The European Financial Stability Fund (EFSF) is planning its first issue this week. Talk was of a €3-5 billion ($4-6.70B) of a 5-year issue priced 8-10 bp on top of swap rates. This would imply a yield of about 2.85%, compared to a 2.32% German 5-year yield. The EFSF bonds are expected to be priced tomorrow. As was the case of the EFSM bonds sold earlier this month, we expect demand to be strong, as there is a shortage of AAA paper in Europe.
Seeing how strong the demand will be, market talk now suggests €5 billion ($6.70B) will be raised. A number of sovereigns, including China, Japan and Russia, seemed to express interest, but not necessarily in addition to current holdings.
Some observers suggest that the EFSF bond will be the first proxy of the fiscal state of the eurozone, but this seems a bit exaggerated as the EFSF is structured in a way to establish its triple-A status. However, even this is not clear, though Tuesday 's bond will be AAA. There is some talk that maybe to make the EFSF guarantee/loan ratio more efficient, the EFSF can offer bonds of various yields (i.e., risks/ratings).
In fact, this is one way in which the EFSF differs from the EFSM. Exactly what the EFSF is is not clear. What is clear is that of the various new initiatives that European officials are debating, the EFSF is the centerpiece. Even ECB President Jean-Claude Trichet is calling for improved quality and quantity of the EFSF. ECB board member Jurgen Stark has cited the possibility that the EFSF purchases bonds and/or injects funds into commercial banks.
EFSF head Regling said last week that in order to preserve its AAA status, the EFSF could only really lend €250B ($341B) rather than the €440B ($600B) headline figure. The debate among finance ministers is over whether, instead of increasing the size -- which Germany and others are balking at -- it should instead be allowed to lend the €440B that has been guaranteed.
Market developments -- peripheral and sovereign banks' CDS, bond spreads and the euro rally -- point to dramatic position adjusting, and a powerful short squeeze, in the idea that the EFSF will be reformed and allow European officials to get ahead of the curve of market expectations.
Nevertheless, there are many issues that need to be resolved, and we are not convinced that the political context will allow as smooth a resolution as the market seems to be pricing in. For example, if Greece can borrow from the EFSF to buy back its own bonds, will that not force other holders to mark-to-market? What is the seniority of EFSF obligations? Will officials accept the EFSF as the largest creditor of a country that is rated below investment grade?
The market seems to be looking beyond these issues today, Monday, with a consultant report out suggesting that a resolution of the debt crisis in the coming months will free the ECB to hike rates in the third quarter. This is a bit later than the Euribor strip implies, but is still fairly aggressive in our reckoning. Not only does the ECB expected price pressure to peak by early Q2, but recall too that Trichet steps down in early Q4. Is it really likely that the last thing he does in office is hike rates? One would suspect that the new central banker would be "given" the opportunity to brandish his or her anti-inflation credentials. In this case, as we strongly expect BBK President Weber to succeed Trichet; his anti-inflation cred is stellar.
Ultimately, we think that the debt dynamics in the periphery of Europe is such that lower interest rates are not sufficient and that some kind of restructuring to lower to debt burdens will be necessary.
Meanwhile, the euro's two-week rally is extending into the new week. The move above $1.3635-50 Monday is important and will embolden the short-term speculators and suggest scope for another two-cent advance.
Disclosure: No positions