Positions in Europe: Long Germany (EWG); Covered Spain yesterday (EWP)
Today the ECB announced that its Main Refinancing Rate would be raised 25bps to 1.50%, yet the attention of the press conference that followed was focused squarely on the implications of Moody’s credit downgrade of Portugal to junk (on Tuesday) and the fiscal states of Greece et al that teeter on default.
What’s our take-away from today meeting? From Trichet’s comments it’s increasingly clear just how far the ECB (or more broadly Troika that includes the IMF and EU group) is willing to step in to subsidize member nations, either in the form of borrowing from the ECB, through additional bailout packages, and/or concessions on debt repayments to avoid the nasty words of default/restructuring at all costs. [And this should act as a support for the EUR vs major currencies over the near to intermediate term, more below on our levels].
Importantly, today Trichet announced that Portugal would join the club of Greece and Ireland that have special privileges to post debt that is rate junk as collateral when borrowing from the ECB window. Questions quickly turned to the possibility that any or all of the main credit rating agencies could rate a peripheral country’s credit “in default”, while Trichet states that a default of any member nation is not possible.
The rub here is an obvious one, especially considering that credit ratings agencies have already stated that under their technical definitions a rating of “default” would be issued if any sovereign debt is restructured (or re-profiled). And as we know, over recent days plans have been floated from France and Germany to voluntarily “restructure” the Greek debt holdings of its banks, including by extending repayment on shorter term paper (5 years or less) to 30 year maturities. Hummm….
It’s important to note that while the ECB’s official mandate is to regulate price stability, preservation of the Eurozone remains the ECB’s highest call, yet the disconnect is that no European central authority has control over the fiscal policy of any member nation. This leads to a game of finger pointing between the ECB and individual governments over fiscal consolidation (or austerity programs) to fix grossly imbalanced budgets, that is compounded by the downgrades in a country's credit rating by the agencies, all of which erodes investor confidence, exacerbates contagion and leads to the game of providing short-term fiscal band-aids to one country after the next, before seconds are handed out after they creep up once again.
With respect to the volatility that a downgrade from a credit rating can have on a country, just yesterday in Berlin Finance Minister Schaeuble said there's a need to "break up" the dominance of the big three rating companies, and German Foreign Minister Guido Westerwelle called for an independent European rating company to be set up. This debate is in the early innings, yet it's important to note that push back on the big three is being voiced by a major player like Germany.
Returning to the only agenda that Trichet really wanted to speak of, the 25bp hike should help mitigate some of the inflationary pressures the region has seen over the intermediate term. Eurozone CPI in June measured 2.7% year-over-year, above the Bank’s mandate of the 2% level. We’re calling for the ECB to be on hold for further hikes into year-end as Deflation of the Inflation plays out global, but particularly in the US and Europe as comps get more favorable and energy and food costs come in.
As we noted above, Troika has made it very clear that it will backstop any European country that faces the threat of a default/restructuring. This, we believe, is a critical point that should lend support to the common currency. Yet as we get incrementally more bullish on the USD, we’ll be focused on the intermediate term TREND line (3 months or more) of $1.43, a critical momentum line that the pair is just holding above intraday. Below we chart our TRADE levels (3 weeks or less) on the EUR-USD, which is $1.41 to $1.45.
To say the least, we’re very cautious on owning European countries on the long or short sides. To the latter, we think there’s more downside from here for the capital markets of the periphery. We remain long Germany (via the etf EWG) in the Hedgeye Virtual Portfolio, a position that has worked well for us over the last two years. We’re however cautious on Germany as the high frequency data has slowed in recent months and contagion, even for a fiscally sober country like Germany, is a pressing threat. The DAX has outperformed the S&P500 for the balance of the year, at 8.2% YTD. We covered our short position in Spain (EWP) yesterday.