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Calamatta Cuschieri Weekly Commentary – 14 December 2012

Eurozone

The EU Council announced on Thursday its agreement on bank supervision (Single Supervisory Mechanism), with the aim of adopting the legislation before year-end. The implementation will be on 1 March 2014 or 12 months after the entry into force of the legislation. The agreement includes two regulations: one discussing supervisory tasks on the ECB, the other modifying regulation. The ECB will be responsible for the overall functioning of the SSM and will have direct oversight of eurozone banks in close cooperation with national supervisory authorities. The ECB will also have direct responsibility for banks with assets of more than €30bn or representing more than a fifth of a state’s national output. However, the ECB retains the power to intervene in any bank and deliver instructions to national supervisors.

The market has interpreted that SSM as being positive for the banking sector in the longer term, although in the shorter term national regulators are likely to become more stringent under ECB scrutiny and this could hurt weaker banks. Also, it is a positive surprise that agreement was reached even if implementation is delayed. EU Commissioner Barnier pointed out that there is the potential for direct recapitalisations to take place, even before the ECB fully establishes its supervision regime in 2014. However, German Finance Minister Wolfgang Schaeuble made it clear that direct ESM recapitalisations are out of the question until well into 2014.

Market direction was dominated by Italian politics this week, with Berlusconi’s re-emergence, Mario Monti’s expected resignation and earlier Italian elections, now due in mid-February 2013, taking centre stage. This jolted European risk premia, but only briefly, as the bullish broader backdrop continues to underpin credit spreads. This week’s events have in essence launched the pre-election campaign in Italy. Headline noise is set to persist over the next two months, keeping Italian risk premia on a more fragile footing in the shorter term. Italian bank spreads reacted strongly to the news and their spreads have been on a roller coaster over the past week. Lower Tier 2 bonds have now retraced about half of the initial move wider.

Berlusconi’s political manoeuvring and Monti’s expected resignation may prove a blessing in disguise, given the prospect of Monti running as a PM candidate and the earlier election date, potentially leading to an earlier resolution of political uncertainty. Indeed, Berlusconi was quoted that he could withdraw his candidacy if Monti accepted the request of the whole moderate bloc to run for PM. This appears contradictory to previous statements of his, but somewhat encouraging and possibly an indication that Berlusconi’s position may be weaker than thought. In any case, significant uncertainty surrounds the Italian election outcome. T

Meanwhile, the Greek story reached another milestone this week, with the successful completion of Greek public debt buyback, with €31.9bn of GGBs tendered at an average clean price of 33.8c. This reduced Greece’s debt by €21.1bn approximately, or 10.8% of Debt-to-GDP. Post buyback completion, the Eurogroup approved on Thursday the disbursement of €34.3bn to Greece in December. This amount will be split between €10.6bn for budgetary financing and €23.8bn in 6-momth EFSF notes for the second instalment of bank recap funds.

US

In the US, headlines around the fiscal cliff debate have subsided over the week, with the Fed taking centre stage instead in a bullish context for risk. The FOMC statement on Wednesday confirmed that the Fed will proceed with $85bn of Treasury and Mortgage purchases per month ($45bn and $40bn respectively) starting from January 2013. Furthermore, the Fed has now explicitly linked their policy rate to employment, committing not to raise rates until the unemployment rate drops sustainably below 6.5%, providing the inflation rate does not exceed 2.5%. Such a condition will potentially extend the low rate environment for longer. The policymakers assert that these thresholds are consistent with its earlier date-based guidance with the Fed’s long-run inflation goal remaining at 2.0%.

The range of maturities eligible for purchase was expanded from 6 to 30 years under the Operation Twist program to 4 to 30 years under the new program. The degree of monetary accommodation is similar, though the implications for the shape of the Treasury yield curve are different. Changes in the QE program will depend on a “qualitative” assessment of a variety of economic indicators, making it more of a guessing game in which markets will have to watch economic data and policymaker statements.

US real GDP growth has been in line with expectations, with the forecast for 2012 being that of 2.3%. A split in the economy continues to develop between the manufacturing sector, which has been weighed down by a weakening in export orders and a slowdown in domestic capital spending, and the service sector, which has begun to rebound of late. The ISM manufacturing index has deteriorated from earlier in the year and been fluctuating around the breakeven 50 level, while the ISM nonmanufacturing index has moved higher over the past few months and is now consistent with solid growth in the sector. This is a significant development, as the service sector is responsible for 86% of the jobs in the US economy.

Forex

EURUSD has had its twist and turns in 2012 and was dominated by the developments in the Eurozone crisis. The EUR had a strong start to the year as the Fiscal compact was agreed and endorsed on 30 January. EURUSD went on to reach a year high of 1.3487 on 29 February. However the major turning point came on 6 May when there were large gains for the anti-bailout parties in the Greek election, brewing concerns over the possibility of a Greek exit. EURUSD fell to year low of 1.2042 on 24 July. Nevertheless Draghi inspired confidence back into the markets on 26 July as he said that he was “ready to do whatever it takes” to preserve the EUR. Draghi delivered on his promises on 6 September as he announced the ECB’s unlimited bond buying programme.

Meanwhile, market participants continue to digest and discuss the Fed’s latest initiatives to support the economy, including additional outright Treasury purchases of $45bn per month and the separate note linking zero interest rate policy to unemployment and inflation. The announcement of new Treasury bond purchases was close to market expectations, as it follows the expiration of the Fed’s "operation twist" program in which they were also buying $45bn per month in long-term Treasury securities, but selling an equal amount in shorter dated paper. The new program therefore represents a further, substantial addition to the Fed’s balance sheet, and when coupled with the MBS purchase program of $40 per month initiated in September. This theoretically means that the Federal Reserve will expand the balance sheet by another $1 trillion in the coming year. This, in essence is an open-ended program, meaning the buying program could extend beyond the coming year, with even greater, or lesser, amounts of securities being purchased.

2013 looks set to be a year of very disappointing growth, most notably in the eurozone, and a year when the ECB delivers on its promise to buy bonds of countries which ask for help. When that has happened, or has been entirely priced in, the market will be at risk of renewed euro weakness as well as renewed bond market volatility. This could in fact provide support for the USD heading into Q12013.

Corporate Credit

European credit markets continued to grind tighter this week, amid a backdrop of sporadic policy progress and relatively mild macro data. Global policy progress remains at the forefront of financial markets. In the US, negotiations continue regarding the “fiscal cliff”. It is likely that the negotiations will spill over into January as the market expects a relatively soft near-term solution that avoids material real economic damage. In Europe, policymakers have continued their efforts toward systemic stability; a framework for a single supervisory mechanism for European credit institutions emerged this week, with a goal of the ECB taking up its supervisory role by 1 March 2014, though many details remain uncertain.

Greece accepted EUR31.9bn face value of bonds through its tender offer, at a weighted-average price of 33.8% of face value, and European finance ministers approved EUR49.1bn in disbursements to Greece by the end of March, EUR34bn of which is to be disbursed immediately. While Greece’s long-term solvency remains in question and the European crisis is likely far from over, these incremental steps forward are supportive.

European investment grade credit is entering relatively uncharted waters in terms of post-crisis valuation. We are likely to head into 2013 at all-time lows in yields, and post crisis lows in spread. Historically, spread levels have been a reasonable predictor of January returns, hence investors who are now expecting a powerful January rally could be disappointed, particularly given the strong issuance that we have seen in recent weeks.

The resiliency of the Euro HY market continued this week, although on lighter volumes heading into the end of the year. Ratings momentum has remained generally negative, with a number of downgrades this week. The negative effect of political uncertainty on WINDIM, however, was more short-lived, as most bonds regained any losses. Renault has been a notable outperformer following the company’s announced disposal of its remaining stake in Volvo for EUR1.5bn. Furthermore, despite the on-going struggles around the direction of CEDC, bonds were up nearly 5 points over the past week.

Bond Picks of the Week

? € 6.375% Commerzbank AG 22/03/2019 (BBB rated) @ 105.75 (Subordinated, Tier 2 Capital)

? € 6.00% Macquarie Bank Ltd 24/09/2020 (BBB rated) @ 107.50 Subordinated, Tier 2 Capital)

? € 8.50% Labco SAS 15/01/2018 (B+ rated) @ 103.50 (Senior Secured)

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