Raymond James Bond Market Update: The €100 Billion Buffer

Raymond James Bond Market CommentaryBy Benjamin Streed
June 11, 2012

European optimism was alive-and-well Monday morning after Spain requested bailout funds over the weekend; finally helping to assuage market concerns that the country’s banking system needed additional capital to remain solvent. With this request, Spain becomes the fourth country in the European Union (EU) to request bailout funds since the beginning of the European debt crisis that began three years ago. The country is asking for as much as €100 billion ($125 billion) in funds, which is nearly 3 times the amount mandated by the International Monetary Fund (IMF) to keep the banks operating. In a report from June 8th, the IMF noted that Spanish banks would need at least €37 billion for it banks to help them withstand a slowing economy. Some market participants are hoping that the additional cash funding available to the banks will allow the institutions to finally recognize embedded losses on their balance sheets and help increase investor and depositor confidence in the country’s banking system. In a political faux-pas, the country’s Prime Minister, Mariano Rajoy, recently stated that the country’s banks did not need bailout funds and he will continue to face ongoing fiscal concerns as the country attempts to deal with persistently high unemployment and entitlement reforms. The money lent to Spain will be directed into its so called “bank-rescue fund”, and will in-turn relay it to individual banks after an assessment is completed by independent auditors to determine the needs of each individual bank. Prior to the announcement of the bailout the rescue-fund only had around €5 billion in cash on hand, having been significantly depleted after €19 billion was used to nationalize Spain’s third-largest lender Bankia last month. Although the banking system as a whole appears to have received its “white knight”, the stress tests won’t be completed until June 21st, which could shed yet another cloud of uncertainty over the ongoing banking crisis. Rajoy commented that the country sought a “buffer” of funds above and beyond what is needed since, “the message it sends to the market is much clearer and more forceful”. The ongoing banking crisis in Spain is one of two European events currently straining global capital markets, with the ongoing political and fiscal drama in Greece being the other culprit. The market awaits the results of Greece’s June 17th elections in which the country will potentially determine its fate as an ongoing member of the EU.

Spanish Borrowing Costs Easing 

Inverting Inflation Expectations

The U.S. Treasury Inflation Protected Securities (TIPS) yield curve has experienced an interesting development in the last few months; the front-end of the curve has inverted sharply, pushing 1-year expectations for inflation down to zero percent. As a reminder, TIPS are inflation-indexed securities that are designed to track changes in the Consumer Price Index (CPI) and are generally used as a gauge of investors’ expectation for inflation over the life of the instrument. The analysis below is derived from what is known as the “breakeven” rate, or the difference in yield between a TIPS security and a traditional Treasury bill or note. This analysis is made easier thanks in part to the nearly zero percent yield on the 1-yr Treasury bill which has fluctuated between 10bp and 20bp all year. For example, with 1-yr Treasury yields at zero percent, if investors hold 1-yr TIPS securities with a yield of -1.00%, they are effectively betting that inflation will be at least 1.00% over this period in hopes of “breaking even” relative to the traditional Treasury security. The current inflation expectation of zero percent (light blue circles) is in stark contrast to February (blue boxes) where the expectation was for a rate of at least 2.60% and even contrasts with last month’s reading of 1.00% (blue stars). In simpler terms, this means that back in May the markets thought that inflation would increase by 2.60% per year and have now sharply reversed this sentiment and expect effectively no change in inflation.

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