Part 2 : Coming Week Market Movers & How To Profit
Market Reaction To EU Summits Of October 23rd and 26th
It’s unclear what will be announced at which summit, though it appears that the big announcements will come on the Wednesday October 26th meeting.
Whether or not markets are pleased will likely depend on whether markets believe the EU plan simultaneously achieves 2 key yet contradictory goals:
- Cut Greek Debt To Realistic Levels: Greece, and by implication other GIIPS, get enough debt forgiveness (up from 21% in the July plan to over 50% rumored, with some believing much more needed) to convince markets that Greece and the other GIIPS now have a chance to recover (despite a global slowdown, increasing spending cuts, and uncompetitive slow/no growth economies) and pay off the remaining debt.
- Convince Markets No One Gets Badly Hurt From Greek And Other GIIPS Bond Defaults: There’s a convincingly large and credible plan to ensure both
- the stability of EU banking after it’s hit with these massive losses, not just from Greek bonds, but also from other GIIPS bonds as the rest of the GIIPS block undoubtedly seek similar treatment.
- Future bond purchasers won’t suffer similar losses, otherwise much of the EU won’t be able to afford to issue bonds in the foreseeable future.
The key word here is simultaneously. One without the other doesn’t work
Haircuts Unavoidable But Kill EU Unless Present & Future EU Bond Holders Protected
The haircuts to the banks holding Greek bonds are unavoidable, Greece can’t pay. The only way to put Greece and the other GIIPS on a credible road to recovery is to cut their debt to manageable levels. Yet when even the more modest 21% hit was announced as part of the July rescue plan, this presumed cure caused the crisis to worsen, most notably spreading to Italy and France. Why the sudden loss of confidence? ALL GIIPS bonds were now suddenly seen as much riskier and those exposed to them were now viewed as much worse credit risks. Whatever concessions Greece got could well apply to other GIIPS bonds. Thus the banks of these nations were now much less creditworthy, many were exposed to losses larger than their equity. So now these nations and their banks, which had retained market confidence, now saw doubts were raised about the creditworthiness and solvency of both their banks and governments. Bond yields rose, bank shares plunged, credit downgrades and threats of more followed. France was now widely expected to lose its AAA status as the EU slid. These developments accelerated the need for a comprehensive solution.
In sum, whatever plan emerges must meet two contradictory goals:
1. Lighten Greece’s Debt Burden: Also, assume the other weak economies to get similar deals. Good luck selling their voters on anything less.
2. Backstop EU Banks And Future Bond Buyers
Insure that those exposed to GIIPS bonds either directly or through the banks taking the losses on these bonds, be they lenders or depositors, are protected from losses. Otherwise the EU is toast. Here’s why:
- The GIIPS Won’t Ever Sell Another Bond: The original 21% haircut made the crisis worse, as bond buyers now factored in additional risk of loss, driving GIIPS yields higher and spreading contagion to France because its banks were heavily exposed to losses. Now losses of 50% or more are believed to be on the table; that risks further scaring off bond potential bond buyers and worsening the crisis. Think about it. Italian and Spanish 10 year bonds are already near the redline 6%. If a buyer of new bonds must consider a risk of a 50% loss, wouldn’t they want a ~12% yield (or more) to compensate for the new and likely worsening risks? How will these nations be able to then sell new bonds? Game over for the EU.
- EU Banking Dies: As noted above, many large EU banks can’t survive the losses imposed from the haircuts, and even those that can may be unable to get funding. Game over for the EU.
How Will They Do It?
The October 23rd and 26th meetings are expected to finalize a rescue package that focuses on 3 issues:
Here’s how to evaluate EU performance on each:
- Prevent Greek Default: Via a new package on Greece including 50% – 60% (or more) haircuts applied to Greek sovereign debt: Smaller ones may fail to convince markets that Greece can pay off its remaining debt and so won’t need yet more bailouts. Deeper cuts will be more convincing and actually bullish for markets, but again, ONLY IF….
- Stabilize Confidence In The EU Banking System Via recapitalization plans for EU banks: The EU forces banks to increase core capital from 5% to 9% in the coming 6 months or accept government money and become nationalized. Estimated cost ~ $100 bln, anything less risks being seen as too little and inviting speculative attacks on banks
- Stabilize Confidence In EU Credit & Retain Access To Bond Markets: In other words, halt the spreading contagion of rising borrowing costs from lack of trust in EU creditworthiness. The current likely plan involves expanding the EFSF bailout fund, but given the time it took expanding it to €400 bln, an increase to €2 trln would seem to present far greater political and financial obstacles. One way to avoid these currently under consideration is to lever the fund by having it guarantee the first 20% of losses. The current EFSF, which only has about 270 bln left, could cover ~20% of the gross funding needs for Belgium, Spain, and Italy. We doubt markets will consider that sufficient. Unless we get a genuine expansion to around the ~€2 trillion level, we question whether the plan will work. However something less may convince markets that the crisis has again been deferred long enough for a tradable rally.
There are complications and disagreements to resolving all 3. For example,
Lawyers warn using the EFSF to guarantee against bond losses violates the EU’s no bailout clause.
Will markets believe that France, Italy, or Spain taking on more debt to support their banks is a real solution? Probably not, but again, markets may well accept another temporary solution if it allows enough time for a tradable rally.
If you start getting too swept up in the optimism, we refer you to the great decision tree from stratfor.com we showed in Part 1.
In short, there’s a decent chance the coming week could bring a relief rally. Everyone wants it. We remain skeptical that this week sees anything close to an end to the crisis.
For more details on the coming EU rescue plan, there pros and cons, see here and here.
More French Downgrade News?
Both Moody’s and S&P have warned about downgrading France’s AAA rating. S&P can’t really avoid it after downgrading the US, which is less exposed to the EU crisis, and can at least print its own currency as needed. Certain French banks are so vulnerable to a Greek default that they continue to refuse to recognize anything more than a 21% loss, even after France’s stock market regulator urged them to do so. German and UK banks have recognized a 50% loss. Once the higher haircuts are official, will coming French bank bailouts bring loss of the AAA rating?
Earnings
Quarterly earnings typically start to lose their influence by the third week because so many big names have already reported and the tone is already set.
Top Calendar Events
Monday
AUD: PPI
CNY HSC flash mfg PMI
EUR: batch of EU, French, German mfg and services PMIs
NZD: CPI
Tuesday
GBP: Current Account
CAD: Rate statement, retail sales
USD: DB consumer confidence
Wednesday
AUD: CPI
USD: Durable goods, new home sales
EUR: EU Economic Summit
NZD: RBNZ rate statement
Thursday
JPY: BOJ rate statement, press conference
USD: Advanced GDP, pending homes sales
Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.
