“What to Watch” in the Coming Months

We have seen some improvement in sentiment as we enter the year, on the back of better than expected forward-looking indicators in the US, Asia and even in Europe.

Despite the improvement the market is likely to continue to be event driven. This is, in particular, the case for the longer maturities in the government bond markets, but also global stock markets are sensitive to development in the European debt crisis.

We have an array of critical events in the coming months: 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.

Key events

Markets continue to be event driven. Below we go through the key events that are likely to influence market sentiment in the coming months. (This research note is  an updated version of the “What to watch” first published on 21 December).

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  the  EBA)  would imply that these banks need recapitalisation amounting to EUR30bn, which  would have to come from the EFSF/IMF. In recent days there have been reports in the Greek press that the haircut could be even higher and that it might be a forced (not voluntary) haircut. Both Greece and the IIF have said that an agreement must be reached by the end of the month.  The next big redemption (EUR14.4bn) is due to take place at the end of March. The Troika is also set to return to Athens on 16 January to begin negotiations on the next aid programmeand to review the economic policy.

Auctions in Italy and Spain

The next government bond auction in Spain is set to take place on 12 January and in Italy on  13 January, see Government bonds weekly. The bond issuance in Italy and Spain is due to be stepped up in 2012. The total issuance in these two countries amounts to about EUR450bn in 2012 and in Q1 alone it is set to be just below EUR150bn. Since week five of “SMP2” (in which Italy and Spain were included) and until the introduction of three-year LTROs was announced the SMP purchases havebroadly equalled the total issuance of Italy and Spain.

If market sentiment starts to deteriorate and this pattern is set to continue the ECB would have to step up its purchases considerably in Q1. However, since the three-year LTROs  were introduced, peripherals yields in shorter maturities  have  decreased substantially, which may reduce the need for ECB government bond purchases.

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 negative, but it is  more or less  priced into 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, 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.  

Bank recapitalisation in Europe

The Europeans banks capital shortfall, estimated by the EBA, is set to EUR115bn –see EBA statement of 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 would 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 could the EFSF be used.

EU Summit details

The next EU Summit is scheduled for 30 January, but the Eurogroup and ECOFIN meeting on 23-24 January are also likely to  attract attention. There are a number of details following the last  EU  summit that need to be spelled out and since implemented. The next meeting between Merkel and Sarkozy is scheduled to be on 9 January. On  11 January Merkel  is set to  host a meeting with  Mario  Monti.  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  would be required from the European Court of Justice to approve national “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.

EFSF role in secondary markets

The EU leaders have tried to increase the firepower of the EFSF via two models. The first model introduces sovereign bond “partial risk protection” and the second option is a “co-investment approach”. The protection would be between 20% and 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 would be split between the two models, but the combined firepower would be below EUR1,000bn, as was suggested in October. Since the announcement in November there has been very little news on when the EFSF  is likely to 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  would contribute  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 likely Francois Hollande, although 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  the  EU crisis fighting tools. Hollande said on 12 December: “If I am elected president, I will renegotiate the (fiscal compact) agreement to include 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  issues. The presidential elections are followed by general elections on June 10 and 17, 2012.