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Positions in Europe: Short EUR-USD (FXE); Spain (EWP); Italy (EWI); UK (EWU)

We don’t subscribe to the theory that securities or countries have “risk on” or “risk off” profiles, rather risk is always “on”. Over the last 24 months European capital markets (particularly the PIIGS) have shown a pattern of underperformance alongside sovereign debt contagion, with positive performance in the days directly preceding discussions or announcements on bailout and austerity packages followed by renewed underperformance after the event. Credit rating downgrades from the rating agencies have also done a number to drag down performance following the announcement. 

And Greece’s second bailout announced last Thursday (7/21) follows this mold to a “T”: buy the rumor sell the news, and sovereign debt contagion is far from over. And just today Moody’s chummed the water further by downgrading Greece’s debt from Caa1 to Ca. [For more on the terms of the bailout see our post from 7/21 titled “Framework of Greek Bailout Part II: Skepticism Abounds”].

Now we appear to be playing a game of semantics in determining if Greece is in default.  What’s clear is that these short term “band-aid” bailouts or obfuscating language will not solve Europe’s longer term fiscal imbalances and therefore we expect peripheral capital markets to trend lower over the intermediate term.

The Semantics of Default

The big debate is whether or not Greek debt is in default and the pricing of risk based on this rating. The International Swaps and Derivatives Association (ISDA), which governs CDS pricing, has ruled that the Greek restructuring does not constitute a credit event, which means that CDS will not be triggered. 

However, the credit rating agencies have said that under technical definitions, any restructuring of debt is a default, so the current plan (as defined under Greece’s second bailout) for banks to roll over shorter term Greek debt into long term debt (~ 15 to 30 year maturities) should constitute a default. In fact, the language has morphed into an “orderly” default and “partial” default, and is expected to be rated as such only during the window of late August and early September when the banks may voluntarily decide to participate in this bond swap.  Thereafter, the expectation would be that a rating above default would be returned.

Further, ECB President Trichet refuses to recognize any member state in default and does not see Greece’s newest package triggering a credit event (default). In fact, Trichet along with other EU officials went so far as to say they’ll rely less on the ratings from the main ratings agencies, without indicating a surrogate rating source.

Certainly these results leave plenty of gray areas, including how risk is priced. It appears CDS swaps will be a useless instrument for pricing default or hedging default. Conversely, bond yields may flip around in the next weeks and months depending on the “success” of the bank swap, the actions of the ratings agencies (including their language); and the general psychology of the market which over the last 18-24 months has turned violently against those peripheral countries in the spotlight.



More Kinks in the Chain

To add more fuel to the fire, amendments to the European Financial Stability Facility (EFSF), which to date has provided the bailout funding to Ireland and Portugal, must receive approval from all EU countries, which cannot happen until mid-September when the parliamentary returns from summer break.   Therefore the risk profile of the peripheral is further heightened as indecision about increasing the facility and the terms of debt could arise, and not until mid-September.

Risk Swings

Of note is that sovereign bond yields and cds across the periphery fell off a cliff last week on a week-over-week basis. Over this period 10YR government bond yields fell -323bps in Greece; -208bps in Ireland; -168bps in Portugal;-50bps in Italy; and -46bps in Spain. On Friday (7/22) alone, following Thursday’s late day announcements, 5YR CDS fell a monster -644bps in Greece; -261bps in Portugal; -249bps in Ireland; -59bps in Spain; and -55bps in Italy!!! Our call remains that despite these massive dips, the trend line will resume up and to the right.

European Risk Monitor: Risk On/Risk Off - 1. HHa

European Risk Monitor: Risk On/Risk Off - 1. HHb

Our European Financials CDS Monitor showed that bank swaps in Europe were mostly tighter last week, with 34 of the 38 swaps tighter and 4 wider, which rhymes with the “risk-off” trade following the announcement of Greece’s second bailout package.

European Risk Monitor: Risk On/Risk Off - 1. HHc

We remain short the EUR-USD via the etf FXE in the Hedgeye Virtual Portfolio and expect the pair to trade in a range of $1.41 to $1.43. The EUR-USD is dancing around our TREND line of $1.43, an important momentum level. We’ve position ourselves to take advantage of downside in the periphery, being short Italy (EWI) and Spain (EWP). Further, with stagflation sticky in the UK, we’re short the country via EWU.

Matthew Hedrick