Monday, November 28, 2011

Spin The Bottle - European Sovereign Debt Edition

Spin the Bottle
-Jeff  @thekillir  Kilburg 
Sr. Development Director at Treasury Curve 

We all remember the game of risk that involved spinning a bottle in junior high.  Unfortunately, over in Europe there are 17 participants with one member looking a bit worse for the wear than the next.  

We have seen Portugal, Ireland, Italy, Greece and Spain in quite a puckered state during the past year but, our concern is now cast upon the core.  

Last week, Germany saw for the first time in quite some time a failed bond auction.  

What does this mean?  They simply could not sell the debt they designated to sell for that specific auction.  

Specifically, they were only able to ascertain about 3.8 billion worth of bids for the 6 billion they wanted to unload.  This makes some think that this European crisis could be rotten to the core, pun intended.  

Subsequent to this auction, we witnessed the disparity between U.S. government 10 year yields and German bund yields widen to an uncomfortable level alarming those that look to the fixed income markets for myself.  While the U.S. 10 year stays hunkered down underneath 2%, new lows in yields seem imminent as safe-haven trades have become scarce.

As all eyes in the circle continue to be affixed to the 10 year yield in Italy, which is substantially above the 7% barometer of solvency, I am focused on France.  

There are three grave concerns that exist in France.  First, the banks that hold sovereign debt on their balance sheets.  (Just back in September, the three largest banks in France owned 45% of all of Italy’s $2.6 billion worth of debt)  And yes, that is merely a snapshot on one sovereign) Second, Dexia’s need of French government guarantees could provide to be the catalyst for the rating agencies to downgrade the French Government to AA from AAA.  The argument that France has retained its AAA rating and the United States has no is valid.  Third, “oops” I forgot the third.

So what about Austria, Belgium, Cyprus, Estonia, Finland, Luxembourg, Malta, the Netherlands, Slovakia and Slovenia? 

We have seen these 10 year yields spike as well.  Despite how strict the European Union is on austerity/austerity implementation, these dramatically higher borrowing costs will negate any beneficial effects that is implemented.  

All eyes are on Dec. 9 meeting in Brussels to see if the EU treaty can be ratified and the European Central Bank can play a much more significant role in extinguishing fires and quelling fears that the EU will no longer exist.  

Despite the challenges within, I always thought a mandatory voluntary EuroBond would effectively bring borrowing costs down to assist the much needed austerity to find traction.  

However, the significant cultural/philosophical differences may keep the realization of the EuroBond locked away…possibly deeply locked away in the Black German forest.

So whose turn is it to spin the bottle? Newly appointed head of the ECB,  Italian Mario Monti, French President Sarkozy or German Chancellor Angela Merkel?  

Merkel has painstakingly had the bottle firmly held in her hand and continues to look around the circle with dissent.  

In addition to Chancellor Merkel’s angst, she continues to see the ECB buy bonds that will most likely see severe haircuts by the time the trade ticket confirmations arrive in the mail to the ECB.  

Is there a silver bullet?  No but, maybe we just need the ever so dapper/sexy bazooka to come out of her arsenal…the EuroBond.  

She stated that it would be “extraordinarily inappropriate” to ever embrace let alone kiss a EuroBond.  

However, I believe the outcome of the European crisis has become quite binary.  Either the 17 countries in the EU currency disband or Merkel closes her eyes and puckers up.  

And just like when I had to kiss the acne covered, heart of gold, best personality girl in the circle….I persevered and survived.  

One last recommendation for Merkel, feel free to show a sense of urgency before we see another week like we did last week.

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