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Positions in Europe: Long Germany (EWG); Short Spain (EWP)

With the Greek Confidence vote won, austerity approved, confirmation over the weekend that the country will receive its next €12 Billion tranche on July 15th (from its original €110 billion bailout package), and talk that Greece’s second bailout package (est. €70-120 Billion) will be announced in mid-September,  the intense spotlight on Greece may dim in the coming days and weeks. Yet, the debate will now turn to recent proposals from France and Germany that its banks would voluntarily “restructure” Greek debt holdings by extending repayment on shorter term paper (5 years or less) to 30 year maturities. However, the specific terms, including the interest rate commanded, remains uncertain and as they say, the devil is in the details.

Importantly, under such a plan, great friction will develop with the main ratings agencies, which technically rate any form of restructuring (or re-profiling) as default.  We, however, expect some sort of back-door dealings between Troika (EU, ECB, IMF, and institutional banks) and the ratings agencies to modify debt repayments schedules without the mark of “default”, or else some other proposal may be drafted altogether.

Our European Risk Monitor signals that risk has mitigated week-over-week following the insurance from PM Papandreou’s confidence vote and confirmation that Greece will receive its next bailout tranche from the EU/IMF. This is represented in the charts below of sovereign CDS spreads and peripheral government 10YR bond yields.

European Risk Monitor: Greek Pause as Troika and Credit Rating Agencies Wrestle - m1

European Risk Monitor: Greek Pause as Troika and Credit Rating Agencies Wrestle - m2

A similar trend is seen in our European Financials CDS Monitor, in which bank swaps across Europe were wider for only 11 of the 39 referenced banks week-over-week, while 28 were tighter.

European Risk Monitor: Greek Pause as Troika and Credit Rating Agencies Wrestle - m3

While uncertainty surrounds potential restructuring of Greek debt held by public and private institutions, we expect the common currency to hold support with implicit guarantees from Big Brother Troika to prevent default of any member nation, and into the ECB’s interest rate announcement this Thursday (7/7). Trichet has indicated in recent weeks that the Bank is “strongly vigilant” and ready to act against rising inflation that remains above its target of 2% (Eurozone CPI currently stands at 2.7% in May Y/Y). We expect the ECB to raise rates 25bps on Thursday to 1.50%, and remain at that level for the remainder of the year.

In the EUR-USD cross, $1.43 remains a critical short-term support trading level we’re managing risk around. Our TRADE resistance stands at $1.45.

An important catalyst to keep on your sheets is the announcement of the second round of European Bank Stress Tests, expected on July 13th. Rumors swirl that up to 15 of 91 banks could fail the tests, but the number could be a token figure to convey that the tests were "stringent" enough.

Services PMI figures out today showed contracting to slowing figures month-over-month (see table below). Much like Manufacturing PMI figures out last week (for more see our post on 7/1 titled “European Manufacturing Cools in June”), both surveys  point to slowing growth expectations ahead as inflation remains elevated and sovereign debt contagion presses. Italian Services is a notable underperformer in the June survey, with a reading under 50 representing contraction.

European Risk Monitor: Greek Pause as Troika and Credit Rating Agencies Wrestle - m4

Matthew Hedrick

Analyst