Markets update - Credit - Great Expectations

"Take nothing on its looks; take everything on evidence. There's no better rule."
Charles Dickens, Great Expectations

Another reference to Charles Dickens, following on our conversation "A Tale of Two Central Banks", given the importance of the rally year to date in the credit space. Indeed, it seems to us markets have "Great Expectations", and although Charles Dickens decided to rewrite the end of his book as the ending was deemed too sad, we think it would be preposterous for us to revise our negative stance on Europe, given the current PSI overhang reminiscent of a Damocles sword and the acceleration in the deterioration of the Portuguese situation (which warrants cautious monitoring in the coming weeks/months).

In our credit conversation we will go through the significant tightening witnessed since the implementation of the LTRO supported by the latest FOMC decision by the FED.

The Credit Indices Itraxx overview - Source Bloomberg:

The Itraxx Crossover 5 year CDS index (50 European high yield companies) has dropped 30 bps to around 606 bps, reaching its lowest level since August 17 according to Bloomberg. The Itraxx Main Europe 5 year CDS index (125 European companies investment grade) dropped to 140 bps whereas Itraxx Financial Senior Index (linked to senior debt of 25 banks and insurance companies)  declined to 211 bps, the lowest level since October 28 whereas Itraxx Financial Subordinated 5 year CDS index is at a 5 months low at 372 bps.

Itraxx Financial Senior 5 year CDS index, a significant tightening movement since the December tender by the ECB, as of the 26th of January - source Bloomberg:

Itraxx Crossover 5 year CDS index, a significant tightening movement as well, as of the 26th of January - source Bloomberg:

30 bps tighter on Friday, a significant move for the European High Yield credit risk indicator.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):

The liquidity picture, as per our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

The new reserve period for deposits started on the 18th of January and the deposits level parked at the ECB remains elevated, while both the Itraxx Financial Senior Index and 3 months Libor-OIS is receding thanks to the ECB's recent intervention to support the financial sector.

The current European bond picture with Italy starting much tighter again in conjunction with Spain and France receding towards 3% yield for 10 years government bonds - source Bloomberg:

"Flight to quality" picture, with tighter Germany 10 year Government bond and falling 5 year CDS spread for Germany - Source Bloomberg:

Itraxx Financial Senior 5 year CDS crossing again with the Eurostoxx, indicating the strength of the rally so far year to date - source Bloomberg:

Ireland 5 year sovereign CDS versus Portugal 5 year sovereign CDS spread, a new record - source Bloomberg:

While the Greek PSI will be taking center stage on the 30 and 31st of January at the next European summit, all eyes are on the next LTRO, to see how the next carry trade will play out and how banks will participate. Given the trend is your friend, with Central Banks flooding the markets, we can expect to see tighter spreads still in the credit space thanks to the ongoing support.

Our subordinated bond tender theme initiated in 2011 is still playing out in 2012. BNP Paribas offered to buy back 3 billion euros worth of hybrid securities known as "Cashes" between 45% and 47% of par value, indicating more pain for subordinated bond holders. These securities were issued initially by Fortis Bank. BNP Paribas took control of Fortis in 2009, taking a 75% stake. BNP Paribas was not alone in tendering some subordinated bonds, Credit Agricole as well offered to repurchase subordinated debt. We expect all non-compliant Tier1 paper in Basel 3 to either be called or bought back.

In relation to the new issue space for Senior Unsecured space, given the positive tone in credit, it is not surprising to see a flurry of new issues. Lloyds came to the market to raise 1.5 billion euros, on 5 year. Lloyds priced its new issue 305 bps more than the benchmark swap rate. Last time Lloyds issued Senior Unsecured bonds was March 2011 at 190 bps more than the benchmark swap rate. A 244 bps premium. The game is still the same, conceding consequent large premiums in the race to raise capital.

But back to our title "Great Expectations", given we sit in the skeptical camp in relation to the outcome of the European crisis. It appears that Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008 and is now a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics had some interesting thoughts in his latest column published by Bloomberg on 23rd of January entitled "Europe’s Debt Crisis Is Still Likely to End Badly":

"History is full of fixed exchange-rate arrangements that broke down. In fact, a cynic might even point out that all attempts to fix exchange rates, whether against gold, the dollar or other currencies, ultimately fail.
Think about the gold standard in its various permutations: the post-World War II Bretton Woods system, attempts by East Asian countries to peg their exchange rates in the 1990s, or even the ultimately disastrous Argentine currency peg from 1991 to 2002. They all illustrate that holding on to an exchange peg for too long is a classic policy mistake. Usually when it ends, there is a great deal of concern about the future, but such worries are often overblown: A depreciation in the exchange rate can help an economic recovery, as long as the lid can be kept on inflation.

Good Times Over

But Europe’s problem isn’t just that some countries have the wrong exchange rate, and no way to adjust it within the existing system. The main issue is that governments borrowed heavily during the good times, which are most definitely at an end.
Italy has more than 1.9 trillion euros ($2.5 trillion) in debt outstanding. Bringing this under control through austerity alone is unlikely to work. In countries such as Greece and Ireland, the economic contraction is further undermining fiscal sustainability."

In our last conversation we were pondering whether the recent FOMC decision was in fact putting a floor under the Euro versus the US dollar. A weaker Euro would undoubtedly help European exports, and therefore boost growth, which would help mitigate current debt dynamics in various European countries. We would therefore have to agree with Simon Johnson that the Greek restructuring exercise will be followed by others, Portugal is of course the most likely candidate as highlighted by CDS levels, but others could follow...:

"But at some point in every fixed exchange-rate regime, even the most powerful people have to confront basic arithmetic. When budget deficits cannot be financed, when enough capital is flowing out, and when the central bank has gone beyond the limits of what is responsible, it is always time to move the exchange rate.
When the country that devalues has borrowed heavily in a foreign currency - as the euro effectively is for Italy at this point -- there is a sovereign debt crisis and usually a restructuring of the government’s obligations. Avoiding some version of this in the euro area will be hard."

In our last conversation we also argued that European growth would linger, putting additional pressure on unemployment and debt dynamics. With Spanish unemployment reaching 22.9%, the highest in 15 years, and with Spanish economy contracting 0.3 percent in the fourth quarter, we have a hard time believing in a happy ending, but contrary to Charles Dickens masterpiece, we currently see no need in rewriting the ending for our "European flutter" story.

As reported by Bloomberg, Stephen Roach from Morgan Stanley, seems to agree, the focus is going to be on rising unemployment in Europe and the recession:

"The euro area is in a “fairly protracted recession” and European leaders will shift their focus toward fighting rising unemployment, said Stephen Roach, non-executive chairman of Morgan Stanley Asia.

Stephen Roach also added in the same article:

“Europe is in a recession now, and it’s likely to be a fairly protracted one with a very limited recovery in the years ahead.”

On a final note, Bloomberg chart of the day:
 The CHART OF THE DAY shows the price of Greek notes maturing on March 20 fell to a record-low 36.35 percent of face value on the 26th of January as Greece struggled to reach an accord with private creditors to cut its debt. A bond-swap agreement is needed for the nation to get a second financing package before the 14.5 billion-euro ($19 billion) payment comes due. “It’s pricing in an increased chance for either a forced restructuring before its maturity, or a fully-fledged default,” said David Schnautz, a fixed-income strategist at Commerzbank AG in London. “Chances for the bond to be redeemed in full have been scaled back.”

"The problems you sow, are the troubles you're reaping,
Still, my guitar gently weeps."
The Beatles - George Harrison - 1968 - While My Guitar Gently Weeps - unused line.

Stay tuned!

Markets update - Credit - The law of unintended consequences

"It is easy to dodge our responsibilities, but we cannot dodge the consequences of dodging our responsibilities."
Josiah Stamp

"The law of unintended consequences has come to be used as an adage or idiomatic warning that an intervention in a complex system tends to create unanticipated and often undesirable outcomes." - source Wikipedia

According to Robert Merton Senior there are five causes of unanticipated consequences:
"1.Ignorance (It is impossible to anticipate everything, thereby leading to incomplete analysis)
2.Error (Incorrect analysis of the problem or following habits that worked in the past but may not apply to the current situation)
3.Immediate interest, which may override long-term interests
4.Basic values may require or prohibit certain actions even if the long-term result might be unfavorable (these long-term consequences may eventually cause changes in basic values)
5.Self-defeating prophecy (Fear of some consequence drives people to find solutions before the problem occurs, thus the non-occurrence of the problem is unanticipated.)" - source Wikipedia.

So in this latest post, the latest FOMC's decision has brought to our attention another analogy, the law of unintended consequences. In this credit conversation, while going through our usual credit overview, we will be revisiting some of our calls with some additional subordinated bond haircuts (Unicredit this time around) creating more pain for subordinated bondholders, Portugal in the headlights (which does not come to us as a surprise), and we will attempt to analyse the latest FOMC's decision relative to the existing swap lines agreement between the Fed and the ECB and the consequences that come to our mind.

Time for our Credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:

Not much has changed since our previous post, the Markit Itraxx SovX Western Europe 5 year CDS index (representing 15 countries)  is marginally tighter, around 332 bps points whereas both Itraxx Financial Senior 5 year index and Subordinated index are wider by a couple of basis points. Not a lot of volatility going on.

In relation to the liquidity picture, it is more of the same as well, as per our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

The current European bond picture with Italy starting to widen again slightly in conjunction with Spain - source Bloomberg

Some change in "Flight to quality" picture, with wider Germany 10 year Government bond flirting again with the 2% yield level  and falling 5 year CDS spread for Germany - Source Bloomberg:

 The 10 year German Bund and the Eurostoxx seem to reconnect at least from a directional point of view - source Bloomberg:










It is of no surprise to us to see Portugal taking center stage, following on current Greek negotiations with private bondholders (PSI). In fact we first noticed the decoupling between Ireland and Portugal in August last year in our post "Ireland June trade surplus - A glimmer of hope?":
"But, we are starting to see divergence between Portugal and Ireland, not only in the CDS 5 year space, but also in the 10 year government bond space:
Ireland 5 year CDS versus Portugal 5 year CDS, correlation was one and breaking since a couple of weeks."
Ireland 5 year sovereign CDS versus Portugal 5 year sovereign CDS spread.

Portugal 5 year Sovereign CDS has reached a new record level at 1312 bps, representing a cumulated probability of default of over 67% according to CDS data provider CMA.
The LTRO sparked rally on both financial stocks and senior bonds so far this year. But in relation to Portugal Sovereign CDS versus Portuguese banks financial CDS there is indeed an interesting dislocation as highlighted by a credit trader. Banco Espirito Santo senior 5 year CDS trades around 865 bps, 200 bps tighter year to date, whereas Portugal Sovereign CDS is around 240 bps wider year to date.   This is indeed the direct consequences of the ECB intervention as highlighted by Bank of America Merrill Lynch in our previous conversation, mainly due to the fall in correlation between the banks and the sovereign spreads. This dislocation is only a function of the outlook for peripheral sovereign debt given current banks'exposure to the periphery. While banks have indeed inherited from unconditional support from the ECB courtesy of the three years LTRO, as indicated in Nomura's recent note from the 24th of January entitled "36-month LTROs: A pyrrhic victory?", sovereign so far have not received unconditional support:

"Through these operations the ECB is providing an interim solution to the liability side of bank balance sheets; it is not intended to resolve the significant impairment on the asset side. Although there has been a large repricing of the front-end of sovereign curves into and since the operation, we do not think this demand will persist as the ECB’s operation is not about adjusting the dynamics of the stock or flow demand problems faced by European sovereigns."

We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities of the ECB will have to depreciate. It is therefore not a surprise to see the ECB's current reluctance in getting a haircut on their Greek holdings in relation to the ongoing negotiations revolving around the Greek PSI.

But back to the title of our conversation, the law of unintended consequences, given Nomura in their report indicated the following:

"In light of the LTRO-spurred rally, we analyse whether the LTRO has indeed
formed a sea-change in the eurozone debt crisis. We conclude that:
The 3yr LTRO significantly reduced the tail-risk of a liquidity-driven
collapse by a European bank...
...but that the ECB liquidity will have adverse unintended consequences
for private sector financing of banks...
...and that it is more expensive funding than commonly viewed…
...which provides an effective floor to front-end rates as driven by ECB liquidity...
...both of which will limit the size of next month's LTRO...
...as such, without non-bank investor demand, we do not think the LTRO will lead to a durable flow of liquidity into Europe's non-core bond markets...
...meaning that we retain our bearish strategic view on non-core European bond markets."

Nomura also adding:

"LTROs are increasingly punitive and lead to subordination of senior unsecured bank debt. The haircut structure and increased asset usage effectively means that further ECB liquidity is increasingly punitive, utilising ever more balance sheet. The more the facility is used the greater the degree of subordination to senior creditors, which previously would have partially relied on the assets, now pledged to the ECB, as security against senior debt. This problem is particularly pertinent given that banks have already been using the covered bond markets to raise funds, which require over-collateralisation in order to achieve higher ratings and to meet the criteria laid down by the ECB in order to be deemed eligible collateral for operations."

Meaning dwindling quality collateral to pledge in the process, the law of unintended consequences...which we thing will of course lead the ECB to lower again its collateral standards in the near future.

Which brings us to the most recent subordinated bond tender offer by Unicredit and this is what our good credit friend had to say:
"Unicredit announced this morning a tender offer on Tier 1 and Upper Tier 2 bonds for a total of 3 billion euro. Prices range from 50% to 86% depending on the securities...Which is a nice haircut for subordinated bondholders!

At the same time, the Italian bank plans euro 25 billion covered bond issue (which reminds me of what happened with the Irish Banks covered bonds)."

Nomura expects the second round of LTRO in February to be not only smaller but to have the following effect:

"In aggregate we think that the total level of funds taken down through the ECB operation will be less than the previous round. In our estimation this is likely to be in the €200-300bn range.

If the size is bigger than this, perhaps in the range of €500bn or greater, the effect on bank balance sheets in Europe will be distinctly negative in our view, and would make future wholesale and term funding from private sector sources significantly more difficult."

For more on the subject Joseph Cotterill in FT Alphaville goes into more details about the impact of the LTRO in his post - "Margin call, the LTRO movie"

In "A Tale of Two Central Banks" we argued:

"You cannot ask the ECB to suddenly morph into a Fed. This process will undoubtedly take time and a due process, but a larger involvement of the ECB is so far conditional to stricter fiscal discipline."

This leads us to the latest FOMC's decision in relation to the existing swap lines agreement between the Fed and the ECB and the unintended consequences that come to our thoughts as indicated by Martin Sibileau:

"The institutional weakness of the Euro zone, having failed (back in March 2011) the move towards a unified bond and fiscal integration, triggered the jurisdictional arbitrage of deposits (Euro funding). Deposits were taken from banks in the periphery (Greece, Portugal, Spain, Ireland, Italy) and shifted to the core (Germany, France, Netherlands). This situation generated a funding squeeze that was and continues to be addressed by long-term refinancing operations (“LTROs”) by the ECB. In these operations, the ECB extends collateralized Euros to EU banks. These are loans, assets to the ECB, and liabilities to the EU banks. Since its inception, the ECB has steadily been decreasing the minimum quality of acceptable collateral and increasing the tenor of the financing. Most of these funds have been returning to the ECB as excess reserves, a disturbing fact. But at one point, the repression by the political apparatus and the temptation to use these cheap funds to buy high yielding EU sovereign debt is too strong and we start seeing the use of these funds to monetize (i.e. purchase sovereign bonds in the primary market) EU fiscal deficits."

Hence the difference between the FED and the ECB, with the ECB financing flows (deficits).

Unintended Consequences according to Martin Sibileau:

"With the Fed swaps, as we pointed out on September 12th, the Euro is still artificially stronger than without the swaps, which makes the EU less competitive. Finally, the institutional uncertainty of the EU zone remains unaddressed. All these factors only contribute to prolong the recession and a high unemployment rate."

Given today's decision of the FOMC to maintain US rates low until late 2014, it seems to us that the European recession can only be prolonged as indicated by Rcube Global Macro research in our previous conversation, increasing the likelihood of a Euro Breakup.

Again, like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content.

Does the FOMC's latest decision put a floor to the drop of the euro versus the dollar? Are the FED's swap lines and latest FOMC decision delaying a painful adjustment in Europe? We wonder.

"Logical consequences are the scarecrows of fools and the beacons of wise men."
Thomas Huxley

Stay tuned!

Markets update - Credit - The European Overdiagnosis

"Analysis does not set out to make pathological reactions impossible, but to give the patient's ego freedom to decide one way or another."
Sigmund Freud

Following on our meditations on Bayesian outcomes, and the "European Principle of Indifference", it appeared to us appropriate this time around to focus on the unintended consequences of applying nonsensical decisions to nonsensical results, hence, we have decided this time around to use the analogy of overdiagnosis relating to our European issues:

"Overdiagnosis is the diagnosis of "disease" that will never cause symptoms or death during a patient's lifetime. Overdiagnosis is the least familiar side effect of testing for early forms of disease – and, arguably, the most important. It is a problem because it turns people into patients unnecessarily and because it leads to treatments that can only cause harm." - source Wikipedia

Indeed, this analogy seems to us particularly right relating to the current European and American "Balance Sheet Recession" which has been a recurring theme from Richard Koo, chief economist at Nomura Research Institute, as pointed out by Cullen Roche on Pragmatic Capitalism - "DEFICITS ARE GOOD DURING A BALANCE SHEET RECESSION":

"This (austerity) is akin to a doctor telling a patient suffering from pneumonia to go on a diet and get more exercise. While exercise is important, it assumes a healthy patient. If the patient is sick, he must build up his strength until he is physically capable of exercising again."

So, in a longer credit conversation than usual, we will first have a credit overview given recent significant price action (tightening spreads and much better tone in the credit space), before dealing more directly with the current" European Overdiagnosis" and unintended consequences courtesy of my global macro friends at Rcube Global Macro Research, quantifying "The likelihood of a Euro Breakup" in their latest paper, which follows on their previous analysis of Eurozone's core issue, namely Unit Labor Cost Divergence, which we discussed in our "European Flutter".

The Credit Indices Itraxx overview - Source Bloomberg:

"The Markit iTraxx Financial Index of credit-default swaps linked to the senior debt of 25 European banks and insurers now costs a record 120.5 basis points less than the Markit iTraxx SovX Western Europe Index of swaps on 15 governments. That compares with a 28 basis-point gap at the end of November and a previous high of 118 in July. Historically, it costs more to insure banks than governments." - source Bloomberg news - Abigail Moses and John Glover.

The Year of the Dragon should be rebranded the Year of the European Central Bank, given the significant tightening in credit indices which we have witnessed in Europe since the beginning of the year as indicated by Bank of America Merrill Lynch research - The ECB trade - 17th of January:

"The ECB funding “put”
Away from S&P’s downgrade distraction, we think funding stresses in the credit market have improved significantly over the last month. Three themes paint a better picture. Firstly, ECB 3yr LTROs have had big take-up, and more is to come.
Secondly, fixed-rate senior unsecured bank issuance has reached €15bn YTD, half of the entire 2H supply last year. And finally, as our banks colleagues highlight, government guarantee schemes can be a powerful solution to a bank funding crisis. With the ECB helping to transform funding pressures in credit, we think short-dated spreads can keep rallying."

As indicated above the fall in the Itraxx Financial Senior 5 year index has been significant versus the SOVx 5 year index (relating to 15 European sovereign CDS) courtesy of the breakdown in the correlation between Sovereign and credit spreads, as indicated by Bank of America Merrill Lynch in their report:

"Sovereign and credit spreads - the correlation is finally breaking
Thanks to ECB intervention, credit spreads have been much less correlated to sovereign spreads over the last month (although still positive). In fact, our work shows that the correlation between bank and sovereign spreads has fallen from 90% in mid December last year, to 40% currently. This isn’t far from the lowest correlation between the two since the start of 2010. How long this lasts will ultimately be a function of the outlook for peripheral sovereign debt, given banks’big exposure to the periphery."

In fact as my good macro friend pointed out early January, it is interesting to track the relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):

Volatility has been falling faster than the Itraxx Crossover index and the index is clearly trying to catch up at the moment.

In relation to the liquidity picture, it has somewhat  improved as indicated in our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

New reserve period for deposits started on the 18th. It will be significantly important to track upcoming peripheral government bonds auctions, given that, while the ECB's intervention is clearly supportive for banks, volatility will depend on the Greek PSI outcome, upcoming downgrades for banks and corporate rating downgrades (following up on sovereign downgrades and which have already started).

As Bank America Merrill Lynch put it in a note published on the 16th of January - "Perhaps it's not so bad after all":
"Banks better placed than sovereigns?
It is certainly the case that European banks have a lender of last resort who is dealing very flexibly with their needs – something the ECB has so far proved reluctant to do with sovereign debt."

But, there is a catch and Bank of America Merrill Lynch report from the 17th is on target:
"It isn't all about European banks' sovereign exposure - its also about private sector lending, not just sovereign bond holdings."

"How long the low correlation between bank and sovereign spreads lasts will ultimately be a function of the outlook for peripheral sovereign debt, and Standard and Poor’s sovereign downgrades don’t help. Despite the ECB’s welcome funding, European banks’ exposure to sovereigns remains vast, as chart 7 shows. Note European banks’ large private sector lending to peripheral countries." - source Bank of America Merrill Lynch.

And Bank of America Merrill Lynch to conclude their note with the following advice in relation to credit in 2012: "a more trading, "macro-driven" credit market."

Truth is, while everyone is anxious about the results relating to the Greek PSI, Sovereign CDS wise, Portugal looks to be the ideal candidate for some additional haircuts as we indicated in our last post "The European Principle of Indifference".
Sovereign CDS, between Ireland and Portugal, a new record between both countries with a spread difference of 604 bps - source Bloomberg:

Portugal 5 year Sovereign CDS is now at 1245 bps, which according to CDS data provider CMA equates to a cumulated probability of default of 65.67% within 5 years.

Meanwhile, the disconnect between the 10 year German Bund and the Eurostoxx is still noticeable but today we saw some widening courtesy of German Bund 10 year spread climbing 9 bps and closing on the 2% level, (we noticed this disconnect first time around in November in our post "Mind the Gap...") - source Bloomberg:

In relation to our previous conversations relating to bond tenders and other steps taken by banks to shore up capital requrements (BBVA benefiting from a tax credit courtesy of a goodwill impairment as discussed recently), it was interesting to see the Wall Street Journal catching up with us in relation to the unusual steps taken by some European banks to raise capital in order to reach the 9% Core Tier 1 Capital threshold set up for June 2012 -
"Banks Seeking Capital Ideas - European Lenders Are Taking Unusual Steps to Meet Their Cash Requirements". But what also caught our attention was seeing Bank of America entering as well the raising capital game of bond tenders, offering to buy back 1.5 billion dollars worth of subordinated bonds on the 19th of January. As reported by Zeke Faux in Bloomberg:
"Bank of America is reducing long-term debt as Chief Executive Officer Brian T. Moynihan, 52, seeks to cut holdings, expenses and staff while raising capital to meet demands from regulators for a larger cushion against losses."
So European bankers, please take solace, you are not alone.
"The bank is offering about 95 cents for those securities, it said in the statement", according to Bloomberg, on 6.22% Subordinated bonds due in September 2026, which amounts to a smaller haircut than what we have witnessed in Europe recently on some subordinated bond tenders last couple of months.

But back to our main story, namely European politicians' "Overdiagnosis". What could happen if austerity bites too much, could it lead to Euro Breakup? This is what my friends at Rcube Global Macro Reasearch have recently worked on:

The Likelihood of a Euro Breakup

Since late November, the 2 year yields of both too-big-to-fail PIIGS have crashed (by 350bp for Italy and 320bp for Spain). This indicates that the latest initiatives to save the Euro – most notably the LTRO – have succeeded in lowering the perceived short-term risk of a Euro breakup. This is undeniably a bullish signal for risky assets in the short term. On the other hand, 10 year yields remain stubbornly high, especially in the case of Italy (which is still trading at around 6.5%). This shows that the market believes (as do we) that the question of the Euro’s long-term viability remains unresolved. In order to quantify the likelihood of a Euro exit for each endangered country, we have built a simple model based on CDS spreads and excess unit labor costs. Before showing the model itself, let’s explain why we don’t believe that solving the PIIGS’ government debt problems (through ECB initiatives and fiscal austerity) will be sufficient to prevent a Euro breakup.

In our recent paper about unit labor cost divergence (Macro Analytics 19/12/2011), we suggested that the Euro’s issues went beyond the current debt crisis. The Euro created competitiveness imbalances between Eurozone countries by preventing currency adjustments, which were prevalent in the period between the end of the Bretton Woods system (in 1971) and 1999:

We see some occasional swings, but the dominant pattern is a rather regular fall of most currencies – at different speeds - against the Deutsche Mark, the only exceptions being the Austrian schilling and the Dutch guilder. Unsurprisingly, countries whose currency deteriorated the most during this 28 year period were the PIIGS (the Greek Drachma led the trend with an impressive 95% devaluation against the DEM). When we look at unit labor costs compared to Germany between 1995 and 2012, we notice that countries’ rankings are close to being the opposite of their former currencies’ strength:

If we more thoroughly analyze the relationship between the devaluation rhythm of former currencies’ (+: depreciation, - : appreciation) during the 1971-1995 period and unit labor cost increases between 1995 and 2012, we find a Pearson correlation coefficient of 0.70, and a Spearman correlation coefficient of 0.87. This indicates a strong (albeit non-linear) relationship between those two data items.

Despite the stories about the Mileuristas in Spain, the Milleuristi in Italy and the 700€ Generation in Greece, wage-earners in the PIIGS faired relatively well on a productivity-adjusted basis during the 1995-2008 period, as if they were still being paid in a weak currency that justified regular wage increases. As an illustration of this, we recently learned that Italians now have the highest net worth amongst G8 countries, despite the dismal performance of Italy’s economy over the last decade (this is also a byproduct of Italy’s housing bubble).

Had the Euro never existed, it is fair to assume that PIIGS’ currencies would have naturally adjusted to compensate for their high relative unit labor costs. As countries renounced their ability to devaluate, their competitiveness suffered considerably. Even in the case of France, which is not (yet) considered as one of the PIIGS, its balance of trade went from +3.2% of GDP in 1997 to –3.0% in 2011.

By eliminating currency crises, which were common until the mid-1990s (and at the same time preventing evil “speculators” from making billions on them), the Euro built an economic crisis of far larger proportions. Once again, economics provides a good illustration of the old proverb “the road to hell is paved with good intentions”.  

It is an understatement to say that finding a politically acceptable solution to restore labor cost balance within the Euro framework will be difficult. In addition to the deep cuts that are currently being imposed on government budgets, real wages will have to fall across the board (and not only minimum wages). As people tend to think about money in nominal terms (Keynes’ money illusion), it might end up being easier to find a smart (i.e. non chaos-inducing) way to return to a system of floating currencies, rather than to impose years of internal devaluations.

This is the main reason why we believe that the question of the Euro’s long-term survival goes beyond knowing whether the ECB will finally use its proverbial bazooka during the next 12 months. Even if Greece’s government debt was reduced to zero (which could end up being the case someday), it would not change anything regarding its current lack of competiveness (exports: 7% of GDP, imports 21%). As an anecdote, we recently read that Greece had to import olive oil from … Germany.

A simple model to assess market-implied Euro exit probabilities:

We believe that a large part of Eurozone countries’ CDS spreads reflect their long-term probabilities of exiting the Euro, rather than their default risk within the Eurozone. Indeed, even though we’re not sovereign debt experts, it seems evident to us that if a country was to exit the Eurozone and switch to a new currency, it would have to convert its government debts to the new currency. This would most likely constitute a default in legal terms for most countries[1], but we cannot imagine a country keeping a huge debt denominated in a foreign currency. This would create a Weimar-type vicious circle and would inevitably crush the new currency into oblivion.  Additionally, defaulting without exiting the Euro would not solve the competitiveness issue of many European economies (we’ll soon be able to check this theory with Greece).

If we assume that new currencies would have to devaluate to readjust their unit labor costs to their 1995 level, we can work out theoretical recovery values after redenomination (from which we take a haircut of 20% to take into account overshooting). We then calculate 1-year and 5-year Euro implied exit probabilities by using a simple formula for default probability (Default Probability = Spread / ( 1 – Recovery Rate) ]. This gives us the following implied exit probabilities for the main EZ countries[2] that have a 5 year CDS spread higher than 100:

Despite the rather simplistic assumptions we made in our calculations, these levels appear to be close to what we would have expected: in the short-term (1 year or less), exit probabilities are rather low for most countries, with the exception of Ireland and Portugal. Too much political capital has been invested in the Euro by the last two generations of politicians. Additionally, it would be a mistake to believe that the system is out of ammunition. In a fiat money world, the ECB cannot run out of Euros.  Everything ultimately depends on politicians’ (especially Merkel’s) willingness to “save the Euro”. On its own, the ultimate kick in the can (massive debt monetization) would certainly extend the Euro’s life for quite a few years.  

Consequentely, we believe that the Euro will muddle through for a while, in a climate of painful fiscal tightening for most European countries…

However, if as we fear will be the case, austerity plans do little to address the underlying competitiveness problems faced by many countries, their growth rates will remain anemic. Instead of the rosy “J curve” that would have been promised to justify deep cuts in government expenses, weak EZ countries will experience the dreaded “L”. Rather than going through another purge, some countries will then make the choice to exit the Euro. In this context, the 5 year implied exit probabilities do not appear to be exaggerated to us. 

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[1] Under ISDA rules, G7 countries (Germany, France and Italy) could decide to redenominate their debt without provoking a credit event.

[2] Outside from Greece whose default/exit probability is already 100%

"The physician must give heed to the region in which the patient lives, that is to say, to its type and peculiarities."
Paracelsus

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