You Can’t Spell Tooth Faeries Without EFSF

Chart GTITL5YR

Just focusing on 5 year yields, shows how much work is yet to be done. Since the end of September, stocks have staged a great rally, yet, from a credit standpoint, the problem has gotten worse. EFSF, Italian and Spanish yields are significantly higher. The ECB has been buying and that has failed to staunch the bleeding. The ECB cut rates, and that too failed to solve the problem. The Italian 5 year bond started the week at 5.73%. It was trading at 6.13% right before the ECB rate cut, it dropped to as good as 5.82% (picking up the rate cut and more), but failed to hold that level (in spite of alleged ECB buying) and finished the week at 6.19% (just below the highs of 6.26%). This is a clear signal that Italian 5 year bonds are not rate instruments, but credit instruments. The ECB can continue to employ policy tools that help countries that trade as rates – Germany, France, Holland, etc., but it is not affecting Spain and Italy, because the credit risk is real, and 25 bps (or even 100 bps) on the short end ECB financing rate, is not enough to offset the fear of default and the losses from that.

We saw it in Greece, we saw it in Ireland and Portugal, and now we are seeing it in Spitaly. Outright yields are going higher, and are not responding to traditional interest rate policy tools. The curves are flattening. The Italian 2 year hit a yield of 5.4%. That is extremely high for 2 years, and is actually relatively flat to the 5 years considering the overall rate levels. It is also higher than it was Thursday prior to the rate cut. If the 2 year bond of a country is not a transmission mechanism for central bank rate cuts, than what is?

The rate cuts should at least affect the good countries, and that should translate into a savings for EFSF. In principle that would work, except German 2 year yields are already only 0.4%. Clearly they are not trading at 0.4% because of some carry trade with ECB rates at 1.25%. That is the problem, the good countries already trade inside of the ECB overnight rates, so the benefit is marginal, and the bad countries are no longer responding to interest rate policies because they are credit products. EFSF gets no real benefit, and as the complexity and self-referencing financing nature of the whole program gains attention and the potential political problems when it comes time to pay become more apparent, the premium of EFSF to France will increase.

Lost in the shuffle this week is the fact that there still is no IIF plan. No definition of what an NPV haircut is, or how much EFSF support is going to the banks as part of this “haircut” and which prong of EFSF money this will come from. Merkozy can complain about Papandreou backing out of “the plan” but honestly, don’t you think he should have been given a plan? A vague promise by bankers of a 50% NPV haircut so that Greece can achieve 120% debt to GDP in 9 years, doesn’t sound that great. I don’t believe Greece was on board with any plan, and probably haven’t even seen what it will look like. Once the IIF comes up with their plan, I suspect some people will be disappointed – Greeks and the taxpayers of countries that see more money going to banks, rank right up there as candidates to be disappointed.

What I have finally seen, is some actual discussion of what default would mean. For all the talk about “Greek Default” very little serious work has been done on it. The instant reaction is “horrible for Greece”, “stone ages”, “togas and sandals”, “hyperinflation”, etc., yet as some analysis starts to come out, more and more is showing that Greece could have a much better debt burden while retaining core state assets if they head down the path of default or repudiation. After the initial nasty comments that came out of European leaders forced Greece back on the “path”, more reasoned voices are coming out – slowly, but at least starting to come out. If Greece defaults, would they even have to give up the Euro? Important leaders have said they would, yet there is no mechanism to force them, and would be a great way for Greece to wipe out its debt and not experience hyperinflation. If Greece left the Euro, could it remain in the EU? There are 17 countries that use the Euro, but 27 in the EU, so it would seem possible that they could leave the Euro but remain in the EU. That too is only starting to be discussed. The initial headlines were all about – don’t pay and get kicked out and starve, but the reality is likely much different and probably much better for Greece.

The EU leaders may be able to stop this line of thinking, but as people get over the initial “shock and awe” of the word “default” they are realizing it is not the end of the world for Greece and may in fact be the fresh beginning they need – Argentina and Russia might be better examples than Zimbabwe.

I am not sure what exactly has happened to the Greek government. So far, it is being interpreted as positive because they will go along with the plan. I guess that is the case, but I find it hard to believe that the people will be pleased that the referendum was taken away. I think as they also start seeing proper and reasoned arguments against accepting the terms being forced on them, the level of dissent will grow. There were no tanks rolling into town squares to send the people back to their homes in fear, but enough has potentially been done to turn the tide of the people against the politicians. I don’t think we have seen the end of dissent in Greece, and if anything, I would expect it to become more vocal, and supported by more facts about what Greece could do, rather than just fear mongering of default and fewer summit invitations.

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