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Germany May Hold Trump Card in European Crisis

Tuesday, 08 June 2010 03:59 PM Current | Bio | Archive

Given the recent downward move of the euro, I thought we could refresh our views of where the European markets are positioning themselves and the different sentiments for the different European markets and the euro.

Outflows from Greek and Italian sovereign debt are still rising, albeit at a far slower pace that we saw through April and May. In recent days, outflows from Portuguese sovereign debt didn’t match that seen at any point since mid-April. At the same time, both the local Greek and Portuguese equity markets continue to see net outflows, although at not quite the same pace we were seeing in April and early May.

The longer dated Greek/German spreads continue to widen from their early May lows, notwithstanding the moves pale when compared to those seen in late April/early May. The 10- year spread has widened out from 459 basis points on May 12 to 582 basis points today (a gain of 123 basis points).

However, while movements in the other major Southern European/German spreads have been a little more modest than those seen for Greece, it is also true that many are widening at an accelerating pace. It is also worth highlighting that the five-year and 10-year Spanish/German and Italian/German spreads have broken through to all-time highs.

In Francophone Europe, we see both France and Belgium having some modest outflows starting to emerge from their local bond markets since early May. Belgian spreads having started to move out during the past month with both the five-year and 10-year spreads over Germany breaking through to new highs in recent days. French spreads have, to a large degree, remained immune to the crisis until recently.

However, there appears to be little impact sentiment toward local equity markets as both have seen solid inflows during the past month, hereby reflecting the positive impact that a weaker euro will have for their export industries.

Besides all that, we continue to see the northern European bond markets remaining by far the absolute favorite of “all” international and European investors. The northern European equity markets remain somewhat more mixed with only Germany, Austria and interestingly, also Ireland, currently attracting sustained inflows.

Almost inevitably, the prices of credit default swaps on southern European sovereign debt have followed a very similar pattern to the movements of the relevant yield spreads in the European sovereign debt markets with the cost of insurance rising since the early May lows.

However, the sheer scale of some of these recent moves demonstrates a very sharp deterioration of confidence over the past week or so. The Greek five-year CDS has moved out from an interim low of 569 basis points on May 11 to 820 basis points COB Monday. This compares not only to the all time high of 1011 basis points hit on May 7 but also the 1,100 basis point price hit by the five-year Icelandic CDS as its banking system collapsed in October 2008. Currently, only Venezuelan and Argentinean sovereign debt would cost more to insure with 1,494 basis points and 1,195 basis points, respectively.

Although the movements seen in the other southern European CDS prices are modest when compared to those for Greece, they are nevertheless telling. In particular, we note that both the Spanish and the Italian five-year CDS prices have broken through to new all time highs in recent days with 270 basis points and 251 basis points, respectively.

The net buyback of euros that had been underway since the euro bottomed in mid-May now appears to have come to a halt.

Remember that an important number of investors have been assuming that the euro would be able to stage a reasonable recovery through the summer. The latest price actions must therefore be of some concern to them. In the latest IMM (International Monetary Market) commitments of traders, we see that holdings of speculative players in euro futures contracts don’t suggest that short positioning is particularly aggressive.

So, what does all that tell us?

I’d say that it still seems fair to say that the euro isn’t oversold. And although Greece and Portugal remain the twin epicenters of the crisis, concerns are spilling over into other southern European markets.

Indeed, the latest price movements seen in the CDS market show that worries about Spain and Italy have risen beyond the levels in early May.

Finally, it seems also fair to say that the majority of investors don’t trust the southern European countries and continue to seek the safety of northern European bond markets.

However, there are also two broader and at least in my opinion, far more concerning points to be made.

The recent rise in the level of concern has come despite the absence of any significant fresh news coming out of southern Europe, except Spain. Indeed, most of the news to emerge in recent weeks has concerned differences of opinion within core Europe. The evidence is that the deterioration in sentiment is being driven less by short term news flow and more by a fundamental reassessment of the long term outlook for European markets and, of course, consequently for the euro.

Unfortunately, all this has come despite the truly remarkable EC/ECB/IMF support package that was put together for Europe in early May.

To put it more bluntly, if the equivalent of more or less $1 trillion dollars is insufficient to calm investor concerns — then we need to ask ourselves what could?

Finally, euro zone finance ministers gave their final approval to their 440 billion ($520 billion) rescue package and said the special entity set up for emergency lending would aim for the highest possible credit rating.

Germany, France and other strong nations will effectively be leveraging their own high credit ratings to support their less-creditworthy euro-zone fellows.

The euro zone agreed last month that its members would back the bailout with loan guarantees in proportion to their shares in the European Central Bank — roughly in order of economic heft. The rescue vehicle will borrow on capital markets for its funding. That idea has met with political resistance from countries that would be effectively subsidizing others' borrowing.

Investors shouldn’t overlook that fact that the German government reportedly filed an argument with the country's highest court urging it not to approve a member of parliament's recent request for an injunction against its involvement in the bailout fund.

The risk is still out there, albeit small, the Germany's constitutional court might yet grant the injunction.

I don’t think it will come that far but if that happens, believe me, the fallout wouldn’t be nice.

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Given the recent downward move of the euro, I thought we could refresh our views of where the European markets are positioning themselves and the different sentiments for the different European markets and the euro. Outflows from Greek and Italian sovereign debt are still...
Tuesday, 08 June 2010 03:59 PM
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