What to Watch in the Coming Months...

The markets continue to be event driven. This is in particular the case for government bond markets, but also global  stock markets seem to be  more  sensitive to the development in the European  debt crisis than signals from forward looking  growth indicators.

Focus continues to centre on the development in the euro area debt crisis. There are an array of critical events in the coming months, such as ECBs 36 months LTRO, PSI negotiations in Greece, European bank recapitalisation, details/implementation in the wake of the EU Summit and large government bond auctions in Italy and Spain.

In the short term the primary tools to fight the crisis will be the ECB and the EFSF possibly combined with further help from the IMF. In the long run can Eurobonds or redemption bonds be part of the solution.

Key events

The markets continue to be event driven. Below we go through the key events  that are likely to influence market sentiment in the coming months.

Result of 36-month LTRO

The first of the two 36-month longer-term refinancing operations (LTROs), with the option of early repayment after one year, will receive allotment today. Note, that there will also be allotment on a three month tender. These tenders are full-allotment at the average refi rate over the period. Note that banks that took from October  one-year ECB tender are offered the right to shift into the three-year tender. Furthermore the right to end the three-year tender after one year is valid at any time after one year and for partial redemption as well. So basically the tender is flexible maturity from  one year to three year, see ECB statement.

The allotment at today‟s  three-year LTRO is expected to be high due to the attractiveness of securing  three-year liquidity at a low cost and due to the expiry
profile of  the  ECB‟s open market operations. Yesterday‟s  one-day fine-tuning operation (FTO), which was aimed at bridging the weekly main refinancing operation
(MRO) with the three-year LTRO saw big demand (EUR142bn) indicating that many banks sought to switch funding to the three-year LTRO. Furthermore, it is reasonable to assume that a decent part of the three-month LTRO (EUR141bn), which expires today is rolled into the three-year LTRO. Finally, it seems obvious that banks would prefer to switch from the one-year LTRO (EUR57bn allotted on 27 October) to the three-year LTRO, due to the early repayment option of the  three-year tender. For these reasons we would estimate a lower bound for today‟s allotment to be around EUR250-300bn. Given the very large demand for Spanish T-bills at yesterday‟s auction and given the strong performance of sub  three-year  PIIGS bonds in recent days we would judge the demand could  easily  be significantly larger and possibly even above EUR400bn.

These very long LTROs could potentially improve the liquidity situation for the
banking sector and thus alleviate refinancing risks and thereby the speed of balance sheet deleveraging. However, for the banks that are challenged on their capital position, this will not help them in this respect. The introduction of LTROs could also have an impact on yields in sovereign debt markets in particular  at the short-end as the proceeds from refi operations can be invested in for instance Italian and Spanish bonds yielding a high carry. However to what degree this effect will materialise is very uncertain. So far we have seen some decoupling between two-year and 10-year yields. Draghi induced euro area banks to use this facility by saying: “we want to make it absolutely clear that in the present conditions where systemic risk is seriously hampering the functioning of the economy, we see no stigma attached to the use of central banking credit provisions: our facilities are there to be used”. This is a sharp change in the tone from the ECB that previously has used the term „addicted bank‟,which actually stigmatised these facilities. This change in the tone implies that a large allotment will actually be seen as being positive for market sentiment.

Negotiations on Greek PSI deal

At the European Council meeting on 26 October it was announced that the haircut in the private sector involvement (PSI) would likely be 50%. The negotiations between representatives from the Greek government and the private sector are ongoing. The main disputes are: i) What should the new interest rates be; ii) Should the new bonds be issued under Greek or UK law; and iii) Whether there also should be a haircut on some of the official money  – for instance the ECB‟s holdings. Recall that the debt exchange is optional. The Greek commercial banks will have to endure  big losses which (according to EBA) implies that these banks will need a recapitalisation amounting to EUR30bn, which would likely be financed through the EFSF.

Bank recapitalisation in Europe

The capital shortfall estimated by the EBA is set to EUR115bn, see EBA statement from 8 December. Recall that “banks will be required to establish an exceptional and temporary buffer such that the Core Tier 1 capital ratio reaches a level of 9% by the end of June 2012. The amount of any capital shortfall identified is based on September 2011 figures and the amount of the sovereign capital buffer will not be revised.  Sales of sovereign bonds will not alleviate the buffer requirement to be achieved by June 2012”. The shortfall is biggest in Greece (EUR30bn) followed by Spain (EUR26bn), Italy (EUR15bn) and Germany (EUR13bn).

A detailed plan on what banks intend to do to reach targets will have to be submitted by  20 January. This has been postponed from the previous deadline which was 25 December. In order to reach the targets banks should first aim at using private sources of funding, including retained earnings, reduced bonuses and new issuances of equity. For banks where this is not an option they should rely on official support from their national governments and only as a last option can the EFSF be used.

Rating move on EU17 and EFSF

S&P placed 15 euro area countries on negative watch prior to the December summit including the six AAA countries.  A downgrade of France and the EFSF would be clearly negative, but it is likely partly priced in the market. A downgrade of Germany would be much more negative as this would be a big surprise. While the market still waits for the final verdict from S&P, both Moodys and Fitch have been very active. Moodys downgraded Belgium two notches to Aa3  on  Friday, while Fitch  cut its outlook on France and placed Spain, Italy and Belgium on “Rating Watch Negative”. The Fitch review is set to be finished by the end of January. 

EU-Summit details

There are a number of details following the last summit that first needed to be spelled out and since implemented. Van Rompuy has announced that the legal details in the agreement from the summit should be finalised by the end of January. So far it is not clear what role the EU institutions should play and what will be required from the European Court of Justice to approve national the “golden rules” (structural deficit should not exceed  0.5%), see  Statement from the euro area  leaders. Finally the implementation risk remains very high and  historically these processes have had a tendency to be longer than planned.

Auctions in Italy and Spain

The bond issuance in Italy and Spain is due to be stepped up in 2012. The total
issuance  in these two countries amounts to around EUR450bn in 2012, and in Q1 alone it is set to be just below EUR150bn. Since week five of “SMP2” (where Italy and Spain was included) has the SMP purchases  on average  been around the total issuance of Italy and Spain. If this pattern is set to continue the ECB will have to step of its purchases considerably in Q1.

EFSF role in secondary markets

The firepower of the EFSF has been boosted via two models. The first model is
introducing sovereign bond  “partial risk protection” and the second option is a “coinvestment approach”. The protection will be between 20-30% and this option was set to be implemented in December. The second option  was set to be implemented in January. It was not clear from the EFSF statement of 30 October how the EFSF funds will be split between the two models, but the combined firepower will be below EUR1000bn, as was suggested in October.  Since the announcement in  November there has been very little news on when the EFSF will initiate both the partial risk protection model and its operations in the secondary market.

IMF role in debt crisis should be clarified

At the December summit it was  announced that Europe will contribute with  up to EUR200bn additional funding to the IMF via bilateral loans from the member states central banks, see statement. EUR50bn should come from non euro members.  The contribution from the euro area has already been approved, see statement. However, it is not clear what these funds should be used for. At the December ECB meeting Mario Draghi said  “More generally… the mechanism by which money is being channelled to the European countries should not obscure the fact that we have a Treaty which says there should be no monetary financing of governments. The issue of whether the IMF could be used as a channel is legally very complex. But the need to respect the spirit of the Treaty should always be present in our minds”.

General election in France

France will hold presidential elections on April 22 and May 6 2012. The main
candidates are incumbent President Nicolas Sarkozy and most likely Francois
Hollande though candidates can be declared until mid-March. Domenique De villepin has also announced his likely candidature, but he is an outsider. If Hollande wins we could see renewed uncertainty about EU crisis fighting tools. Hollande said on 12 December: “If I am elected president, I will renegotiate the (fiscal compact) agreement to put what it lacks  today”, mentioning that he would push to include intervention from the European Central Bank, the creation of eurobonds and a financial relief fund. Germany is unwilling to accept these steps so a push for this could prove unsuccessful. More alarmingly, Hollande also said that he would not vote for the balanced budget rule, which is to be implemented in national legislation. This could cause a serious setback for the political process in Europe  and after years with Merkozy‟s intensifying leadership it could become rather uncomfortable for the financial markets to watch a Hollande publicly showing that he is very much in disagreement with German Chancellor Angela Merkel on several accounts. The presidential elections are followed by general elections on June 10 and 17 2012.

ECB, EFSF and IMF are short-term fire-fighting tools

Although it was not the original intention, we expect the ECB‟s SMP programme and the EFSF will work side by side as long as the market turmoil remains at the current elevated levels. This would likely be combined with additional help from the IMF. In the long run can Eurobonds or redemption bonds be part of the solution.