Rally Holds (for now)
Risk assets staged a strong rally overnight following policy announcements released from the EU summit. We remain fairly skeptical over the finer details however and look to fade some of the moves. EURUSD jumped over 150 pips as the headlines hit the newswires and has been fairly stable. Eurozone periphery debt markets responded accordingly, with 5y Italy and Spain at one stage 65bp and 70bp tighter versus Germany, respectively. These moves along with EURUSD and risk assets in general retraced slightly as investors began to analyse the implications of the policy developments. In terms of the headlines, 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. Our fixed income strategists note that this is also a fairly inefficient way of buying bonds compared to the SMP, since every bond bought would need to be funded. 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. We note that one of the principal reasons why the ESM was ratified in several of the European parliaments is because there is a seniority clause embedded, so the longer term implications of this decision are concerning. 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”. The council note however that proposals will be studied and banks analysts note that the actual establishment of a single bank oversight body could take years and would be hugely difficult to reconcile individual states’ interests in this. We therefore remain fairly skeptical about the effectiveness of the policy announcements, and while respecting the market rally (largely a function of very low expectations beaten), we maintain our fundamentally bearish view on the euro. 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 America
UBS Investment Bank