BMI View: Despite efforts by the European Central Bank to quash volatility in the eurozone by eradicating left tail risk (there is now surprisingly little talk of a euro breakup) we warn of the possibility of a major blowback in 2014. We keep coming back to same fundamental constraint facing the euro area: a lack of serious structural reform of the currency union. Progress on a combined banking, fiscal and political union, as well as efforts to bolster internal and external competitiveness, has been minimal and suggests that the ECBs anaesthetic could abruptly wear off.
The eurozone in 2013 is a markedly different place to the eurozone of 2012. The breakout in financial market turmoil last year, underpinned by speculation of the euro area disintegrating, has given way to a period of relative bond market stability alongside stagnant economic growth. We have euphemistically referred to this transition as the eurozone crisis shifting from an acute to more chronic phase. Talk of the eurozone breaking apart has died down leaving a dearth of volatility and a more optimistic narrative. However, we view this newfound optimism in the markets as somewhat misplaced.
While we believe that policymakers have successfully defused near-term risks, we come back to the same constraint: a lack of serious structural reform. Without a fundamental overhaul of the euro area to tackle the internal and external competitiveness deficit, as well as progress on implementing the final stage of monetary union to satisfy all primary conditions of an optimal currency area (namely full banking, fiscal and political integration), the crisis can only ever be put on the backburner. With this in mind, we believe that volatility is cheap, which opens up opportunities on the long side for VSTOXX futures, as well as there being scope for some bearish sovereign credit positions. Below we take a closer look at what is pinning down volatility, possible reversal triggers and potential volatility and sovereign credit plays heading into 2014. In the case of the latter, we highlight in particular French and German bonds, which we have long believed would eventually be ripe for a bearish position.
Part 1. The Roots Of Eurozone Risk Re-Pricing
The most obvious signs of a low volatility environment are the stabilisation in periphery sovereign bond yields and subdued VSTOXX pricing. The VSTOXX index is analogous to the VIX and reflects implied volatility based on EURO STOXX 50 option prices. Although we have previously warned about implied volatility inference (see our online service, September 2012, "The VIX: A Cautionary Tale In Prediction"), particularly in light of lower equity trading volumes, the chart below nonetheless coalesces with the stabilisation of eurozone financial markets since the end of 2012.
| All Calm On The Western Front |
|Eurozone - VSTOXX Index & EUROSTOXX Volume|
Euro net specs have clawed back with the futures market now net long. This has mirrored developments in the basis swaps market, with the 2-year swap paring back towards 2011 levels as extremely negative investor sentiment is wound down.
| Confidence Returning |
|Eurozone - EUR Net Specs & 2-Year EUR Basis Swap|
Broadly speaking, we believe that there are three factors which have underpinned risk re-pricing in the eurozone. The first two are obvious: the ECB's liquidity provisions to the banking sector and the much lauded Outright Monetary Transactions (OMTs). The third, Germany's federal election in September, is more subtle. We address each of these in turn.
Interbank Market Stability Is A Red Herring
One of the most striking signs of the volatility squeeze has been in the banking sector, which began with the heavy handed intervention in the interbank market in 2008. This has been epitomised by the 3-month FRA-OIS spread, which has both compressed and become more stable. The spread, depicted in the chart below, reflects the difference between 3-month EURIBOR and 3-month EONIA. Both rates measure unsecured lending in the interbank market, with EURIBOR reflecting a term lending rate and EONIA a pure overnight rate. As such, EURIBOR is associated more with principal risk than EONIA and so should command a premium. Therefore, the drop in EURIBOR rates reflects a lower premium for unsecured fixed-term lending compared to the overnight rate. What this means in practice is less clear cut. On the one hand, the spread compression reflects an improvement in risk sentiment given that efforts to boost liquidity (reduced collateral requirements, emergency liquidity assistance, LTROs etc.) have improved the near-term credit quality of European banks.
| Eerily Calm? |
|Eurozone - 3-Month EUR FRA-OIS Spread|
However, it also reflects a decline in unsecured interbank lending (EONIA volumes are down by around one-third compared to 2007) as the aforementioned liquidity provisions from the central bank have reduced demand for funds in the wholesale market. For example, back in October 2008 the ECB switched to offering liquidity via the MRO (Main Refinancing Operations) at a fixed rate open tender from a variable rate fixed tender, which improved liquidity and simultaneously reduced demand for interbank borrowing. Whereas previously banks would bid on a set amount of liquidity with the rate determined in a competitive auction, the new framework allows banks to acquire as much liquidity as needed (subject to a collateral constraint) with the ECB determining the cost.
| EONIA Volumes Head South |
|Eurozone - EONIA Volume, EURbns|
Though important at the time, support from MROs has since been dwarfed by the expansion of the ECBs Long-Term Refinancing Operations. MROs and LTROs are the staple of the ECB's Open Market Operations, with the former historically providing the bulk of the liquidity to the banking system. MROs are conducted on a weekly basis and have a short maturity of a week, while LTROs are conducted monthly and now have maturities up to three years compared to the three-month expiry that prevailed before the financial crisis. By securing a block of liquidity at low cost for three years, the eurozone's shakiest banks have been effectively taken out of the interbank market and put in quarantine since the first LTRO allotment was provided in December 2011. This does not mean that banks are fully funded at the ECB, but that demand for traditional wholesale funds has reduced significantly.
Although banks can now acquire as much liquidity as needed, there is still a collateral constraint. However, this has been diluted in the past to free up more cash. In addition, many banks ploughed into cheap Spanish and Italian bonds in 2012 which had further bolstered their ability to secure funds outside of the wholesale market.
The combination of these factors means that bank funding stresses have been disguised by support from the ECB, and have not been showing up in higher spreads and volatility in the interbank market. In other words, the combination of relatively high short-duration cash supply coupled with lower demand for wholesale funds has killed off interbank volatility, at least for now. Finally, aside from the evolution of demand and supply dynamics, the LIBOR scandal has reduced confidence in opaque rate setting and further driven borrowers out of the market.
OMT: Try Before You Buy
What the LTROs and MRO adjustments have done to bank funding, the OMT has done for sovereign funding. Although yet to be tested, the OMT facility provides the ECB with scope for discretionary bond purchases in the secondary market under certain conditions (namely a target sovereign issuer first committing to a structural macroeconomic adjustment programme). The mere provision of such a facility has indicated the central bank's willingness to cross the Rubicon and directly support the sovereign debt markets, which under the leadership of previous ECB Governor Jean-Claude Trichet was still considered borderline heretical.
The impact on the markets has been clear to see. The Spanish and Italian sovereign curves have been reined in, with 10-year yields down around 300bps and 200bps respectively since mid-2012. A messy Italian election in February and growing risks of the current coalition folding, coupled with the ongoing corruption scandal engulfing the Spanish government, has failed to usurp the OMT feel good factor which continues to anchor yields.
| German Premium Persists |
|Eurozone - General Collateral Rates Relative To Germany, %|
By backstopping periphery sovereign bonds, the ECB has concomitantly restored stability to the repo market, with general collateral rates for Spanish and Italian paper converging back towards German bunds. An optimal currency area requires centralised fiscal policy and ideally a single issuer of sovereign bonds backed by the public finances of the Member States. Otherwise, as has been the case during the eurozone crisis, the market will differentiate between stronger and weaker credits, which amplifies the asymmetry in liquidity conditions (i.e. Germany being cash rich and Greece being cash poor). Put simply, not all sovereign bonds are created equal. The convergence in general collateral rates in the chart above therefore suggests that differentiation based on near-term credit risk has subsided, although clearly the German quality premium persists.
While we cannot deny the power of the OMT, we remain sceptical about how long the goodwill can last. It seems to us that the market has run with it, without fully scrutinising the framework. For instance, it remains unclear when the ECB would decide to intervene (even if a sovereign state seeks a bailout, the central bank still has discretion over the timing of purchases) and how large its bond buying programme would be. For us, the biggest uncertainty concerns the period after the ECB begins to purchase sovereign bonds. Would the ECB threaten to stop purchases if the government in question failed to meet its reform targets, which would risk triggering a funding crisis? Or, would the central bank provide rolling support regardless, in which case its independence and credibility would be compromised? For the moment these questions are not being asked and the ECB has the benefit of the doubt, but eventually such concerns will come back to the fore if there is no progress on structural reform and use of the OMT becomes more likely.
The World Waits For Germany
While the OMT has done much of the heavy lifting in terms of stabilising the bond markets, we believe that widespread expectation of a favourable shift in eurozone policymaking after the German federal election in September has also had a part to play. Indeed, sentiment seems to have converged on the view that the somewhat implacable stance adopted by Chancellor Angela Merkel and her Christian Democratic Union (CDU) party will soften once a new term has been secured. Austerity demands would concomitantly ease, with more progress on measures such as universal deposit insurance and a single banking supervisor. While we believe that a shift in rhetoric is likely, we do not expect a major volte face as German lawmakers are unlikely to do anything markedly different to that of recent years. The pace of reform will be as pitifully slow as it is now.
Part 2. Trigger Points
In light of the aforementioned dynamics holding down volatility it is possible to identify potential reversal triggers. The most immediate risk comes from short-term rates which are under pressure on several fronts. Most recently, taper talk has jolted markets across the board as the Federal Reserve paves the way for an eventual normalisation in monetary policy. In the eurozone, short duration government bonds have sold off and EURIBOR futures have followed the short-sterling market in bringing forward the first expected rate hike. Volatility is especially pronounced during turning points in the cycle (historically this occurred at major inflexion points for policy rates, whereas now this could come in the form of diverging QE trajectories) and is not just confined to the money markets, with equity and FX similarly hit. A continued slew of positive economic data out of the US (particularly non-farm payrolls) would strengthen the case for Fed tapering and underpin greater volatility in European markets.
Although we see few risks of the ECB beginning to hike rates, given that its restrictive mandate has left it further behind in the monetary policy cycle, money market rates could nonetheless head higher. With the refinancing rate already at 0.50% and the deposit rate hitting the floor, coupled with the limited ability to provide direct liquidity in the near term, the ECB has very little influence over short rates and the term structure other than verbal intervention. Moreover, the fact that the central bank hiked rates by a cumulative 50bps in 2011 to ward off a perceived inflation threat, despite the global economy still being in the throes of crisis, has meant that a perverse precedent has been set which could feed into market expectations of tight policy, particularly as eurozone demand picks up. Even if short rates head higher without becoming more unstable, such a transition in the markets would nonetheless undermine the fixed income complex and potentially trigger heavy selling that would then propagate volatility.
Aside from potential taper contamination, developments on the ECB's balance sheet - particularly banks' repayment of LTRO funds - provide cause for concern. Given that the LTROs have become the dominant form of liquidity provision, loan repayment has dramatically shrunk the ECB's supply of credit to the financial system, with nothing in place to fill the void. The credit transmission channel is clearly still broken.
| Passive Tightening |
|Eurozone - ECB Balance Sheet Data, EURbn|
Although LTRO repayment is a form of passive tightening, one could argue that that ability to begin repaying loans is a positive sign of reduced liquidity stress in the banking system. However, we would caution that this masks significant disparity at the micro level, particularly between banks in the core and periphery. Around two-thirds of the LTRO allotments were taken up by Spanish and Italian banks, which are far from returning to full health.
| Spain & Italy Load Up On LTROs |
|Eurozone - Estimated LTRO Take Up, EURbn|
The chart below shows that while 90% of LTRO-1 has been repaid and 75% of LTRO-2, only 40% of banks have fully repaid the first allotment (expiring in December 2014) and 20% of the second. It is likely that as the first maturity looms ever closer, funding stresses at individual banks (mainly in the periphery) will resurface.
| LTRO Gradually Being Repaid |
|Eurozone - Cumulative LTRO Repaid (%, LHS) & Cumulative Number of Banks Fully Repaid (%, RHS)|
Excess Liquidity Is Still Key For The Money Markets
Measures of excess liquidity at the ECB, which provide an indication of tightness in the money markets, nuance our argument further. Excess liquidity can be calculated by combining bank current account holdings with use of the deposit facility, while subtracting the marginal lending facility and reserve requirements. This provides an indication of how much liquidity is available that is surplus to requirement.
| Dwindling Excess Liquidity |
|Eurozone - ECB Balance Sheet Data, EURbn|
As the chart below shows, EONIA volatility surges when excess liquidity is low. Some have suggested a threshold between EUR200-250bn, but for illustrative purposes we have used EUR300bn as the benchmark. As it stands, excess liquidity is now down to around EUR243bn at the time of writing.
| A Potential Volatility Trigger? |
|Eurozone - Excess Liquidity At The ECB & EONIA Volatility|
We have also measured the surplus by differentiating between the supply of liquidity and the demand for liquidity, which provides an almost identical estimate to the one above. On the supply side we have augmented Open Market Operations (mainly MROs and LTROs) with the Covered Bond Purchase Programme (CBPP 1&2). The Securities Market Programme (SMP) has been left out of this calculation as previous purchases have been sterilised and so do not affect aggregate liquidity. On the demand side we have combined required reserves and autonomous factors. The excess of supply over demand obviously provides the liquidity surplus. The chart below shows the drawdown in excess liquidity has been driven as much by LTRO paydown as by a rise in autonomous factors. Autonomous factors are effectively outside of the ECB's control as they are factors unrelated to counterparty liquidity demand or the central bank's own liquidity management operations. The ECB has to estimate the volume of autonomous factors, which largely comprise banknotes in circulation and government securities, as well as some residual factors.
| Another Take On Excess Liquidity |
|Eurozone - ECB Balance Sheet Data & Excess Liquidity, EURbn|
Ultimately what this all tells us is that demand for liquidity has been gradually increasing at a time when the supply is being sharply cut back. Historically that has triggered considerable EONIA volatility. It is possible that during the crisis there has been a regime change such that EONIA and other benchmark money market rates are now less responsive to excess liquidity than before. There is merit to this argument given the aforementioned drop in interbank volumes and other signs of inflexion such as EONIA decoupling from the ECB's main refinancing rate. However, we warn that as LTROs are paid back, liquidity stresses could build and force weaker banks back into the interbank market at a time when there is less excess liquidity.
The first signs of stress will likely be in the repo market, where most banks operate. Unsecured lending, which the EONIA rate represents, occurs mainly between large and financially robust banks. If secured repo rates rise and become more volatile, banks will be pushed into the unsecured market with volatility being transmitted through to EONIA and the wider fixed income universe. This would be exacerbated by hoarding of quality collateral. That the repo market (we have used the Eurex GC Pooling rate) has become more volatile since the beginning of the year as LTRO repayments have increased, is a somewhat ominous sign in our view.
| Watch The Repo Market |
|Eurozone - EONIA & Repo GC Polling Rate, %|
There is a caveat, of course, which is that the ECB could expand LTROs to ease liquidity conditions, which could in turn dampen volatility. Even if this were the case, volatility would spike before settling down. We would also nonetheless warn that there is a limit to how much liquidity the ECB can continue providing a banking sector which has yet to fully deleverage and restructure. Indeed, if the ECB had to continually prop up eurozone banks with cheap loans, eventually the market would question the long-term solvency of individual names.
The Political Dimension
Much like our belief that excess liquidity at the ECB could resurface as a volatility trigger, we believe that political risks will similarly re-emerge. As we stated above, the OMT facility has contained the fallout from political ructions in Italy and Spain this year, which would otherwise have risked another bond market rout. Even a collapse of the Italian coalition may not be sufficient to precipitate major turbulence in the markets, at least not for an extended basis (Italy has had a long history of revolving door governments since the Second World War). However, we believe that the German federal election in September will be important. The actual result per se may not spur much activity in the markets, but the realisation after the ballot that eurozone policy will not be fundamentally altered over the next few years could reignite fears about the future trajectory of the euro area. It is at this point that the realisation of no major policy shift in German policy, political instability in Spain and Italy, Fed tapering, declining excess liquidity at the ECB, renewed scrutiny of OMTs, weak economic growth and perniciously high unemployment, could combine into a potent cocktail which triggers a new wave of financial market turbulence.
Although it is difficult to pinpoint the exact trigger, the current low volatility environment will not last indefinitely. The markets cannot be continually placated if there is no major structural reform in the eurozone to restore competitiveness, boost growth, bring down unemployment and stabilise sovereign debt trajectories. With this mind, and given the distinct lack of meaningful reform thus far, we believe that there are opportunities to be long volatility heading into 2014, and short some sovereign credits. Our first port of call is the VSTOXX index and the associated futures. At current pricing, we believe that there are opportunities on the long side across the curve.
EURIBOR futures are a tougher play. Given the lack of control the ECB has over short rates in the near term, we see scope for EURIBOR futures, particularly in the 2014 to 2016 maturity area to drift lower (i.e. pricing in a higher policy rate). Ultimately, however, if money market conditions continue to tighten, the ECB may be forced to intervene at which point EURIBOR contracts would normalise towards the refinancing rate, particularly as monetary policy tightening will not be on the agenda for some time yet. It is also possible that if the Bank of England intervenes to rein in the short sterling market (the BoE has far more discretion in pumping in liquidity to the market than the ECB) in the coming months, this could similarly pull in EURIBOR rates.
| ECB Risks Losing Influence Over Short Rates |
|Eurozone - EURIBOR Contracts, Implied Rate %|
In the sovereign credit space, the ECB has made it very difficult to short Spanish and Italian bonds. However, there may be scope on the short side of core debt. For example, a pickup in German growth, coupled with taper contamination and the fact that the ECB will not be buying bunds (as is a possibility for Spanish and Italian debt), could push German yields higher. France could similarly present a short opportunity but for different reasons as weak economic growth compounds the increasingly ugly narrative about declining competitiveness and a hefty public debt burden. Again, the ECB's OMT facility, if used, would not extend to the French market, further suggesting that the market could push yields higher.