Recap 10-27-11

Main Items:

  • The EFSF will be levered 4-5x and have EUR 1 trillion in capacity, with 1st loss guarantees between 20-25%. Banks have agreed to accept a 50% write down on Greek debt, which will reduce the debt burden by 100bn. Europe says this will be enough to help Greece reach a debt/GDP level of 120% by ’20. The new Greek bailout package should be agreed to by the end of ’11 (it looks like the value of the Greek bailout package in aggregate is being boosted from EU109B to EU130B). The new PSIs (expected to occur in Jan) will be voluntary, thus avoiding triggering CDS. The EBA said EU banks will need to raise 106bn in capital, which will include contingent convertible bonds. They have until 6/30/12 to hit core T1 capital ratios of 9%.
  • US GDP rose 2.5% QoQ in 3Q as exp vs 1.3% prev. Personal consumption improved 2.4% vs 1.9% exp. The economy entered the expansion phase of the business cycle, as the level of GDP has eclipsed the peak in the prior cycle in Q4, 2007.
  • Initial Jobless claims were basically unchanged at 403k last week vs 401k exp and 403k prev


  • German CPI declined to 2.8% YoY in Oct as exp vs 2.9% prev


Near term catastrophe will be avoided, and the pain trade of higher risk assets is in full effect. Instead of taking the pain now, EU will delever in a ‘paradox of thrift’ environment over the next year and most likely longer. This will drive down employment and core CPI in the EU and allow the ECB to maintain easy policy for a long time, absent a spike in commodity prices. Headline HICP is expected to peak by year end, which has historically coincided with the start of ECB cuts.

Talk that the sovereign CDS market has broken (since the 50% Greece haircut will not trigger CDS) got a lot of attention today, but the broad fallout should be limited. First, according to the DTCC, the gross notional value on major EU sovereigns is only estimated to be ~1trn. The total notional size for Greece is just 75bn, with net exposure of 3.7bn. To some extent, it will drive some more deleveraging, but the larger effect may be felt on Italian bonds because the active BTP futures market makes it easier to short.

In the US, there is now a broad expectation of some economic weakness, but no recession. Absent a credit event in Europe, this looks reasonable. The Fed is clearly concerned about the stickiness of unemployment here, and is waiting for core inflation to fall before acting further. Several options are now on the table, including purchasing MBS, more treasuries, or nominal GDP targeting. As the hurdle for further Fed action is also lower inflation, trends in the components of core PCE deflator should be closely watched. It is currently forecast to peak in Q1 2012.

As a result, market opportunities appear to be forming in rates markets across both sides of the Atlantic.
1) Euribor futures are pricing in just over one 25bp cut over the next year. Also, if the funding guarantees discussed in the EU press release actually gets some traction, we could see substantial compression in the 3m Euribor-EONIA spread, which currently 70bps vs a 2009 average of 25bps.
2) Additional QE in the US is obviously good for treasuries, but there is likely more room for repricing there, given expectations for when inflation peaks as well as the FTQ premium. Either MBS purchases or Nominal GDP targeting is likely to have the largest impact on the 10+ year sector, IMO.
3) Both of the central bank scenarios described above is of course positive for Gold.

The intermediate term prospects for the S&P look positive. I missed the recent run up, partially because I missed seeing the forest amongst the trees. In the short term, month end and the fact that the S&P has crossed above the 200 day moving average will likely bring in new buyers. Seasonal effects are also positive. Historically, the S&P has continued to gain following monthly rallies of more than 10%, with a great deal of volatility:


6 thoughts on “Recap 10-27-11

  1. In FX land , the euro over 1,40 yday and seems to follow its trend up (1,418 here), started in begin oct at 1,32.

    Is it fair comment to say this is primarily due to ECB rate (1.50) diff over Fed rate (0.0-0.25) ?

  2. Agreed. Better question is how soon does the euro become a short? I mean all indications are that they have a brief recession on the horizon and are still in a very delicate fiscal situation.

    Much longer term, the problems that led to the sovereign debt crisis have not been introduced and still pose an existential threat to the EMU.

    1. Very true… but in the short term, it could squeeze higher. I think a lot of people have to chase this move in risk assets higher, and that will be positive for the EUR, esp since people seem to be most underweight EU assets.

      Remember, the USD goes down forever story a few months ago… I think that comes back

      1. I suppose there is the ongoing European bank deleveraging of USD assets and repatriating those flows, as well as reserve manager diversification out of the USD which will also support the euro.

        How the USD could go down forever when the aggregate European balance sheet is probably in worse shape than that of the US is somewhat beyond me, but hey I am not here to reason with the market, just to profit from an understand of the psychology of its participants…

        1. The thing is, aggregate public balance sheet in the EU is better than the US (~85% of GDP) – it’s just that their fiscal and monetary systems aren’t able to work in harmony. Remember than deflation is good for a currency – look at the Yen.

          The USD bear story is predicated on the horrible current account balance, which does not look like improving soon until there is some kind of energy independence…

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