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Sunrise Market Commentary

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The ECB is concerned about public finances

Fri, Nov 27 2009, 08:13 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Wednesday, European bonds rallied sharply from start to finish, as equities hit the skids. Risk aversion flared up with a vengeance after fears of a default of the big state-owned Dubai World popped up. At first, bonds were still contained, also as there was some reticence to break through the key Bund support at 123.04, despite falling equities. However, ultimately, the Bund broke through the resistance, strangely enough when equities had stabilized. Following a stabilization of both bonds and equities, bonds resumed its up-trend in the afternoon, following a bit later by a resumption of the sell-off in equities. In a daily perspective, bond gains were juicy. The EMU curve shifted downwards with the very long end lagging the rest of the curve. In yield terms, the 2-to 10-year yields fell 10 to 12 basis points, the 30-year yield dropped 5.6 basis points.

Regarding the Dubai affaire, we doubt it is of a systemic order that may shock financial markets in a major way for long. The sums involved ($60B) may look big, but aren’t really particularly large in a global context. On top of that, the very rich Abu Dhabi and other neighbours have sufficient deep pockets to prevent the country to go into bankruptcy. So, the problem may remain contained. Nevertheless, we understand the current uncertainty. The recent financial crisis and the Asian crisis in the nineties have taught us that small problems may become bigger ones as the result of contagion. If Dubai would be a show case of the kind of real estate madness that was multiplied in other emerging Asian markets, it would be greater cause of concern, especially as some countries show signs of a property bubble. However, after having weighted all the elements currently available to us, we think that the risks of contagion are limited. Why are markets reacting so vehemently? Equity markets had a terrific run since March of this year and showed sign of fatigue. It was already for a few weeks our view that the uptrend was running into resistance, first in Japan, than in Europe, but not yet in the US. The Dubai debacle was a showcase example of a trigger to convince investors it was time to book profits. In the run-up to year end, a de-risking of positions seemed even smarter than usual. The absence of US equity investors only exacerbated the reaction on the equity markets. The reaction of the European market is a bit strange as the news item was fully known on Wednesday and apparently didn’t affect US trading. Neither did it initially push Asian bourses much lower yesterday. It is difficult to predict how US markets will react today, as trading desk will be thinly staffed. We suppose that Wall Street might decline sharply, but we are especially looking to the US equity markets early next week. We suspect calm to return gradually, even if we of course keep our view that also US markets will slide into sideways trading pattern, but as indices are near the highs this nevertheless means a decline in the indices is possible.

In the EMU bond universe, it was of course safe haven German bonds that outperformed. The weaker the credit, the bigger the spread widening was yesterday. Greece stands out as the weakest credit that is hit also by a number of home-grown issues (see below). It spread literally blew out by 22 basis points to 201 basis points. There are risks that the Greek bonds could get dragged further down and even an outright crisis is a possibility. The Irish 10-year yield spread rose by 14 bps, while Italy’s by 9 basis points. Other spreads widened less. (Belgium: 5, Spain 4, Netherlands 3 and France 2, to name some).

Today, the eco calendar is again empty in the US. In the euro zone, the European Commission confidence indicators (November) and Spanish and Belgian CPI (November) are on the agenda.

In November, EU confidence is forecasted to show the eighth consecutive improvement. The consensus is looking for an increase from 86.2 to 88.0 due to a widespread improvement. We have no reasons to distance ourselves from the consensus as also the EMU PMI’s and German IFO indices increased further this month. After German Y/Y CPI returned to positive territory in November, according to a report published yesterday, also Spanish Y/Y CPI is forecasted to have increased again following eight months of negative inflation. In Belgium, inflation might remain negative, but less so than in the previous month. While inflation is forecasted to edge further up in the coming months, due to energy-linked price effects, underlying inflation will remain subdued as growth will recover further on a rather slowly pace.

ECB’s Weber said that Central Bank and government support cannot be increased further and is no substitute for a self-sustaining recovery. He acknowledged the economic improvement and the healing in financial markets, but saw no reason for exaggerated optimism. He did not discuss the question of the timing of exit strategies. As the “purdah” period started, he refrained from discussing monetary policy issues. ECB’s Sramko said the EU Commission was somewhat soft in giving some EU members until 2013 to cut fiscal deficits. It could have been stricter he added. The ECB is concerned about public finances, as Trichet has repeatedly said in various press meetings. Sramko is to our knowledge the first ECB member to openly criticise, albeit rather softly, the latest EU recommendation.

Downward pressures on Greek government bonds intensified yesterday. The increased risk aversion as a consequence of the fears of a default by Dubai World explains only part of the huge spread widening (+20 bps) that took place yesterday. A few days ago, we signalled that the Greek central bank governor Provopoulos warned Greek banks that they needed to lessen their dependence from ECB liquidity. He also signalled that the ECB may tighten its collateral rules, by raising the rating quality of eligible collateral. What is it all about? Banks have been strong buyers of government paper (according to ECB statistics) and Greek banks made no exception. It is likely that Greek banks bought mostly Greek debt. It is also proven that Greek banks relied (on a relative basis) more on ECB funding than banks in most other countries. This funding most likely has been used to buy government and so pick up a juicy spread. Greek banks would be potentially more hit when the ECB starts redrawing its liquidity. On top of that the Greek rating of A- (Fitch) and A1 (Moody’s) have a negative outlook, respectively watch negative, making a downgrade to BBB+ a not too wild idea if one looks to the fiscal deficit of about 12% and a debt rate above 100% of GDP. Currently, the ECB accepts BBB- government paper as collateral, a deviation from the pre-crisis standard of a minimum A- rating from one rating agency. The ECB is expected to return to its pre-crisis rule of A-, but probably not in the near future. In that case, there might obviously be a problem for the Greek banks. This all adds to the intrinsic risks of the Greek finances. Indeed, the fiscal problems of the country are already huge and at the same time, the country has lost competitiveness inside Europe and now potentially might face problems in its banking sector. In the run-up to the year end, investors have already the natural behaviour of reducing risks and thus now have an additional reason to shun Greek paper. It is difficult to gauge whether the Greek problems will lead to a full fledged crisis, but we suspect it won’t, as it is difficult to imagine that Europe would remain on the sidelines if the situation escalates.

Regarding bond trading today, the environment is again intrinsically bond positive. Asian equities are sliding further away and some are showing losses of about 5%. We didn’t see anything new on the Dubai affaire, but it seems that it remains the theme markets are trading on. Eco data will be of little importance. Of course, all indications show that bonds are way overextended, but this doesn’t mean anything if risk aversion remains elevated. Of course, as explained above, we doubt whether the Dubai problems might escalate in a new crisis. Therefore, while traders will prefer to go with the flow, one should be attentive for sudden reversals that may be violent too. However, we expect such signals to come from the US markets and with the post- Thanksgiving trading traditionally very thin, such risks on reversals seem small today.

The technical Bund picture improved further with a break above the 123.04 resistance level (contract high) that now confirms the double bottom formation on the charts.

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Published on  Fri, Nov 27 2009, 10:35 GMT