By Zach Berg, CFA
July 02, 2012
Heading into last week, expectations towards positive coordinated actions out of the 19th EU crisis summit had become so downtrodden that last Thursday evening’s announcement of new agreements provided an unexpected surprise. The gist of the EU Summit news centers on three points:
The European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) will be used to purchase secondary debt of troubled European nations (Italy and Spain) with a Memorandum of Understanding (MoU) signed, but will not have the strict monitoring attached such as in Greece. Currently, the EFSF has approximately €150bln at its disposal, while the ESM has only been ratified by 7 nations. July 9th would be the earliest the ESM may be ratified.
The ESM may be used as a direct source to recapitalize the EU banking system, thus breaking the link between banks and their corresponding sovereign. This recapitalization would not occur until after the establishment of a “single bank supervisory mechanism, involving the ECB.” Although some read the press release as to say this supervisor mechanism would be in place by the end of the year, in actuality it says the leaders will sign off on a plan for a regulator by the end of the year. Once this regulator has become “effective,” then the ESM can be used to inject money into the banks.
The ESM super senior creditor status will not take effect for Spain once the funds distributed to the nation via the EFSF are transferred to the ESM. Again there is some confusion here, as some read into the announcement that the ESM would no longer be super senior; however, the statement does not say future distributions that come directly from the ESM will not be senior or that any use of ESM funds for other recapitalizations/bail outs will not be senior.
Although concrete details were lacking from the announcement, the unexpected news sent risky assets soaring with the Dow posting a 277 point gain on Friday. Treasury yields increased across the curve, led by a roughly 8bp jump in 30-year yields, while corporate credit default swap spreads tightened over 6bp during the day. The peripheral bond yields of Spain and Italy witnessed substantial declines as each country’s 10-year yields fell 60bp and 38bp respectively. Granted, the improvement for each nation simply brought these corresponding yields back to levels present one week earlier.
For all of the euphoria though, the absence of specifics and the appearance the negotiations were very contentious, with Germany being cited as “losing,” should strike a note of caution amongst investors. The notion that the “devil is in the details,” which has become a motto for reviewing EU announcements, will be key as the vagueness of certain points will require clarity in the coming weeks. Already Monday morning, Finland and the Netherlands are stating that they will block the ESM from buying bonds in the secondary markets. Additionally, Thursday evening’s proposals produced nothing tangible in the form of long-term solutions such as creating a banking union or the joint issuance of Euro bonds. Hence, the low hurdle rate required to surpass expectations and subsequent risky asset rally may soon find itself susceptible if the reality of the situation once again becomes engulfed in disagreement amongst European leaders, which seems more probable than ever after last week’s summit.
Friday’s fireworks segue into this upcoming July 4th holiday week. The shortened trading week may witness the focus shift from the European dominated storylines of the past two weeks, the Greek elections followed by last week’s summit, towards important domestic economic data releases including ISM Manufacturing, Factory Orders and the release of May’s non-farm payrolls figures on Friday. The importance of the non-farm payrolls release goes without saying, but that single data release has consistently produced the largest swings in Treasury yields. The chart below displays data from the non-farm payroll figures beginning in 2011 through last month, highlighting the effects on average that a better than or worse than print has had on the change in 10-year Treasury yields on the day of and over the following week. The average beat or miss is calculated off of the Bloomberg survey figure.
Delving further into the data, on occurrences where the absolute difference in survey versus actual results are 50,000 or more, the 10-year yield change was a full basis point more than for those changes less than 50,000. Rather intuitive results, but over a weekly basis that shock of the miss appears to tend to mitigate with the change in basis point figure dropping to roughly 0.5bp. This Friday’s non-farm payrolls expectations call for a 90,000 gain with the unemployment rate remaining unchanged at 8.2%, according to Bloomberg data.
Depending on which way, if at all, Friday’s figure surprises, the fairly tight trading envelope for 10-year and 30-year yields over past few weeks of 1.55-1.70% and 2.64-2.82% respectively, may find itself tested. Last Friday’s “risk on” mode pushed 10-year yields to 1.68% before settling into the weekend right at 1.644%. 1.683% serves as a point of support for 10s should pressure continue to mount, with a break above opening up a potential move back towards 1.8%. On the downside, 1.55% remains a key resistance level. For 30s, Friday’s close at 2.75% keeps rates within their range, but upside probing may see support first at 2.80%, followed by 2.85%, and 2.88% before making an attempt towards 3%. From a rally standpoint, 2.639% has held over past four weeks, while 2.5% serves as the ultimate level of resistance. See accompanying graphs below.