Flying Pigs

 |  Includes: FXE
by: Acting Man

Euro Area Carry Trade - From Disbelief to Consensus?

When we noted about a year ago that the ECB's LTROs were likely to give banks incentive to initiate carry trades in the bonds of euro area peripherals, it was an opinion very few people shared. We wrote at the time:

Is is clear from the above that Spain's banks - and this goes of course for the banks in all the other "PIIGS" nations too, even though the details of their problems differ from case to case - should be more concerned with getting their leverage down and generally getting their house in order rather than embarking on yet another carry trade. And yet, from the point of view of the banks, things may look a bit different. As noted before, the fate of banks and their sovereigns is in any event closely intertwined. A bank that may one day require a government bailout will go under anyway if the government debt crisis worsens further. So it has actually nothing to lose by adding to its holdings of bonds issued by said government. They will both sink or swim together no matter what.

A new story has emerged yesterday that illustrates what actions governments and banks in the euro area are taking behind the scenes to ease the bank funding crisis. It should be clear that one of the unstated objectives of these activities is to free up money for the purpose of banks adding to their sovereign debt holdings.

It later turned out that Spain's banks did both: they deleveraged by reducing their loans to the private sector, but they also jumped on the carry trade opportunity in bonds issued by the government. The same essentially happened in Italy. At the time of the LTROs, most observers disagreed quite vehemently with the idea and we noted in our 2012 outlook (which got a few things right and a few wrong, in almost perfect coin-flip fashion), we were also looking for a bit more upheaval in the first half of the year, which we did indeed get.

It seems that the carry trade idea has now been accepted more widely - see this freely accessible report by Nordea entitled "Some Pigs Can Fly", which is well worth reading for two main reasons. For one thing, it makes an important point about how benchmarks play into the decisions of investors - the pertinent quote is:

One of the reasons behind the recent strong performance of e.g. Italian bonds has been the fact that not having Italian bonds in your portfolio has been expensive, if you still use a broad Euro-zone government bond index as your benchmark. Thus many have felt the need to add these bonds to the portfolio. After all, Italy has the biggest bond market in Europe, so its weight in indices is notable.

Bond fund managers wouldn't want to underperform benchmarks, both for obvious psychological reasons as well as practical ones (such as year-end bonuses). This is probably also one of the reasons why Central and Eastern European (CEE) sovereign bonds and senior bank bonds in the euro area performed extraordinarily well in 2012: a general "hunt for yield" broke out in order to catch up.

Click to enlarge

A chart of Italy's 10-year government bond yield illustrating the situation. When yields began to fall sharply in the second half of the year, not owning these bonds meant underperformance relative to popular benchmark bond indexes - via BigCharts

(click chart to enlarge)

The other reason why it is well worth reading the report is that we think it describes an emerging consensus. As far as we can tell, this consensus is shaping up as follows: there will be more gains in both euro area and most CEE sovereign bond markets, but they won't be as heady as in 2012.

We can certainly state that the monetary backdrop appears to be much looser than it was at this time last year. In the euro area as a whole, true money supply growth has recently accelerated to 6.1% annualized (as of end October 2012, data via Michael Pollaro), which is the highest since mid 2010 - and in 2010 it was heading down, not up. To be sure, monetary inflation in the euro area is very unevenly distributed. There is mild deflation in the peripherals, while inflation is accelerating in the 'core'. However, the total is increasing and has done so with unwavering regularity over the past year. It is also noteworthy that money supply growth in the euro area has shifted mostly to growth in uncovered money substitutes, which means that it is currently due to credit expansion on the part of commercial banks. The ECB merely provided the tinder.

However, keep in mind that this also means that the future pace of monetary inflation is highly dependent on the recent improvement in confidence holding up. Failing that, more intervention by the ECB will be required. Our guess on that front is that the consensus may well turn out to be wrong again in 2013. The main reason for that expectation is that the governments of the countries that were in the market's crosshairs at most recent crisis peaks (late November 2011 and early July 2012) will continue to miss their deficit and debt targets. At some point the markets are likely to rediscover their suspicions - the benign neglect of recent months is not an immutable condition. One must also keep in mind that yield-chasing as a rule always goes wrong, as by its very nature risk continually increases as long as the hunt is on and yields on ever riskier paper continue to decline. The only thing that is uncertain is the precise timing of the next capsizing of the ship.