As G(u)ilt(y) as Greece?

The past couple of weeks have witnessed yet more UK-bashing, with Gilts underperfoming significantly, as the Bank of England has remained dovish in the face of rising inflation, fiscal concerns have spilled over from Greece and the rest of the iPIGS, opinion polls have moved to indicate that the UK is heading for the much-hyped "hung parliament", and economists have written contradicting letters to the Sunday Times & FT.

Professionals have pointed to the (undeniably) large deficit numbers and the fact that the Bank of England is no longer on the bid, and thus, encouraged by the successful speculative attacks upon Greece, many are declaring the UK as "next". Certainly, I share their worries. The deficit is unsustainable and something needs to be done about it, and will be done about it. Regardless of what Gordon Brown says in his electioneering, there is already a consensus within Westminster with regards to reigning the deficit in. Although, undoubtably, markets would react unfavourably on the news of a hung parliament, I believe that such a dip should be bought. The UK has a long history of successful fiscal consolidation, and surveys show the population is onboard. But all of this is an issue for another day - probably the 6th May.

More currently, Gilt valuations look stretched, with Gilts trading as wide to Bunds (see chart below) as they have since 2005 when UK rates were significantly higher than EU rates. So adjusting for this, it is clear that they are very cheap for one reason or another.

Looking at Bonds vs OIS is perhaps a better way to gauge value as it represents the difference between what the bond yields and the (more or less) risk free way of funding them overnight. The below chart shows 10yr Gilts vs SONIA (green), the GDP-weighted EMU 10yr yield vs EONIA (orange), 10yr Bunds vs EONIA (pink) and 10yr USTs vs OIS (white). Prior to the introduction of QE, Gilts traded somewhere in between the overall EMU spread and the Bund spread at similar levels to the US (although this widened somewhat as RBS and Lloyds went into meltdown in January 2009). As I'll discuss below, the Gilt/Sonia spread has been affected by QE, but the dramatic widening of this spread since August to now be right at the same levels as the EMU average is notable. Regardless of whether the UK really is AAA or not, it is clearly not the several notches lower that the EMU average represents. In fact, Gilts trade wider to Bunds than Italy or Spain.

Next, let's zoom in on the Gilt/Sonia spread to look at the effects of QE (see below). The introduction of QE in March was followed by a sharp tightening in the spread, representing the increased demand for Gilts coming out of the BoE (initially appearing to be ~50bps). The tightening went further (~15bps) as the BoE extended the plan. From the summer onwards the market anticipated the end of the QE program and unwound the richening in Gilts as this demand was priced out. But the spread has widened something like 40bps further. Much of this move can probably be attributed to fiscal/election issues discussed above, but with speculative positioning looking short, any positive newsflow is likely to lead to a short-covering rally. Indeed, opinion polls are yet to capture the response of voters to the latest reports of Brown being a bully.

Regarding the amount of Gilts that the DMO needs to sell, many neglect to account for the fact that the private sector is currently running a financial surplus as a result of a need (real or perceived) to rebuild balance sheets. In fact, the country as a whole is likely to record a Current Account surplus (see chart below - currently a deficit of 1.28% as of Sep2009), meaning that - as in Japan - there will be significant demand for Gilts from banks intermediating the private sector surplus. This is a key difference with Greece (C/A ~15%) and the rest of the iPIGS - the UK does not require much external funding. And finally, UK monetary policy has been eased aggressively and the exchange rate has depreciated markedly, providing a very large amount of stimulus, providing a support to growth that the EMU periphery have not had.

Now, there is a 50yr syndicated deal to be priced tomorrow and a 10yr auction on Wednesday that have a combined duration of around 110,000 contracts. Use the dip to scale into longs vs Bunds.

TLGP for the Eurozone

The background to the Eurozone fiscal crisis that began with Greece needs no introduction, but the constant "will they or won't they" aspect of recent press reports has added significantly to uncertainty around the end-game. This is a case of too many policymakers, too many journalists, over-reliance on algorithmic translators such as Babelfish and the impatience of the market with respect to a resolution.

The universal view of market participants has been that a resolution of the Greek issue would only cause speculators to move onto the next victim. This was a lesson learned in 2008 as the way in which Bear Stearns was bailed out provided a relatively low risk way for speculators to create a synthetic run on a bank (creditors were bailed out, equityholders were wiped out - so buying protection in CDS and shorting the bank equity was at worst a dirty hedge in the end game, and at best a home-run). As the chart below shows, this has indeed happened as speculators have moved onto Portugal and Spain.

Of course, with respect to Eurozone debt, the scenario is somewhat different. The most obvious is the lack of "equity" (how do you short the "ownership" of a country?). Market participants have therefore (rationally, perhaps) shorted the EUR and European equities (especially those of the peripheral) and these have obviously performed very poorly. The second major difference is that market participants expect this scenario to play out and are thus positioned as such. The payoff profile of these trades is thus very different from the bank scenario (despite the protestations of many Americans, the EUR cannot go to zero), and what was at worst a Mexican Hedge (i.e.-not a very good one) is more like a Texas Hedge (i.e.-double the risk). This means that a policy response which deals with the system-wide problem will be far more potent.

Many have argued that it is unfair that Germany should pick up the tab for the profligacy of other Eurozone nations, and also that it is unfair that Ireland has embraced austerity in the name of restoring credibility and sustainability, while other states are bailed out. They have also argued that Germany will refuse to pick up the tab as it would introduce Moral Hazard and raise Germany's borrowing costs.

All of these points are very true. But they miss some, in my view, very important points. Firstly, Germany is aware that Greece will struggle to introduce austerity and, as a result, requirements attached to assistance only need to appear stringent to a domestic audience. Secondly, the experience of Lehman Brothers demonstrated what happens when an entity is sacrificed on the alter of Moral Hazard - there is no interest in Europe to ignite yet another financial crisis when the Eurozone bank balance sheets still hide significant losses. Thirdly, according to the BIS survey of banking claims (http://www.bis.org/publ/qtrpdf/r_qa0912.pdf ...page 62/63), to Greece alone, there are $245bn of claims, $39bn of them from Germany and $73bn from France.

This is a side effect of the Eurozone as a whole running a balanced Current Account. Forthly, contagion has already begun as speculators have moved onto other nations - Germany hates speculators. Finally, Germany is a "hard money" country, with a desire for a strong currency - it does not want a currency that trades like the Drachma, it wants one that trades like the Deutschmark - this is a matter of national pride.

The Wall Street Journal last night ran an interesting story (http://online.wsj.com/article/SB10001424052748704182004575055292744721172.html?mod=WSJ_hps_LEADNewsCollection) reporting that Germany and the EU are considering loan guarantees for Greece and for other troubled nations. This is interesting because it clearly demonstrates that EU policymakers have taken on board the lessons regarding the domino effect on banks in 2008. Secondly, it does not cost anything upfront apart from, perhaps, a small rise in German CDS as the market moves to price in the reality that there really is a single fiscal authority in the Eurozone. In many ways, if enacted (I believe it is inevitable that it will be), this shows striking similarities with the TLGP (Temporary Liquidity Guarantee Programme) announced by the FDIC at the height of the panic in October 2008. This was a loan guarantee program for bank debt and marked the point at which the wholesale run on the banking system ended (see the below chart of Libor-OIS spreads). This strongly suggests that such an announcement would lead to a very sharp tightening of Sovereign spreads.

This move, of course, would also serve to hurt speculators. The French & Germans must be rubbing their hands with glee.