Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Tuesday, 3 April 2012

TARGET2 Trade Idea

The Trade: Buy Germany 5Y CDS vs selling UK 5Y CDS

The rationale:
  1. TARGET2 imbalances mean that the official sector in Germany and other northern European countries is funding current account deficits in peripheral countries and replacing private capital fleeing out of those countries.
  2. The Bundesbank had €547bn worth of TARGET2 assets in Feb-12 (up 70.6% YoY). This is largely balanced by liabilities incurred by peripheral central banks.
  3. As I’ve said earlier this can end in one of two ways:
    1. Fiscal/wealth transfer (one example being through writing off TARGET2 liabilities)
    2. Disorderly breakup and capital flight out of the entire Eurozone
  4. Unless the ECB monetises, in each case Germany’s fiscal position will be worsened.
    1. The positive outcome of a more integrated Europe means that Germany foots a large part of the bill.
    2. The negative outcome of EZ breakup or exit of some members means that Germany suffers losses on its TARGET2 exposure.
  5. In contrast, UK does not suffer from this problem. A Eurozone crisis will also impact UK but to a much lesser extent than Germany.
  6. Additionally, UK not only has full control of its monetary policy (Bundesbank may influence but cannot dictate to the ECB) but it is taking the path of Sterling (GBP) depreciation and inflation to reduce real debt burden.
  7. Therefore credit stress in the UK will mostly be borne through Sterling (GBP) depreciation.
  8. In contrast, credit stress in Germany will be reflected in yields (in the fiscal/wealth transfer case) or in CDS (in event of monetary breakup and associated banking costs).
  9. Shorting bunds is not equivalent to buying CDS since flight to quality and need for collateral can lead to a rally despite credit deterioration.
  10. At a 10bp differential (Germany @ 72bps and UK @ 62bps), the trade is a great low cost way to be long volatility and hedge against EZ event risk. 

1 comment:

  1. The documentation of the complete TARGET2-debate: http://www.robertmwuner.de/materialien_euro_literatur_target2.html