Stock markets around the world rallied in the closing days of June — as did the euro, along with French and Italian bonds — after the European Council said it would let the fledgling European Stability Mechanism (ESM) make payments directly to troubled banks. A similar market move unfolded 10 days earlier when Greece voted to keep the euro. Yet another move took place 10 days before that when Spain agreed to the terms of a $125 billion bailout — the same bailout that drove up Spanish interest rates and forced the ESM decision.
In each case, however, traders made money by selling into rallies — because each of the solutions that sparked each of the rallies turned out, upon inspection, to be built on the kind of wishful thinking that worked well in the high-water years of the Internet boom and the housing bubble. That has proven woefully inadequate now that the tide has gone out.
This latest flurry of disappointing stopgap measures began late last year when the EU decided to bid an early adieu to the European Financial Stability Facility (EFSF). The EFSF was the largest of the emergency lending facilities that the European Union set up two years ago to provide a safety net for faltering EU economies — a safety net that relies on two of the weakest economies for 30% of its support (see “European financial regulation update,” September 2011) — and saw its own credit rating cut in January. The EFSF and the European Financial Stabilization Mechanism (EFSM) already were slated to be folded into the ESM next year, but EU leaders moved that date up to July.
This time, however, the market is demanding follow-through and yet, 10 days after the late June announcement — in other words, 10 days into the month in which it was to debut — the ESM remained in limbo and the euro was making fresh lows against the dollar.
“They’ve been kicking the can since 2008, and markets don’t believe them anymore,” says Holger Schindler, a Hamburg-based risk manager who, two years ago, was among the handful of analysts that took the possibility of a Greek exit from the Eurozone seriously (see “World rattles on wobbly euro/dollar axis,” March 2010).
Back then, he says, a Greek exit might have been a good thing, but no longer. “It’s less likely now, even though more people are talking about it, and it would be a disaster if it happened,” he says. “The time for a clean break was 2010 — and that time has passed.”
The problem, he says, is that European leaders have spent the last two years treating insolvency as if it were just a liquidity problem — implementing quick-fixes when a major overhaul was necessary, in the hope that things would get better on their own. It’s a habit, he says, that developed slowly over the past half-century with good intentions, but over the last few years it let Greece’s problems spread across the Eurozone in the form of bad loans and unpaid obligations.
“They should have recognized Greece as a symptom of something much larger, instead of treating it as an isolated illness,” he says.
Seeds of destruction
“The European Union grew out of the European Economic Union, which grew out of the European Coal and Steel Community, which grew out of World War II,” Schindler says. “It was all about peace, and that led to a sort of idealism that promoted expansion at all costs. A lot of stuff got swept under the carpet, and now it’s coming out.”
As it comes out, it erodes the trust that people have in European institutions — leading to a series of failed fixes that provide both opportunity and peril to anyone looking to trade the euro against the dollar or the peripheries (British pound, Scandinavian currencies or Eastern European currencies) or take a swing at Eurex’s futures on French and Italian bonds.
“We already have seen a torrent of figures, proposals, and decisions — all of which are questionable,” Schindler says. “More and more, the market is treating hard news as soft news and assuming that every bit of good news just covers a bit of bad news.”
Bill Black agrees. He’s an associate professor of economics and law at the University of Missouri-Kansas City and the former Executive Director of the Institute for Fraud Prevention, among other things.
“Take a look at the numbers being bandied about when people talk of what a Greek exit from the EU would cost,” he says. “These numbers are massively larger than what Greece actually would cost, because they’re really telling you that Greece will set a precedent, that other economies would follow and that those economies would take banks with them.”
That deduction, he says, flows from the general assumption that banks across the European Union have massive unrecognized losses that would be forced into the open if a country like Spain left the EU.
“This means they actually knew that the Spanish banks were massively under-reserved, which is a great open secret,” he says. “This despite the fact that the Spanish Securities Market Commission (Comisión Nacional del Mercado de Valores, or CNMV) is the one European financial regulator that always gets good press.”
When best isn’t good enough
As the financial crisis unfolded, he points out, the CNMV was held out as a shining example of counter-cyclical regulation.
“It required extra reserves during the boom time, which is a good thing,” he says. “Unfortunately, the reserves it required were miniscule relative to the size of the losses, so — yes, they were directionally correct — but it’s kinda like you know you have to go up the hill to escape the tsunami, and you go up six feet but the tsunami is 60 feet.”
It gets worse, because as losses began to materialize, the CNMV used its reputation to cover losses. “It became the worst of the regulators in terms of requiring recognition of losses, and that has continued all the way up until the last week of June, when they had this silly exercise of bringing in the foreign experts to do their supposed scrub,” Black says. “The trouble is, they actually don’t look at the bad assets.”
The Spanish stress tests were carried out in cooperation with the European Banking Authority (EBA), a London-based regulator created in January of last year to monitor the financial soundness of banks. Both the EBA and the CNMV lost credibility when Spanish banks got rubber-stamped despite obvious evidence that they were in trouble.
“Spain went through almost as big a residential real-estate bubble as Ireland did, which was twice as bad as in the United States in terms of percentage of GDP,” Black says. “Yet they said everything was fine here.”
Worst of all are the country’s caja de ahorros, the savings banks that made the bulk of the housing loans. In 2010, seven of them were scooped into a conglomerate called Bankia, which was nationalized in May to prevent a collapse.
“People ask why the market goes bonkers immediately after good news, and the answer is clear,” Black says. “It’s because nobody believes them anymore.”
The trickle-down debacle
Those hardest-hit are the ones unprotected by Eurozone membership — the Central and Eastern European (CEE) countries, whose banks are nonetheless dependent on the Eurozone.
“Of Poland, Hungary and the Czech Republic, Hungary is the most dependent and the Czech Republic the least with Poland in the middle,” says economist Daniel Hewitt of Barclays Capital. “The Czechs have a low loans-to-deposit ratio, so their personal financing structure is very self-dependent even though their banks are foreign-owned.”
Hungary’s situation is complicated by the fact that its high interest rates drove people to borrow money abroad — mostly Switzerland and the Eurozone, both of which have seen their currencies soar relative to the koruna.
“Hungarians began shifting to FX loans in 2004, when the government stopped subsidizing [Hungarian] forint loans,” says Hewitt. “Everyone started borrowing in FX, from individuals with mortgages to major corporates. Today, two-thirds of Hungarian bank loans are in foreign currencies.”
Roughly half of those loans are to corporations, but many of those companies are export-related — meaning they’re naturally hedged. A growing proportion of corporate debt is related to project loans, 21.5% of which are non-performing.
The Polish economy is among the fastest-growing in Europe, and the Czech economy is shrinking, but risk — not interest rates — is driving exchange rates between the two countries.
“Monetary policy in Poland and [the] Czech Republic started to diverge significantly,” says Thu Lan Nguyen, a currency analyst at Commerzbank. “While the Polish central bank hiked key rates in April to counter inflationary pressures, the Czech central bank has eased monetary policy to support the domestic economy.”
That, she says, sparked a surge into long zloty/short koruna positions — positions she says haven’t been rewarded when markets are in risk-off mode.
“When risk aversion started to rise following the first Greek elections at the beginning of May, the koruna actually was able to outperform its CEE peers,” she says. “It thus seems that the currency instead partly has regained its status as a safe haven within the region.”
Indeed, if you’re looking for an indicator, skip interest rate differentials and focus on bad loans. “Since 2010, changes in interest rate differentials have had hardly any explanatory power for the changes of the zloty/koruna exchange rate,” she says. “But changes in the difference in credit default swap spreads were able to explain exchange rate movements rather well” (see “Fiscal trumps interest,” above).
Traders have tended to overlook the Scandinavian currencies, even though they offer more stability. “In principle, the Swedish krona benefits from positive fundamental arguments compared to the euro: Positive growth, a roughly balanced budget and low public debt,” says Antje Praefcke, FX strategist at Commerzbank. “On the other hand, the economy of Sweden suffers from the recession in the Eurozone and the recent intensification of the debt crisis.”
Sweden, she says, is likely to record a small budget surplus in 2011 and 2012, and the government has little reason to add any new debt. She sees debt levels dropping from near 37% of GDP to around 33% by 2013 — giving the currency added safe-haven status.
“The only problem is that in times of high global risk aversion, the SEK always comes under selling pressure, [because] Sweden only has a small and relatively illiquid capital market compared with the major currencies,” she says. “Moreover, the Swedish economy can’t decouple from the recession in the Eurozone, which means that the upside potential of the krona is limited.”
Swedish Finance Minister Anders Borg recently announced plans to implement a stimulative package in autumn. However, thanks to the solid national finances, the Swedish government can relax because there will be only a small budget deficit in 2013 but an expected additional 0.5% growth.
However, the close relationship with the Eurozone economy, Praefcke says, will lead to sideways movement that can be traded using momentum indicators.
The Norwegian economy is in a similar situation — its 1.4% first-quarter rise in GDP nearly tripled Germany’s 0.5%, and not just because of oil. “A strong plus in exports came as a surprise,” Praefcke says. “Norway’s mainland economy — without shipping, oil and gas activities — expanded by 1.1%.”
She sees that strength continuing, but warns that high household debt leaves the country vulnerable to rate hikes, and believes any slowdown in the still-booming housing market might be an early warning of something amiss.
Back to the Eurozone
As we go to press, details of how the ESM will work or when it will come into being are still sketchy. Though initially promised for July, it must be ratified by enough countries to guarantee at least 90% of its €500 billion capacity and won’t become operational until the ECB sets up an independent authority to oversee its loans. That might not happen until the end of the year.
As for the late June decision, all that’s really known is that it will make it possible for the European Central Bank to make loans to member states and banks in those states without first imposing German-style austerity measures — but it also will be supervised by an independent authority that is being billed as a precursor to a banking union.
“They agreed to allow direct recapitalization of European banks instead of forcing them to hand the money to governments,” says Cagdas Aksu, a fixed-income strategist with Barclays Capital. “This [broke] the banks of the negative feedback loop, and led to a massive rally in Italian bond futures.”
He believes the impact of German recalcitrance has been exaggerated. “Germany did not agree to Eurobonds, the debt redemption fund, Euro T-bills or any of these kinds of proposals,” he concedes. “But on paper, they have achieved bank solvency, which is very important and could get us through the summer.”
French and Italian bonds
Within the Eurozone, Eurex’s two newest bond products offer an opportunity to capitalize on interest rate differentials among Germany, France and Italy. Volume in futures on the Buono del Tesoro Poliennale (BTP) Italian Treasury bond futures contract (see “New bonds on the block: Prometheus revisited,” October 2011) has more than tripled this year from roughly 6,000 per day to 20,000 per day.
Also, in April Eurex added futures on the notional long-term bonds issued by the French Republic (Obligations Assimilables du Trésor — OAT), and volumes have been impressive from the start (See “OAT and BTP: New bonds in old Europe,” below).
“In BTP futures, which we launched in September 2009, nowadays 142 members are active” says Joachim Heinz, who led development of the new OAT contract for Eurex. “In OAT futures, we were seeing average volume of 20,000 contracts per day already in the second month of trading, and open interest peaked at 72,000 contracts — that’s close to 10% of what we see in the Bund future.”
Both contracts are available to U.S. investors, who currently account for 8% of BTP volume — up from 3% last year.
While hedging tools may help offset the risk associated with the Eurozone, the near daily trend of alternating between a sense of imminent doom and recovery for Europe appears to be with us for some time to come.