The Bill Gross Effect

Since the beginning of the year, but particularly over the past month, Bill Gross and Ed Ball's brother, both of PIMCO, have been encouraging professionals to be underweight or short Gilts on the back of a hung parliament and general "the UK is history" (haven't we heard that before) story. Now this is interesting because it has not only resulted in Gilts weakening with respect to Bunds, but also resulted in a very large underperformance of the Gilt Future and its CTD.

In the below chart, the underperformance of Gilt Futures (and CTD) since mid-March can clearly be seen. Yellow line is the 10yr Gilt/Bund benchmark yield spread, the Orange line is the spread between the two CTD yields, and the White line is the ratio of the futures prices.

What is even more interesting is that in the same period, the underperformance of the CTD is marked against the curve. The below chart shows the spread of the yield on the CTD against the benchmark 10yr Gilt. Since mid march there has been an exceptionally large 13bps cheapening.

The point here is that the above evidence points to the conclusion that much of the recent weakness in the Gilt market and steepening pressure has been entirely futures led, and is thus very likely to be speculative and potentially vulnerable to a wash-out.

The Brussels (lack of) Consensus

Larry Summers once said:

"When markets overshoot, policymakers must overshoot too"

This "shock and awe" philosophy has been at the heart of the Washington Consensus that developed during the 1980s and 1990s. Hank Paulson in 2008 failed to follow these principles in dealing with Bear Stearns, the GSEs and Lehman Brothers, only finally "over-shooting" with the introduction of the TARP. The US policy response up to that point had failed to deal with the problem adequately, but the unveiling of a program to deal with the systemic problem was a clear "overshoot". But by then, it was too late to avoid the large systemic contagion as a result of the administration's prior policy. Nevertheless, as markets gained confidence that the banking system had been underwritten and that a Japanese-style malaise had been avoided, confidence was restored.

There appears to be a vast divide between the Washington Consensus and the Brussels Consensus. Well not so much a divide, as more like the latter does not exist! An example:

*VAN ROMPUY: EU CAN HELP GREECE IF MARKET FINANCING INSUFFICIENT

A damp squib from a man with the personality of a damp rag and the appearance of a low-grade bank clerk (with apologies to Neil Farage of UKIP).

But more seriously, I am astounded by the inability of the EU to come up with an adequate policy response. It is incredible that Greece has decided to market itself as an EM issuer when it has such a large amount of debt to finance over the next few years, to an investor class that is highly proficient with respect to debt restructuring. It seems barmy to expect this to result in anything but higher yields. The German stance with respect to only lending to Greece at market rates only serves to compound the problem - Greece last borrowed from the market at around 6%, a rate that ensures fiscal insolvency very rapidly.

The price action of Greek bonds (see below) and general commentary from market professionals suggests that many now are resigned to the prospect of a Greek debt default and restructuring. As one astute person commented to me, the markets appear to have an erie sense of calm about them, as if such a default would have no contagion whatsoever. Perhaps it is one of those "the market needs to see it" type of events and until then it will be business as usual?

In January and February, the view of contagion to the rest of the PIGS was practically universal, and markets moved accordingly, to some degree. But with the threat of CDS regulation and the EU finance leaders' initial statement on Greece that all died down, presumably, because it gave the impression that it was a more broad mechanism for assisting the other troubled states. However, the Greek situation just keeps getting worse. Perhaps the market is right to ignore them, judging that the Greeks are a special case in that they have such a poor track record with respect to implementing reform/reporting statistics etc., and the others will be fine?On the other hand, I have a hard time believing that a Greek restructuring would have little contagion. As a friend reminded me today, the fiscal contagion to the rest of the Eurozone is multiples of Argentina.

I was definitely one of the optimists early on (as per my earlier posts on Greece), but that was based upon the premise that the EU had learned the lessons of Paulson's utter screw up with respect to BSC/FNM/FRE/LEHetc and would come up with some sort of systemic programme to avoid such contagion. But they can't even deal with the first entity!

Are the Germans likely to change their tune on market rates vs subsidised rates? Perhaps, but it is probably already too late, given that GGBs trade like LEH stock did in those last two weeks.