The EFSF and The Euro
By Marc Chandler
The European Financial Stability Fund (EFSF) is planning its first issue this week. Talk was of a 3-5 bln euros of a 5-year issue priced 8-10 bp on top of swap rates. This would imply a yield of about 2.85% compared to 2.32% German 5-year yield. The EFSF bonds are expected to be priced tomorrow. As was the case of the EFSM bonds sold earlier this month, we expect demand to be strong, as there is a shortage of AAA paper in Europe. Seeing how strong the demand will be, market talk now suggest 5 bln euros will be raised. A number of sovereigns, including China, Japan and Russia, seemed to express interest, but not necessarily in addition to current holdings.
Some observers suggest that the EFSF bond will be the first proxy of the fiscal state of the euro zone, but this seems a bit exaggerated as the EFSF is structured in way to establish its triple A status. However, even this is not clear, though tomorrow’s bond will be AAA. There is some talk that maybe to make the EFSF guarantee/loan ratio more efficient, maybe the EFSF can offer bonds of various yields (i.e., risks/ratings).
In fact this is one way in which the EFSF differs from the EFSM. Exactly what the EFSF is not clear. What is clear is that various new initiatives that European officials are debating, the EFSF is the center piece. Even ECB President Trichet is calling for improved quality and quantity of the EFSF. ECB Board member Stark has cited the possibility that the EFSF purchases bonds and/or injects funds into commercial banks.The EFSF head Regling said last week that in order to preserve the AAA status, the EFSF could only really lend 250 bln euros rather than the 440 bln headline figure. The debate among finance ministers is instead of increasing the size, as Germany and others are balking, allowing it to lend the 440 bln euros that have been guaranteed.
Judging from market developments–peripheral and sovereign and banks CDS, bond spreads and the euro rally–point dramatic position adjusting, powerful short squeeze in ideas that the EFSF will be reformed and allow European officials to get ahead of the curve of market expectations.
Nevertheless there are many issues that need to be resolved and we are not convinced that the political context will allow as smooth of a resolution as the market seems to be pricing in. For example, if Greece can borrow from the EFSF to buy back its own bonds, will that not force other holders to mark-to-market ? What is the seniority of EFSF obligations? Will officials accept the EFSF being the largest creditor of a country that is rated below investment grade?
The market seems to be looking beyond these issues today with a consultant report out suggesting a resolution of the debt crisis in the coming months, will free ECB to hike rates in the third quarter. This is a bit later that the Euribor strip implies, but is still fairly aggressive in our reckoning. Not only does the ECB expected price pressure to peak by early Q2, but recall too that Trichet steps down in early Q4. Is it really likely that the last thing he does in office is hike rates ? One would suspect that the new central banker would be "given" the opportunity to brandish their anti-inflation credentials. In this case, strongly expect BBK President Weber to succeed Trichet and his anti-inflation cred is stellar.
Ultimately we think that the debt dynamics in the peripheral of Europe is such that lower interest rates are not sufficient and that some kind of restructuring to lower to debt burdens will be necessary.
Meanwhile, the euro’s two week rally is extending into the new week. The move above $1.3635-50 today is important and will embolden the short-term speculators and suggest scope for another two cent advance.