The term “perma” seems to get attached to anyone who has an opinion for more than a couple of weeks, but yes, I have changed my view on Europe. By the end of LTRO2 when most of the world was bullish we were bearish. It was painful for a bit, but we saw the signs as early as March 2nd, and accelerating by March 16th that Spanish debt was struggling. We remained bearish for quite some time but gradually shifted to a bullish bias. Too early as we had to ride it down further, but got more bullish on the back of two main catalysts – Grexit and JPM.
How did Grexit Make Me Bullish?
The fact that Europe was finally starting to face up to the possibility of Greece exiting became a positive for me. The people I have spoken to at the German Ministry of Finance and senior Greek politicians all admitted that until recently almost no time had been dedicated to what a Greek exit would look like.
In spite of all the negotiations around the bailout, neither side had taken a serious look at what it could mean. Both side were living in a world of assumptions about how it would play out that had no basis in reality. Germany somehow had this vision of not having to make good on all its guarantees, that the ECB would get paid, and the “firewall” would stop contagion. All of those are laughable assumptions yet basically is what the “core” of Europe believed. So on June 2nd when we wrote our widely read Why a Grexit would make Lehman look like childs play piece, the basis for the bullish view was formed.
The Grexit would be far more dangerous than Germany or the rest of the EU could risk. By actually looking at and “planning” for a Grexit, which the market took to be as a bad sign, we took as a positive. We were convinced that Germany and others would come to the same conclusion that we had – that the core was massively exposed to a Grexit and had butchered policies over the past 2 years so badly that a Grexit was far more dangerous and costly now than it had ever been.
That is why the Grexit possibility became the premise of our bullish view on Europe, and the PIIGS in particular. Europe would finally do the work and realize, they had already provided so much money and put in so many contagion creating policies that they would have to back down and change how they deal with the problem.
The Spanish bank bailout, was in our opinion a confirmation of that idea. Although the markets finished that first day deeply in the red, we saw the market reaction as incorrect. At the close on the 11th on Bloomberg TV we talked about how Spanish debt may see more wild swings but that the deal was a turning point in how Europe is addressing their problems. The use of FROB was a key and too many market pundits were focused on the wrong issues, including over dramatizing the issue of subordination while underestimating the potential power of the proposal. As rumors that the FROB would receive low cost, long dated funding failed to sway the market and incorrect after incorrect headline came out about how FROB would work, or how the EFSF (and ultimately ESM) works, we had to fight the market, but became more convinced that the market just yet hadn’t accepted that there was a change in attitude.
We also came out early that the Greek package would be renegotiated. It is a horrible deal for Greece and with Europe rightfully afraid of the consequences of a Grexit, it seemed clear there would be room for compromise. The market didn’t think it was clear, but we did, and now, post election, it looks like Europe is willing to compromise.
The barrage of headlines out of Europe continues. Some are great and some are bad, but as you sift through them, it is hard not to see a change of attitude. Growth policies, for better or worse are on the table. New and possibly creative ways of fighting the bond speculators are on the table. Renegotiating bad deals is a possibility. A focus on providing cheaper and longer funding to those countries needing help is making its way around. After a year of talk about bank recapitalizations we may finally get them, and the use of FROB was intentional, trying to separate the sovereign support from the bank support.
Europe has had a tendency to fail. To make great promises and then not support them, but for once, the promises seem reasonable. They aren’t launching programs with big headline numbers that can’t be used (like how they used to talk about EFSF in terms of total commitments, rather than usable commitments). There is just enough going on to keep us convinced that Europe has shifted their attitude and is trying to bring out a big comprehensive package, that coupled with the bearishness, will be enough to further this rally.
On the 11th, Spanish 10 year yields were 6.49%. They have been volatile and are only back to 6.52%. The IBEX was 6,516 on the 11th and has rallied to 6,800. The Euro, which on the 11th was possibly the most detested trade on the planet, went from 1.248 to 1.269, so the call has seemed right.
The S&P 500, with support from JPM in particular, has gone from 1,309 to 1,356 as of yesterday and even IG18 which has been heavy, managed to trade back from 125 down to 114. These rallies have been fought by most of the market. It is safe to say that this has been a rally that only a mother could love given how much daily negative commentary there is and how ready everyone is to bash European policy.
Perma-bullish? No. Bullish? Yes
For now, I remain bullish. It is far scarier at these higher levels, but evidence continues to mount that Europe is going to try and launch something big and new. A change in attitude there could go a long way. Too many people keep babbling about subordination, which is a potential issue, but far less of one if people become convinced that default risk is being taken off the table. Europe, like the U.S. is drifting towards a “banking book” mentality. The goal seems to be to remove assets from market to market and trading books and hide them away. Rely on limiting the amount of bonds available to trade to reduce the volatility, and change policies so that volatility doesn’t have the same impact it used to (margin requirements, etc.).
It is also “different this time” because the U.S. and China are both struggling and we at least seem desperate for something or anything to get the economy moving. Global coordination was one thing when Europe seemed to be isolated, but now that everyone is sinking we are more likely to see aggressive new programs. Up until now, the EU has spread risk, but the “donor” nations haven’t been aggressive in their risk taking. That seems to be changing.
At the first signs that it is back to business as usual in Europe, with a lot of chatter and no proposals, I will run for the hills. Until then, I am going to operate that we are still in the early stages of a policy shift that will see the core and the ECB take new steps to give the problem one massive kick down the road.
Will the plans actually work? I highly doubt it long term, but for now will reserve judgment. I thought LTRO1 was good for the banks. I massively underestimated how carried away the market would get with the carry trade in LTRO2. A stark reminder of how little freely traded Spanish debt there is and how quickly the momo crowd can push something. Being too early on doubting how much of an impact LTRO2 had is fresh in my mind. Maybe that is a mistake I’m making here, or, maybe too many who are pooh-poohing Europe’s efforts are the ones who forget how quickly attitude can shift – especially when it is something as subtle as “fear of subordination”.
Cues to be watching
Sure, you can watch the illiquid Spanish bond market for a cue, though frankly that market has been beating to its own drum recently and anyone trading U.S. stocks based on what Spanish bond yields have been doing has been annihilated.
Look to JP Morgan as key. Is the whale trade behind us? Has the market accepted that while a big number for you and me, or even the other Morgan, it just isn’t that big of a number for JPM. Is the risk of severe regulation for banks that much worse than before the loss? Probably not, as the loss will get buried in an otherwise good quarter, and the pro-regulation group is making the same mistakes it always does. People are touting Meredith Whitney’s line that “the only hedge is loan loss reserves”. That would take about 2 minutes for Gorman to trash as a silly idea, let alone Dimon or Blankfein. There is a real chance, that progress could be made, but it seems that as usual some dumb ideas will be pushed forward in the haste to punish banks and they will fail as they are just simply stupid. Using this time to encourage specific capital surcharges for big trades etc would be far more useful than having the pedantic debate over what is or isn’t a hedge etc.
Look to the high yield market. The market remains well set up for high yield. Once again, any leveraged longs got shook out, and so long as the U.S. economy does okay, and treasury rates remain at zero, the reach for yield will continue and HY will benefit. HYG is an easy way to get a quick read on the market it now has a 0% total return since May 11th when the JPM conference call hit all the U.S. credit markets. Look for HY to continue to do well, though upside is becoming capped, and I would move away from a “beta” play like HYG and into specific bonds or a specific asset manager. For the more adventurous, HY18 is a potential play as it has underperformed, and due to its composition has a bit more room to run than the bonds do. IG18 is another one to watch and right now it has gone bid-less and is back to trading at 112.5. It is trading right around intrinsic values, so can more either direction, but tighter right now seems most likely, especially if JPM had been buying it against IG9 10yr as part of a “hedge and wedge” strategy and is closing out IG18 shorts in parallel with closing out IG9 longs.