iPIGS + CBs = GSEs Redux

That's QE behind us and if yesterday was Xmas eve then today feels like Christmas afternoon, with the parents on the sofa having eaten too much QE and sold even MORE dollars. But the ADHD market kids having unwrapped their pressies, broken most, lost the rest and will be looking for something else to play with. TMM have been waiting for Europe to fill the role for some time.

As regular readers will know, we have taken a somewhat negative view of the European situation. But even we have been surprised by just how quickly the situation has deteriorated further in Greece and especially Ireland. When the Eurocrats finally cobbled together the EFSF multi-GigaEuro bailout fund, we kind of expected that Europe would manage to muddle through somehow, but present TMM with plenty of opportunities to laugh at them. We've not been disappointed on the latter, but it is increasingly looking like we were wrong on the "muddle through" bit. Mangler Merkel, attempting to ward off those nasty German Law Professors who want to ruin the European Project for everyone, has come up with a proposal presumably drawn up by Darth Vader in the Ministry of Defence Bundeathstar that essentially aims to make the lending programme permanent, but impose burden-sharing on bondholders. In terms of making the Euro more sustainable (as far as the fiscal side goes), this is much more like the standard IMF bailouts seen in the past, but there is a clear separation of fiscal authority and thus no single Euro bond. In the medium term that means that bond yields amongst the group will have to trade like EM Sovereign's external debt. Credit risk is now explicitly back on the table.

In the short term, however, TMM reckon this has an even more worrying impact. Readers might recall TMM wrote about the similarities between peripheral debt and the GSEs and the behaviour of Official FX Reserve managers back in 2008. As a quick refresher, these guys had been buying Agency debt as if it were a UST substitute, and in July 2008 when Paulson was forced to load his "Bazooka" by authorising an equity injection should it be needed, but stopped short of "explicitly" guaranteeing the GSEs. In response, reserve managers quickly came to the conclusion that they had credit risk that they didn't like and started selling in short order (see chart below: custody holdings of USTs - white line, custody holdings of Agencies - orange line). By the time they were done, they'd sold about 25% of their ~$1trn Agency holdings and replaced them with USTs.

The reason we bring this up is that the EU restructuring mechanism essentially *explicitly* says that peripheral debt is *not* guaranteed by the rest of Europe, and that if fiscal sustainability is a problem, there'll be a restructuring. Now, at the risk of causing controversy, TMM would point out at in a lot of the regimes that employ FX piss-taking intervention and reserve management, human rights aren't really too high up the priority list. And the guys deciding the allocations are running the risk of getting thrown in jail (or worse) if they take a bath on this stuff. The incentive to dump anything that is starting to look a bit too risky is clearly there. And so, when Russia came out yesterday and removed Irish and Spanish debt from the list of securities in which its SWF can invest in, our ears pricked up.

Updating our ball park model for official holdings of USTs (see chart below, green line) and EGBs (orange line), we were struck by how reserve managers stuck with Europe through the crisis, presumably the EFSF etc have given them piece of mind. But, that looks to be changing. The model estimates that something like $1.23trn of EGBs are held by these guys, probably bought at an average FX rate of something like 1.25, which gives around EUR1trn. Extending this finger-in-the-air guesstimate a bit further, if we assume that the bond allocations were by GDP weight that gives about EUR 730bn non-German holdings. Following their GSE behaviour, that would imply a sale of about EUR 180bn of peripheral debt...

Now, China has been playing the nice guy, buying Greek & Irish paper & the like, but TMM doesn't think that they included the possibility that the EU would let them sink. Funnily enough, we are reminded of Rio Tinto's jilting of Chinalco who in return labeled them "a dishonourable woman". Stern words... we wonder if they'll be used again.

But more specifically, the news-flow from Ireland just gets worse and worse, with dealers reporting huge selling (some, up to 40% of their total sovereign flow yesterday!) with only the ECB buying. This clearly isn't a sustainable situation, certainly not if Darth Weber has anything to say about the matter. The chart of the 10yr bond (see below) increasingly reminds us of the price action in a bankrupt company: long-only selling. We are increasingly of the opinion that a dash to the EFSF is imminent for Ireland...

With this in mind we are we are pulling the trigger on EUR/CHF shorts ( bypassing the USD noise) with planned stop through the 200 day moving average.