Soros says the following:
“Given the magnitude of the crisis it is again too little too late,” Mr Soros said of the Brussels deal at a dinner organised by Pi Capital investor network on Thursday. “It will bring relief partly because the markets were so obsessed by the lack of leadership. The mere fact that something was achieved was a major relief and it will be good for any time from one day to three months.”
“Unfortunately it is not the last crisis because the fundamental issues have not been settled. It is clear that the amount of debt that Greece has accumulated and is accumulating is untenable and the country is effectively insolvent.”
“Unfortunately, the 50pc haircut is effectively less than a 20pc reduction in the overall debt [for Greece] because it only involves the private sector and excludes all the debt that is held by the ECB [European Central Bank] and the other public authorities and also the debt held by Greece because the banks, of course, will now be insolvent and the pension funds also,” Mr Soros said.
“It is not at all clear that the private sector will actually deliver this voluntary cut because many of the banks are hedged by holding credit default swaps and this doesn’t trigger the credit default swaps. As a private institution you could argue that it is the fiduciary responsibility of the board to look to the benefit of the bank rather than the common benefit.
“So, from the banks’ point of view it is better to have a credit event where the CDS become active and protect them from the loss. That is an unsolved problem which may emerge in the next few weeks.
“The failure in terms of governance and the lack of understanding among the leadership how to deal with the market is really quite astounding. You have to lead markets, that is what they don’t understand.”
Three key issues dealt in the EFSF are:
1. Lever EFSF to Increase its fire power
2. Greek debt Haircuts (10% vs 50%)
3. Recapitalisation of European banks
We look at each of these in some level of detail on what it holds for bond markets, the only true barometer of what lies ahead.
1. EFSF Leverage:
The EFSF was not granted a banking license which would have given it an ability to raise capital off ECB balance sheet and hence resolve the whole matter. This was anyways impossible without A FISCAL UNION. So am not sure why the markets were even talking about it. The EFSF as it stands will increasingly phase out ECB bond buys.
There are two important options via which EFSF will deal with the issue of bond purchase:
- A peripheral country issues bonds with a partial insurance certificate to be covered by EFSF bonds, which the peripheral has bought using an EFSF loan and deposited with a fiduciary. If the peripheral defaults, the fiduciary will deliver the EFSF bonds to investors in compensation. From an economic vantage point, the EFSF will provide partial insurance against a default of the peripheral bonds. It is important that EFSF maintain its AAA rating at all times for this to work. It is also important to understand on how the EFSF will deal with losses exceeding 20% like in the case of Greece.
- An SPV(special purpose vehicle) buys existing or new peripheral bonds. The EFSF will make a financial contribution to this special purpose vehicle by participating in the most risky tranche, which would be the first to shoulder the losses in case of a default on the peripheral bonds bought by the vehicle. Other investors would buy the less risky tranches. Just as under the first option, the EFSF would ultimately insure the repayment of the peripherals against default up to an amount that is still to be defined.
According to the statement, both options might be used to insure bonds up to the four or fivefold volume of the EFSF assets. The EFSF may lend € 440 bn at most. Taking into account the already committed funds (€ 133 bn) and the funds needed for other purposes (such as banking recapitalisation), the EFSF might have € 200 – 250 bn at its disposal. If it insures 20 – 25% of
the repayments of the peripheral bonds, it could provide insurance for bonds with a total volume of about € 1,000 bn. That would certainly be enough to cover Spain’s and Italy’s financial needs until the end of 2014. We expect that Spain and Italy will require a total of € 710 bn; usually, the IMF takes on one-third of that amount. However, the key question is whether investors will be willing to buy large volumes of insured bonds and thus put an end to the government debt crisis. This will be tricky for the following reasons:
- The very fact that Government needs to provide insurance will spook bond investors who will perceive that these bonds are not at all secure. Bond investors close to EU markets may deal with this contradiction differently from Bond investors in US or Asia who will be far skeptical of such a mechanism
- Many investors may doubt the credibility of this partial insurance. If the governments state that a haircut for a peripheral country is “voluntary” as in the case of Greece, investors might think that the EFSF as insurance provider may not pay in the case of future haircuts.
It is also to be seen on how EFSF is able to leverage its existing pool of equity. Given China reluctance, it may ultimately be left to private investors who will be far more demanding and hence threatening the whole leverage story itself.
2. Haircut is significant but insufficient
Even with haircut of 50% for Greece debt (more than 12% agreed on July 21), the country still has a debt/gbp ratio in excess of 100% and hence future defaults cannot be ruled out. The community of states would contribute another €30bn, presumably in order to enhance the new bonds with collateral and thereby provide a bigger incentive for private sector creditors to participate in a debt exchange.
According to the community’s plans, Greek debt would decline by an amount which is estimated
to correspond to 50% of Greece’s GDP.
3. Bank recapitalisation
As expected, the heads of government agreed that European banks shall have a core capital ratio of 9% in the future even if the government bonds they hold are accounted for at market valuations. According to the statement, banks shall reach this target by mid-2012. In order to do this, banks shall primarily raise funds themselves. The EFSF shall take action only if neither the banks themselves nor the national governments have enough funds to recapitalise the banks. But as we reported from Reuters that the Bank recap is a political problem more than an economic one and hence we will back the EU politicians to throw their weights around to solve the problem of bank recap.
The shortfall created by a tougher stress test is certainly large. Take the 90 banks that participated in the European Banking Authority’s now-discredited exam in July. If banks were forced to mark their sovereign debt to market and achieve a core Tier 1 capital ratio of at least 7 percent under a stressed scenario, they would need 93 billion euros. Raise the pass mark to 9 percent, and the hole is 260 billion euros.
That’s a giant leap from the gap of 2.5 billion euros identified by the EBA in July. However, when judged against the economies of the 21 countries whose banks sat the test, it’s still manageable. A 93 billion euro capital injection is equivalent to only 0.7 percent of the countries’ expected GDP for 2011. Even with a 9 percent pass mark, the bill is still just 2 percent of GDP.
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Concluding remarks
While the partial insurance scheme should provide stability to debt problem and cover Spain and Italy needs well into 2013, we are not bought into the story given lack of details. Italian auctions after the launch of EFSF did not comfort investors as yields hit the roof again at 6%, a level which will not be sustainable for Italy weak cash balance sheet.
Euro zone is developing from a monetary union characterized by the Maastricht Treaty towards a transfer and liability union. If the current EFSF mechanism fails to please the bond investors, the governments may request their parliaments at the end of the day to increase their guarantees for the EFSF another time so as to enable the EFSF to cover the funding costs even of the large peripherals Italy and Spain for three years. Further leverage may be difficult to get approval and if they do get approval, EFSF itself may lose its rating and hence risking the entire structure. This alone is enough for us to suggest that crisis worsen far more before before ebbing off.
As we predicted from the day the EFSF deal was announcement, that we look forward to more rumors and market moving news with no substance behind it, it does seem that the stream of rumors have started!
Chinadaily now report that Chinese officials have backtracked from their in principle approval given to Sarkozy about investing into the leveraged version of the EFSF, saying they need more details to invest into EFSF.
This news should end the EURO rally of October and now make it move back to more sane levels of 1.35 in Nov.
C3X
The barriers to a solid recapitalisation of Europe’s banks look political, not economic as per reuters.
The shortfall created by a tougher stress test is certainly large. Take the 90 banks that participated in the European Banking Authority’s now-discredited exam in July. If banks were forced to mark their sovereign debt to market and achieve a core Tier 1 capital ratio of at least 7 percent under a stressed scenario, they would need 93 billion euros. Raise the pass mark to 9 percent, and the hole is 260 billion euros.
That’s a giant leap from the gap of 2.5 billion euros identified by the EBA in July. However, when judged against the economies of the 21 countries whose banks sat the test, it’s still manageable. A 93 billion euro capital injection is equivalent to only 0.7 percent of the countries’ expected GDP for 2011. Even with a 9 percent pass mark, the bill is still just 2 percent of GDP.
True, the overall cost might be higher, because the lenders that sat the EBA test only represent 65 percent of those countries’ banking assets. However, smaller banks tend to hold bigger buffers. And some bigger lenders may be able to raise capital privately.
Peripheral states would still suffer. At a 7 percent pass mark, Greek and Cypriot banks would need a combined 36 billion euros of extra capital. Footing the bill would push Greece’s 2011 debt-to-GDP ratio to 171 percent, from 157 percent. Cyprus’ post-recap debt would be 86 percent of GDP, 26 percentage points higher than before. But both those countries’ banking systems always needed help to cope with a Greek default.
The real question is whether Spain and Italy, which face a combined bill of 22 billion euros, need bailout money as well. However, financing the recap will only add 1 percent to their respective debt-to-GDP levels.
France and Germany have recently squabbled about whether the recapitalisation of their banks should be financed by the countries themselves, or by the European Financial Stability Facility. With self-help perfectly plausible, it suggests the real problem is justifying further bank rescues to voters.
C3X
Source: Reuters
…Unfortunately not very pleasing.
1. Why is EFSF destined to fail (Telegraph)
2. G20 prepare for Cannes ( Guardian )
3. IMF Plans for new lending facility
4. Germany gets lucky with an extra 55 billion of cash (BBC)
5. Economist advise Osborne: Time for Plan B (Guardian)
6. Trichet is preparing for Rate cut as he says low inflation for 10 years (Reuters)
While last week saw an extra ordinary rally in risk, which was quite unexplainable to the sombre bond crowd who just frowned while the dogs were barking. The divergence could not have been more stark as the Italian borrowing costs blasted the 6% barrier for the second time after the introduction of the EURO.
Italy is saddled with €1.9 trillion in debt, with more than €200 billion of it coming due next year. A country which is now increasingly being losing credibility with investors with Berlusconi facing increasing pressures to bolster growth. He not only needs to persuade his fractious cabinet to sign off, but also the Italian Parliament, where he has a thin majority. Having lost one of his credible cabinet ministers who had steered his country through much of last year volatility, Berlusconi faces an uphill tasks.
The Friday Italian auction were not exactly as planned as Italy was forced to pay higher yields than in the recent past. Most significantly, 10-year debt—a market benchmark—was sold at a yield 6.06%, up from 5.86% only a month ago.
“With a 120% debt-to-GDP ratio and 10-year Italian bonds yielding roughly 6%, they can’t do that forever or the borrowing costs will get to an unsustainable level,” said Eric Stein, portfolio manager at the Eaton Vance Global Macro Absolute Return Fund. “As your rates go up, it means you’re paying more and more to service your debt, and your whole debt dynamics become harder and harder and harder.”
Why are Bond markets worried?
There 3 reasons why Bond markets arent too faked into a rally mode yet:
1. Investors are skeptical of the plan to use the EFSF to insure against losses on government debt. Under the agreement, the EFSF would absorb the first 10% of losses on debt issued with the insurance. Investors figure that if losses amount to 50%, which was the case with Greece, that wouldn’t provide enough protection.
2. To what extent will the European Central Bank be the buyer of last resort for sovereign debt? The ECB started buying bonds of indebted European governments in mid-2010. After an 18-week pause, it restarted the program in August as the euro zone’s debt crisis spread to Spain and Italy. But influential voices within the ECB, in particular in Germany, want to end the program.
3. Bond investors also are worried about the potential for a macro economic slowdown hitting European market esp Germany which could make it more difficult for some countries to reduce their budget deficits, which, in turn, could lead to addition downgrades in their credit ratings.
C3X
“What a week” is all we have been to say. A week that saw Merkel and Co holding hands to tell the euro skeptics that they are wrong. Only time will tell whether there was anything substantial in those EU Summit plans.
We close the week with total pips at 1939 up from 1819 last week.
A few notes:
- The week could have been even better if we could trade our biases which was for a spike to 1.42. In fact there was an unfilled EUR/USD trade lying at 1.393/50 for a target of 1.41. We could not chase the pair as the stops had to be nearer 1.388. But we took some satisfaction in chasing down EURJPY during the spike albeit only to 106.8.
- The week saw a near 250 pip spike in USDCAD which was a fake and it came back down to 0.999 levels. That was tough to trade either ways. The USDCAD alone dug into our profits by over 100 pips.
- The highlight of the week had to be AUD/USD and clearly we could not catch that either. It has now retraced the entire fall from 1.07 in Sept even with a dovish RBA hanging over it. Only QE3 could be blamed for this or rather the “death of the dollar”
- Gold broke out from 1665 and then in the same week also took out 1745. These are bullish times for Gold and we are now set to test $2000 and we will not be surprised if it happens this year
- The effort has been to continue to make the winners BIG and the losers to be small. This has resulted in trade success ratio to dip to 49.8% from an elevated 70% in August when we were trading a mere 38/40 calls a month. As a comparison, October and Sept winning trades itself are nearly 1.5 x of the overall trades in July and August.
Happy trading and see you Monday at the Live trading session.
C3X
Many believe that EUR action is all about Dollar Index. We dis agree. The times we live in now are no more led by Dollar action but rather by EUR action given the tremendous implications of what is happening in EU zone. Who would have thought that a disparate group of politicians, each subservient to their political goals and with a tinge in common between them would chart a path to common fiscal union. We had doubts as did markets. But for the first time, we feel that fiscal union and treaty change are now a matter of time rather than whether they will happen! It may not happen now but the counters of this are now presented at the EU Summit and the clash of German led bloc with Anglo Saxon alliance is already reminding that EU now is more politically arrogant and integrated than ever before. We may still see EURUSD disappointed and drop down like a rock but that does not take away the fact that fiscal union is now on the horizon in 2012/13.
But having said that, EU still has a problem. And that is stagnating growth in Germany which has led the powerhouse for the last 18 months. We will be looking at the PMI charts for EU zone as a whole. PMIs have always projected forward quarterly stagnation.
Before we get into intricate details, we do a quick update on where exactly are we with the deficit reduction in PIIGS.
Slow progress is being made among the PIIGS for reducing the deficits. Portugal and Spain lag Ireland which is doing the best.
Sources: National financial statistics and Stability Programmes
- Portugal reduced its deficit by about € 2 bn (1.2% of GDP) year-on-year during the first nine months of the year. However, in order to reach the deficit target for the year as a whole (6%) the deficit would have to be slashed by another almost € 5 bn during the remaining three months of 2011 – a goal which seems quite out of reach in view of weak economic growth.
- Spain will probably miss its fiscal target this year.
- Greece austerity package has increased the chances of this year’s deficit coming in below last year’s.
- At the moment Ireland is clearly doing best. In fact, the Irish deficit might narrow somewhat more strongly than planned this year, provided that the economic uptrend of the first half of the year continues.
- Italy will probably reach its quite unambitious goal for 2011, too.
Given the Debt overhang, the technical picture needs to be analysed especially if you are a trend trader as often Technical lead the macro reversals. It is all baked into the price.
EURUSD Weekly Charts
The weekly charts have well advanced after the powerful weekly hammer at 1.315 early October. It also coincided with bearish hammer on the eur volatility charts, both of which together projected the October rally in EURUSD.
- The 9W stochastic is at 53, marginally bullish but we would not read too much into this mild bullish bias yet.
- The Vortex 9W are indicating further falls in EURUSD on weekly.
- The cluster zone at 1.3930 to 1.4050 are well in place. We spoke about this zone when EURUSD was at 1.3660 and how this zone will magnetically attract the price action. It has been validated now as EURUSD entered the zone a high of 1.3960 a level at which we shorted the market and netted over 120 pip.
EURUSD Daily Charts
- The 200 DMA has been supporting price action over the last 6 months but now may be capping the rally at 1.42 levels. It is not a coincidence that price action is so near to this level at the importance of the EU Summit on wed.
- If they do implement Rompuy proposals for a common treasury at Frankfurt, then this cluster zone is history as EURUSD will soar.
Looking at other charts to understand price action will help us. EUR Volatility are always a good indication of ground realities.
EUR Volatility charts (weekly)
As always EUR volatility continues to be one of the best weekly trend tools which allow us to judge the actual lending volatility on eur pairs. Higher volatility means higher uncertainty and therefore bearish pressure to rise on the pair. Volatility also derives itself from euribor rates which accurately gauge the ground realities between banks lending in the euro zone.
The volatility is now stabilizing at 17 levels which can be considered to be high but well inside the well behaved uptrend. Stochastic and Vortex continue to forecast mildly bullish bias for the volatility.
This is what we said about EUR volatility on 2 October and how well was that chart predicting the rally of October. EUR Volatility predicting upside.
A quick look at the EURIBOR charts will also tell us about the rising stress in the system even with the EU summit underway. This can be considered an important *macro bearish divergence* in the EURUSD price action.
EURIBOR Charts
Euribor came in at 1.588% which is the highest clocked this year and is clear indication of the worsening situation in EU banks. Interbank lending is getting stressed. But the Interbank overnight Eonia is at 0.937% well below the 1.22% of October 10, 2011.
To Gauge the normal market risk perception, important to understand general trends in Dollar Index.
Dollar Index (Monthly)
The dollar index has broken through 200 DMA right after the FED announced the Twist operation with the short term yield yanking upwards and pulling the Dollar upwards. The dollar breakout came after 4 months of consolidation and as seen in the past, every such breakout was accompanied by a trend change in the 200 DMA as it turn back up. Will that be case this time around?
The Aussie pairs are an important parameter to judge risk which is a direct derivation of trade and capital flows into commodity rich countries like Australia. It also derives it internal from China where Yuan is not yet fully floated.
AUD/USD Daily charts
The AUD/USD pair has broken out and is now leading the way to 1.07 levels by year end. The currency is gaining in strength in our indicators and we expect a strong move to 1.07. The vortex indicator has crossed over bullishly, the stochastic are well above 75 levels and RSI is well positioned. The AUD/USD broke out after China reported PMI above 50 indicating expansion. The markets have taken this as a sign of an economy which is resilient even in the wake of high borrowing rate.
Bunds too are indicating that the October RISK rally (predicted by us on Oct 2) may just extend into the year end.
Bunds have led the powerful eur rally as rising yields in a benign credit market, have supported flows into equity/risk markets. How will this change on Wed Oct 26 2011?
A look at DAX charts will indicate the point we are making with Bunds and AUD/USD pairs.
Our subscribers were alerted on [10 Oct ] when DAX was at 5790/5830 that a rally to 6060 was in the making and it was based on two pillars:
Falling Bunds which broke 135.2 and AUD/USD which pulled itself above 0.9880 both of which lent strength to our internal indicators on RISK.
We also need to update our analysis on the fundamental drivers which are weakening EU economy. So even if the debt crisis does not get worse from here, there is still the question of the secular growth story.
Source: Reuters
The leading indicators continue to fall. The purchasing manager index for manufacturing industry fell by a further 1.2 points in October 47.3. The index for the service sector dropped by 1.6 points to 47.2 – level at which in the past the Eurozone economy has shrunk. This shows that the uncertainty provoked by the sovereign debt crisis has reached danger point.
The euro economy is likely to have grown by a respectable 0.3% from Q2 to Q3. The outlook for the final quarter is increasingly gloomy, however. We expect economic output to decline by 0.2%. For 2012 as a whole we expect the Eurozone economy to stagnate. But even this is based on the assumption that the sovereign debt crisis does not get any worse. In the event of an uncertainty shock like that which followed the collapse of the American investment bank Lehman Brothers, the Eurozone economy would contract significantly on average over 2012.
We will be further updating our analysis on latest from the Bond and Forex markets as we analyse and trade trends into November. Markets are setting up for a strong move on either side into the year end and inter-market gives you advance warning as we have observed over the last few years and months.
C3X
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The European finance ministers have progress on the negotiations to the recapitalization of banks. It ‘says the German Chancellor, Angela Merkel, the summit in Brussels for EU crisis, adding it expects “ambitious decisions” and a “turning point” in the second EU summit convened for Wednesday ‘. “We far-reaching decisions, which must be prepared properly. I believe that ministers of Finance have made progress, so that we can achieve our ambitious goals Wednesday. The turning point there will be ‘Wednesday’ ”
In essence they met to meet again.
