Positions: Short EUR-USD (FXE)
Ah, the chaos… it’s hard to know what to believe out of Europe this week – from falsified media reports to conflicting statements from Eurocrats on solutions to Europe’s sovereign and banking imbalances, all on the backdrop of intense strikes and riots in Greece, heightened volatility in capital markets and rising risk metrics across Europe’s core and periphery. While we don’t have a crystal ball, we’d like to review the proposals on the table to aid the sovereigns and recapitalized the banks, the challenges and contradictions and market implications imbedded in these proposals, and suggest a framework for thinking about the timing of this European soap opera.
Directly below we show a near-term calendar of European meetings, which begins tomorrow with the European Finance Ministers’ meeting. As we move into Sunday’s EU Summit, the major issues for discussion will include expansion of the EFSF, bank recapitalization funding, and a broader Eurozone fiscal union (which would require constitutional amendments) to govern country budgets, set terms on loans, and more broadly enforce fiscal responsibility (think Stability and Growth Pact 2.0). Note: this last point, however, is far out on the curve. The key word here is “discussion”. There has been no indication/we’re not of the opinion that concrete policy—that is signed, sealed, and ready for implementation—will be delivered for Monday morning (10/24).
Oct. 21 – European Finance Ministers’ Meeting, Brussels
Oct. 22 – European Affairs Ministers’ Meeting, Brussels
Oct. 23 – EU Summit, Brussels
Nov. 4 – G20 Heads of State, Cannes, France
Buy the Rumor, Sell the News
A clear mismatch has however developed between market participants wanting clear cut resolution to Europe’s sovereign and banking crisis NOW, versus the much slower hand of Eurocrats who have yet to show that they 1.) know how to handle this situation, and 2.) can collectively agree on the terms of a bailout for the sovereigns and banks.
Remember, ratifying the July 21 EFSF terms took months to carry out. And as recently as today there’s talk that a second EU Summit will have to be called (possibly next Wednesday) because German Chancellor Merkel has not been able to get a mandate from the Bundestag to increase the size of the €440B EFSF, namely because there was delay in Troika announcing that Greece would receive its 6th tranche of funding –approval came just today. [To get to the €750B EFSF rescue fund = €440 from Eurozone member nations + €250B from the IMF + €60B from the EU].
In any case, we’re not saying that Eurocrats can’t craft something in the coming weeks, we just wouldn’t put all of our eggs in the basket of it happening this weekend. This chain gang of Eurozone heads has not proven to be efficient in decision making, so, the “Bazooka”, may be on hold, and the November 3/4 G20 Heads of State meeting would be the next logical event around which a more concrete proposal could be pushed/the market would expect some decision.
According to Merkel: "Government debts were built up over decades and that's why they won't be removed in one summit," she warned this week, saying the meeting would be just one of several important steps.
Contradictions at Play
Here it’s important to point out key differentiators among the players at work. The heavyweights in decision-making are Germany and France—notably Trichet and the ECB continue to hold the tight line that they don’t want to take on the balance sheet exposure to the region. In short, Trichet sticks to the convenient but impractical line that the ECB’s sole mandate is price stability across the 17 member states -- that is governing through monetary policy. While the ECB reignited its bond purchasing program in early August, named the Securities Market Program [SMP], to buy secondary sovereign issuance (total = €165B), mainly from the periphery and in particular to support Italy and Spain, there’s clear positioning from the ECB that the SMP will not be THE facility to shore up sovereign funding issues. Instead, and without providing the details, Trichet has referred to the EFSF as a facility to address both sovereign and banking risk (ie provide bailouts and buy up debt) across the member states.
So what’s the problem? The EFSF is far undercapitalized to deal with these funding issues (more below).
Merkel vs Sarkozy
In numerous comments, Merkel has signaled a willingness to save the economies of the Eurozone (and the common currency) at ALL COSTS, however, hasn’t had the backing of her constituency, including her Finance Minister Wolfgang Schaeuble, who has been quick to temper expectations of expansion of the EFSF over the last weeks. On the other hand, French President Sarkozy has indicated the swift need to expand the EFSF (possibly through leverage), and indirectly implied that the Germans would carry more of the risk in expanding the facility.
Problem at hand: France’s credit rating. France holds a AAA credit rating from the three main agencies, however is in threat of losing it in our opinion. (For more see our recent work titled “France is Going to Get Downgraded” on 10/18). With a 20% contribution to the collateral of the EFSF, the second largest behind Germany at 27%, this is after all a huge problem. Eurocrats in recent days, including Michael Barnier of the European Internal Market Commission, said that his agency is considering a move to ban the agencies from publishing outlook reports on EU countries entangled in a crisis. This is a larger topic in and of itself, however the bottom line is that if France loses its AAA standing, the EFSF is back to square one, which has huge negative market implications.
The entire make-up of the EFSF (at least in theory) is to be a funding vehicle backed by AAA guarantors (although not all contributing members are) that can raise and buy up debt (in some cases toxic) from sovereign and banks and through its AAA rating (basically the handshake of Germany and France)maintain its credibility as a facility.
Going into this weekend, it’s clear the market wants a Bazooka—some funding package to capitalize the sovereigns and banks to pull them out of Europe’s ongoing crisis. On the banking recapitalization side, the figures being thrown around are anywhere between €100-300B. If the lower end of the range was agreed upon, we’d largely expect the market to sell on the news, including the EUR-USD, equities (banks in particular), and bonds, especially across the periphery.
We’ve included Italy’s 10YR yield at 6.02% in the title of this note (and in charts below) for it’s a signal the market doesn’t think Eurocrats will get a plan done this weekend. As we hit on numerous times, the 6% level on 10YR government bonds has been a historical level. When Greece, Portugal and Ireland broke through this level, yields shot up expediently and the individual countries required a bailout in short order. This time around, there’s no facility large enough to bailout Italy, which is sitting on €1.9Trillion of debt, or a Spain, or a large nation requiring assistance to prop up its banking sector. Here we mean to say that the game is not only dealing with the sovereign and banking needs of Greece, Portugal, and Ireland. [Below we also show the CDS of Italy and Spain, both trading above the 300bp line, which we’ve named the Lehman Line, after the bank moved expediently off the level into collapse].
On raising the size of the EFSF, numbers have been thrown around between its existing size of €440B up to €2-3 Trillion. The top side of the range factors in sovereign default/bailout needs of Italy, Spain, and banking bailout across the region. Here’s it’s hard to know exactly what the market views as appropriate to blanket the risks that have been growing across Europe over the last two years, but should proposals not come in towards the high side (which we think is very probable in the next couple of weeks), or the facility remain on hold at its current capacity, again, we’d expect this news to create selling pressure. Should the top-side be met, or closely considered, we’d expect markets (equities, bonds, and EUR-USD) to fly higher—perversely, despite this huge fiat socialization program, we still see the common currency getting a bid.
It’s not clear if the banking recapitalization proposals would come out of the EFSF, be directed from member countries on their own banks, some combination of the two, or from an entirely new facility altogether. European banks taking haircuts on Greek paper is also not understood -- whether write-downs would be at the previously established 21% (from JULY 21 Resolutions and the level pushed by Sarkozy) or closer to the 50-60% range that many German spokesmen have outlined. However, both issues will need resolution. We'd also be surprised to see the ECB stay on the sidelines.
Rough numbers suggest European Banks have exposure to Greece in the amount of €128 Billion; €819B to Italy; and €2.2 Trillion to the PIIGS. The web of European exposures is thick—so too is the resolve of Eurocrats to save the Eurozone at all costs. Given the structural imbalance of linking uneven economies by one currency and monetary policy, and the severe fiscal imbalance generated by its weaker members over the last ten years, we’re not of the opinion that a panacea, that is a “Bazooka”, is unloaded in the next days that is a cure-all for the region. That said, depending on the size and scope, potential bailout package(s) could go a long way to boost European market performance, many of them hit hard over the last months. Getting ahead of the Eurocrats requires a crystal ball—we don’t have one but are trying to prepare for likely outcomes.
We remain short the EUR-USD in the Hedgeye Virtual Portfolio given the unlikelihood of an imminent panacea, bullish bias on the greenback, and larger sovereign and banking threats we see on the horizon.
Oh, and don’t forget that the Chinese and BRIC nations have whispered that they’ll come to Europe’s aid. Don’t you just love all the whispers!