Troubles in Europe: Risk Reward Opportunity in German Bonds?

Includes: ERO, EWG, FXE, SPY
by: Macro Man

While the market's attention has been focused squarely on QE2 and currency wars, quietly bubbling underneath the surface has been the significant tightening of eurozone financial conditions, with the EUR TWI up about 7% in the past month and money market rates up about 40bps (in EONIA) over the same period.

Team Macro Man's arch-nemesis Darth Weber has struck many a blow to those who have been either short EUR or long the front-ends, with his persistent protestations (subsequently slapped down by Baron von Trichet) that the toxic waste dumped by Club Med on the ECB's balance sheet should promptly be sent to Sellafield.

At the same time, numerous ECB members have warned that banks should not rely or become addicted to the ECB's liquidity programmes in the form of the unlimited allotments. And so the banks listened, and last month's 3m LTRO had no take up. The Eurostriches then claimed:

Hurrah! The European banking system is OK! The crisis is over!

But it looks to Team Macro Man to have been something of a screw up, given the subsequent squeeze in EONIA, not to mention the 5%-odd contraction in the ECB's balance sheet over that same period...

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Now Team Macro Man totally gets the German strength story, but finds it difficult to believe that this will continue as the US is slowing, and it certainly can not continue while the rest of the eurozone is undergoing a large fiscal adjustment. The feedback mechanisms with the banking system are material, and at a time where peripheral bonds still don't look too healthy, a tightening of financial conditions is just going to end in tears in TMM's view.

A more realistic reason for these moves, the Team believes, is that the banks behaved liked good little bunnies and didn't bid for cash, then subsequently discovered that there was actually a lot less cash available than they expected, and that they'd have to pay up for it.

In addition, the September LTRO matured on Christmas Eve, which is not a particularly great time for liquidity to roll off when the bank's Treasury departments would rather be doing the last minute shopping for the kids. Whatever the reason, it's clear that the liquidity situation has become somewhat dire (see chart below, average current account holdings in the current maintenance period - orange line) and EONIA (white line) has spiked higher, causing something of a sell-off in the front-end.

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Team Macro Man has learned over the years that trying to pick up positions in the front end of Europe usually ends up with Darth Weber removing our fingers with his light saber, and to this point we have had our hands securely tied behind our backs.

But with the October LTRO next week, there are grounds to expect a large take-up: EONIA is high, Euribor is above 1%, and the period of the operation covers the year-turn, a time when funding is often difficult, so Treasury managers prefer to cover their turn-funding in advance.

If, as TMM expects, take up is high, then EONIA should begin to fall off and the downside pressure on the European front-end should reduce. Dec10 Euribor (chart below - brown line) is pricing 3m rates at 1.15%, now even if EONIA hits 1%, that puts 3m Euribor at about 1.3%, so the downside is pretty small there. But the juice in Schatz looks to be bigger, sitting at 1% and at the bottom of the trend channel.

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A cheeky long in the normally shit Schatz with a tight stop looks like good risk reward to us.

Disclosure: No positions