Heightened Focus on Eurozone Debt
Recent market commentary reveals negative sentiment on Eurozone sovereign debt, with price actions often driving narratives regardless of their plausibility. Now, when the Bund futures sell off risk assets catch a bid. Despite higher Bund yields, the BTP/Bund spread did not narrow much today, while other European sovereign bonds did.
We strongly caution against the short France (OATs) and long Italy (BTPs) trade recommendation from a well-known independent research firm, which Jefferies has also endorsed. This note is not an agreement with their analysis but an acknowledgment of their influence on market professionals.
The recommendation to buy BTPs (Italian sovereign bonds) versus OATs (French) is based on the premise that Italy's government dynamics are more favorable than France's. However, this investment thesis has both fundamental and technical flaws.
1. Debt Projections & Bond Yields: Most market participants rely on the same independent agencies for debt growth projections, whether national or international. If bond markets operated purely on these projections, yield differentials on long-dated OATs would already reflect this information. By this logic, Japan would have experienced a severe debt crisis.
2. Debt Sustainability & Sovereign Debt Crisis: Debt sustainability analysis depends on subjective and uncertain economic growth forecasts. Studies on past sovereign debt crisis have not found universal prerequisites as a condition for a trigger. Sharp economic contractions and high levels of public debt held by foreign investors are common occurrences. The average maturity of the national debt is also important. France and Italy have similar average debt maturities of around 8 years. Political instability also contributes to sovereign debt crises.
3. Eurozone Contagion: The OAT/BTP spread convergence thesis assumes France's situation worsens without affecting other regions in the Eurozone. We find this unlikely, and investors are not adequately compensated for the additional risk compared to OAT/Bund spreads. The recent market price moves suggest clients are selling OATs and European stocks to buy Bunds, not BTPs, and this trend is likely to continue. Most of the spread widening has been driven by the Bund rally.|
The Perfect Hedge is in Larry Ellison's Garden… or Selling Positions
Changes in investor sentiment and market structure bottlenecks are more critical factors for Eurozone debt. Moreover, entering new trades as macro hedges only adds complexity to portfolios and risks complacency toward underlying exposures.
Key Factors in BTP/Bund Spread Widening Thesis
To expand on our previous update, we provide the following charts and calculations, starting with the total stock of public debt as market securities across major economies:
1. Impending EU Political Turmoil
The signals coming out of the EU are not very encouraging, suggesting a lack of cohesion among the top leaders. Credible candidates such as Antonio Costa and Mario Draghi, previously rumored as contenders for senior positions at the EU Commission, are no longer in the running. Instead, former Italian Prime Minister Enrico Letta’s name is being floated. There is now a sense of urgency within the EU to quickly finalize an agreement on the most senior roles in anticipation of challenging times ahead.
2. Disorderly Market Functioning
Inadequate capital levels held by local banks (primary dealers) can facilitate transactions during market stress. We provide relevant statistics for this.
Too Much Government Debt, Not Enough Bank Capital
Charts below show each nation's government bond market size relative to the market capitalization of the top 5 or 10 domestic banks, respectively:
European nations have realistically at most five banks that can be relied upon during bond market turmoil, compared to ten for the US and Japan. The US has recently launched facilities to access Fed liquidity on Treasury securities, bypassing the banking system if needed. Rising public debt shifts banks' priorities toward their home nations. We urge caution when interpreting figures for non-G7 nations with less developed capital markets.
While domestic government bonds receive favorable treatment regarding risk-weighted assets in held-to-maturity portfolios, this does not apply to dealer inventory.
Negative Eurozone Theme Trade Expressions
Depending on the fundamental view, here are some some alternative ways of expressive a negative view on Eurozone debt:
1. Buy OAT/Bund Spreads
This is the cleanest and most direct way to express a negative view on France and a risk aversion into Bunds without concerns about the Eurozone periphery.
2. Bund Swap Spreads
This trade involves buying the on-the-run 10-year German government bond and hedging the interest rate exposure by paying swaps with matched maturity. This trade is likely to perform if European banks come under stress and/or demand for Bunds rises. Unlike a long/short position on cash instruments, this trade carries some counterparty risk on the interest rate swap (IRS) leg, especially when purchased from a European bank.
3. Buy 5-year CDS on France in USD
Sovereign Credit Default Swaps (CDS) denominated in US Dollars are the most direct means of speculating on the creditworthiness of a borrower while limiting currency correlation (quanto) risk. Personally, I’m not a fan of Armageddon bets with CDS due to non-negligible counterparty risk and illiquidity. Lower liquidity in sovereign CDS products generally works in the buyer's favor on the way up but not when it moves against. Typically, bank dealers have tighter risk limits on CDS exposures compared to government bonds. There are also fewer trade venues and counterparties to execute these trades.
The smartest action we heard someone took recently was reallocating his pension from Europe to UK equities due to shifting political landscapes. Addressing the basics first makes it easier to think clearly. In the grand scheme, getting hung up over yield differential of a fraction of a percent might distract us from better opportunities elsewhere. We care because soon enough, others will too.
Updates
The following article in Le Monde in English is quiet the read: How Macron threw his supporters into a panic by calling snap elections
“And you, Sébastien, what do you think?” asked Macron, turning to his Minister of the Armed Forces, Sébastien Lecornu. “I'm not going to answer you as a minister, since you've already made up your mind, but as an activist,” began Lecornu. “Have you done any secret work over the last fortnight to suggest that these legislative elections might go better than the European ones?” Macron replied: “No, we haven't done any polls. This is a new election, so it will be a new dynamic.”
As Lecornu continued, one could have heard a pin drop. “We're off to a Blitzkrieg election. The reasons you are going to give this evening for summoning the electorate once again will have to be very well understood by the French people. If it doesn't start right, we won't be able to put it right.”
