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Hope springs eternal in Europe (Video)

The deadline and hurdles for Greece are passing at a pace. Yesterday it was the decision that CDS would not be activated on Greek bonds, although this does not mean that they won’t be in the future (for lengthy technical reasons).

The other factor to note is that, even thought the EU has delayed the approval of the full EUR 130bln of the second aid package, there were positive responses to the degree of progress made by Greece to date in fulfilling the 38 requirements needed before full approval will be given. Video:

Don’t expect any major headlines from the remainder of the EU summit today, with just a set-piece signing of the ‘fiscal compact’ on the main agenda.  The other small slice of good news was an agreement to further speed up payments into the new rescue fund (European Stability Mechanism) which starts in the middle of the year.

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The single currency was feeling heavy during yesterday’s session though, seemingly still pondering the implications of the ECB cash injection from earlier in the week.


The recovery of gold. Wednesday’s fall in the gold price was the largest for two years. As with the moves in other markets, it’s not easy to split out the different between the many competing factors that were at play on the last trading day of the month. Partly given the spurious nature of the decline yesterday, we saw a modest recovery yesterday in a calmer trading environment. Indeed, the feeling is that markets had got ahead of themselves if they were seriously thinking that they were going to get a strong message of further QE from the Fed Chairman at Wednesday’s testimony. The other strange thing is that this fall occurred on the day of the ECB’s 2nd auction of 3Y funds. As we’ve pointed out, the net liquidity injection (taking into account maturing repo offers) is around double that seen in December. Furthermore, whilst December’s offer was all about preventing a full-blow credit crunch in the eurozone, there is greater uncertainty as to what use banks are going to put these funds this time around. But this uncertainty also creates a greater likelihood that it offers further support to risk assets, such as gold. Naturally, there are dangers with such an assumption, not least the risks of a central bank-supported rally in risk assets that pushes valuations beyond what most would see as ‘fair value’. That said, with ETF holdings of gold at a record high and real global interest rates falling further into negative territory, there remain pegs onto which further gold prices gains could be pinned.

The liquidity risks in Europe. After the volatility of Wednesday, it was telling to see this nature of price activity emerging yesterday – the first trading day of the month – and a much calmer environment. It pays not to read too much into the moves we saw yesterday and it’s also comforting to see a modest recovery today. What was notable though is that the Aussie was leading the way while euro did not play a part.   The big difference between now and December (the ECB’s first 3Y auction) is what we’ve seen in peripheral bond markets. Italian yields are nearly 200bp lower, with the 10Y yield moving below 5.00% earlier yesterday. These moves emphasise the bigger risk this time around that we are seeing an external carry trade (euro being used as a carry currency for overseas investments) vs. the internal one of December, when a sizable proportion of LTRO funds were recycled back into the bond market. The debate during March is likely to hinge on the extent to which the euro does become a funding currency, leaving aside the ongoing risks that surround events in Greece, and the successful passing of the Greek private sector bond swap. From this angle, it’s not surprising that the German Bundesbank is becoming increasingly concerned at the impact of such liquidity injections on asset markets in general and the issues with the exit strategy, something that we’ve highlighted over the past week. In contrast to 2009 there are fewer assets at distressed levels and this is even more the case vs. Dec ’09 – particularly in relation to peripheral eurozone debt. We could be heading for interesting but also dangerous times.

What makes Portugal different.  Portugal is being asked to implement austerity and reforms against an economy which will contract this year, by more than 3% according to the latest forecasts from the troika. The current level of yields (nearly 14% 10Y) reflects a growing concern that Portugal will not be able to return to market funding when the current aid package runs out in a year’s time. That Portugal sold-off on the day the ECB auction took place was concerning, because it could well be that the ECB favours LTRO as a means of support rather than its bond-buying program. The last two weeks of data have shown no bond purchases from the ECB and, whilst there was talk of the ECB checking prices on Portugal yesterday, there did not appear to be strong confirmation of buying. The issue is that, with the ECB having secured its place as a senior creditor to private sector bond-holders, the more it ramps up its purchases the greater private sector investors will fear taking the hit on any eventual restructuring. Germany has been at pains to point out that the private sector involvement in Greece will be a one-off event, but markets appear unable to take this assurance at face value, not least because this crisis has been littered with about-turns and indecision. At current yields, Portugal stands no chance of returning to the markets when the current aid package runs out and achieving the required level of austerity and reform as the economy contracts by 3% or more is historically unprecedented within the recent history of OECD countries. This is why Portugal will remain vulnerable over coming months.

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