Morning Brief – Continental chaos

Continental chaos

This morning I bring you a story from Europe that should show you just how vulnerable the financial world has become and therefore just how unstable it could prove to be during in the coming year. It comes in the form of fixed income products in Europe that, let’s not forget, have an important impact upon the foreign exchange market.

What do you do when harbouring money in the German government for 10 years costs you more than 40 basis points? You quite rightly look for alternatives and, if they exist, you’ll make a rational decision to buy the alternative instead of the costly Bund. It’s not rocket science – if your favourite brand of shampoo let’s say becomes 10 or 20 times more expensive than its substitutes you’ll strongly consider switching. Trading and investment decisions are no different. The problem comes when the alternative shampoo you’ve purchased in a bright shiny bottle brandished with more superlatives than Donald Trump’s speech writer is actually full of poison. When everyone who used to love the same shampoo you used jumps ship to the new one the behaviour of the herd will mean that we all soon forget what lies within.

Queue Italy and Greece, two protagonists of the European Sovereign Debt crisis in 2010-2014. Loaning to the aforementioned governments was seen as one of the fastest ways to lose your money during this crisis. Expectations of default and economic fundamentals convinced investors that European fixed income products, in particular those of Italy and Greece would never be repaid. They were, ultimately, wrong in their conclusions.

The speech of Mario Draghi promising to do whatever it takes restored some order to the market with Greek debt coming down from its perch above 30% yield. Where investors weren’t mistaken was in their appraisal of the debt. Crucially, the structural problems that created this bondmageddon haven’t changed. The reason bonds rallied so far in the run up to this crisis was because investors believed that whatever they purchased was basically German debt with a different name on it. Why not, right? They’re in a monetary union with each other of course they’ll bail each other out. Wrong! The lack of risk sharing and fiscal Union meant that Germany, as it always promised would be the case, did not come to the guarantee of the Greeks and Italians when investors decided to close their purse strings.

So surely to get back down to the perilously low yields before this crisis something must’ve changed. Surely Eurozone states share risk better now and there is a guarantee to these bonds. Wrong! We had Draghi, we now have Lagarde that built up biblically large balance sheets at their central bank to sure up Eurozone debt and the wider economy but private markets still aren’t willing to take up the risk the central bank has racked up. The very actions undertaken by the European Central Bank are still facing legal action in German courts with no decision forthcoming for almost a decade. Even more concerning than that is the bonds themselves are running out!

Take Italy for example: last week it auctioned off €9bn 16-year duration debt. For this auction it received a record €50bn worth of bids. The yield on debt of this duration is below 1%, down from about 3% at the beginning of last year, baffling levels versus the +35% yield in 2012. When this event unfolded and peaked in 2012 the Euro sold off as far as 1.40 versus the US Dollar and peaked at 1.40 also versus the Pound a few years later. If the bubble dissipates which I’m sure it will eventually, the risk surrounding Eurozone assets including the Euro will be severe and cause a flight to real safety – queue safehaven demand including the US Dollar.

Discussion and Analysis by Charles Porter

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