Since our last post about a month ago, markets around the world have rallied strongly, based on perceived better news out of Europe, but also stronger U.S. economic data, as well as hopes that the Federal Reserve will institute another Quantitative Easing Program (QE 3?). We will try to catch up on some of the developments that have occurred over the past few weeks, as well as what is currently going on.

LTRO – What is this?

 
No, it does not stand for Lord of The Rings Online, it is the acronym for Long-Term Refinancing Operation (LTRO). Without getting into too many of the gory details, the European Central Bank (ECB) regularly conducts these open market operations as a means of implementing monetary policy and controlling short term interest rates. In late December with yields on European debt from countries such as Italy and Spain skyrocketing ( due to risks of default), the ECB announced that they would loan money to European banks at 1% to allow them to buy the high yielding debt of many of the Euro nations. Since the banks are able to borrow money at 1%, they are able to buy debt such as 6 month notes from countries like Italy & Spain which are yielding much more than 1% and make a profit on the difference. The banks can then pledge this new debt as collateral to the LTRO.

A simpler way to think of this is summed up nicely by Edward Harrison of the firm Credit Writedowns,

“So what the ECB has done with the LTRO is that they are providing liquidity to banks that must use government IOUs as collateral for that liquidity. Essentially, the ECB is winking to banks that it will provide them liquidity out to three years for lesser collateral (read: Italian bonds) as long as the fiscal austerity union is still in play. That means that the ECB’s providing bank liquidity is really a back door way of allowing the Italians to roll over their debt at less painful rates. This is otherwise known as monetization. You give me euro area government collateral and I give you free money for the next three years. That’s what LTRO means.”

Since the LTRO in late December, markets around the globe have rallied sharply as investors perceived this move has taken a systematic banking crisis off the table in the short-term by addressing the funding problem and the liquidity crisis in the European banking system. However, the longer term risks still remain, especially if a country such as Italy defaults or there is a run on European banks. As we have said before it is more kicking the can down the road.

Why does Greece want to swap their debt with their bondholders?

Meanwhile, Greece has a 14.5 billion euro ($18.5 billion) bond coming due on March 20, which they are not going to be able to pay on. Thus they need to find a way to come to an agreement with the bondholders to swap the existing debt with rather high interest rates for new longer term debt with more manageable interest rates. They need to work quickly though, since the paperwork to get this accomplished reportedly takes at least 6 weeks. This is all part of a plan to get the Greek debt burden down to a more manageable level by the year 2020.

Greece – Selective or Outright Default:

If Greece is unable to come to an agreement with the holders of its debt, primarily Europe’s largest banks, and a plethora of hedge funds and the European Central Bank (ECB), things could get rather messy. If they fail to agree and are unable to pay the principal to the bondholders on March 20th, since they don’t have the money, then the conditions necessary to secure its second bailout are not met. Some of the ratings agencies also believe that Greece is going to default on its debt, but are not sure whether it will be an orderly (Selective) default or a hard (outright) default.

A selective or orderly default would be one where Greece is able to get the bondholders to swap their existing debt for newly issued debt with more manageable (lower) interest rates. By doing this the bondholders would end up taking losses (haircuts) on the debt they own, and would voluntarily write down the losses which could be greater than 50% ( and even up to 70% or so) on the bonds. Markets currently appear to be pricing in an orderly default.

If no agreement can be reached, then a hard or outright default would occur as Greece would be unable to repay bondholders the principal on the maturing bond. This is also known as a disorderly default and is something that is not likely priced into the markets and could possibly disrupt the global financial system much like Lehman Brothers did in 2008. This could also tip the precarious world economy into a recession. No side wants to see this happen, but the hedge funds that own a large portion of this maturing debt seem to be driving a hard bargain and may have the upper hand. Greece had offered a 3.5% interest rate on the new, longer dated debt that would be swapped for the old debt, but the hedge funds and banks do not appear too enamored with this and are looking for something north of 4% or so. The 3.5% rate does appear to be rather low when you consider that long term US Treasury notes (30 Year) currently yield around 3.15%. So it appears the Greek creditors are not afraid of the hard default if there is no agreement by the end of the week. Most of them are hedged in the event things in Europe get nasty, so they may not be in such a bad position anyway.

If the swap were to go through with the 3.5% long term rate, it is anticipated that once the bonds trade in the open market the yields would instantly go to around 20% or so (because the long term Greek financial situation is still going to be dire), and the bondholders would have immediate losses of greater than 80%. Remember when bond yields go up, prices go down. So you can see why the hedge funds are reluctant to agree to this 3.5% rate and are demanding a higher rate.

So, the next few days and weeks should be interesting to see which way the negotiations go. Right now markets do not seem too concerned with the proceedings, but things can change on a dime if an agreement on the debt cannot be reached and the prospects of a hard default become more of a possibility. It will be interesting to see how other struggling countries such as Italy, Spain & Portugal react as well as the European economy which already appears headed for a strong recession, because of the credit crisis and the austerity measures to try to get things under control.
Stock markets are screaming higher right now, but valuations and sentiment indicators are getting near extreme levels that have signaled tops in the past, so the odds are increasing that some kind of pullback is likely in the cards in the near future. Don’t look now but bond yields in Portugal are up where Greece’s bond yields were a few months ago.

What Does the Federal Reserve Decision to Keep Rates Low through Late 2014 Mean?

The Federal Reserve held their regular committee meeting this week and released a statement that they are going to continue to keep short term interest rates low through late 2014. Last year, the Fed stated they were going to keep rates low through 2013, so this is extending that time frame of very low interest rates.

Apparently, Ben Bernanke and his friends at the Federal Reserve do not seem as excited by the improving U.S. economic data as some analysts do, so they intend to keep interest rates low to continue to try to “goose” the economy. This will continue to impact savers and retirees living off income, as rates will likely continue to be historically low for some time yet. The imminent rise in interest rates that almost everyone continues to say is just around the corner will continue to be “just around the corner”, that corner likely being at least 2014.

This will also keep mortgage rates at historically low levels, so there is no rush to run out and buy that house right away because mortgage rates look to stay low for some time yet. Plus, the housing market still looks to be in a state of decline for the most part. So when that realtor or mortgage broker is trying to persuade you to pull the trigger on that new home, because rates cannot stay this way for long, do not let that rush you into a decision. Low mortgage rates should be around through 2014.

It also means that inflation remains subdued for the time being and longer term inflation assumptions are also tepid. Of course, if the economy really does get a head of steam, and employment picks up, inflation could pick up before 2014, but right now it does not appear to be a high probability event.