Thursday, 27 October 2011

Mike Lenhoff: Market tactics 27 October 2011

Better to travel than arrive but hopefully there’s more travelling.

While the detail of what was agreed early this morning by eurozone leaders has yet to be worked out, the markets’ initial response is correct. Eurozone leaders have demonstrated a sense of unity and determination in delivering on what is needed to tackle the issue of debt sustainability and to help stabilize the financial system. Hopefully the spread in the chart, denoting stress in funding markets, will narrow and the CDS premium, denoting counterparty/default risk for banks, will fall, though the action might come in fits and starts.   

Agreement has been reached on the following:

·    A private sector ‘voluntary’ haircut of 50 percent on Greek bonds so as to reduce Greece’s debt burden to 120 percent of GDP by 2020. The agreement has the backing of the Institute for International Finance, which represents the international banking community. With this, the intention is also to put in place by the end of this year a second financial package for Greece totalling 130 billion euros (as against the 109 billion euros agreed back in July).  

·     A requirement by the European Banking Authority for banks in the EU to hold core Tier 1 capital (‘of the highest quality’) of at least 9 percent of risk assets with a time line for implementation by June of next year.

·    A boost, through leveraging, of the European Financial Stability Facility by offering insurance or first loss guarantees – something that has been discussed for a while – and/or by introducing a Special Purpose Investment Vehicle (SPIV) aimed at attracting both private and public investors (e.g., in the developing world in the case of the latter). The indicated leverage is up to 1 trillion euros.     

Importantly, the new President of the ECB, Mario Draghi, indicated yesterday that the Securities Market Programme would continue to provide any necessary support for government bond markets (e.g., Spain and Italy).

Financial markets should welcome the entire effort. Peripheral bond markets can be expected to firm up a little and German bunds along with other defensive assets can be expected to lose ground a little. Counterparty risk for eurozone banks should ease thus helping to alleviate the stress in funding markets and as for equity markets they should do more of what they’re doing this morning – rally!

Agreed at last is a programme to be taken forward though caution still applies. There are likely to be plenty of glitches along the way in nailing down the detail of it all but the good news is that a broad outline for a workable agenda has been put in place where none existed before and this is progress. Disclaimer >   

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