Good morning,

Markets are called lower this morning. This is what's happening today:

  • Moody’s yesterday cut Spain’s rating three steps to Baa3, one level above junk, from A3, citing the nation’s increased debt burden, weakening economy and limited access to capital markets. Moody’s also lowered Cyprus’s bond rating to Ba3 from Ba1, attributing the downgrade to the material increase in the likelihood of a Greek exit from the euro area, and the resulting increase in the probable amount of support that the government may have to extend to Cypriot banks;
  • Rifts are deepening with Greek elections on June 17 risking the first exit from the single currency as voters buckle under the continent’s most-severe austerity program;
  • Spanish bond yields reached a record after the nation’s request for aid for its banks fueled speculation the world’s 12th-biggest economy may need a full rescue;
  • 10-year Italian debt is yielding 6.171%, 10-year Spanish debt is yielding 6.705% and 10-year Portuguese debt is yielding 10.698%;
  • Italy will be auctioning E4.5bln in 3-year paper;
  • Brent is trading at $97.61;
  • This afternoon pricing of 3 Malta Government Stock issues will be announced.

Moody's downgraded Spain from A- to BBB-, just one notch above junk status with a negative outlook. Moody's downgraded Spain for three main reasons being:

  • The E100bln loan increases the debt burden of the Country. Spain which had a debt/GDP ratio of 70% now has a debt/GDP ratio of 100%;
  • The Spanish government has limited access to financial markets because of rising yield and the high debt/GDP ratio;
  • The Spanish economy is expected to remain in recession till at least next year.

What will happen if Greece leaves the Eurozone? Here is what Socgen expects will happen if Greece leaves the Eurozone:

Direction contagion:

  • Greece will see a fall in GDP of 25-50%;
  • A devaluation of their new currency by 50% against the Euro;
  • We will see E360bln being wiped off from Eurozone GDP (Eurozone’s total exposure to Greece) which is c3.8% of Eurozone GDP;
  • Equities will fall by c10%;
  • The EURUSD will fall to $1.1 from the current level of $1.2524;
  • To hedge the portfolio investors should be exposed to US Treasuries, Gilts and Bunds – stay away from peripheral euro debt.

Indirect contagion – the effect of this is much worse than that of direct contagion:

  • European equities will fall by c50%;
  • Significant deleveraging due to deposit outflows (20-30% as in Greece);
  • Funding gap of E200-400bln in Italy and E145-280bln in Spain;
  • Particularly damaging for countries like Hungary and Czech Republic because their GDP is effected significantly by external trade;
  • Potential to generate a ‘Lehman Moment’ in the Eurozone;
  • ECB heavily constrained, meaning LTRO3 is unlikely;
  • Doubling of the ESM from E500bln to E1trn.

Even the most die-hard fans of monetary union cannot rule out the possibility of Greece exiting the eurozone. It is not as simple as believing that we will wake up on 18 June, after the re-run elections, to find that the Greek people have voted to either stay in or leave – any departure would be drawn out and messy. Furthermore, a decision to stay in would not make the stresses within the system go away. Investors need to be ready for the possibility of a Greek exit but also remain aware that Europe’s problems will continue irrespective of which countries are still using the euro at the end of the year. Structural reform to Europe’s finances is needed, as is a plan for growth, and whether or not Greece sticks to an austerity programme, Spain is caught in a lethal web of recession, a weak banking system and stretched government finances.

The re-run of the Greek elections is being portrayed as a choice between keeping the euro and sacrificing it in return for rejecting austerity. This is a massive over-simplification, though one which suits the ‘pro-bailout’ parties, as recent opinion polls show. A single outright winner of the election is unlikely, so a fresh round of bargaining will be needed before a government can be formed. Syriza wants to reject the terms of the bailout but does not want to leave the eurozone. Carrying on down the current path doesn’t look sustainable over the long term anyway. And whatever anyone says now, in reality all sides will seek a compromise which causes the least possible damage to the eurozone and to Greece. In short, uncertainty is the only certainty about the post-vote environment.

Dollar Bull – We remain strategically short the euro. Since inception, the EUR/USD has averaged around 1.21, and it goes without saying that the euro’s survival has seldom been more precarious. Our best guess is that in the first instance, a Greek exit would take the EUR/USD to 1.10 – though we may be closer to that level by 17 June anyway.

Bund overvalued compared to other safe havens – Bunds are less attractive than Gilts or Treasuries. Any solution to keep the eurozone together is going to require very accommodative monetary policy from the ECB (low rates, bond buying) for a long time. That anchors the front end of the European curve, but the safe-haven flows out of the peripheral bond markets into Bunds has gone too far: 1.36% 10-year yields sit uncomfortably next to a 1.26% 10yr CDS spread which has widened as European sovereign credits have remained under pressure.

Understanding the difference two French banking perps which are callable next year

  • 8.667% BNP 2013-49, BBB+, priced at 97.50 yielding 11.05%
  • 7.756% Socgen 2013-49, BBB-, priced at 78 yielding 40.80%

Two French Banks, both perps callable next year yet with prices which are totally different from each other. The market is telling you that there is a close to certain probability that the 8.667% BNP perp will be called though the market is unsure about whether Socgen will be calling the 7.756% Socgen perp. Considering callable bonds have negative convexity, the 7.756% should be trading close to par like the 8.667% only if the market thinks it will be called.

In times of uncertainty, for those investors who are hesitant to invest in bund or investment grade bullets because the yield is too low, the next best thing would be the likes of the 8.667% BNP which gives a descent yield considering the volatile markets plus there is a much greater probability that the capital will be paid back as opposed to the 7.756% Socgen which is questionable.

For further information on these two bonds or other stocks and bonds we offer, contact our offices on 25688688.

Good day and happy trading!

Kristian Camenzuli