Eurozone government bonds offer attractive plays

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At various times since the euro came into being, hedge funds, private speculators, and various colonies of euro-sceptics have looked for ways to bet on its break-up. The most popular, especially after the constitution failed to be ratified in 2005, was in long-short trades where the speculator was short the government bonds of one country, typically Italy, and long the bonds of another, typically Germany.

Unfortunately for the euro-sceptic-speculators, these trades were as exciting as watching moss grow, with Italy perhaps blowing out all of five additional basis points in the 10 years, or nearly 10 bps when things got really fun.

I am a euro-sceptic myself, though, since I write from New York, I am safe from any attempts at extradition for the moment. But the euro-sceptics were missing some interesting, and more imminent, speculative possibilities, which arise not from the break-up of the euro, but from the continuation of the eurozone in its present form.

These are the prospective large divergences in the prospects for corporations across the eurozone, particularly those serving their domestic markets, such as builders or retailers. This is probably a next year event, but one that could easily start to be discounted in equity markets later this year. Then it would be discounted yet again in the corporate credit markets, which will give the euro-sceptic-spec another bite at the apple.

Because I don’t get asked out often enough, I spent quite some time studying the EU Commission’s last Quarterly Report on the Euro Area. In a totally fascinating section called “The contribution of labour cost developments to price stability and competitiveness adjustment in the euro area”, on page 32, there’s a chart entitled “Intra-euro-area real effective exchange rates based on unit labour costs, selected countries”. Anyone who thinks that there aren’t any great trades left should take a good look at this.

The curves of declining competitiveness of the southern tier countries, particularly relative to Germany, are relentless. What it shows is that Portugal, Spain and Italy, in that order, should devalue their currencies by at least 15-20 per cent, relative to Germany, whose policy requirements are driving euro-area policy.

Oh, right, they can’t.

Now one could go over and over whether or not the European Central Bank should or shouldn’t provide generous rediscount facilities for the bonds of euro area governments, or what other transfer payment support will or won’t be available for the governments of member countries in distress. We won’t know until the unwinding of the global Ponzi scheme. In the meantime, the spreads between euro area governments will move in those one, or at the most, two, digit rates. What we do know is that corporations won’t be offered this support.

At first I was thinking fixed income, say a basket of credit default swaps on Spanish consumer-exposed companies against a basket of comparables dependent on the German consumer.

But as a London credit strategist for an American bank pointed out to me, “Your thesis is on the right track, but CDS would not move the most, at first. If you bought protection on Spanish issuers (went short), and sold protection on German issuers (went long), you would, initially, probably just have a better return on the German paper. That’s because there are few European companies that are overextended. You can have significant changes to the top (revenue) line without affecting credit ratings, because balance sheets are still quite strong.”

However, stock prices are another thing. Spain, to take what is probably going to be the market most dramatically affected by a decline in ready, cheap, credit, has a huge exposure to builders. Construction employment in Spain is 12.5 per cent of the total labour force, compared with 6.5 per cent in Germany and 5.9 per cent in the Netherlands. What would have been a decline in prosperity due to a lack of competitiveness has been offset by a cheap-credit-based building boom. In this respect, Spain is most similar to the US, except, of course, that it can’t devalue.

So a short-Spanish consumer basket of shares, relative to a long position in the German consumer, makes a lot of sense. If you have real conviction, which I think is supported by the data, go for that pair trade using equity options.

That’s the this-year-and-early- next-year trade. As the unwinding of the global cheap credit trade develops from a prospect into a reality, to a continuing reality, it makes sense to move further up the seniority chain of the capital structure. So months from now, or even a year or so, the volatility at the margin, or the gamma, will move from the equity level to the CDS market.

Big Spanish banks, which have lots of foreign assets, will be much less affected than construction companies or retailers. Also, the euro policy tribe will be much more inclined to support a banking system than save the corporados.

Cheap credit buoys Spanish equities in two ways: it keeps the construction bubble going, and it offers the stockholder the prospect of a debt-financed takeover. So anyone long Spanish shares should look on what’s happening to the US subprime borrower with concern.

The advantage of the credit derivatives market is it offers the speculator the opportunity for two bites at the apple in a trend. After cashing in the equity short, you go short again using CDS.

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