Position: Long Germany (EWG); Short Italy (EWI) and Euro (FXE)
As we mentioned in the Early Look this morning, this week global markets are tuned squarely to Europe’s bond auctions and statements from the region’s leaders on its sovereign debt issues. This morning also saw announcements from the ECB and BOE to keep their main interest rates on hold at 1.0% and 0.5%, respectively; and while the BOE has recognized the risk of rising inflation this year, today ECB President Trichet made it clear that he’s willing to raise rates to fight inflation.
Over the short-term we’d expect European markets to continue to make gains on the heels of announcements from China (earlier this month) and Japan (on Tuesday) to buy European bonds and statements from EU Economic and Monetary Commissioner Olli Rehn (yesterday) that EU officials are trying to forge a “comprehensive” plan to contain the sovereign debt crisis and from German Chancellor Angela Merkel who indicated a desire to do “whatever is needed to support the euro.” Rehn also ruled out debt restructuring for Greece or any other euro-area member state.
As a catalyst, European finance ministers meet in Brussels next week to discuss initial details of a more "comprehensive package" and German Finance Minister Wolfgang Schaeuble said today that the EU member states will assemble this package by March when EU leaders are schedule to meet for a summit.
With this kind of support, it’s no surprise that investors cheered, markets boomed, and European bond auctions have found plenty of demand, including Spain’s auction of €3 billion of 5YR bonds (at 4.542%) this AM.
While yesterday saw substantial outperformance from the peripheral equity markets, with gains from: Spain’s IBEX +5.4%; Greece’s Athex+ 5.0%; and Italy’s FTSE +3.8%, today these same equity markets closed in positive territory, however with lesser gains: Spain’s IBEX +2.7%; Greece’s Athex +0.3%; and Italy’s FTSE +0.9%.
It was on the bounce yesterday that we shorted Italy via the etf EWI and the Euro via FXE in the Hedgeye Virtual Portfolio.
However, and arguably as a more important forward-looking indicator, credit markets have improved substantially over recent days. Below we refresh the chart of 10YR bond yields of the PIIGS (see chart). You’ll note that yields (on the 10YR) have fallen precipitously since 1/7, down -144bps in Greece; -77bps in Ireland; -35bps in Portugal; -16bps in Spain; and -9bps in Italy as risk abates on the aforementioned supportive announcements.
Importantly in this chart we flag the gravitational pull of the 7% level. This level proved ominous last year for it was a mere 17 days after Greece broke through it that the country received a €110 Billion bailout (May 15, 2010), whereas Ireland received a bailout of €85 Billion a month after breaking through the line on October 29th. Portugal is dangerously near this level.
However, over the longer term our concerns for the region remain grave: the road ahead for Europe will be mired in the inability of some governments to meet their targeted debt and deficit reduction figures (Italy, Spain, Portugal), and the bailout band aids that we’ve seen already in Greece, Ireland, and perhaps Portugal soon, will simply offer temporary solutions to longer term fiscal imbalances. Further, along with lower growth prospects across the region this year and next, we could see more pushback on the austerity measures issued by many governments and political instability from countries like Italy, Belgium, and Hungary, to name a few.
Perhaps blame for Europe’s woes can be attached to the idealistic goal of binding unequal states under a common currency and monetary policy, but what’s clear is that the EU and Eurozone must figure out longer term attainable policy to punish fiscal excesses and incentivize its member states to maintain fiscal balance.
In any event, European markets could soon lose the near-term support we’re seeing across European markets. It all depends on the means in which European officials want to support and direct this ship. We could learn more on this front as soon as next week.