Tuesday proved to be a fairly exceptional day in European markets. At the same time that Spanish yields were rising, so were those of Germany. In the past year, we’ve only twice before seen a rise in Spanish yields of 20bp or more being accompanied by higher German yields. Normally, the flight to safety would push them lower. Could it be that markets fear Germany may have to relent and share a greater burden in order to keep the eurozone intact? It will be important to see if this dynamic is sustained over the coming days to provide more clarity to that question. What was also notable was the resilience of stocks in the face of this broad-based bond weakness. FX markets were fairly stable in comparison, although the Aussie continues to looks vulnerable to a short-squeeze higher (see below). For the single currency, it’s a matter of waiting for the Greek elections this Sunday, although hopes for clarity immediately afterwards are likely to be dashed as parties once again vie to form a coalition.
Commentary
The vulnerability of Aussie shorts. After a nine big-figure slump last month, those with Aussie short positions have been burned by an impressive snapback in the first couple of weeks of this month. At the same time, the bulls have not had things their own way either – twice over the past week, parity has been reached only to be met by aggressive sellers. Also, the AUD remains well below critical long-term moving averages, which implies that despite some short-term pain, the bears are still firmly in charge. From a fundamental perspective, the picture down under has been rendered murkier of late by some surprisingly positive macro news. First quarter GDP was much stronger than expected, and the labour market recorded another decent gain in jobs last month. This followed a period when the direction of travel for the economy was consistently negative, prompting the RBA to lower the cash rate by a cumulative 75bp at their May and June meetings. It is also worth pointing out that traders have completely thrown in the towel on the Aussie. Through February-April and into early May, traders and short-term speculators were substantially net long the Aussie, according to CFTC data. However, over the past five weeks, traders have completely altered their books and are now carrying the largest short position in the AUD since the CFTC started compiling this data 20 years ago. Aussie shorts need to be very careful, as it is becoming something of a crowded trade.
BoJ impotence. Supporting the slightly weaker tone to the yen overnight has been the nomination of two BoJ board members understood to be in favour of further monetary stimulus. Both still have to go through the approval process. Regardless of the board composition, the BOJ will recognise that previous attempts at firing up the economy have achieved very little, and that they have utilised virtually all of their firepower. In recent weeks, for instance, bond buying under the asset purchases program has fallen short because of a lack of supply. Just like many major central banks are discovering these days, the BOJ has also been rendered impotent against the backdrop of these enormously challenging economic and financial circumstances.
Italy’s fate. Whilst markets are pulling apart the lack of details in the Spanish banking rescue, Italy has been caught up in the subsequent market turmoil, bond yields rising and stocks falling. Whilst the Italian economy is nearly 50% larger than Spain, its mortgage debt outstanding is just half that of Spain. Furthermore, Spanish mortgage debt has increased four-fold in the past 10 years, whilst in Italy is has risen by less than half that amount. Remember, interest rates were almost identical for both during this time. Compared to what was going on elsewhere in the run-up to 2008, Italy was not drinking from the cheap credit oasis in the same way as its neighbours. Italy wasn’t running as fast though, with growth averaging 1.5% between 1999 and 2007. Spain was running 2.5 times faster than Italy and Ireland 4 times faster during the same period. But Italy was bloated, always carrying a triple-digit ratio of government debt to GDP, with modest dieting allowing a fall from 113% to 103% over the same period. Whilst Italy does have its challenges, it does have a determined government and more quantifiable mountain to climb vs. Spain, where the true extent of the bad loan situation is a true “known unknown”. The issue is that as time goes on and EU solutions continue to be piecemeal and last-minute, markets are becoming less patient and discerning. These are the dynamics by which Italy will sink or swim in the coming months.
