More trouble ahead? PIIGS CDS Spike alongside higher yields and weaker Euro + A look at the US-China

A quick recap to the previous week post before we move to this week analysis on refocused attention in PIIGS.

We were excited to see that our call for the S&P500 bounce to be over by the 15th of May 2018 due to Fed's QT action to be proven right as with almost all of the previous QT days. The S&P500 ended the 8 day winning streak on Monday and for the week was down 0.5%. The next QT date will be 31/5/18 for 29B maturity, in which we think will provide a cap to the equity market bounce and could have us test downside levels once again within the next 2 weeks.

EU Debt Crisis 2018/19

Most of the attention this week was on the PIIGS bond yields and CDS spiking, alongside continued pressure on the Euro, not just against the Dollar, but also safe havens like the Yen and Swiss Franc which proves we are seeing some fund flow into safe havens compared to the earlier weeks where by it was mainly Dollar strength dominated flows.

Portugal, Italy, Ireland, Greece and Spain – the peripheral European Union states with the weakest economies were under attack again bringing back memories of the good old 2011 days when the PIIGS blowup saw major equity markets volatility which prompted the ECB then to do whatever it takes ( ECB introduced QE) to save the EU from breaking up.

It seem like we could have finally found the can which was kicked down the road from 2011 back on our path this week.

This week for the first time since 2011 which we saw the following doomsday cocktail correlation.

1.Rising Peripheral EU Bond Yields

2.Falling Core EU Bond Yields

3.Falling Euro against major currencies

4.Falling EU Stock Market Indices

5.Rising EU Credit Default Swaps

We are now very worried for the ECB whom has been the largest buyer of EU bonds since their QE Programme. The question now is will they be buyers of the CDS next to insure against their massive holdings?

Leaked documents this week saw a government proposal late Tuesday that showed populist parties drafted plans to ask the European Central Bank for debt forgiveness of 250 billion euros.

With the ECB owning 300 Billion Euros of Italian Debt, and yet only having a mere 10B in registered capital, we wonder can we use the too big to fail ideology on a Central Bank? And perhaps the next big crisis will be similar to that of the 2008 US financial crisis, but just this time it is the Central Banks in trouble instead of the commercial banks.

With the ECB admitting to lower growth in their last ECB press conference, along side now trouble with the PIIGS, we think it will be reasonable to call off any Hikes or reduction of QE by the ECB as without them as a buyer of PIIS bonds, it will be a repeat of the EU debt crisis once again.

Renewed volatility on financial markets derivatives likely to hurt various financial participants in particular insurers who have been buying bonds in the past 5 years and now having to see the bond bubble on the verge of bursting, with rollover effect likely on the financial markets if they were to reduce bond holdings or take on some form of market hedging.

As below is data from the IMF Working Paper WP/17/210, Interconnectedness of Global Systemically-Important Banks and Insurers showing total assets.

We now call for the EURO to be 15% lower than it current levels against major currencies, with EUR/USD target of parity within 2 years. We are in doubt that the ECB can even eventually reach the stage whereby they can start balance sheet reduction. They will need to continue asset purchases to keep PIIGS Yields low to prevent a repeat of the debt crisis and to protect their own balance sheet from losses.

We in particular are positive in the Gold/Eur Long trade going forward. A renewed EU Debt Crisis on the works if EU or US Equity Markets see a major drop this year would just be the very thinkable event in 2019 as we all know well how the ECB is always being lead by the market on their policy marking decisions.

US-China Trade Talks

Now let's take a look at the weekend breaking news of the White House statement on China - US Trade Consultations.

Most traders would likely take this piece of news as bullish, however we do think while this is bullish for the US as a whole, it is a negative for Asia due to FX effects on the longer run.

While there was no target level to the annual trade deficit reduction, there were some talks for the figure to be around 150B to 200B per annum. This would reduce the US-China trade from 375B to around 175B on an annual basis. This would likely be done so with China increasing imports, rather than US reducing imports from China.

We look at the follow effects for this change.

1.Stronger USD

2.Weaker CNY , while also translating to weaker Asian Currencies.

3.Weaker domestic economy in China

As with out previous post on EM / Asian FX, we take the above points as negative to Asian Economies and call for continued Dollar strength against EM/Asian FX which will lead to carry trade unwind and outflow from Asian Equity Markets.

China is willing to weaken her domestic economy by agreeing to the US terms for a bid to have a reversal in the ZTE trade restrictions which would have a large impact on China being a Tech giant going forward.

In April, the Commerce Department announced a seven-year ban on US companies selling goods and services to ZTE. That was in response to ZTE’s violation of an agreement that the US and ZTE had come to in March 2017, after the telecoms company was caught shipping materials to Iran and North Korea.

Trump could face serious issues at home trying to reverse the ZTE Ban which likely is crucial to China agreeing on the new trade terms. We thus do not put too much weight on the statement released overnight and opt to sell any rallies on Monday as a result of short term bullish sentiment.

Good Luck Trading!

The Bad Bear

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