Backtrack

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If the weekend deal on Spain was meant to reassure markets, there was little sign of it during a very choppy session yesterday, defined by wide ranges and multiple turning points across asset classes. This was all too apparent on the euro, which traded more than two big figures during the day. 

Spanish bonds alone traded a 50 basis point range on the 10 year yield, whilst the opening gap higher on German bonds (of 10bp) was totally reversed by the end of the day.  Deals created in haste are invariable deconstructed at the markets leisure, but it didn’t take long to find the holes in this one.

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The Spanish sovereign bond market fears that it will be massively subordinated by the package (because the debt created would be rank above it in the credit pecking order) and there were also rumours that the technicalities could result in Spanish CDS being triggered.  But the history of credit crises shows that few (if any) are resolved by adding to debt, unless accompanied by either devaluations and/or restructurings of existing debt.

Commentary

No escape for Italy. It is hard to separate the financial perils endured by both Italy and Spain at the present time. The former has an eye-popping government debt mountain worth 120% of GDP, which with 10yr yields at 6.0% is becoming very expensive to finance. As noted by the head of Italy’s debt agency last week, foreign investors have been shunning Italy’s regular debt auctions this year, with the result that the government was becoming increasingly reliant on domestic investors. Of concern to both investors and traders alike is that Mario Monti has been unable to deliver the comprehensive reform agenda that many had hoped for. Although Monti had a big win early on with pension reform, he relented soon after on labour market reforms which themselves are bogged down in parliament. He also back-tracked on service sector reform, despite sounding tough initially. And on spending, although he has promised significant cutbacks, the specifics of where the axe will actually fall is still sadly absent. Italian bond-holders want to hear the detail, because if he does not tackle this soon then an automatic increase in sales tax rates will be forthcoming in the second half of the year. As elections in the spring of next year draw closer, Monti’s ability to get important structural reforms through Parliament will wane. As things stand, it is hard to see how Italy can avoid the same fate as Spain.

Expect plenty more Chinese Stimulus.  Across both the production and expenditure sides of the economy, the evidence of weaker growth is continuing to build. Retail sales in May rose by 13.8% yoy, the lowest annual increase outside of the traditionally weak months of January/February for six years. Demand for home appliances in the year ended May was only slightly positive. Firms are cutting back on capital spending as well – fixed asset investment growth in the first five months of 2012 was the slowest in yoy terms since 2001. Sluggish domestic production and weakening domestic/foreign demand are resulting in an intensification in deflationary pressures. Producer prices fell by 1.4% yoy in May, a third straight decline, while consumer prices growth fell to 3.0% last month, a two year low. The official target inflation rate for 2012 is 4%. In retrospect, the sudden decision to reduce rates on Friday is totally understandable given the weekend news on production, demand and inflation. Moreover, we can expect further measures over coming months, including additional rate cuts, bank reserve ratio reductions, and targeted fiscal spending and tax cuts. The government will continue to push infrastructure spending forward, and selectively ease financing conditions for households and small governments.

IMF nudge the yen lower. The yen has softened overnight on the back of comments from the IMF referring to the “moderately overvalued” Japanese currency and also pointing out that intervention can be used.  Both of these are nothing new and yen bears are the most battered, disappointed and frustrated participants in the FX markets. But ahead of the Bank of Japan meeting later this week, the timing has served to trim longs.

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