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 “”, 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.
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!
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: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke
One Response to “Flying Pigs”
Most read in the last 20 days:
- Gold Sector: Positioning and Sentiment
A Case of Botched Timing, But... When last we wrote about the gold sector in mid February, we discussed historical patterns in the HUI following breaches of its 200-day moving average from below. Given that we expected such a breach to occur relatively soon, the post turned out to be rather ill-timed. Luckily we always advise readers that we are not exactly Nostradamus (occasionally our timing is a bit better). Below is a chart of the HUI Index depicting the action since the January...
- India: The next Pakistan?
India’s Rapid Degradation This is Part XI of a series of articles (the most recent of which is linked here) in which I have provided regular updates on what started as the demonetization of 86% of India's currency. The story of demonetization and the ensuing developments were merely a vehicle for me to explore Indian institutions, culture and society. The Modimobile is making the rounds amid a flower shower. [PT] Photo credit: PTI Photo Tribal cultures face...
- March to Default
Style Over Substance “May you live in interesting times,” says the ancient Chinese curse. No doubt about it, we live in interesting times. Hardly a day goes by that we’re not aghast and astounded by a series of grotesque caricatures of the world as at devolves towards vulgarity. Just this week, for instance, U.S. Representative Maxine Waters tweeted, “Get ready for impeachment.” Well, Maxine Waters is obviously right – impeaching the president is an urgent...
- The Long Run Economics of Debt Based Stimulus
Onward vs. Upward Something both unwanted and unexpected has tormented western economies in the 21st century. Gross domestic product (GDP) has moderated onward while government debt has spiked upward. Orthodox economists continue to be flummoxed by what has transpired. What happened to the miracle? The Keynesian wet dream of an unfettered fiat debt money system has been realized, and debt has been duly expanded at every opportunity. Although the fat lady has so far only...
- Welcome to Totalitarian America, President Trump!
Trump vs. the Deep State If there had been any doubt that the land of the free and home of the brave is now a totalitarian society, the revelations that its Chief Executive Officer has been spied upon while campaigning for that office and during his brief tenure as president should now be allayed. Image adapted from the cover of “Deep State #5” - depicting an assassin from the future President Trump joins the very crowded list of opponents of the American...
- Searching for Truth
Heresy or Truth? RANCHO SANTANA, NICARAGUA – In the fifth century, Christian scholars counted 88 different heresies. Arianism. Eutychianism. Nestorianism. If there was a way to “offend” God, they had a name for it. One group of “heretics” argued that there was no such thing as “original sin.” Another denied the trinity. And another claimed Jesus was not divine. Which one had the truth? Depiction of the first Council of Ephesus in 431 AD, convened by Emperor...
- Gold and the Fed's Looming Rate Hike in March
Long Term Technical Backdrop Constructive After a challenging Q4 in 2016 in the context of rising bond yields and a stronger US dollar, gold seems to be getting its shine back in Q1. The technical picture is beginning to look a little more constructive and the “reflation trade”, spurred on further by expectations of higher infrastructure spending and tax cuts in the US, has thus far also benefited gold. From a technical perspective, there are indications that the low at $1045.40,...
- The Unstable Empire – A Campfire Tale
Campfire Tale Caesar: The Ides of March are come. Soothsayer: Ay, Caesar, but not gone. — Julius Caesar, Shakespeare GRANADA, NICARAGUA – Today, we stop the horses and circle the wagons. For 19 years, we have been rolling along, exploring, discovering. We began with the assumption that we didn’t “know” anything - so we kept our eyes open. Now we know even less. Famous people who knew nothing and were not shy to admit it: Sergeant Schultz...
- Why Silver Went Down – Precious Metals Supply and Demand
Rumor-Mongering vs. Data The question on the lips of everyone who plans to exchange his metal for dollars—widely thought to be money—is why did silver go down? The price of silver in dollar terms dropped from about 18 bucks to about 17, or about 5 percent. Reportedly silver was already assassinated in the late 19th century... so last week they must have assassinated its corpse. [PT] Illustration taken from 'Coin's Financial School' The facile answer is...
- Systematic Trading - Unwrapping the Onion
Lumpy but Robust [ed note: this article has originally appeared at the Evil Speculator and was written by trader and ES contributor Scott. We provide a link to Scott's past articles below this post for readers who want to get more familiar with his ideas and/or any unusual terminology used in this article] One continual theme in my trading is that every time I think I have it figured out, I get punched in the face by an unexpected problem. The tendency is to go more...
- LIBOR Pains
Wrong Focus If one searches for news on LIBOR (=London Interbank Offered Rate, i.e., the rate at which banks lend dollars to each other in the euro-dollar market), they are currently dominated by Deutsche Bank getting slapped with a total fine of $775 million for the part it played in manipulating the benchmark rate in collusion with other banks (fine for one count of wire fraud: US$150 m.; additional shakedown by US Justice Department: US$625 m., the price tag for a deferred prosecution...
- “People Need to Understand that their Biggest Asset is Individual Liberty” - an Interview with Claudio Grass
Preserving Liberty in a Difficult Time In his latest interview for the X22 Report, Claudio Grass shares his views on the future of the Euro, the Trump Presidency, the monetary system and the advantage of of owning gold in these times of global uncertainty. Claudio Grass, managing director at Global Gold As election season is upon us in Europe and political and economic tensions are heating up, Claudio Grass notes that “the euro is the most artificial...