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SEB report: The Greek chicken race


In this edition of Fixed Income Insights, SEB's experts take a closer look at recent developments in the eurozone debt issue and conclude that the political system will continue to ensure a crisis is …

In this edition of Fixed Income Insights, SEB's experts take a closer look at recent developments in the eurozone debt issue and conclude that the political system will continue to ensure a crisis is avoided. Market implications include continued upward pressure in intra-EMU spreads up until the EU summit in June, further macroeconomic concerns, volatility and lower risk appetite. With an acute crisis averted, the experts believe the ECB will continue to raise rates gradually, delivering its next hike in July followed by another in the fall.

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  • 1. THURSDAYThe Greek chicken race 26 MAY 2011In this edition of Fixed Income Insights, we take a closer look at recent developments in the Euro- EDITORzone debt crisis and conclude that the political system will continue to ensure a crisis is avoided. Jussi HiljanenMarket implications include continued upward pressure in intra-EMU spreads up until the EU +46 8 50623167summit in June, further macroeconomic concerns, volatility and lower risk appetite. With an acutecrisis averted, we believe the ECB will continue to raise rates gradually, delivering its next hike in CONTRIBUTORSJuly followed by another in the fall. Page 4 Olle Holmgren +46 8 7638079Take profit on SGB3105 vs. SGB3107 flattenerDriven by a flattening of the nominal curve and a slight increase in SGB3107 (2017) relative to Elisabet KopelmanSGB3105 (2015) BEI, our SGB3105 vs. SGB3107 flattener recommended on Mar 17 has almost +46 8 50623017reached its target. Given the carry outlook, we prefer to take profits on the position. Page 2Expect further widening in swap spreads Anders SöderbergFollowing the Swedish National Debt Office’s forecast of lower borrowing than either we or the +46 8 50623021market had expected, SEK swap spreads widened with long spreads reaching and breaching ourend-2012 targets. We continue to expect wider swap spreads, revising our forecasts upwards.Next Fixed Income Insights due on Jun 9Due to public holiday on next Thursday (Ascension Day), next edition of Fixed Income Insights is dueon Jun 9. SEK FRA curve (bps) Who owns the Greek government debt? (pie chart approx. figures. Boxes: likely effect of a 50% haircut) 60 Total debt ~€340bn Quake EMU/IMF IMF 55 Intra-EMU spr emergency loans not likely to be EMU 15 w idening written down 38 Greek and foreign 50 pension funds and Other other private 45 ECB will take a 115 investors will take loss but has ECB the full loss bought its bonds 40 40 below par. It will face additional losses if Greek 35 banks default PIGS banks have tiny exposures. 30 Greek Banks German and Greek banks will 60 need capital Foreign banks French banks 25 Jun12 / Dec13 72 have most injections of about exposure but €25bn to handle a losses should be 20 50% write off Jan 1 Feb 1 Mar 1 May 1 Apr 1 manageable 34You can also find our research materials at our website: www.mb.seb.se. This report is produced by Skandinaviska Enskilda Banken AB (publ) for institutionalinvestors only. Information and opinions contained within this document are given in good faith and are based on sources believed to be reliable, we do not represent that they are accurateor complete. No liability is accepted for any direct or consequential loss resulting from reliance on this document. Changes may be made to opinions or information contained hereinwithout notice.
  • 2. Fixed Income insightsCentral banks ECB Fed Bank of England Riksbank Norges BankCurrent repo 1.25% 0.00-0.25% 0.50% 1.75% 2.25%Next rate ann. Jun 9 Jun 22 Jun 9 Jul 5 Jun 22Action expected Unch QE2 completed Unch +25bps UnchTradesDirectional Levels & P/L StatusSwedish government bond portfolio (Jan 27). We track the OMRX T-bond index Return YTD Holdand may deviate +/-1 year from benchmark duration. We changed portfolio duration SEB portfolio +2.87%from neutral to 0.5y short on Jan 27. Index +3.09%Sell a 2.90% put, buy a 3.10% call, sell a 3.30% call and sell a 3.40% call on Cost 0.5bps HoldDec11 SEK FRA (original position on May 5; modified on May 10). On May 10, P/L -17.8bpswe changed our Dec11 FRA call spread to a call ladder by rolling down the long callby 10bps and selling the 3.30% call at a cost of 0.5bps. We expect the position togenerate a profit of 20bps. We express the P/L including the cost of 0.5bps.Sell a 3.40% put on Jun12 SEK FRA (Feb 10). When the position was established, Upfront premium 33bps HoldJun12 traded at 3.40%. Now 44.3bps P/L -11.3bpsSell a 3.05% 2y in 1y SEK receiver swaption (Jan 13). Swaption expiry 12.1.2012. Upfront premium 57bps HoldSwap dates 16.1.2012-16.1.2014. We expect the Riksbank to hike much more (non-annualised)aggressively than discounted by the market. When the position was established, 2y Now 33bpsin 1y forward traded at 3.17%. P/L +24bpsRelative value Levels & P/L StatusBuy SGB1047 (2020), sell SGB1054 (2022) nominal vs. nominal and receive Established -106bps Holdfixed in a SGB1047/SGB1054 fwd swap (May 19). We expect SGB1047 to be a Target -60bpsnatural buy-back candidate in the NDO’s exchanges vs. SGB1054 on May 30 and 31, Stop -125bpsforecasting the SGB1047/SGB1054 curve to steepen and the SGB1047/SGB1054 Now -101bpsfwd ASW spread to tighten from current extreme levels. Carry is +0.2bps over 3m. P/L +5bpsBuy C1578 (2016) vs. C1577 (2015) in nominal vs. nominal and pay fixed in Established 125bps HoldC1578/C1577 fwd SEK IRS (May 5). We regard 1y in 4y forward CB ASW spreads as Target 80bpstoo wide relative to both current 1y spot ASW spreads and stressed levels prevailing Stop 145bpsduring the financial crisis (Stadshypotek: 50-60bps). Now 120bps P/L +5bpsBuy SGB3107 (2017) vs. SGB3105 (2015) in risk neutral terms (Mar 17). The Established 23.5bps Closeposition has almost reached our target and we close it with a profit of 5.6bps Target 12bpsincluding carry of -4.9bps. Stop 28bps Now 13bps P/L +5.6bpsBuy Dec11 SEK FRA vs. Mar12 RIBA in risk neutral terms (Mar 3). When the Established 60bps Holdposition was established, pricing of FX forwards implied a 3m SEK TED spread of Target 100bps100bps by year-end. We continue to see risks of wider TED spreads especially over Stop 45bpsIMM June due to large CB redemptions at that date. Now 49bps P/L -11bpsBuy SEB566 (2013) vs. SEB565 (2012) nominal vs. nominal, pay fixed in 1y in Established 66bps Hold1.3y fwd SEK IRS (Feb 24). The SEB565/566 (1y in 1.3y) forward ASW spread Target 20bpstrades at a relatively high level and significantly above the 1y spot SEB ASW spread. Stop 66bpsThe position could withstand 1y covered bonds in 1y revisiting levels last seen at the Now 34bpsheight of the financial crisis (~55-60bps). P/L +32bpsBuy-and-hold switch from OATei2012 to SGB3106 (2012) in risk neutral terms Established 136bps Hold(Feb 24). This is a real money switch. In addition to a real yield pick-up of 136bps, Target n/awe expect Swedish inflation accrual pending SGB3106’s maturity to exceed that of Stop n/athe EMU. We recommend hedging FX using a zero-cost seagull strategy. To follow Now 85bpsup the switch, we express levels as a real yield spread. Currently, the total position P/L +51bpsP/L is -1.0%, including the currency component (cash & hedge) P/L of -1.13%.Buy SGB1041 (2014) vs. SGB1046 (2012) nominal vs. nominal and pay fixed in Established -5bps Holdan SGB1046/SGB1046 fwd SEK IRS (Jan 27). Although the position has reached Target -70bpsour initial target, as SGB1041 remains only slightly squeezed in the repo market we Stop -40bpsprefer to retain an open position with a revised target at -70bps. From Jan 27, 3m Now -59bpscarry is +5.6bps. P/L +54bpsNote: Until the position is closed, P/L is expressed without taking carry into account and using mid-prices. 2
  • 3. Fixed Income insights that the decline in long yields has gone hand in handMarkets this week with downwardly revised central bank expectationsLOST HIGHWAY. Recent price action in European bond indicates that instead of being driven only by safe havenand FX markets has been dominated by escalating Euro- buying, the decrease in long yields has been motivatedzone debt concerns, increasing uncertainty and a lack of by increasing uncertainty regarding real macroeconomicpolitical consensus. No one knows what a solution to the developments. In Sweden, current market pricing fordebt crisis will look like or how long it will take to devise. end-2011 is in line with the Riksbank’s own repo rateThis is especially so given adverse political conditions in path for end-2012 and ~40bps below it for end-2013. Inseveral EMU countries, the widening gap between the past two months, we have recommended positioningpoliticians and voters and, to some extent, between for higher short rates via options (see “Trades”) in orderpoliticians and the ECB. While we maintain our main to obtain some downside protection relative to ourscenario involving restructuring Greek, Irish and forecast. Considering the current uncertainty wePortuguese debt with Spain possibly also seeking a bail- certainly continue to prefer options positions.out from the EFSF/ESM as outlined in Nordic Outlook, Riksbank repo rateMay 17 (see “The path to European debt restructuring” Market SEB Riksbank Market vs.on pages 14-15), very recent market developments have Effective pricing forecast Apr 2011accelerated more dramatically than we had expected. As date Repo chg Repo chg Repo chg SEB RBa result, our short duration Swedish government bond 2011-05-26 1.75 1.75 0 1.75portfolio has not performed since mid-April when the 2011-07-06 1.99 24 2.00 25 1.94 19 -1 5ongoing collapse of both short- and long rates began. 2011-09-14 2.19 20 2.25 25 2.10 16 -6 9 2011-11-02 2.30 11 2.50 25 2.28 18 -20 2While uncertainty is high concerning near term bond 2011-12-21 2.43 13 2.75 25 2.45 17 -32 -2market developments, we maintain our short duration 2012-02-15 2.50 7 3.00 25 2.55 10 -50 -5for the time being, not least given the extent to which 2012-04-18 2.62 12 3.25 25 2.79 24 -63 -17Swedish rates are stretched on the downside. 2012-07-04 2.68 6 3.50 25 2.89 10 -82 -21 2012-09-05 2.74 6 3.75 25 3.00 11 -101 -26TECHNICAL OUTLOOK: SGB1050 (2016). Having 2012-10-24 2.79 5 3.75 0 3.05 5 -96 -26passed our primary downside correction target of 2012-12-19 2.83 4 3.75 0 3.20 15 -92 -372.96%, the secondary target 2.76%, was activated. With 2013-02-13 2.86 3 3.22 2 -36 2013-04-17 2.89 3 3.35 13 -46the market now having arrived and halted at the 2013-07-03 2.91 2 3.43 8 -52resistance we stand ready looking for an upside print to 2013-09-04 2.93 2 3.50 7 -57add confidence of a completed downside correction. A 2013-10-23 2.95 2 3.56 6 -61return to above 2.99% will be the ultimate such a move 2013-12-18 2.97 2 3.60 4 -63and more or less confirm that we will be back on track for 2014-02-13 2.98 1 3.65 5 -67 2014-04-17 2.99 1new cycle highs. Breaking (and especially if closing)below the 233d ma, 2.66%, we will take a more neutral STRETCHED ON THE DOWNSIDE. While recent Euro-stance awaiting new directional guidance. zone developments make our repo rate forecast more uncertain, we still regard SEK FRAs as stretched on the Yield downside. Interestingly, the market discounts rate hikes totalling almost 100bps over the next 12 months, but 3 only 25bps between mid-2012 and early-2014 (see the 38.2% 2.761 front page chart). We reiterate our view that the Euro- 2.7 zone debt crisis alone should not justify this flat FRA 50.0% 2.588 curve tail given the low absolute level of green FRAs. 61.8% 2.416 2.4 While we regard it as attractive positioning for a steepening of red vs. green FRAs, we prefer to await for 2.1 better timing to enter the trade due to currently excessive volatility. Sep Oct Nov Dec Jan Feb Mar Apr May Jun EXPECT FURTHER WIDENING IN SWAP SPREADS. Q3 10 Q4 2010 Q1 2011 Q2 2011 Following the Swedish National Debt Office’s forecast of lower borrowing than either we or the market hadLONG RATES DRIVEN BY LOWER RATE HIKE expected, SEK swap spreads widened with long spreadsEXPECTATIONS. The decline in long rates (around reaching and breaching our end-2012 targets. We45bps both Germany and Sweden since mid-April) has continue to expect wider swap spreads and will publishbeen accompanied by substantially lower rate hike revised swap spread forecasts early next week.expectations concerning both the ECB and Riksbank(around -50bps in EMU and -40bps in Sweden Jussi Hiljanen & Anders Söderbergconcerning end-2013 pricing of the repo rate). The fact 3
  • 4. Fixed Income insights Government deficit, % of GDPEuro-zone debt crisis 2.5 2.5INCREASING CONTAGION FEARS. The euro-zone 0.0 0.0debt crisis continues to run its course while spreadwidening between peripherals has intensified in recent -2.5 -2.5weeks. So far 10y Spanish and Italian spreads have been -5.0 -5.0relatively stable, having avoided following countries -7.5 -7.5receiving EU/IMF support higher. -10.0 -10.0 10-year yield spreads to Germany 4.0 -12.5 -12.5 10 00 01 02 03 04 05 06 07 08 09 10 11 12 3.5 3.0 Forecast EU-commisson Spain 8 Italy 2.5 Forecast EU-commission 6 2.0 4 1.5 With the exception of Greece and Ireland budget and Irel 1.0 debt forecasts for Euro-zone countries remain largely 2 0.5 unchanged according to the EU Commission. The Italy 0 0.0 following chart summarizes budget and debt forecasts 08 09 10 11 for selected countries with budget deficits shown on the Average Greece, Portugal, Ireland left hand scale and debt as a percentage of GDP on the Italy bottom. Dots show the development in both debt and Spain deficit between 2009 and 2012. For example, theSince Standard & Poors (S&P) put Italy on negative Spanish deficit is expected to decline to just over 5% inoutlook last week, spreads have begun to widen both 2012 from 9% in 2010, while Italian debt will stabilise atthere and in Spain. S&P justifies its negative outlook on around 120% of GDP. The chart also shows that SpanishItaly more in terms of political uncertainty than either the debt remains below the Euro-zone average, with theweaker than expected budget or growth outlook. same true for the Italian budget deficit. This suggestsPolitical gridlock is jeopardising much needed structural that confidence problems concern not only publicreforms and the commitment to reduce budget deficits. finances but also the general economic situation in theseWhile the economic outlook for both Italy and Spain countries. An illustration of possible threats to thisremains weak, it has not deteriorated further so far this situation is the increase in the Irish budget deficit to 30%year. We forecast Italian GDP growth of around 1.5% in of GDP when the country’s banks requiredboth 2011 and 2012, with Spanish growth slightly lower. recapitalisation in 2010. Eurozone public finances outlook (ECFIN) 0 Germany 0 Belgium Italy 2012 PMI, Composite Gen.Government budget balance (% of GDP) 2012 -5 -565 65 2012 2012 -10 Spain -1060 60 Portugal 2009 2009 Greece -15 -1555 55 2009 2009 -20 -2050 50 -25 -2545 45 Ireland -30 -3040 40 -35 -3535 35 50 60 70 80 90 100 110 120 130 140 150 160 Government debt (% of GDP)30 30 00 01 02 03 04 05 06 07 08 09 10 11 CURRENT ACCOUNTS REMAIN IN DEFICIT. Also of Spain Euro Zone Italy concern, current account deficits remain large while the improvement which occurred in Spain during 2008 hasBUDGETS IN LINE WITH FORECASTS. Both Italian and ceased. In our view this indicates that the adjustmentSpanish budget deficits are developing in line with process has further to run. Further, many questionsofficial forecasts with the EU Commission even making remain regarding the banking sector. We still think itsmall downward revisions to its deficit forecasts in April. highly likely that Spain will eventually require an EU/IMF rescue package. 4
  • 5. Fixed Income insights Current account balance, % of GDP ORDERLY RESTRUCTURING BUT NOT NOW. What to make of it? Our view, as presented in our recent Nordic 0 0 Outlook, is that Greece will be unable to successfully -2 -2 manage current government debt of around EUR 350bn, equivalent to 150% of GDP. Some kind of “hard” (albeit -4 -4 orderly) restructuring involving haircuts (amounting we -6 -6 believe to around 50% of private debts) will be necessary. For several reasons – not least the risk of -8 -8 contagion to other PIIGS economies – we do not think -10 -10 this will happen before 2012, at the earliest. Irrespective of restructuring, new funds from the EMU/IMF will be -12 -12 00 01 02 03 04 05 06 07 08 09 10 needed to, among other things, cover recapitalisation of the banking sector. Well before the end of 2011, EU Italy Spain governments and the IMF will need to agree to extendGREECE ON THE EDGE. Fears that Greece may default present support and/or ease its terms.and worries about serious contagion effects on otherEuro-zone countries have increased recently, partly Who owns the Greek government debt? (pie chart approx. figures. Boxes: likely effect of a 50% haircut)triggered by conflicting official statements and clear Total debt ~€340bnsigns of divisions between Euro-zone governments, the EMU/IMF emergency loans IMF 15Greek authorities and the ECB. We regard this as part of not likely to be written down EMU 38 Greek and foreignthe political process and therefore not necessarily a sign ECB will take a Other pension funds and other private 115 investors will takethat the will of European states to reach a solution has loss but has bought its bonds ECB 40 the full lossbeen exhausted. In the following analysis we highlight below par. It will face additionalseveral current key issues. We still believe the political losses if Greek banks default PIGS banks havesystem will once again do whatever it takes to avoid a Greek Banks tiny exposures. German and Greek banks willcrisis while deferring more difficult questions till later. need capital 60 Foreign banks 72 French banks have most injections of aboutNevertheless, markets are likely to have a bumpy ride €25bn to handle a exposure but losses should be 50% write offahead of the EU summit in June. manageable 34The Greek position and both how and when it isaddressed are now critical. The IMF’s fourth mission to REPROFILING CANNOT BE EXCLUDED. We do notGreece is scheduled to result in a report in mid-June. believe soft restructuring or “reprofiling” involvingUnless further measures are taken the country will in all voluntary extension of the private sector’s holding oflikelihood not qualify for a further EUR 12bn instalment Greek sovereign debt will resolve the country’sof its EUR 110bn loan facility due in June. If that happens, underlying problems. The main objective would be toGreece says it will be unable to continue to repay lenders buy time, similar to the original but now failed rescuei.e. effectively threatening a messy default. At the same package. Still, such a course carries a number oftime, the Euro-zone and the IMF have still not devised a attractive features.solution on how to handle Greece next year when, Firstly, a voluntary extension would remove the almostaccording to the original plan, it is meant to begin re- EUR 50bn of maturing principal that falls due betweenaccessing bond markets, something it will clearly be now and end-2012, representing almost all the nearlyunable to do. EUR 60bn left of the EMU/IMF loan (including EUR 20bnSo far the official stance has been that these problems in June). Consequently, the need to demand taxpayersshould be resolved by: throughout the rest of the EU to provide more funds for Greece would diminish proportionately.1. further Greek reform efforts and Secondly, damage to Euro-zone banks holding Greek2. Greek privatizations totalling around EUR 50bn. debt would probably be limited compared to a haircut.Whether such measures would work is highly doubtful, According to an OECD study in Aug 2010 only 17% ofeven if the Greek political system had faithfully bank exposure to Greek sovereign debt was held inimplemented all agreed measures. How, for example, will trading portfolios and therefore exposed to aGreece find foreign buyers (a prerequisite for improving revaluation. The vast majority of strategic holdingsits external debt situation) for a fire sale of assets would probably not be affected in a way likely to triggerbelonging to a country teetering on the brink of default? any immediate large negative effects on either results orMeanwhile the ECB is threatening to pull the plug on the capital.Greek banking system in the event of restructuring – beit soft or hard. 5
  • 6. Fixed Income insightsThirdly, the longer it takes before the private sector IMPORTANT EVENTS AHEAD. We see several keybecomes involved, the less debt will be held by it if and events going forward which will be crucial for thewhen hard restructuring is in fact implemented. continued debt crisis negotiation process:At the same time there are several issues to resolve  June 9. ECB meeting. If our forecast of a July hike isconcerning even soft restructuring. How should such an correct, we would expect the ECB to signal it in itsoffer be constructed in order to attract sufficient lenders statement by regular wording. We see no majorwithout exerting too much upside pressure on the price changes to the ECB’s liquidity facilities.of existing Greek bonds? Are private lenders willing tovoluntarily worsen their situation without any form of  Mid-June. IMF fourth mission report on Greece.official guarantee from, for example, the EFSF/future We expect Greece to present measures sufficient toESM, one which would in fact only increase the risk justify payment of the next instalment.borne by taxpayers? Could indeed such guarantees be  Mid-June. European Stress tests published. Theextended without changing the situation for other bond tests will not include scenarios involving sovereignholders in a way that would be characterised as a credit default or losses on the banking sector’s strategicevent and trigger, for example, CDS contracts? The sovereign bond holdings. However, its individualconsequences for CDS contracts are ambiguous (for sovereign debt exposure will become more widelymore, read the assessment of our credit strategist Jonas known, increasing market discipline over respectiveRanneby here). Most importantly, it is difficult to assess banks to raise capital. The stress test will bethe contagion effects on other PIIGS and whether such followed by a procedure to strengthen capitalactions would only raise expectations of eventual hard wherever necessary with the objective at least torestructuring in Greece, and perhaps Ireland and increase resistance to future debt restructuring.Portugal too.  June 5. Elections in Portugal.As regards the ECB, its harsh statements are a part of thenegotiation game. We have a hard time believing the  June 20. Euro Group meeting. The group will needbank would in fact act in a way likely to bring only to reach an agreement on the ESM, the rescuedisaster to the Greek economy and probably to the Euro- mechanism to replace the EFSF, and issues leftzone financial system as a whole. However, the ECB is unresolved at the March EU summit, including, forlikely to demand the recapitalisation of Greek banks, as example, private sector involvement. This will alsohas been done in Ireland, as the price for continuing to make a future rescue package for Spain easier tofinance the Greek banking system in the event of a soft deal with, whenever it may become necessary.restructuring. Markets will also expect a decision on how to finance Greece beyond 2011.  June 24. EU summit. Decision on the ESM. Olle Holmgren & Elisabet Kopelman 6