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Last week, we deliberately turned our attention away from Europe to the USA, as we were waiting for action, rather than mere words, from European leaders. This week we return to Europe, even though the final details of the euro rescue plan are still to emerge. |
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While the politicians are fiddling, the banks are burning. Dexia has been consumed by the flames, but the fire is far from extinguished. Banks in Europe have lost all mutual trust. They are depositing spare cash not with each other, but with the ECB, while those who need to borrow are also turning to the central bank. In addition, some multi-nationals in Europe, reflecting their lack of confidence in banks, are depositing their spare cash directly with the ECB, who we can only assume are making an attractive spread as both a deposit-taking and lending agency! |
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Since Libor rates are reflective of inter-bank lending, they presently have little meaning. However, rates are still being published, albeit at artificially low levels, which naturally helps keep down the interest costs of floating rate notes – issued mainly by banks. |
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The bond market is at its most illiquid since 2008. Trading of both government and corporate bonds, be it buying or selling, is extremely heavy going, as market makers’ books are so thin. In addition to the growing inter-bank distrust, this may also be down to tighter compliance since the latest UBS scandal, with traders being told to take no sizeable positions. |
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The euro crisis is therefore manifesting itself as a systemic bank problem. Replace sub-prime with Greek debt and, dare we say, Bear Stearns, with Dexia, and there is a remarkable parallel with the US sub-prime crisis of 2007-2008. At that time, the financial system was kept afloat through energetic intervention by the US Administration (and by the UK and even Swiss governments). What a pity that current euro zone leaders are not acting with that same energy! |
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They are, however, doing something. Increasing the equity capital requirement of banks to 9% is designed precisely to strengthen the banks and restore confidence. We expect the extra capital to be raised mostly as straight equity; in fact, the threat accompanying the ruling is something like “raise the funds in the market or we, the governments, will take a share in the capital”. Maybe the newly merged Russian-Chinese Sovereign Fund will come to the rescue, or potentially even certain Middle Eastern countries! |
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Our interpretation of these events is that the recapitalisation of banks, being pushed through in months, rather than the years required by Basel 3, is in anticipation of Greek default, which will somehow be delayed until the banks have sufficient capital to absorb it. Talk now is of the Greek haircut being closer to 50% than the 20% first mooted. It should not be forgotten that Ireland is also likely to expect as severe a haircut for their bank bondholders as that deemed appropriate for Greece. |
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What does this mean for fixed-income investors? For some weeks we have been recommending corporate debt over government. That is still our position. It is however difficult to define a long-term investment strategy without resolution of the euro crisis, and in a market which remains more suited to short-term trading (even allowing for the ongoing liquidity constraints). There is an emerging case for moving between government and corporate bonds as a function of market sentiment, loosely described as “risk-on” vs. “risk-off”. |
Market Focus |
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- USA: non-farm payroll numbers were better than expected, with upward revisions to the two prior months; the unemployment rate was unchanged at 9.10%. Mortgage rates fell, sending longer-term borrowing costs below 4% for the first time on record ( a 30-year fixed loan 3.94%)
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- Germany: industrial production fell less than economists forecast in August, having surged the previous month. However, factory orders fell for a second month in August, declining 1.40% from July, when they dropped 2.60%
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- Euro zone: EU and IMF officials indicated that Greece will receive an €8 bln loan next month as part of the €110 bln bailout. French industrial production unexpectedly rose for a second month in August, climbing 0.50% from a revised 1.80% in the July. Spanish house prices fell 7.40% in September from a year earlier. For the first time in almost 20 years, Moody’s cut Italy’s rating, by three levels to A2 from Aa2, on concern that weak growth will make it difficult to reduce debt and keep borrowing costs low
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- ECB: Jean-Claude Trichet’s final decision as head of the ECB was to resume covered-bond purchases and reintroduce year-long loans for banks. The ECB will spend €40 bln on covered bonds beginning next month and will offer banks two additional unlimited loans of 12 and 13-month durations. The benchmark rate remained unchanged at 1.50%
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- UK: the British Chamber of Commerce suggested that the new round of QE may not be enough to prevent the economy from falling back into recession after the anaemic growth of the last year, including 0.5% in Q3. Manufacturing fell 0.30% in August, while factory output prices rose in September, by 0.30%
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- BoE: the central bank announced a bigger and earlier expansion to the asset purchase scheme than most market commentators expected. The MPC raised the ceiling for asset purchases from £200 bln to £275 bln. Mervyn King justified the move with a particularly gloomy outlook commenting that the current situation was the most serious financial crisis since the 1930s, possibly ever
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- Switzerland: inflation accelerated more than expected in September, consumer prices rose 0.50% from a year earlier having rose 0.20% in August. GDP is forecast to be flat for Q4
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- Credit: Moody’s cut the ratings of nine Portuguese banks on concerns about funding, bad loans and holdings of government debt. The ratings agency also cut the senior debt and deposit ratings of 12 British financial institutions, stating that the downgrades did not reflect a deterioration in the financial strength of the banking system or that of the government, but rather the lower commitment to government rescue in the event of failure
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