'Euro-Copter' Lifts the S&P Higher; Bonds Aren't on Board

Includes: FXE, IEF, JNK, SPY
by: Abigail Doolittle

Euro-Copter to the Rescue

It seems the S&P 500 and the euro have been pulled from the brink again.

Since June 8, or just one day after the “details” around the European Financial Stability Facility were released, each has rallied nicely. This reminds one of the brief period of relief seen after the original May 10 announcement of the 750 billion euro emergency rescue package. But that reprieve turned out to be short-lived as investors realized that some 440 billion euro were to be funded in some unspecified manner by a yet-to-be-created entity.

Well, the entity is now an official Luxembourg LLC with some vaguely official details on how the 440 billion euro will be raised from the capital markets. It’s expected to be operational this month but with Luxembourg as the sole shareholder until the other 15 euro-using countries, Greece was excluded, “reconfirm their commitment to enter the capital of the EFSF as soon as possible” by completing “the relevant national parliamentary procedures” one would have to think that it is not.

Putting aside that small detail, the not-so-small task of obtaining triple A status for the EFSF looms. Some reports seem to indicate this is unlikely to be a problem, but I’m not so sure. Beyond the fact that it seems unclear as to whether the funding will be raised in advance of a sovereign emergency or simultaneous to such an emergency, it still feels flawed that the very countries guaranteeing the bonds that are to be bought by investors could be rescued by the funding to come from those bonds and investors.

On paper, it has been detailed that once a country needs to draw a loan from the EFSF, it will then be taken from the guarantee pool, but before the vehicle’s even been driven anywhere, we have a case in point on the problem with the idea. After all, Spain is the fourth largest guarantor to the 444 billion euro at 53.9 billion euro, but isn’t Spain the very country to sit in the hot seat this week?

And this begs the question on how exactly a withdrawn guarantor’s contribution would be redistributed among the remaining members. On the 67% combined guarantee of Germany, France and Italy, or the minute likes of Cyprus and Malta?

I certainly don’t have these answers, but I’m not sure anyone does and without real specificity, it seems unlikely that the rating agencies will simply rubberstamp this concept with a triple A rating after the debacle of the sub-prime crisis.

Should this be the case, should it show up that the EFSF sounds nice in theory but doesn’t have the proper choppers to fly, it will be a rude drop for Wall Street.

Bonds Aren't Buying It
The S&P 500 may be up more than 6% in just 8 trading days after closing at 1,050 on June 7, but the credit markets aren’t going along for the ride.
  • The spread between Bloomberg’s 10-year AA composite and 10-year BB composite (high level junk) has widened to 314.5 on June 16 from 302.2 on June 7 and 262.2 on April 12 (a randomly chosen date for comparison before the S&P’s current 2010 high on April 23).
  • The spread between the same BB composite and the 10-year Treasury has widened to 433.8 on June 16 from 421.7 on June 7 and 359.8 on April 12.
  • The 10-year Treasury yield is at 3.21%, which while 4 bps higher than where it closed on June 7, moved down 9 bps yesterday, and compares to 3.85% on April 12.
  • While 3-month LIBOR has not moved up since the end of May, it has held steady at 0.54 or almost double its 0.30 on April 12.
  • The TED spread, or the difference between the 3-month Treasury Bill and 3-month LIBOR, has widened further in June as the yield on the 3-month bill moved down to 0.09 on June 17 from 0.16 on both June 1 and April 12 as LIBOR moved to 0.54 bps from 0.30 bps on April 12.
Considering that the earliest signs of the original credit crisis began with the ever-so-slight widening in spreads as Treasuries began to build into a bubble, the widening that we continue to witness today should not be taken lightly.
The FT recently highlighted the fact that the Bank for International Settlement is comparing 2010 to 2007 rather than Greece and Spain to Bear and Lehman. Specifically, “The BIS sees the sovereign debt crisis as akin to the start of the credit crunch – with losses on exposures to Southern European countries taking the role of the sub-prime mortgage assets as the root cause.”
It would seem that the continued cracks in the credit markets back up the BIS’ contention while the S&P 500’s newfound comfort found in the volatility that first began in earnest in late 2007 would too. Should this be the case, should the problems of 2010 prove to be a forewarning of darker times ahead, we should all seek shelter now.

Disclosure: No positions