Summit Exceeds Expectations
The euro surged over 150 pips overnight after the EU summit produced several euro-positive surprises. First, it appears the EFSF could soon begin to buy Italian and Spanish sovereign bonds in the secondary market. The text of the formal statement referred only to “using the existing EFSF/ESM instruments in a flexible and efficient manner in order to stabilise markets”. However, Italian Prime Minister Monti later made it clear that sovereign bond buying was exactly what was being implied. He said that countries would be able to ask the EFSF to help stabilize their bond markets without inviting troika oversight. However, he stressed that Italy had no intention of making such a request at this time. Second, the issue of seniority was satisfactorily addressed – at least partly. Holders of Spanish sovereign bonds will not now be automatically and explicitly subordinated when Europe provides funds to help recapitalize the Spanish banking system. However, the text of the ESM Treaty itself will not be changed – instead, the seniority issue will be side-stepped by using the EFSF to provide the funds, and the seniority issue goes away because the EFSF does not enjoy explicit senior status. This should offer bondholders come comfort today, although investors will also be aware that this does not offer bulletproof protection – after all, when Greece defaulted in March, private sector bondholders shouldered the full burden, even though neither the ECB nor the IMF have explicit senior creditor status. Third, as a long term ambition, EU Leaders have expressed the desire to allow the ESM to recapitalize banks directly, but this would only happen after “an effective single supervisory mechanism is established, involving the ECB”. We note that so far the EU Commission have not even made specific proposals in this area and therefore this innovation will likely come far too late to be of immediate use during the recapitalization of the Spanish banking system. As such, any funding provided to recapitalize Spanish banks over the coming months is still very likely to inflate the Spanish sovereign debt levels. The focus now shifts to a parliamentary vote in Germany tonight on whether to ratify the ESM Treaty and the Fiscal Compact Treaty. The debate is scheduled to begin at 1500 GMT.
Click here to read the full report: UBS Morning Adviser Europe
UBS Investment Bank