China lends a hand

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Another sudden burst of risk-avoidance yesterday morning after the meaningless statement from EU leaders the night before resulted in some heavy losses for both risk assets and the single currency. The EUR fell to a low of 1.3830 and European equities suffered significant losses as yet another bout of risk-aversion provided a further boost for both safe-haven currencies (the yen, Swiss franc and the dollar) and core government bonds.

Souring the mood was speculation that six Spanish banks had failed the bank stress tests, due for release this Friday, and comments from the Dutch Finance Minister who stated that a selective default was no longer excluded. However, once the euro had plumbed the depths, a very rapid short-covering rally ensued, which ultimately dragged the EUR back through the 1.40 level and offered the peripheral bond markets some much-needed respite. There was a strong rumour that China had opened its wallet to snap up cheap euros and even cheaper European bonds. Also, with Italy holding a large bond auction tomorrow, ex-BOE policy-maker Willem Buiter claimed that the ECB was likely to recommence its bond-buying program which has been put on ice for the past four months, in order to ensure that all goes well.  The euro’s sudden bounce gave equities a boost, although there were still significant losses on the day. EU leaders are supposed to reconvene on Friday to discuss Europe’s debt crisis, although this was subsequently denied by Chancellor Merkel.

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Commentary

Strong Chinese growth steadies investor nerves. Amidst the confusion and (at times) outright panic over Europe’s sovereign debt crisis that has dominated trading over the past week, last night’s strong Chinese growth numbers have really helped to steady investor nerves. In the second quarter, Chinese GDP rose by 9.5% YoY, after a 9.7% increase in Q1. Growth in Q2 itself was 2.2%, after a 2.1% increase in the March quarter. Separately, fixed asset-investment continues to soar, up more than 25% in the year ended Q2, retail sales rose by 17.7% YoY in June (up 11% in real terms), housing transactions jumped by 31% last month, and industrial production surged by 15.1% YoY in June (well above expectations). Notwithstanding the signs of a slowdown in some of the recent manufacturing surveys, these numbers suggests that the progressive tightening of monetary policy over the past year has, at least so far, failed to have much impact on the pace of growth, which remains very rapid. For policy-makers, it makes their task of containing inflation even more difficult. As such, with inflation climbing to 6.4% last month, well above their target for the year of 4%, it is very likely that monetary policy will need to be tightened further, and quite possibly very considerably.

Buying-in to buy-backs. EU leaders on Monday night resurrected an idea that was last floated earlier in the year, but was rapidly shot down by Germany. At around the time it was last floated in February, default by Greece was not seen as a significant likelihood, at least not by CDS markets. That position has now changed substantially as the 600bp increase in 10yr yields over this time illustrates. In essence, a program of buy-backs has more chance of getting off the ground that the ill-fated ‘voluntary’ restructuring plan of the past few weeks, which was never going to pull together. There are two hurdles to overcome. With a buy-back, you are essentially offering a bond-holder the opportunity to redeem their bond(s) early. The government is redeeming the debt early. Of course, the price at which it is done determines the success or otherwise of the deal. If a government wants to retire an illiquid, non-benchmark issue, then they will only have to offer at or slightly above the market price to entice investors to take the offer, allowing them to switch into more liquid, benchmark issues. But with the likely buy-back undertaken by the European Financial Stability Facility (EFSF), investors will be facing a very different choice. It will be whether to take what’s on offer now, or risk getting less in a default. For example, the current 10-yr (maturing June 2020) is bid at 52 cents. Investors who took up a buy-back would not be looking to switch into another issue, but would be looking to recover more from their investment than they would from a default. The other issue is the financing. Greece currently does not have the funds to redeem any significant proportion of its outstanding debt. But it is only Greece which could buy back its own debt, so the EFSF would have to offer the funding for Greece. However this would again be in the form of loans, so, the exchange itself would reduce the Greek debt burden but would be offset by the increased debt obligation to the EFSF. Furthermore, of the EUR 254 bn in bonds outstanding, not all investors will be able to participate; a fair proportion of banks holding the bonds on their hold-to-maturity books which have not been marked to market (obviously, an exchange would mark it). The upshot is that unless the held to maturity investors can be enticed, it’s unlikely that a buy-back can be structured in a way that would prove attractive to bond-holders and achieve a substantial reduction in the Greek debt burden.

Obama seeks a ‘grand bargain’ on debt and fiscal policy. The US President continues to ratchet up the pressure on the GOP, with a demand for a broad package of both spending cuts and tax increases to put the US on a sounder fiscal footing. Obama wants to achieve a reduction over ten years in the size of the fiscal deficit of at least $4trln, and wants the debt limit lifted well before the August 2nd deadline. For its part, Republicans remain inextricably opposed to lifting taxes in any way, and want any increase in the debt limit that is agreed to matched at the very least by total spending cuts over the next decade. The President has explicitly ruled out lifting the debt limit for a short period like 60 or 90 days. The bickering continues. Thankfully for Washington, Europe has a more serious debt crisis which is dominating the headlines.

Pound benefits because it is not the euro. For the pound, it is being helped at the margin by the fact that it is not the euro, but apart from that it has little else going for it. Two economic reports out yesterday provided further confirmation that the economy is still going nowhere. The latest RICS housing survey, the UK’s most comprehensive, suggested that the pressure on house prices remained downward last month, while the BRC survey for June recorded a decline in year-on-year sales. Furthermore, the News International phone-hacking scandal represents a blow to the credibility and integrity of Prime Minister Cameron, which could start to weigh on the pound if it starts to threaten his leadership or authority.

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