Positions in Europe: Short EUR-USD (FXE); Covered short EUFN (European Financials) position today
European equity indices closed last week down -9 to -14% week-over-week with neither the periphery nor core immune to the move. This weekend’s European news flow on the ECB’s decision to re-implement its bond purchasing program (SMP) and buy Italian and Spanish debt had some impact on bond yields for Italy and Spain today, however the terms of the program remain vague and largely appear at best an intermediate term package or cover before the terms of the EFSF is voted on in mid to late September by the EU. In any case, European equities got smacked today alongside this weekend’s news, falling -2 to -6%.
In our eyes, neither facility will be a panacea to the region’s longer term fiscal imbalances. At the right price we’re getting more comfortable shorting the equity or credit of Germany or France as debt risks move beyond Greece, Ireland and Portugal and closer to Italy and Spain, which should erode the sovereign credit worthiness of Germany and France and its lending institutions, and drag on the broader equity indices. While consensus, we’d also short the equity markets of Italy (EWI) and Spain (EWP) on any bounce.
New News and More Known Unknowns
Late Sunday the ECB released a statement following an emergency meeting Sunday afternoon in which it praised actions by the governments of Italy and Spain in the last days to accelerate and enlarge austerity measures in order to (better) adhere to Eurozone debt and deficit targets. We’ve been largely negative on peripheral countries’ ability to meet accelerated deficit targets, nevertheless Spanish Economy Minister Elena Salgado said on Sunday that the government would use an August 19 cabinet meeting to outline further savings. Salgado did not give details except to say that €2.5 billion of savings (worth an estimated deficit reduction of half a percent of GDP) could be made through changes to the methodology for large companies' tax payments. Spain is projected to run a 6% deficit (as a % of GDP) this year.
On Friday, PM Berlusconi announced that Italy will balance its budget, by bringing its deficit to -3% of GDP by 2013 instead of 2014. Finance Minister Giulio Tremonti said costs would be saved in reforming Italy's extensive, and expensive, social welfare system, which includes national health care and generous retirement payments, and by amending its labor laws.
The ECB’s release also noted that it will re-implement its bond purchasing program, known as the Securities Markets Programme (SMP), which began in May 2010 and bought up some €74 billion in bonds from Ireland, Greece, and Portugal, but had remained dormant over the last four months. There were few explicit details in the statement—no individual countries, amounts, or a time horizon was specified. Yet based on rumors over the weekend it appears the Bank will buy Italian and Spanish debt (which it may have started on today) in additions to the paper of the rest of the PIIGS.
Speculation includes a purchasing program of €500-600 Billion spread out over 6-12 months. Tobias Blattner, a former ECB economist, estimates the central bank will have to buy about €200 Billion of Italian bonds and €60 Billion of Spanish securities to make an impact.
The ECB’s positioning is clearly in response to heightening bond yields in Spain and Italy, especially since the second bailout package for Greece was announced on July 21st. As we’ve noted in our work, the critical breakout level on sovereign yields is 6% based on the historical performance of Greece, Ireland, and Portugal, countries which after breaking this level required a bailout package in short order to temper yields (see chart below). While the aforementioned countries received bailout packages to help tame default, should Italy and Spain require a fiscal package to prevent default/meet its maturities, the existing loan facilities of the EFSF is undercapitalized to handle them.
And this is the danger. While Eurozone leaders have agreed to expand the scope of the EFSF, they have not agreed to expand its overall size. This meeting comes in mid to late September. Further, the €440 Billion posted as AAA collateral in the facility has been reduced by existing portions of the original loans to Ireland (€85B), Portugal (€78) and Greece’s second loan (€109B), and we're raising the threat that France could lose its AAA rating, which would greatly impair the facility.
The scenario that presents itself for a “solution” given recent development are:
- The EFSF must be expanded by an estimated 2-4x from its current size of €750 Billion (adding in €250 IMF contribution)
- The ECB unloads far more debt on its balance sheet in directly buying up bonds across the Eurozone
We put “solutions” in quotation markets for neither option is very certain nor guaranteed to be an explicit solution to very pervasive fiscal imbalances across the region that are bottled in with political indifference. To point one, political indecision could well get in the way of expansion (approval is needed from every EU member). To point two, assuming point one isn’t acceptable, it appears the ECB would have to roll out the printing press and take far more risk on its balance sheet. This could have disastrous inflationary consequences for the common currency. This action would go directly against the Bank’s mandate for price stability.
In all of this, the common currency has held up relatively well against major currencies. Against the EUR-USD, we continue to outline $1.43 as an important intermediate term TREND level and $1.40 as a critical immediate term support TRADE level. Should both break to the downside, we don’t see long-term support until $1.28. That said, the pair has traded in a tight range of $1.40-1.45 over the last 4+ months, largely on the back of implicit guarantees of the EU community to support any member country in need with fiscal assistance. We don’t expect this to change, but caution that the terms are going to get a lot more challenging as Italy and Spain take a brighter light in the arena of European sovereign debt contagion.