Tuesday, June 08, 2010
We know that Reserve Managers have been selling Euros on any bounce for a good part of the year. Recent comments from Iran and anecdotal evidence from market makers is that these guys want to get rid of their Peripheral paper and fast. And this is very similar to the GSEs in 2008. Specifically, there are a bunch of essentially insolvent and borderline-liquid entities (the iPIGS™) that have had an implicit guarantee from a higher authority (Greater Germania). The EU/IMF package has made this guarantee slightly stronger, but it is still not explicit given that Germany could just bugger off and leave them to rot.
Let's have a look at what happened to the GSEs. The credit risk priced into the GSEs in mid-late 2008 was justified along these lines: the US government just didn't want to go that extra step and explicitly guarantee their debt - indeed, despite the Conservatorship of September 2008, they are still not officially guaranteed. This is important because in the 1st half of 2008 a negative liquidity dynamic began to appear in the GSEs (and also, for that matter, in USTs), whereby foreign creditors (read: SWFs, CBs and the rest of the currency bandits) would only lend at short maturities. This, of course, came to a head in mid-July 2008 when Hank Paulson
misfired unveiled his "Bazooka" in which the Federal Government was authorised to inject capital into the GSEs. However, it still did not explicitly guarantee them. The Chinese et al. swiftly concluded that the US Government did not stand behind them and began dumping their debt en-masse (see chart below - orange line) and switching it into USTs (white line) to the tune of $446bn by November 2009 when the amount of Agencies held by foreign official institutions began to rise again.
As for the current similarities with the Peripheral Europeans, there isn't any official data for official holdings of Eurozone bonds that I know of (if anyone does, please do let me know!), so Team Macro Man have tried to construct a proxy for it by taking the official holdings of USTs and applying the COFOR FX Reserve shares to it in order to at least come up with an order of magnitude number. At the end of 2009 it looks as though they held around $1trn of
toxic waste Eurozone Government Bonds (see chart below - orange line, $bns), which has probably been acquired at an average FX Rate of something like 1.25. Under those (very back of envelope) assumptions, that is something like EUR 800bn. Under the (also perhaps dubious) assumption that the share of these assets was allocated as per share of Eurozone GDP, then something like EUR 580bn are held in non-German bonds.
Just like in 2008, it seems that reserve managers gave policymakers some time to see what they would do, but just as in 2008, the policy responses have been inadequate and half-hearted. As a result, it now appears that these managers are attempting to cut their exposure to non-German paper quite aggressively. Given that there are only EUR 620bn of tradable Bunds out there, that is quite a small hole to fit into. Perhaps one of the reasons that the GDP-weighted EMU spread to Bunds just keeps leaking wider (see chart below)...?
The fire-sale of US Agencies pretty much ended early-2009, after global deleveraging pressures on FX reserves began to decline, but it took a further six months for confidence in them to return to the extent that holdings began to increase. In this move, just under half of their existing Agency holdings were liquidated, so again, back of the envelope, that would suggest from the beginning of 2010 a need to sell something like EUR 290bn of EGBs. Not a small number.
How are Europe going to stop these internal flows? Team Macro Man just hope they don't hand the job to Mangler Merkel...