rating impact of a higher recovery assumption in the case of Investment Grade securities is small (a 1-2 notch increase at most), hardly changing the position of countries such as Italy or Spain. Particularly if associated with multiple instruments, the protection certificate could be treated as a derivative instrument in banking books, rather than a ‘financial guarantee’. As such, it would fall under mark-to-market rules, with detrimental impacts on demand.
The Sovereign Bond Investment Facility is a more interesting proposition, especially if directed at the primary market. The first loss tranche is remunerated at the EFSF’s cost of funds. This is to the advantage of senior investors, who access a levered return (maximized by the Facility’s manager under a set of guidelines) with lower risk. As an example, Italy’s main fiscal problem pertains to its high debt stock, which needs to be rolled over. The SPV could cover 2 years’-worth of Italian medium-to-long-term maturity bond supply (around EUR400bn). The ‘equity’ tranche could amount to 30% (or EUR120bn), the ‘senior tranche’ could be 50% (EUR200bn) and the remaining ‘super senior’ tranche 20% (EUR80bn). Assuming a recovery assumption of 50%, the expected risk-weighted returns accruing to the senior tranche are attractive. For reference, EFSF July 2021 trades at 3.0%, while BTP August 2021 trades at 4.9%, and 10-year EUR Libor at 2.3%. With the capital allocation used in this example, the expected return on the senior tranche is around 220bp over the BTP, with a higher recovery.
So far, however, it is not clear who would participate in this SPV. Suggestions that sovereign wealth funds and/or the BRIC countries could become potential investors have not led to reported progress and have overlapped with demands for higher contributions from the BRICs to the IMF. Seniority considerations, the legal regime that governs any shortfall and the mechanism for a possible transfer of the participation from the EFSF to the ESM would need to be clearly spelled out for the scheme to work.
3. The ESM—The Permanent ‘Fire Department’
The European Stability Mechanism, or ESM, is a permanent facility that will replace the EFSF from July 2012. The ESM will have an initial lending capacity of EUR500bn (reviewed periodically) and a total subscribed capital of EUR700bn, of which EUR80bn will be in the form of paid-in capital to be phased in with a maximum of five installments.
Under current agreements, the consolidated lending capacity of the EFSF and ESM cannot exceed EUR500bn. But the authorities are actively discussing whether this limit can be increased by combining resources, even though it may not be for the entire capacity of the two funds (EUR940bn). One possibility could be that EUR500bn from the ESM will be added to the existing commitments of the EFSF (EUR17bn for Ireland, EUR26bn for Portugal and EUR102bn for the second Greek package), or to the EUR241bn the EFSF has already been authorized to issue. A decision is expected at the Finance Ministers’ meeting on March 30.
Increasing the total amount of the combined EFSF and ESM fund could have positive effects on the valuation of EFSF bonds, as a greater potential for sovereign credit risk syndication can lower the yield differential between constituents—in practice, German bonds would lose value, while those of Italy and Spain would increase in value. However, a number of issues that could affect the liquidity of the EFSF bond market still need to be addressed. Also, EFSF bonds will be close, but not perfect, substitutes of ESM bonds, because the two facilities enjoy different creditor status.
On the first issue, it is not yet clear what the EFSF’s role will be after July 2012. The EFSF will remain in place until the last bond issued matures. But it has not yet been decided whether new lending programs starting after July will come under the ESM, or whether the EFSF will be able to continue issuing bonds of existing programs. This decision will affect the depth of the EFSF bond market.
On the second issue, both EFSF and ESM loans are junior to IMF loans. However, while EFSF loans have the same creditor status as other sovereign claims on a country basis (pari passu), ESM loans enjoy preferred creditor status over other sovereign claims. This clause does not apply to ESM loans relating to a financial assistance program that came into existence before February 2, 2012, when the new ESM treaty was signed. Hence, while in theory ESM bonds have a better credit status than those issued by the EFSF, in practice this will depend on whether or not lending programs to countries other than Ireland, Portugal and Greece will be activated.
4. Too Much Combustible Material Still Around
The Euro area is a financially closed region, with more than 85% of sovereign bonds held by residents of the area. If we add to this the fact that most claims against governments are held by financial institutions domiciled in the area, the risk of ‘financial fires’ spreading is high. The prevailing policy view that bigger ‘firewalls’ would make investors more comfortable about purchasing sovereign bonds of EMU countries. This is predicated on the idea that the existence of a funding backstop would prevent credit shocks in one of the EMU members from spreading to other issuers. That said, we doubt the current infrastructure can produce the same effects on markets as the ECB’s long-term liquidity injections (LTROs). Our view is based on the following considerations.
- Size: Even if we combine the full uncommitted capacity of the EFSF and the ESM (EUR700bn), the total would not be sufficient to backstop the bigger markets of Spain and Italy. The former’s borrowing requirement (amortization plus deficit) over the next two years is EUR305bn, while the latter’s amounts to EUR525bn.
- Seniority: The ESM holds ‘preferred creditor status’ over existing bondholders (art.13 of the Treaty establishing the ESM). In practice, this means that if the facility is used to provide an EMU member country under conditionality, it would subordinate existing bondholders (twice, if the IMF also participates in a bailout). Given that investors are aware of this, they would require compensation to bear such risk. This could exacerbate, rather than mitigate, a crisis.
- Governance: The existing vehicles cannot intervene pre-emptively in markets at signs of tension. Rather, they would be activated only after a full crisis has erupted. The procedure envisages that the ECB would ring an alarm bell should tensions threaten the stability of the Euro area. The sovereigns experiencing tensions would need to formally ask for help, and sign a memorandum of understanding, before any financial support can provided. Admittedly, a ‘fast track’ option is also available, based on ‘light conditionality’ and allowing the EFSF to intervene in secondary markets. Still, the fixed size of resources could raise questions on the effectiveness of the operations.
5. What Could Help?
As we have indicated in previous research, based on relationships with relative macro and fiscal factors prevailing over the past 20 years, Italian government bonds should currently trade around 130bp over their German counterparts, and Spain at 200bp over Bunds. These spread levels are well below the 320-350bp prevailing at the time of writing. By reinforcing the notion of a ‘conditional mutualization’ of sovereign EMU debt, the expected increase in the size of the firewalls could help stabilize inter-country spreads. But for the reasons mentioned above, we doubt this would lead to a more sustained realignment of rate differentials with their macro underpinnings, particularly at the long end of the curve where uncertainties surrounding subordination are particularly acute.
We would therefore advance two ‘normative’ considerations:
- At this juncture, Spain remains under close scrutiny because of the interplay between the recapitalization of the non-listed banks (saddled with exposure to the housing sector, which has deteriorated on the back of the increase in unemployment) and the challenging fiscal targets that it needs to meet in 2012/2013. On 30 March, the Spanish government will announce the 2012 budget, which should remove part of the uncertainty around the size and quality of the fiscal measures. But concerns about the recapitalization of the non-listed banks are unlikely to diminish any time soon. We have long been of the view that an agreement between the Spanish government and the EFSF to support the recapitalization of the banking sector would be a productive use of pooled fiscal resources. It would avoid an increase in the funding needs and borrowing costs that Spain would face if it had to recapitalize banks using funds from the FROB. In this way, Spain could take advantage of EFSF funds, avoiding the ‘stigma’ of a macro-economic adjustment program, while the planned restructuring/recapitalization would be reinforced by external incentives and controls, and EMU-wide resources would be directed at one of the obvious sources of weakness of the common currency area.
- More broadly, we continue to think that a more direct approach to the ‘debt overhang’ problem affecting the Euro area would remove ‘combustible material’ and speed up the recovery. In this context, the proposal advanced by the German Council of Economic Advisors to set up a Euro area wide Redemption Fund appears to be one of the most promising. We plan to elaborate on this solution in forthcoming research, but the outline is fairly straightforward. The Council suggests creating a fund that would be jointly and severally guaranteed by EMU member countries, in which each participant would transfer government debt (ideally across the maturity structure, and in parallel with ongoing market access) in excess of 60% of GDP. Countries would pledge collateral to the fund, earmark revenues of a specific tax, and commit to repaying their liabilities over a long period (20-25 years). Alongside the fiscal compact and debt brake rules, this initiative has the merit of finally establishing a liquid security (the expected float is in the region of EUR2.5trn) which would reflect the Euro area’s comparatively high aggregate credit quality and thus represent a sound ‘store of value’.
Tags: Backstop, Bondholders, Debt Exchange, Differentials, Efsf, Esm, Fiscal Resources, Garzarelli, Goldman, Hot Spots, Interconnectedness, Limiting Factor, Mfis, Pitfalls, Realignment, Reality Section, Redemption Fund, Seniority, Sovereign Debt, Sovereigns
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