Euro Area Carry Trade – From Disbelief to Consensus?

When we noted about a year ago that the ECB's LTROs were likely to give banks and incentive to initiate carry trades in the bonds of euro area peripherals, it was an opinion very few people shared. We wrote at the time:


Is is clear from the above that Spain's banks – and this goes of course for the banks in all the other 'PIIGS' nations too, even though the details of their problems differ from case to case – should be more concerned with getting their leverage down and generally getting their house in order rather than embarking on yet another carry trade. And yet, from the point of view of the banks, things may look a bit different. As noted before, the fate of banks and their sovereigns is in any event closely intertwined. A bank that may one day require a government bailout will go under anyway if the government debt crisis worsens further. So it has actually nothing to lose by adding to its holdings of bonds issued by said government. They will both sink or swim together no matter what.

A new story has emerged yesterday that illustrates what actions governments and banks in the euro area are taking behind the scenes to ease the bank funding crisis. It should be clear that one of the unstated objectives of these activities is to free up money for the purpose of banks adding to their sovereign debt holdings.”

 

It later turned out that Spain's banks did both: they deleveraged by reducing their loans to the private sector, but they also jumped on the carry trade opportunity in bonds issued by the government. The same essentially happened in Italy. At the time of the LTROs, most observers disagreed quite vehemently with the idea and we noted in our 2012 outlook (which got a few things right and a few wrong, in almost perfect coin-flip fashion), we were also looking for a bit more upheaval in the first half of the year, which we did indeed get.

It seems that the carry trade idea has now been accepted more widely – see this freely accessible report by Nordea entitled “Some Pigs Can Fly”, which is well worth reading for two main reasons. For one thing, it makes an important point about how benchmarks play into the decisions of investors – the pertinent quote is:

 

“One of the reasons behind the recent strong performance of e.g. Italian bonds has been the fact that not having Italian bonds in your portfolio has been expensive, if you still use a broad Euro-zone government bond index as your benchmark. Thus many have felt the need to add these bonds to the portfolio. After all, Italy has the biggest bond market in Europe, so its weight in indices is notable.”

 

Bond fund managers wouldn't want to underperform benchmarks, both for obvious psychological reasons as well as practical ones (such as year end bonuses). This is probably also one of the reasons why Central and Eastern European (CEE) sovereign bonds and senior bank bonds in the  euro area performed extraordinarily well in 2012: a general “hunt for yield” broke out in order to catch up.

 


 

Italy-10-year yield

A chart of Italy's 10 year government bond yield illustrating the situation. When yields began to fall sharply in the second half of the year, not owning these bonds meant underperformance relative to popular benchmark bond indexes – via BigCharts, click for better resolution.

 


 

The other reason why it is well worth reading the report is that we think it describes an emerging consensus. As far as we can tell, this consensus is shaping up as follows: there will be more gains in both euro area and most CEE  sovereign bond markets, but they won't be as heady as in 2012.

We can certainly state that the monetary backdrop appears to be much looser than it was at this time last year. In the euro area as a whole, true money supply growth has recently accelerated to 6.1% annualized (as of end October 2012, data via Michael Pollaro), which is the highest since mid 2010 – and in 2010 it was heading down, not up. To be sure, monetary inflation in the euro area is very unevenly distributed. There is mild deflation in the peripherals, while inflation is accelerating in the 'core'. However, the total is increasing and has done so with unwavering regularity over the past year. It is also noteworthy that money supply growth in the euro area has shifted mostly to growth in uncovered money substitutes, which means that it is currently due to credit expansion on the part of commercial banks. The ECB merely provided the tinder.

However, keep in mind that this also means that the future pace of monetary inflation is highly dependent on the recent improvement in confidence holding up. Failing that, more intervention by the ECB will be required.  Our guess on that front is that the consensus may well turn out to be wrong again in 2013. The main reason for that expectation is that the governments of the countries that were in the market's crosshairs at most recent crisis peaks (late November 2011 and early July 2012) will continue to miss their deficit and debt targets. At some point the markets are likely to rediscover their suspicions – the benign neglect of recent months is not an immutable condition. One must also keep in mind that yield-chasing as a rule always goes wrong, as by its very nature risk continually increases as long as the hunt is on and yields on ever riskier paper continue to decline. The only thing that is uncertain is the precise timing of the next capsizing of the ship.

 

Addendum: A Happy New Year

We wish all our readers a happy, healthy and prosperous new year!

 


 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA

   
 

One Response to “Flying Pigs”

  • Crysangle:

    ‘However, keep in mind that this also means that the future pace of monetary inflation is highly dependent on the recent improvement in confidence holding up. ‘

    How much monetary inflation might you extract from sovereign debt now ? Very little to my view – lowering rates/yields increases the spending permit by a little maybe , but all of the governments (and their economies) are saturated with debt – they cannot take on more . They cannot run up further high deficits , in some cases any deficit . They will be fortunate if they avoid further deficit simply by leveling spending as economies contract. Even the LTRO is unlikely to allow more than refinancing with contained deficits, and leveraging the ESM , if they ever do , will only add to total EU sovereign debt . It would not surprise me if the idea is to shift power to the ESM over a period of time and slowly push out sovereign debt , and authority , in the process . If that is the way the show is being arranged then we might expect quite a lot of friction – even national politicians are not in touch with their population , let alone some financially inspired authority half a continent away.

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • America Goes Full Imbecile
      Credit has a wicked way of magnifying a person’s defects.  Even the most cautious man, with unlimited credit, can make mistakes that in retrospect seem absurd.  But an average man, with unlimited credit, is preeminently disposed to going full imbecile.   Let us not forget about this important skill...  [PT]   Several weeks ago we came across a woeful tale of Mike Meru.  Somehow, this special fellow, while of apparent sound mine and worthy intent, racked up...
  • Retail Capitulation – Precious Metals Supply and Demand
      Small Crowds, Shrinking Premiums The prices of gold and silver rose five bucks and 37 cents respectively last week. Is this the blast off to da moon for the silver rocket of halcyon days, in other words 2010-2011?   Various gold bars. Coin and bar premiums have been shrinking steadily (as have coin sales of the US Mint by the way), a sign that retail investors have lost interest in gold. There are even more signs of this actually, and this loss of interest stands in stark...
  • Credit Spreads: Polly is Twitching Again - in Europe
      Junk Bond Spread Breakout The famous dead parrot is coming back to life... in an unexpected place. With its QE operations, which included inter alia corporate bonds, the ECB has managed to suppress credit spreads in Europe to truly ludicrous levels. From there, the effect propagated through arbitrage to other developed markets. And yes, this does “support the economy” - mainly by triggering an avalanche of capital malinvestment and creating the associated boom conditions, while...
  • Gold Divergences Emerge
      Bad Hair Day Produces Positive Divergences On Friday the ongoing trade dispute between the US and China was apparently escalated by a notch to the next level, at least verbally. The Trump administration announced a list of tariffs that are supposed to come into force in three week's time and China clicked back by announcing retaliatory action. In effect, the US government said: take that China, we will now really hurt our own consumers!  - and China's mandarins replied: just you wait, we...
  • Industrial Commodities vs. Gold - Precious Metals Supply and Demand
      Oil is Different Last week, we showed a graph of rising open interest in crude oil futures. From this, we inferred — incorrectly as it turns out — that the basis must be rising. Why else, we asked, would market makers carry more and more oil?   Crude oil acts differently from gold – and so do all other industrial commodities. What makes them different is that the supply of industrial commodities held in storage as a rule suffices to satisfy industrial demand only for a...
  • Chasing the Wind
      Futility with Purpose Plebeians generally ignore the tact of their economic central planners.  They care more that their meatloaf is hot and their suds are cold, than about any plans being hatched in the capital city.  Nonetheless, the central planners know an angry mob, with torches and pitchforks, are only a few empty bellies away.  Hence, they must always stay on point.   Watch for those pitchfork bearers – they can get real nasty and then heads often roll quite literally....
  • Lift-Off Not (Yet) - Precious Metals Supply and Demand
      Wrong-Way Event Last week we said something that turned out to be prescient:   This is not an environment for a Lift Off Event.   An unfortunate technical mishap interrupted the latest moon-flight of the gold rocket. Fear not true believers, a few positive tracks were left behind. [PT]   The price of gold didn’t move much Mon-Thu last week, though the price of silver did seem to be blasting off. Then on Friday, it reversed hard. We will provide a forensic...
  • Merger Mania and the Kings of Debt
      Another Early Warning Siren Goes Off Our friend Jonathan Tepper of research house Variant Perception (check out their blog to see some of their excellent work) recently pointed out to us that the volume of mergers and acquisitions has increased rather noticeably lately. Some color on this was provided in an article published by Reuters in late May, “Global M&A hits record $2 trillion in the year to date”, which inter alia contained the following chart illustrating the...
  • Cryptocurrency Technicals – Navigating the Bear Market
      A Purely Technical Market Long time readers may recall that we regard Bitcoin and other liquid big cap cryptocurrencies as secondary media of exchange from a monetary theory perspective for the time being. The wave of speculative demand that has propelled them to astonishing heights was triggered by market participants realizing that they have the potential to become money. The process of achieving more widespread adoption of these currencies as a means of payment and establishing...
  • The Fed's “Inflation Target” is Impoverishing American Workers
      Redefined Terms and Absurd Targets At one time, the Federal Reserve's sole mandate was to maintain stable prices and to “fight inflation.”  To the Fed, the financial press, and most everyone else “inflation” means rising prices instead of its original and true definition as an increase in the money supply.  Rising prices are a consequence – a very painful consequence – of money printing.   Fed Chair Jerome Powell apparently does not see the pernicious effects...
  • A Walk on the Wild Side
      A Walk on the Wild Side   “Never play cards with a man called Doc.  Never eat at a place called Mom’s.  Never sleep with a woman whose troubles are worse than your own.” – Nelson Algren, A Walk on the Wild Side   Fresh Fruit or Rotting Vegetables? A subtle gas seems to always be vented into the atmosphere at the sunset of an extended bull market.  As the light fades, an odor that’s indiscernible from that of fresh fruit or rotting vegetables wafts down...

Support Acting Man

Item Guides

j9TJzzN

The Review Insider

Dog Blow

Austrian Theory and Investment

Archive

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

Mish Talk

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com