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Conclusion: European CDS spreads come in alongside insurance from the international community to backstop sovereign debt in Europe and the IMF potentially plays the role of global currency arbiter. In the Hedgeye Portfolio we’re long Germany (EWG) and short Italy (EWI).

 

October-to-date we’ve seen sovereign CDS spreads in Europe come in, an indication of declining risk, which on the margin is positive for the region (see chart below). Here’s a quick look at the improvement in CDS spreads for a select group of countries October-to-date:

Greece  -97bps

Ireland  -47bps

Portugal  -37bps

Spain  -34bps

Italy  -26bps

Iceland  -12bps

UK  -9bps

European Risk Abates on Strauss-Kahn’s Back? - neuste

Importantly, both Ireland and Portugal are trading around or below the 400bps line, a line we’ve found to be a critical breakout line. One read-through on this marginal improvement is the increased insurance from international players, in particular the IMF and ECB, that they’ll backstop any potential sovereign debt risk in the region by such means as adjusting repayment schedules, forgiving debt, and extending bargain-basement borrowing rates.  Consequently, investors appear more willing to take on European debt, despite the continued poor state of many countries balance sheets, especially those of the peripheral PIIGS.

Take a look at the rhetoric from international players regarding Europe’s sovereign debt in recent days:

  1. Greek officials are doing “exactly what they need to do” to rein in spending and meet the benchmarks set out as a condition of aid…and there’s “no reason for default.”  -Dominique Strauss-Kahn, chief IMF.
  2. The IMF has mechanisms to “prolong packages” for countries receiving assistance and is “thinking” about it for Greece, though nothing has been decided.  -Lorenzo Bini Smaghi, ECB executive board member.
  3. “The fund’s options include lengthening repayment periods, replacing shorter-term with longer-term loans, and agreeing to a new program when the current one comes to an end.”  -Simonetta Nardin, a spokeswoman for the IMF.

Concurrently the IMF is restructuring the fund’s governing structure to give emerging-market nations a bigger voice in decision making. Also, with currency tensions the focus of this year’s IMF and World Bank annual meetings, we could see the IMF take on a greater role as the arbiter of global currencies, a move that could appease and take the tension off increased strain between the US and China over the valuation of the Yuan.  This policy shift towards giving the IMF a far heavier hand in international governance could be a slow moving train, or maybe just wishful thinking, nevertheless a development to keep your eye on. 

Another positive sign from Europe today came via Italy’s successful debt auction of 5.5 Billion EUR ($7.7 Bill.) in which yields across maturities fell versus the prior auction of similar maturity, which is positive on the margin, especially given Italy’s high public debt as a % of GDP at 115.2%. Here’s what Italy’s auction yielded:

€3.5 Billion due June 2015 with a yield of 2.53% versus 2.69% on Sept. 13.

€1.15 Billion due 2037 with a yield of 4.53% versus 4.91% on June 11. 

€846 MM due 2023 with a of yield 3.98% versus 4.43% on July 14.

From a fundamental standpoint we’re forecasting slower growth in Europe into year-end and in 2011 as austerity measures cool growth. We’re currently long Germany via the etf EWG and short Italy (EWI) in the Hedgeye Portfolio. The German economy continues to power forward and stands out among its European peers from a fiscal perspective.  

Matthew Hedrick
Analyst