MacroScope

Law of diminishing returns

The law of diminishing returns?
The first euro zone bailout, of Greece, bought a few months of respite, the next ones bought weeks, latterly it was days. Now … hours. Spanish bond yields ended higher on the day and, more worryingly, Italy’s 10-year broke above six percent. It was always unlikely the deal to revive Spanish banks was going to lead to a durable market rally with make-or-break Greek elections looming on Sunday but there were other things at play.

Top of the list is that the bailout will inflate Spain’s public debt and the dangerous loop of damaged banks buying Spanish government bonds that are falling in value. There’s also the fact that Germany and others are keen to use the new ESM rescue fund to funnel money to Spain because of the greater flexibility it offers. That will make private investors subordinate to the ESM which could prompt another rush for the exits which Madrid can ill afford since this is the first euro zone bailout which keeps the recipient active in the bond market.
It’s for the same reason that a revival of the ECB’s bond-buying programme, which it still doesn’t fancy, could prove counter-productive.

Officials are already pondering that conundrum, suggesting that the loan to Spain could initially be made under the existing EFSF bailout fund then taken over by the ESM, though that sounds like the sort of creative thinking in Brussels that generally fails to convince investors.
Another cracking Retuers exclusive following our breaking of the Spanish bailout on Friday, showing European finance officials have discussed limiting the size of withdrawals from ATM machines, imposing border checks and introducing euro zone capital controls as a worst-case scenario should Athens decide to leave the euro, is unlikely to have settle market nerves.

Today, the ECB releases its bi-annual report on risks facing the financial system. I’d imagine it will have a fair amount to say. For now, it seems content to let governments take all the strain of crisis management. Plenty of policymakers, Hollande, Merkel, Monti and Van Rompuy included, are speaking today but having done their bit for Spain over the weekend it’s really eyes down for the Greek election now, swiftly followed by a G20 summit and a key gathering of EU leaders at the end of the month.
There, some light will be shed on longer-term plans to make the euro zone a more durable economic union, although this is going to be a long haul – too late to address the current crisis. We’re expecting French and German briefings today, the latter on the Los Cabos G20.

There’s also a groundswell behind setting up a banking union, including a deposit guarantee fund, quickly. European Commission chief Jose Manuel Barroso, ECB policymaker Christian Noyer and French Finance Minister Pierre Moscovici are all espousing it today. Germany, where the bill will fall, is much more reticent and wants to see the drive to fiscal union, which will take many months even years of negotiation, treaty change and parliamentary ratifications, completed first.

Foreign investors still buying American

Overseas investors have yet to sour towards U.S. assets despite high government debt levels, according the latest figures on capital flows.

Including short-dated assets such as bills, foreigners snapped up $107.7 billion in U.S. securities in February, following a downwardly revised $3.1 billion inflow for January. At the same time, the United States attracted a net long-term capital inflow of just $10.1 billion in February after drawing an upwardly revised $102.4 billion in the first month of 2012.

The data showed China boosted purchases of U.S. government debt for a second month in February, but also some waning of demand for longer-dated securities.

The going gets tougher for Italy and Spain

One trillion euros is a lot of money. And as we have previously noted on this blog it did a lot for stock markets early this year but not much for the real economy.

But recent bond auctions in the euro zone suggest the impact of two rounds of cheap 3-year ECB funding on the region’s struggling bond market may also be fading.

Italian three-year borrowing costs surged more than a full percentage point at an auction to 3.89 percent – its highest since mid-January.

Ireland’s uneasy market comeback

Ireland, hailed as the poster child of euro zone austerity, is hoping to get back into the long-term bond market this year. But analysts say a hasty return could do more harm than good.

Its market position has certainly improved since it was pushed out of commercial markets and forced to seek a bailout, even though the population at large is still struggling with rigorous austerity.

Ten-year Irish yields have halved to just below 7 percent since July – before the European Central Bank began buying Spanish and Italian bonds in the secondary market to stabilise peripheral markets.

Vultures swoop on Argentina

Holdouts against a settlement of Argentina’s defaulted debt are opening a new front in their campaign for a juicy payout more than a decade after the biggest sovereign default on record.

Lobbyists for some of the investors who hold about $6 billion in Argentine debt are in London to persuade Britain to follow the lead of the United States, which last September decided to vote against new Inter American Development Bank and World Bank loans for Buenos Aires.

Washington believes Argentina, a member of the Group of 20, is not meeting its international obligations on a number of fronts. Apart from the dispute with private bond holders, Argentina has yet to agree with the Paris Club of official creditors on a rescheduling of about $9 billion of debt. It has refused to let the International Monetary Fund conduct a routine health check of the economy. And it has failed to comply with the judgments of a World Bank arbitration panel.

Why Germany doesn’t want euro zone bonds

Ever wanted to know why Germany is not keen on single euro zone bonds? Look no further:

from Mike Dolan:

Sparring with central banks

Just one look at the whoosh higher in global markets in January and you'd be forgiven smug faith in the hoary old market adage of "Don't fight the Fed" -- or to update the phrase less pithily for the modern, globalised marketplace: "Don't fight the world's central banks". (or "Don't Battle the Banks", maybe?)

In tandem with this month's Federal Reserve forecast of near-zero U.S. official interest rates for the next two years, the European Central Bank provided its banking sector nearly half a trillion euros of cheap 3-year loans in late December (and may do almost as much again on Feb 29). Add to that ongoing bouts of money printing by the Bank of England, Swiss National Bank, Bank of Japan and more than 40 expected acts of monetary easing by central banks around the world in the first half of this year and that's a lot of additional central bank support behind the market rebound.  So is betting against this firepower a mug's game? Well, some investors caution against the chance that the Banks are firing duds.

According to giant bond fund manager Pimco, the post-credit crisis process of household, corporate and sovereign deleveraging is so intense and loaded with risk that central banks may just be keeping up with events and even then are doing so at very different speeds. What's more the solution to the problem is not a monetary one anyway and all they can do is ease the pain.

Money funds cut Europe exposure, slowly

Prime U.S. money funds further reduced their holdings of euro zone bank paper in December, although the pace of movement slowed while investors continued to hedge against any bank failures, J.P. Morgan Securities said on Wednesday.  The slower movement out of euro zone bank paper was the result of money funds having already strongly reduced their holdings, J.P. Morgan said in a note to clients.

Euro zone bank paper continued to roll off in December from prime money fund portfolios but has seen some slowing as nearly 70 percent of these exposures have been eliminated from prime fund portfolios over the course of the past year. In spite of continued reductions in euro zone bank exposures, prime fund assets under management were basically flat for the second consecutive month reflecting some level of investor comfort in the level of risk in price fund portfolios as much of the cash that left euro zone bank paper has been reinvested in non-European banks and other high-quality products.

The prime money funds had small net outflows of $2.6 billion in December after net inflows of $4 billion in November, according to J.P. Morgan.

Europe sobers up after Italian auction

After a hopeful couple of weeks and the ”euphoria” caused by an agreement to tackle the euro zone debt crisis, financial markets got a reality check from Italy’s sale of 7.94 billion euros of government bonds. The debt met lower demand than at previous auctions, forcing the country to pay the highest premium since joining the single currency to sell 10-year debt.

The results suggest markets did not think the euro zone rescue deal — which includes an agreement on the write-down of Greek debt, recapitalisation of European banks and leveraging of the euro zone rescue fund – went far enough to restore investor appetite for Italian debt.

Italian yields rose as high as 6.03 percent near levels not seen since early August, when the European Central Bank first began purchasing Italian and Spanish bonds in the secondary market to bring funding costs down to more affordable levels. Brian Barry, analyst at Evolution Securities, says that move alone speaks volumes:

Italy bond spreads signal renewed concern

Spreads between Italian and German government debt are blowing out heading into a European Union summit on Sunday that investors are hoping will come up with some action to address the continent’s sovereign debt crisis. Spreads between 10-year Italian government debt and German bonds of the same maturity widened to 398 basis points on Thursday, making for the biggest gap since at least the fourth quarter of 1996, according to Reuters data.

Andrew Wilkinson, Miller Tabak’s chief economic strategist, expands on the implications:

You have to look back to March 1996 to see the spread’s last excursion above 400 basis points. That was when Italian government was trying desperately to meet Maastricht criteria and join the euro. I’m left wondering how pleased they are with that outcome in today’s market. They never bargained for a spillover from Greece lie this. With the French/German yield spread leading the way this week it looks like pressure will continue to build in to the weekend.