Forever means at least until the end of this week…

Mint – Blain’s Morning Porridge September 18 2012

Primary new issue markets are going all out – nearly every single fund manager and investment guru is fully engaged in the new flow. But look over your shoulders… markets stopped for breath yesterday. Some of the heady expectations for US reflation and growth have been scaled back as players anticipate more downside economic news to come. In Europe the “Euro-is-Saved” consensus wobbled with Spain yields flirting over 6% again yesterday.

The trillion Euro question is how strong is the momentum driving the Euro rally? How much more upside for Euro peripherals is still to come? Less than you might think.

The upside has been driven by the relative-performance catch up trade as Euro shorts massively underperformed, but a very interesting comment from JP Morgan’s European Client Survey says: “bond managers have covered their shorts in the periphery for the first time since March, with the largest two-week increase in peripheral risk” in two-years. That’s a critical indication the short-cover rally and the momentum it generated is drawing to a close. It confirms our call the Euro will remain very vulnerable to volatile sentiment shifts in coming months.

So if you thought the days of politics running Euro market sentiment were over… you will be sadly disappointed. Next few months will remain news- and event-driven: volatile, reactive and vulnerable. Which makes us wonder when it’s time to take profits and look for markets to normalise? Sure the downside will be limited by the Super-Draghi effect – save the Euro at any cost – but it’s not going to contain volatility. Reactive markets will become the new normal.

The Euro Elites will no-doubt characterise “Normal markets” being that curious situation where all Euro govvie spreads traded within a smidge of Germany. Forget it. That ain’t never going to happen again. Yet France to Germany spreads have tightened dramatically in recent days, despite the many analysts cautioning France could get dragged much wider if the Euro conflagration brews up again, and that France faces enormous economic and fiscal challenges.

One trade we suggested weeks ago was shorting French OAT futures and going long Bund futures. Since June we’ve seen the spread tighten from 127 to 55 last week. Yesterday it started widening. We suspect it heads back towards its Apr-Sept mean around 100! (Check it out on Bloomberg, or I’ll send you a picture!) That’s normal.

Now the market attention will switch back to Spain and whether Ranjoy et all will be bounced into accepting the bailout rules necessary for Spain bonds to benefit from OMT “limitless” bond buying. Yesterday’s 6% Spain yields will be tested, although this week’s Spain auctions should go well driven by LTRO money and domestic demand.

Spain remains the great test for the Euro’s ad hoc market containment efforts. If and when Spain accepts OMT conditions I will happily fill my boots with Spain bonds safe and secure in the knowledge the ECB will be the buyer of last resort.

But until it does… Spain is a worry. We know the Spanish banking system is utter pants and probably much worse than the published numbers reveal (yeah… will you trust the audit numbers??). We know Spain real estate is massively bad pants. We know the tensions between bankrupt regions and the state are growing. We know the solvent regions are less than willing to become Spain’s domestic Germany. We know for Ranjoy to accept a bailout with terms will be  electoral suicide – Andaluz elections will be “interesting”. So, if you are considering an investment in Spain paper it boils down to the likelihood and inevitability of OMT bailout. Wait for the right moment and place your bets.

Meanwhile, a great tweet from Bill Gross this morning: “Central banks are where bad bonds go to die ” He’s already slashed his Treasury holdings – pre-empting the Fed’s reflation. But is he right about bad European bonds? Bloomberg this morning comments that far from slashing balance sheets, many European banks have been fattening up and buying more government bonds (because they are BIS zero risk)! LTRO money fuelled it – and is still driving many investment trends. Again, markets heavily skewed by the unintended consequences and effects of actions to keep up the Euro illusion. 

Out of time…

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