So there we have it! A new election will take place in Greece next month. The winner gets the prize of telling the EU leadership they will not stick to the terms of the €130bn bailout. The Greeks have yet to reveal whether they intend to pay up on the €436mm foreign law FRN due today. If they pay, there will no doubt be an outcry from bondholders who took the ritual 55% belly cut. But imagine the anger amongst the locals whose pensions and wages are being slashed. All so “evil” hedge funds get paid in full. Politically, this would be a no go. If they don’t pay today, the Greeks are likely to take advantage of the 30 day grace period which coincidently will end just before the new elections take place. So, no immediate default. No solvency! We remain in the twilight zone for a few more days! 

As the announcement was made, guess who took it on the chin? Why of course, it was Spain, where 10-year bond yields jumped to 6.30% and its CDS is now at 535bps, all of 20 bps tighter than ... Hungary! I suspect the big loser out of this is likely to be Germany as they remain the supreme benefactors of the single currency. Their economy after all grew five times the projected rate of 0.1% (!!!) in Q1.

Look for rumours of ECB intervention, FED easing, ESFS/ESM firewalls and all other acronyms that form part of the cavalry. This market needs some props to keep it up.    

GREEK FINANCE MINISTRY TO PAY EU435 MLN BOND [8:10 PM BST]

This just in...

If you are a foreign law bond holder that held out against the PSI, you have just made a killing. Presumably, the act of not paying, even with the benefit of the grace period typically afforded to the Issuer, would still have triggered a hard default. I wonder if bondholders who accepted the PSI may resort to legal action? Recall, Greece had warned the holdouts of a worse deal than those exchanging under the PSI.  

As markets brace for an imminent Greek default and exit from the Eurozone, the Greeks quietly made good on a ¥900m (US $11.3m) coupon payment due on the ¥40bn 4.5% bonds due in 2016. Investors in this foreign law bond had held out against the PSI restructuring. On May 15, another €450m FRN documented under foreign law bond is due to mature. If paid in full, those who did participate in the restructuring will come out with their machetes. If they don’t pay, Greece will officially default for the first time in this crisis. JP Morgan has raised the odds of a Greek exit to 30-50%. The fallout of a hard exit will be painful with estimates of €400bn+ being discussed in the press.

Meanwhile, the weekend’s antics have shown that the Greeks want the Euro but don’t want austerity. The Germans, it appears after Sundays State elections, need the Euro and want austerity - but only for others. The Spanish don’t want austerity and based on the most recent bank bailout plan last Friday, remain in denial on the size of exposure to the still overpriced real estate market. The French are rooting for President-elect Hollande in his negotiations with Merkel on the austerity measures agreed in the fiscal compact. They are about to find out he is as influential as President Sarkozy was. The Italians watch and wait for their time in the spotlight!     

You could not make this stuff up! 

France has a new President. Or, more importantly, Europe has a new first couple, “HoMer”. Is this a reminder from the Gods that Europe is spiraling through its own Greek tragedy? A central theme in tragedy is moral conflict. Well, we certainly have conflict in Europe—austerity versus growth. The people of Europe have overwhelmingly rid themselves of leaders who asked them to die a little now in return for a happy after life. Growth is in. Austerity is (on its way) out. With the political structure in Europe breaking down and the masses rebelling, brash new leadership will likely attempt to renegotiate the fiscal agreements regarding budget and debt that the EU nations signed barely five months ago. No one has asked how over-leveraged economies will fund this growth. But that is a question for tomorrow.

Although the headlines this week have been about Greece and France, the action continues to play out in Spain. In spite of claiming that no more banks would be bailed out, Spain bailed out its 4th largest bank yesterday. Looks like the sovereign carry trade is not working out. Spanish banks have increased their holding of sovereign debt between December and February 12 by €70bn. Given the spike in Spanish sovereign yields since, it is likely that on a mark to market basis, these trades are now under water. It is equally likely that whatever asset was pledged to get the cash under the LTRO is also under water, requiring further margin calls.    

Overall market technical sentiment is poor. Moody's threat of a mass downgrade of European financial institutions does not help. In spite of all the liquidity measures, Counterparty risk in the interbank market is rising. The spread between three-month Euribor rates and overnight indexed swap rates is over 40 basis points.

Another theme of tragedy is a certain inevitability of what is likely to follow. With no tangible support forthcoming from the ECB, are the markets staring into the abyss?

QEu2 anyone?

Ever since the ECB hinted that LTRO3 was off the table, the principal European markets have fallen between 10-20% in the following four weeks. Spain in particular is in a tough situation. Apart from two of its premier teams likely to make it to the Champions Cup Final, little else appears to be going its way. With youth unemployment at 50%, 10-year bond yields having spiked to 6% and the IBEX trading barely 100 points above the March 2009 low, the immediate future looks bleak. Although sovereign debt / GDP ratios for Spain are better than Italy, total private sector debt is nearly 300% of GDP. Spanish banking loans alone equal 170% of Spanish GDP. With no sign of the property market recovering, troubled loans at Spanish banks just hit an 18-year high of over 8%. Spain appears to be following the Japanese model in the 90’s of solving the banking crisis. They will soon realise that merging two bad banks simply gives you an even larger bad bank. What is astounding is the level of general complacency in overall market sentiment. If Spain were to require a bailout, and early signs point to this, watch out as risk investors head for the exit. With French and Dutch voters fighting against strict austerity measures, it is only a matter of time the so called “fiscal compact” agreement now falls through. Without the fiscal compact, it is unlikely Germany will back a common Euro Bond. IMF requests for more funds from Europe have already been rejected. German stocks fell over 3% yesterday as the prospects of Germany leaving the Eurozone just became more likely. 

After three months of non-stop partying, the risk markets appear to be taking a breather. Europe in general—and Spain in particular—looks to be losing its mojo. The Ibex is trading slightly above the November lows. In spite of all the liquidity the ECB and Fed could throw into the pot, bond yields are at 5.50% (lower than the peak of 7%, but high nonetheless). The discontent on Spain can be tracked to the comments made by Rajoy, who minutes after signing the fiscal compact treaty, revealed that Spain will not be able to meet its 2012 debt/GDP target. With soaring unemployment already causing deep stress to the social fabric of the nation, the austerity cuts will only add fuel to the growing fire of anger amongst the masses. In this backdrop, it is only a matter of time before the politics skews towards less austerity and puts the nation in direct confrontation with those that are administering the bitter pills (i.e. Germany, Netherlands). 

It appears from the various signals given by the ECB that we are unlikely to see more QE type liquidity injections. Notwithstanding the positives of having averted a funding crisis, they have drawn a fair amount of criticism on the weak collateral they have allowed to be deposited. Furthermore, they have allowed banks to “create” assets that can be repo’ed into the scheme – such as Government guaranteed bonds (where a bank issues bonds to itself, gets a guarantee from its Sovereign, borrows under the LTRO and uses the funds to buy Sovereign debt) which undoubtedly creates a moral hazard around “gaming the system”. Unlike the Fed, which is going to QE into perpetuity, the ECB appears to be more sensitive to the fallout of too much liquidity being injected into the system. 

This leaves Europe with a major problem. With no further liquidity injections, the solvency concerns around Spain and Italy are likely to grow. The increase in EFSF / ESM to around a €1 trillion (for 2012) will help, but is no “firewall” against a panic in the markets around these two nations’ ability to fund.  Italy has been issuing bonds at a clip, but mostly with a three months – three years maturity and in some cases, in the form of zero coupon bonds. The can is being kicked but not too far down the road.

The question at my last posting has been answered – we continue to party!

The Greece restructuring was completed last week. As expected, CAC’s were forced on all non-consenting holders of Greek law bonds triggering a long anticipated CDS “Credit Event”. The ISDA Auction that sets recovery price is due on March 19. The deliverable obligations submitted by investors include €100bn+ of structured bonds and guaranteed obligations (mostly non-Greek law obligations) that were not known until now. That means that there are a further €80bn+ of losses (assuming Greece recovery is set at 20%) to be absorbed by the market. Provided the obligations have been marked to market and collateral has been posted regularly, these ought not to be a concern. However, this is a big “if”. One European Bank announced last Friday they would need another € 1bn of funding to cover their losses on Greece. Is it possible that there are more skeletons in the Eurozone cupboard?

Non-Greek law bond holders still have a few more weeks to agree to the exchange. Many are resisting – some through legal routes. The newly exchanged Greek bonds are trading at prices that indicate a > 80% probability of another Greek default. A hard default would cause further losses to the new holders (mainly Central Banks) that will feed through to Joe Public’s pension.

Greece is teetering on a default, Portugal credit spreads against Germany remain at 1400bps, Italy and Spain still have their issues. But that’s for another day.

Tons of liquidity injected through QE and LTRO, low inflation and interest rates and a becalmed Eurozone. These headlines and the fear of losing out on what appears to be the most ideal risk investing scenario we have seen in years are pushing stock markets to multi month highs. The credit markets are sanguine but sovereign credit spreads, as represented by SOVX have rallied over 100bps to 225bps.  

In the US, most of the Banks passed stringent stress test results that included scenarios of US unemployment 15%, equity losses of 40% and negative GDP in the next few quarters. As a prize, many of these banks were allowed to announce share buybacks and increased dividends, goosing up the stock market just before its close.

The bulls are set to claim victory – the bears go into spring time hibernation. Politicians and Central Bankers have demonstrated that they can play God and set prices for everything.  With many retail investors frantically jumping into the market, could this be the optimal time for yanking the beer soaked rug underneath.  Be careful out there!