European Bond Supply and Greece's Trojan Horse

Currency in Crisis

European sovereigns return to the capital markets more substantially next week as 2012 issuance gets under way. Between bills and bonds, around 35-40 bln euros will be sold. Maturing issues and coupon payments will cover about three-quarters of the bond issuance.

The market's focus is on the Spanish and Italian bond offerings in the second half of the week. Not to be overlooked though is the Austrian bond sales on Tuesday. Austria has come under pressure in recent days in good part due to its linkages with Hungary. After Greece and Spain, Austrian 10-year yields have risen the most this week, rising 55 bp. And even today, with some relief in Hungary, given the change in tone and tactics of the Orban government, the Austrian 10-year yield is up 9 bp at pixel time, the most in Europe today. Its saving grace next week may be that it may seek to raise only around a modest 1.3 bln euros.

Spain, Italy and France will be issuing bills, and outside of Hungary, bill auctions have generally been well received. We suspect that in some countries, such as Italy, the concerns about the banks, encourages bill buying by retail accounts. Greece also issues bills next week.

There are two key issues facing Greece presently. The first is the final 2011 fiscal position. The target was 9% of GDP after 10.6% in 2010. Between implementation challenges and slower than expected growth (IMF says the economy contracted around 6%), the deficit is likely to have overshot. It is difficult at this juncture to fine tune the size, but estimates range from 9.5% to 10.7%.

PM Papademos is reportedly preparing a response that could include curtailing auxiliary pensions, defense cuts, welfare cuts (including drug and medical benefits) and closing more government entities. Reports indicate that Papademos is becoming increasing frustrated at cabinet meetings. However, apparently not sufficiently frustrated to accept the earlier election time frame (late March) that the New Democracy (leading opposition party) is pushing.

Part of the reason for wanting a later election date has to do with the second issue facing Greece and that is the private sector involvement(PSI). It is proving more difficult than many policy makers appear to have anticipated. For example, in an FT op-ed piece today the president of the Cyprus central bank suggests that the entire idea of private sector burden sharing should be scrapped. This, he argues, will help restore confidence in the euro zone and help lower the borrowing costs for others. To meet Greece's financial needs, other countries should provide 30-year loans at low interest rates.

Recall that it was Germany and some other creditor nations that had pushed for the PSI in the first place. The ECB itself was not an early advocate or supporter. Sarkozy too was opposed and wanted to limit the damage by pushing and eventually getting Germany to agree that Greece was a unique case.

Yet the current PSI does seem most likely to go forward. As we have noted previously, the 50% debt forgiveness by private sector holders can turn into more than a 50% haircut on a net present value (NPV) basis based on the coupon of the new bonds that are given in exchange. A 4% coupon, which would be near the rate France pays on 30-year borrowing, would see the haircut on an NPV basis rise toward 70%.

The PSI agreement appears now likely to be in two steps. The first is a memo of understanding and the second is the specifics. In official circles there seems to be some hope of the former by late January and the latter by mid-March.

This mid-March time frame is important. The next tranche of aid under the first aid package was due at the end of January, but has been postponed into March because of the ongoing talks about the second aid package of which the PSI is a key component. On March 20, Greece has a 14.4 bln bond maturing and needs the aid to cover the redemption.

Assuming that the PSI moves forward and the aid tranche is made, an election is likely in April and therein lies potentially a significant hurdle for investors. The odds-on favorite to win the election is the New Democracy Party. While the former Socialist government and the current technocrat government appears willing to continue to pursue austerity, the New Democracy, at least in opposition, resists. It is opposed, for example, to any more wage cut or tax increases. Could that not be a Trojan Horse?