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!

It is that time of the year again – our semi-annual funding drive begins today. Give us a little hand in offsetting the costs of running this blog, as advertising revenue alone is insufficient. You can help us reach our modest funding goal by donating either via paypal or bitcoin. Those of you who have made a ton of money based on some of the things we have said in these pages (we actually made a few good calls lately!), please feel free to up your donations accordingly (we are sorry if you have followed one of our bad calls. This is of course your own fault). Other than that, we can only repeat that donations to this site are apt to secure many benefits. These range from sound sleep, to children including you in their songs, to the potential of obtaining privileges in the afterlife (the latter cannot be guaranteed, but it seems highly likely). As always, we are greatly honored by your readership and hope that our special mixture of entertainment and education is adding a little value to your life!

   

Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke

   
 

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:

  • TMS-2 fast versionA Date Which Will Live in Infamy
      President Nixon’s Decision to Abandon the Gold Standard Franklin Delano Roosevelt called the Japanese “surprise” attack on the U.S. occupied territory of Hawaii and its naval base Pearl Harbor, “A Date Which Will Live in Infamy.”  Similar words should be used for President Nixon’s draconian decision 45 years ago this month that removed America from the last vestiges of the gold standard.   Nixon points out where numerous evil speculators were suspected to be...
  • Perfect-InvestmentInsanity, Oddities and Dark Clouds in Credit-Land
      Insanity Rules Bond markets are certainly displaying a lot of enthusiasm at the moment – and it doesn't matter which bonds one looks at, as the famous “hunt for yield” continues to obliterate interest returns across the board like a steamroller. Corporate and government debt have been soaring for years, but investor appetite for such debt has evidently grown even more.   The perfect investment for modern times: interest-free risk! Illuustration by Howard...
  • Factories, new vs oldUS Economy – Something is not Right
      Another Strong Payrolls Report – is it Meaningful? This morning the punters in the casino were cheered up by yet another strong payrolls report, the second in a row. Leaving aside the fact that it will be revised out of all recognition when all is said and done, does it actually mean the economy is strong?   Quo vadis, economy? Image credit: Paul Raphaelson   As we usually point out at this juncture: apart from the problem that US labor force participation has...
  • CorporateMediacontrolTrump's Tax Plan, Clinton Corruption and Mainstream Media Propaganda
      Fake Money, Fake Capital OUZILLY, France – Little change in the markets on Monday. We are in the middle of vacation season. Who wants to think too much about the stock market? Not us! Yesterday, Republican presidential candidate Donald Trump promised to reform the U.S. tax system.   This should actually even appeal to supporters of Bernie Sanders: the lowest income groups will be completely exempt from income and capital gains taxes under Trump's plan. We expect to hear...
  • mania1The Great Stock Market Swindle
      Short Circuited Feedback Loops Finding and filling gaps in the market is one avenue for entrepreneurial success.  Obviously, the first to tap into an unmet consumer demand can unlock massive profits.  But unless there’s some comparative advantage, competition will quickly commoditize the market and profit margins will decline to just above breakeven.   Example of a “commoditized” market – hard-drive storage costs per GB. This is actually the essence of economic...
  • Mark Carney starts work as Bank of England governor in Dave Simonds cartoonBank of England QE and the Imaginary “Brexit Shock”
      Mark Carney, Wrecking Ball For reasons we cannot even begin to fathom, Mark Carney is considered a “superstar” among central bankers. Presumably this was one of the reasons why the British government helped him to execute a well-timed exit from the Bank of Canada by hiring him to head the Bank of England (well-timed because he disappeared from Canada with its bubble economy seemingly still intact, leaving his successor to take the blame).   This is how Mark Carney is seen by...
  • web-puzzled-man-scratching-head-retro-everett-collection-shutterstock_91956314News from TINA Land
      Distortions and Crazy Ideas We have come across a few articles recently that discuss some of the strategies investors are using or contemplating to use as a result of the market distortions caused by current central bank policies. Readers have no doubt noticed that numerous inter-market correlations seem to have been suspended lately, and that many things are happening that superficially seem to make little sense (e.g. falling junk bond yields while defaults are surging; the yen rising...
  • old friendsAn Old Friend Returns
      A Rare Apparition An old friend suddenly showed up out of the blue yesterday and I’m not talking about a contributor who had washed out and, after years of ‘working for the man’, decided to return for another whack at beating the market. Instead I am delighted to report that I am looking at a bona fide confirmed VIX sell signal which we haven’t seen for ages here.   Hello, old friend. Professor X and Magneto staring each other down in the plastic...
  • tortoiseThe Fabian Society and the Gradual Rise of Statist Socialism
      The “Third Way”   “Stealth, intrigue, subversion, and the deception of never calling socialism by its right name” – George Bernard Shaw   An emblem of the Fabian Society: a wolf in sheep's clothing   The Brexit referendum has revealed the existence of a deep polarization in British politics. Apart from the public faces of the opposing campaigns, there were however also undisclosed parties with a vested interest which few people have heard about. And...
  • Lighthouse in Storm --- Image by © John Lund/CorbisSilver is in a Different World
      The Lighthouse Problem Measured in gold, the price of the dollar hardly budged this week. It fell less than one tenth of a milligram, from 23.29 to 23.20mg. However, in silver terms, it’s a different story. The dollar became more valuable, rising from 1.58 to 1.61 grams.   Who put that bobbing lighthouse there? Image credit: John Lund / Corbis   Most people would say that gold went up $6 and silver went down 43 cents. We wonder, if they were on a sinking boat,...
  • storming the storeRetail Snails
      Second Half Recovery Dented by “Resurgent Consumer” We normally don't comment in real time on individual economic data releases. Generally we believe it makes more sense to occasionally look at a bigger picture overview, once at least some of the inevitable revisions have been made. The update we posted last week (“US Economy, Something is Not Right”) is an example.   Eager consumers storming a store Photo credit: Daniel Acker / Bloomberg   We'll make an...
  • The CongressThe Fed’s “Waterloo” Moment
      Corrupt and Unsustainable James has been a big help. Trying to get him to sleep at night, we have been telling him fantastic and unbelievable bedtime stories – full of grotesque monsters... evil maniacs... and events that couldn’t possibly be true (catch up here and here).   He turned his head until his gaze came to rest on the barred windows of the main building. Finally, he spoke; as far as I was aware these were the first words he had uttered in more than five years....

Austrian Theory and Investment

Support Acting Man

Own physical gold and silver outside a bank

Archive

j9TJzzN

350x200

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]

 

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

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com