Check Out The Real World

Mint – Bill Blain’s Morning Porridge September 20 2012

Finally, from so little sleeping and so much reading, his brain dried up and he went completely out of his mind…

Look over your shoulder and check what’s happening in the real world.

It seems every bond buyer has been sucked into the New Issue feeding frenzy – apparently every single new deal is massively oversubscribed in a veritable orgy of credit. One client who did call yesterday was only asking if I could think up some really imaginative ways he could tell an investment bank salesman to “have sex and travel far” after a pitiful allocation on one of the hot deals. It was good to feel useful again….

But soon it will be wake up and smell the coffee time. Switch on the TV to news about decent China numbers, and stronger bonds, and worry what next in Spain! Cure the inevitable hangover and start clearing away the party detritus. (That said, we think there will be significant bargains to pick up from this new issue orgy – already some deals are starting to trickle out and wait till they look good value, and it should make secondary liquidity better!)

Back in the real world, last week we warned the Fed pledge to full employment was a game changer. This week we warned financial war had broken out as Central banks from China to the US pledged full employment and growth. Competitive deflation? Where are the safe havens? It’s good to see the press are now picking up the same themes. We’ve got Kaletsky on Reuters telling us: “Central Banks make a historic turn”, “September 2012 is likely to be recorded as a defining moment”, “upheavals in central banking represent a tectonic shift”. If you read the porridge – you already knew that.

That said, I’ve been taken to task from some investors for our recent call on inflation – “Bill, Bill, Bill… how can you even think that when economies remain so fundamentally depressed and any bank reflation is momentary and more related to propping up government markets. No connection!” Fair comment.. but the inflationary threat is certainly there. Prepared is prepared.

The Pain in Spain falls mainly on Billy Blain…

And speaking of “be prepared” – all eyes on Spain this morning. You’ve got to admire Iberian bravado – Spain papers suggest any of the bank bailout money not used is simply given to the state.. Apparently of the €100bn bank cash, the banks actually only need €40bn (WHAT!!!! That’s complete sphericals!). So Spain says, “save the Germans any concerns about approving that money.. we’ll just use it!” That sounds like EU funding Spain without conditionality? Brilliant. But not going to happen. Well should not happen, but I suppose anything is possible in Draghi World.

Today’s Spain auction of three-year notes and 10-year bonds will be a cracker. The short notes will be supported by the OMT pledge to buy out to three years (assuming of course Spain accepts OMT bailout conditions!). However, I’m struggling to think up any new arguments for buying the new 10-year? Conventional wisdom says it will go well – the 10-3 curve is worth 200bps, and if Spain takes the package, you can imagine that curve would flatten dramatically. But but but and but again…

i)                    Everyone is guessing what OMT will do to bond curves.. may flatten, or just shift duration shorter.. it’s unknown, and …

ii)                   Spain taking the bailout is not a given – and even if it does the assumed curve flattening may prove illusionary if the Euro crisis moves to a next stage, and….

iii)                 What are the unanticipated consequences of Spain taking a bailout and triggering OMT on the EU?

As a porridge strapline last week said, “The greatest trick the devil ever pulled was convincing us he didn’t exist”. The greatest trick Draghi is trying to pull is convincing us OMT is a solution and not just a bandage to the Euro crisis. The problem is what happens when OMT is triggered? It could be a case of light blue touch paper and stand well back!

One scenario we’re thinking about is renewed pressure on Spanish and Italian bonds through the coming quarter accompanied by a wider France/Bund spread. Eventually Ranjoy is forced to accept conditionality – pulling Spain spreads cosmetically tighter as OMT buying tightens market. Italy spreads still widen as the focus shifts. Even ahead of next year’s Italy elections the Monti junta (still with a massive 2012 funding burden to complete) also takes the OMT conditionality terms. Far from persuading the market all bonds are capped by OMT, that could simply move the pressure to France.

This raises a host of problems.

OMT will have been seen to have failed. (What??) Yep, simply by being used OMT fails – it’s the central bank equivalent of the MAD doctrine – Mutually Assured Destruction. Unlimited mutualisation of European debt as we roll into a German election year isn’t going to be a vote winner. The EU’s pitiful efforts to cobble together some form of fiscal union accompanied by the risible picture of the Bundesbank regulating 6000+ European banks from January, were never realistic in such short time frames. Achieving fiscal union in a long term project. OMT aimed to provide some breathing space to move there.

If it’s tested too early, it won’t work. Something will give. The Northern European political backlash against unlimited debt mutualisation – for that is what it will be – aint been felt yet!

And on that bombshell…

Out of time

Bill Blain

 

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