Europe, FOMC, Sino-Japanese Rift

News reports appear to be playing down the fears from the end of last week that Ireland and Portugal may have to turn to the IMF/EU for support. Of course there will be official admission until the very last minute. The 440 bln euro European Financial Stability Facility is designed for this eventuality. Just today Moody’s assigned triple-A rating to the EFSF. With nearly three quarters of the euro zone members not possessing the coveted rating themselves, how can the EFSF? Our understanding is that it will limit the loans to about 80% of its guarantees or about 350 bln euros. Even in this environment, this week’s periphery sovereign supply should be relatively easily absorbed.

The market shows a good appetite for high yielding bills and this includes Greece bills sales tomorrow. The challenge of the week may reside with Ireland. It will be selling 4- and 8-year bonds tomorrow (1.0-1.5 bln euros).

We note that the latest flare up in Europe is taking place after several investment houses have recommended taking on Greek bonds exposure. That said, the IMF/EU have approved a month delay in Greek bank stress tests until the end of October. Even with the ECB reportedly buying small amounts of Greek bonds, the premium it pays over Germany stands at almost 900 bp today. The premium, as we have noted before, can be understood as a function of the size of the haircut that is expected and the odds of it.

One way to think about the 900 bp premium Greece is paying is that is consistent with 30% chance of a 30% haircut. Of course, there are other permutations that would be consistent with the premium; the one proposed here is neutral in that it divides the premium equally between the sieze of the hair cut and the odds of a haircut. This can be tweaked. Despite the separate EU/IMF package (from EFSF), and ECB Greek bond purchases, Greek 10-year bonds have only performed marginally better than Portugal and Ireland over the past month (68 bp increase for 90 and 94 respectively).

Tomorrow’s FOMC meeting is among the highlights of the week. Most observers see little change in the FOMC statement. Rates remain on hold for an extended period of time and the vast majority of those surveyed in news wire polls expected the Fed to hold off expanding its balance sheet. In the Jackson Hole speech, Bernanke set the bar at a “significant deterioration” of the economy to spur the Fed into more action. This has not been seen in recent data. He also opined that the pre-conditions exist for higher growth in 2011. A cut in next year’s growth forecast will likely be seen as a precursor of new actions by the Fed and hence may be more important than usual.

Officials are often loath to make a decision until circumstances force their hand. Even there was no debate on the effectiveness of additional Treasury purchases, given the already low yields in Treasury and mortgage market, the Federal Reserve has time to decide if additional stimulus is necessary. Recall that projected mortgage payments of the Fed’s holdings are estimated to be around $400 bln through the end of 2011. The Fed has committed itself to maintain the current size of its balance sheet, which will keep its bid for Treasuries.

China has broken off high level government contacts with Japan over the extended detention of a Chinese fishing boat captain, arrested near disputed islands in the East China Sea. There were anti-Japanese protests in China over the weekend, which also marked the anniversary of Japan’s invasion of Manchuria in 1931. Tensions are high. China is taking an exceptionally tough line here and although the extend detention can last another ten days, it is not yet clear how far China is going to push the issue.

There are a number of international gatherings in the coming weeks, including the anti-poverty summit at the UN this week. APEC and G20 meetings are other near-term gatherings that China could use to express its displeasure. Economic issues are also a source of stress between the second and third largest economies in the world. While Japanese officials have been seeking to underscore the attractiveness of Japanese financial markets, they seemed to take exception with the Chinese purchases of JGBS (largely bills) this year (after having been net sellers last year).

We note that last week’s BOJ intervention looks as if it was nearly as large as Chinese net purchases this year. We say “looks” because there is usually some volatility in the Japanese banking system’s reserve balances, especially this month which marks the end of the fiscal half year. At the same time, however, given that the still tight relationship between the US dollar and the yuan, BOJ intervention last week could also be seen an effort to counter yen appreciation against the yuan. China is the largest export market for Japan.