The amnesiac pixy dust sprinkled by the central banks over the year end had barely started to work when the two headed “fly in the ointment” - S&P decided to gate-crash the party. The fact that they chose Friday, January 13 to downgrade several European Sovereigns is ironic. Until then, markets had been kept buoyant without any major bad news (Europe was on holiday until the 2nd week of January) and moderately successful Italian and Spanish auctions. The downgrade of France, Italy and Spain will ultimately have a negative impact on the rating of the leveraged CDO we fondly know as the EFSF. Whether rating will drive the funding costs wider, we shall have to wait and see. The political response from the EU to the downgrades by S&P has been swift and scathing. In a speech, Ms Merkel confessed she would consider legislation to bar institutional investors from selling bonds when ratings were downgraded, or fell below investment grade. Comforting news – you can buy, but can never sell!
The timing of the Italian three-year bond auction was interesting, if it transpires that Italy knew of its two notch downgrade, but chose not to share this material information with investors. They may have figured that since buyers were Italian banks, who have in turn been funded by the Sovereign anyway, there is no risk of litigation. After all, family is everything. Whilst the buying action was in the short end, the long end of the Italian bond market is under pressure after LCH hiked initial margins (again, having lowered margins just a few weeks ago) to 18% on the 15-30 year duration bonds and 8.30% on the 7-10 year. The Italian curve will get steeper as the long end is sold off to satisfy margin calls and funds flow into the LTRO inspired three-year (and less) maturities. The ECB is also reputed to be buying BTP’s around the Bunds + 500 bps level.
Meanwhile, the Greek restructuring saga continues with investors fighting to avoid substantial write-offs, especially in light of the reprieve provided to investors of all other Euro-zone debt. Recall that much of the secondary Greek Government Bonds (GGBs) have recently been snapped up by activist hedge funds who will not play by the rules. To counter this threat, the Greeks (or their puppeteer, Germany) have unveiled their secret weapon – the Collective Action Clauses (CAC) that can retrospectively cram majority decisions onto the rebel minority. But what if the minority are now the majority?
Further, only private investors are in line to take a haircut and the ECB is off the hook for its €50bn+ of GGB purchases. This structural subordination will have longer term repercussions for funding the Euro-zone. Many investors would refuse to participate or demand higher yields, which in turn will keep the cost of funding for the peripheral nations prohibitively high.
As I write, the market is looking to shrug off the downgrades as “old news” and as “news already priced into the market”. Stock markets are stabilising and Wall Street rhetoric is telling us that the “surprise” could be to the upside in 2012. The plumbing of the financial system – funding – appears to be secure and tightening bank CDS spreads (see chart below) simply that the risks of a major default are receding.
A wise man once told me that people only want to see the value of things they own go up – even if it’s an optical illusion. The sell side of Wall Street remains the greatest illusionist of them all. Watch out for under-invested funds and the retail investor getting sucked into the bullish whirlpool, before the illusion is revealed for what it is. As we have witnessed in the past: receding waves can often be a warning sign of a building Tsunami wave.

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