Help From Unlikely Quarters

An unlikely 'savior' of the moribund markets for PIIGS debt made his entrance on Tuesday…Japan. On Tuesday, one day before the widely and much dreaded Portuguese debt auction, Japan let it be known that it was going to join China in buying bonds issued by the EFSF (European Financial Stability Facility) to help support shaky sovereign borrowers in the euro-area.


At first that piece of news may have invited some bemused head scratching, but it is actually a pretty wily move, in a way.

Bear with us on this…first, here is what the media reported, via Reuters:


“Japanese Finance Minister Yoshihiko Noda said Tokyo was considering using its euro reserves to buy about 20 percent of the AAA-rated bonds to be jointly issued by the euro zone to raise funds to support the region's second bailout recipient Ireland.

"I think it's appropriate for Japan to purchase a certain amount of bonds to boost confidence in the EFSF (European Financial Stability Facility) and make a contribution as a major country," Noda said.

Japan's offer comes days after China renewed its commitment to buy Spanish debt and analysts said it reflected both Tokyo's concern about the impact of the crisis on its export-reliant economy and an effort to reassert itself on the global stage.

A senior adviser to China's central bank said in a Reuters interview that Beijing too should be buying safe, jointly guaranteed euro zone debt rather than riskier bonds issued by troubled member states such as Spain and Portugal.

"In principle we support the euro, but we also need to ensure that our investment is safe and generates returns," said Yu Yongding, an influential economist in the Chinese Academy of Social Sciences, a government think-tank.

"I think it's much safer if we buy the fund as it has a triple-A rating," he added.”


Well, yes, those triple-A ratings are of course important. Not that they guarantee anything, but with the EFSF's debt guaranteed by the entire euro-area it is no stretch to regard buying it as somewhat safer than say buying Portuguese bonds directly.

Anyway, as you can see from the above comments by unnamed analysts, everybody immediately thought 'it's a vendor financing scheme'.  After all, a collapse of the euro, or even just a crisis that threatens to spiral out of control and thus weakens the euro significantly, would clearly be bad for the business of these major exporters to the euro-area. Not a thought we'd dismiss, as it were.

However, we suspect that there is perhaps a deeper motive at work here as well. Japan wanting to appear helpful on the international stage is certainly also an argument that can be accorded some validity, but we are surprised that nobody thought about something that strikes us as rather obvious. Two words: distraction – and contagion.

 Let us say, hypothetically,  that the euro-area's sovereign debt problems do lead to a panicky, out-of-control crisis at some point. This isn't a particularly unlikely scenario after all. All it would take would be a serious lapse in global economic growth and all hell would likely break loose.

What would the markets in such a situation be likely to soon focus on next? Could it be the country whose fiscal debt is the by far highest relative to economic output in the industrialized world? Why yes, that sounds like a possibility, doesn't it? That country has a name, and it is – Japan. By helping to arrest what increasingly looked like a death spiral lately, Japan can achieves inter alia a degree of distraction from its own budding debt problems.

Why might this have become a sudden concern? In this context the second term mentioned above must be considered: contagion. In today's strongly interconnected and highly interdependent financial markets, contagion has a habit to show up in the unlikeliest places.

We have previously noted how CDS spreads on Japanese JGBs have suddenly vaulted higher into what may be described as 'mild concern' territory. In essence, they have begun to move in sympathy with CDS spreads on PIIGS and other European sovereign debt. This is unlikely to be a coincidence – far more likely is that the buyers of these CDS have adopted a very similar chain of reasoning as the one we just mentioned. Perhaps Japan's policy makers have themselves kept an eye on these developments and judged them worrisome. We don't know since we lack mind reading powers, but it seems not too far-fetched. So by offering to buy EFSF bonds, Japan kills several birds with one stone, or at least renders them momentarily dazed.





Portuguese Surprises & Luxury Miracles

If you googled the phrase 'news on Portuguese Auction', on Wednesday, you probably came away with the impression that you were reading about a special form of global warming. As is well known, global warming is responsible for…well, just about  everything. Even for the world getting colder instead of warmer.

The Portuguese debt auction was held responsible for: gains in the FTSE, rising crude oil prices, a rising JSE, a dip in gold prices, advancing world shares, declining yields across Europe, a rousing rally in European banks stocks and lastly, a general sense of relief. Only the euro kept falling in spite of it.

Someone better point out to those forex traders that it is impolitic and impolite to keep selling the euro on such a joyous occasion.

On Monday we wrote:


“In advance of this week's Portuguese debt auctions, bonds of the beleaguered nation fell to new crisis lows, pushing yields to new highs. Depending on how these auctions actually go, there may be a small relief rally this week – as we have noted many times before, the auctions themselves generally tend to almost always go 'better than expected' – while the ECB's balance sheet gets weighed down with more and more PIIGS bonds, which it accumulates with its bond buying program as well as in repos.”


Things that 'always' happen should surprise no-one anymore, but it appears that one of the decisive points was that Portugal actually managed to sell its bonds below a yield of 7%, at an only semi-catastrophic 6.719% for the 9-year maturity. The reason why the 7% barrier is seen as crucial is that it was recently  briefly exceeded in secondary markets and represents the threshold that is widely believed to bring about a bailout if breached.

Portugal has a fairly high cumulative debt-to-GDP ratio, a too large and inefficient public sector and corruption is reportedly a major problem as well. The government of the current Portuguese prime minister Jose Socrates has apparently begun to make some progress toward tackling these problems well before Portugal's boom went bust. His government is quite likely sincere about wanting to get through the crisis without a bailout. Whether it can succeed is not entirely in its own hand however and Portugal's small size makes markets doubt its ability to achieve this goal. Moreover, Portugal's biggest trading partner is its currently economically rather challenged neighbor Spain.

That said, the entire lusophone world's population is about 22 times the size of Portugal's own population and the country has proven well versed in making use of these linguistic ties for purposes of expanding its trade.

The bust has however left Portugal's economy in a quite moribund state and has landed its banks in hot water –  what's more, Wednesday's auction has only removed a tiny portion of the vast debt rollover problems the country potentially faces this year.

As the FT reports,


Portuguese banks have increased their reliance on the European Central Bank for funding, a sign of possible strain in the country’s financial sector.

Portugal’s central bank released figures showing financing of the commercial banks by the ECB rose to €40.9bn in December, the first monthly increase since August, up from €37.9bn in November.

The reliance of many banks based in the peripheral countries on the ECB for funding has prompted some investors to warn that they have become overly dependent on central bank loans as they continue to find difficulty in tapping the private markets.


Analysts said reported European Central Bank intervention this week had helped keep the country’s cost of borrowing below 7 per cent for 10-year debt.

Portugal sold €599m of bonds due in 2020 at a yield of 6.71 per cent compared with 6.80 per cent at the previous auction on November 10. €650m of bonds due in 2014 were also placed at a yield of 5.39 per cent, up from the 4.04 per cent on October 27.

Spain is tapping the markets for as much as €3bn of five-year debt on Thursday, while Italy auctions as much as €6bn due 2015 and 2026.

Portugal needs to sell as much as €20bn in bonds this year to finance its budget and redemptions, and said it planned to market a new bond through banks in the first quarter.

The government faces bond redemptions in April, with repayments that month and in June of about €9.5bn.


(our emphasis)

To summarize all this – firstly, our often voiced suspicion as to the main reason why all these peripheral debt auctions always tend to 'go well' (recall that Ireland never had a failed auction either – quite the feat considering it needed to be bailed out in the end) , namely that the banks show up at these auctions to provide a backstop and then hand the bonds over to the ECB as collateral for repos , looks to be supported by strong circumstantial evidence. Secondly, the ECB evidently 'prepared the ground' for this latest auction with a large intervention via its bond support buying program.

Thirdly, Portugal will evidently have a great many more opportunities to create rallies in everything from crude oil to South African shares this year. Not to mention, dips in gold. This sounds like wonderful news for buyers of risk assets. Sort of, anyway. We like to refer to this effect as a 'luxury miracle', and  € 20 billion in borrowing needs this year alone should perhaps be called a potential 'horn of plenty'. Then again, maybe not – but in a pinch, there's now always Japan, this latest wielder of a fire extinguisher aimed at the euro area, so to speak.

On Thursday, it will be Spain's turn to provide the markets with 'relief'.

Below you find our usual collection of charts that shows the first pullback in PIIGS et al. CDS spreads in some time. As always, it remains to be seen if it is just another brief dip or the beginning of a bigger correction. Our money is on 'brief dip' for the time being. On Thursday we will also hear from the ECB, which is likely to leave rates right where they are. We remember that the last monetary policy meeting also coincided with a relief rally in peripheral bonds, so perhaps there is a short term cycle developing in the markets that's tied to these meetings.


1.    CDS


5-year CDS spreads on Portugal, Italy, Greece and Spain – a pullback has begun. So far it is quite modest, but if there are more successful debt auctions this week, they will likely produce a deeper one – click for higher resolution.



5-year CDS spreads on Ireland's sovereign debt, Bank of Ireland's senior debt, France, and Japanese debt. The 'Japanese distraction' maneuver curiously hasn't helped Japanese CDS spreads to come in yet, but perhaps they will do so with a lag – click for higher resolution.



5-year CDS spreads on Romania, Hungary, Austria and Belgium – all declining in sympathy with the PIIGS, as they usually do – click for higher resolution.



The Markit SovX index of CDS on the debt of 19 Western European sovereigns. A small pullback. It remains a bullish chart – click for higher resolution.



A weekly candle chart of the Markit SovX, for a longer term view. As can be seen here, it currently resides far above the levels seen back when the crisis first came to the world's wider attention in April/May 2010. A bit overbought perhaps, but this chart certainly shows a 'methodical advance' – click for higher resolution.



2.    Euro Basis Swaps


3 month euro basis swap – the recent recovery continues – click for higher resolution.



One year euro basis swap – also still in recovery mode – this is analogous to the recovery in the 3 month, it only looks smaller because it's a longer term chart. Obviously dollar funding problems  for euro-area banks were far worse during the 'GFC' in 2008 – click for higher resolution.



5 year euro basis swap – ditto – click for higher resolution.



3.    Other Charts


5 year CDS spreads on the 'Big Four' Australian banks. These have also slightly pulled back , but we continue to expect some upheaval in the course of this year, so we will continue to keep a close eye on them – click for higher resolution.



The SPX, T.R.'s proprietary VIX-based volatility indicator, and the gold-silver and gold-commodities ratios. Wednesday's Portugal-inspired celebrations have removed some of the budding divergences we had in our sights. Specifically, the gold-commodities ratio's new low for the move confirmed the new high in the SPX –  gold-silver is still diverging a bit, but not enough to cause concern. This does not mean that the stock market as such is not worthy of concern. Sentiment remains extremely lopsidedly bullish as we begin the earnings season, and this is likely to sooner or later have an effect. No-one is really looking down – hedging has become a trickle, and short positions at the NYSE have fallen to a one year low – click for higher resolution.



Here is one divergence that persists – SPX vs. the AUD-JPY rate. Perhaps it's the floods in Australia that have influenced this, as the Canadian loonie continues to act quite well – click for higher resolution.




Numerous Fed governors/presidents have recently held forth on the alleged benefits of QE and we plan to soon post a more comprehensive comment on their remarks. We were mainly waiting for Richard Fisher to have his say as well, which happened today. For now we want to say only this much: it appears that we will have to lower our count of putative 'hawks' to one and a half. Half of Fisher (who expects it to be 'completed barring data surprises') and Plosser, who  continues to voice doubts about the money printing exercise. Both have a vote at the FOMC this year. By contrast, Narayana Kocherlakota sounded supportive of QE2, even though he has previously said he doesn't think it can help the labor market (we agree). His support for the policy does however sound lukewarm, and he is thinking out loud about the future 'exit'. Needless to say, the new vice chair Janet Yellen is not only supportive of QE, she even cites spurious studies that allegedly 'prove' that it has 'created three million jobs'.

Furthermore, a very interesting paper on the inflation/deflation debate from an Austrian School perspective has been published in the Libertarian Papers. What makes it so interesting is that contrary to the view held by most Austrians , this one comes down on the side of deflation. We intend to post a critical appraisal at the earliest opportunity.



Another victim of the Japanese killing several birds with one stone exercise left in a state of acute dizziness. South Park thinks the Japanese hate dolphins…but maybe they really have it in for birds? Watch the end of the episode linked above if you find the time – nowadays they really do! (actually, watch the whole thing…if you like your humor black and irreverent, this one's for you).

(Photo credit: J. Andrew Boyle)



Charts by: Bloomberg



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2 Responses to “Hurrah, We’re Saved (Again) ! Euro Area Credit Watch, January 13”

  • uneasy:

    Saved or not?

    Read this from zerohedge

    Is China’s European Rescue Just A Big “Bait And Switch”?
    Tyler Durden’s picture
    Submitted by Tyler Durden on 01/13/2011 08:01 -0500

    * European Central Bank

    Something interesting happened on the way to China’s bailout of Europe. After recently China stepped up its Eurosupport rhetoric, and even put a token amount of money where it mouth is, €1.1 billion in directly placed Portuguese bonds specifically, and who knows how much in secondary market purchases, many of the clouds over Europe, and specifically the Euro, have been lifted temporarily, resulting in a modest jump in the EURUSD from just under 1.29 last week to nearly 1.32 today. Which makes sense: after all the EU is China’s second biggest trade partner, and as a habitual importer, China needs the EU’s currency as strong as possible to preserve its imports. Yet what is odd, is that over the past 24 hours we have received numerous notifications that it is none other than Chinese banks that have been selling the EURUSD! Which makes one wonder: is China’s European “rescue” just one big bait and switch distraction?

    Keep in mind that it was just announced that Chinese FX reserves swelled to an unprecedented $2.85 trillion, jumping by a massive $199 billion in Q4, the biggest amount on record. And of course, this is not all USD denominated. In fact, according to estimates, the euro accounts for 25% of the total amount, or about $710 billion. Seen this way, it suddenly becomes far more clear why China is much more focused on the EURUSD, and why every marginal change in the pair actually has a far greater impact on the country’s asset allocation decisions.And China is the best when it comes to strategically allocating FX reserves.

    Here’s the math: assuming roughly €510 billion in EUR-denominated holdings, just the last 5 day jump in the EURUSD from 1.29 to 1.31 means that the USD value in a static pool of €-holdings has increased by about $11 billion (on paper). But here’s the kicker: it is not on paper, and if the rumors are true, China is actively converting EUR holdings to USD. It appears that the mid-1.31 range is one appropriate exit point. So from an IRR standpoint, China invests €1.1 billion in Euro peripheral bonds knowing full well that the biggest backstopper is the ECB, in essence letting the country frontrun Europe’s taxpayers. And in return it gets a marginal improvement in its FX holdings to the tune of $10 billion. In other words, every 100 pips improvement in the EURUSD results in a ~$5 billion boost to the USD valuation of EUR-denominated holdings. And if the latest €1 billion investment allowing the country to “buy” $10 billion in FX gains is any indication, China sure knows what it is doing.

    Furthermore, with it allegedly actively selling EURs as a result, it appears that the country is in effect betting against Europe, and is continuing to reduce its 25% EUR allocation, with the USD as a beneficiary.

    This is certainly not Euro-positive, but it means that every time the EURUSD drops below 1.30 China will ramp up the rhetoric of its European support, and do an occasional €1-2 billion direct investment, which allows the country to offload another several billion in EUR at a higher fixing.

    To those who see this as a great bait and switch, you are not alone. Yet this is nothing more or less than perfectly permitted FX-warfare, in a world in which countries like China with a pegged currency will do all everything in its favor to preserve exposure in whatever currency it finds strongest.

    The only question then remaining is at what new low threshold level in EUR-denominated FX reserves will China say enough and pull back the rhetoric… and its wallet?

    • There can be little doubt that China pursues its own interests first and foremost. As I see it , China can only gain from its own perspective by extending a ‘helping hand’ to sovereign euro area borrowers in trouble. First of all, it risks very little, as the ECB and EFSF are for now backstopping all the dodgy debts. Secondly, by helping to shore up confidence in the euro, China hopes that one of its biggest export markets is spared additional upheaval – China would certainly not profit from a more extensive crisis in the euro. Thirdly, China has such big forex reserves it hardly knows anymore what to do with them. Throwing a few billions around to help the euro area periphery is at least a form of diversification. And lastly, by being seen as helpful, China hopes to be able to have an easier time deflecting criticism of its own mercantilist trade and foreign exchange policies in the future.

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