Turky and IMF End Aid Talks

In a long engagement, Turkey and the IMF have been negotiating a stand-by package for well over a year. Today Turkey announced that there would be no marriage afterall--no deal. The impasse appeared to be over municipal expenditures. PM Erodogan's government had previously negotiated two programs with the IMF since coming to power in 2002.

There is disappointment in some quarter of the end of the protracted talks as some suggest the talks themselves had lent support to the lira and the bond market. As noted yesterday, the poor inflation news at the end of last week, coupled with the heightened political anxiety and withholding tax uncertainty have weighed on Turkish bonds. Yields yesterday rose to their highest for the year amid a lukewarm reception to the bond auction and there is follow through selling today.

Turkey does not have a long-term bond. It's benchmark 2-year bond yield is at 9.52%, up 6 bp today. For the year to date, the yield has risen 33 bp, the same as Portugal's 2-year bond and well behind Greece's 133 bp increase this year. Portugal's 2-year yield remains a lowly 1.75%.

The euro has fallen about 2.5% against the lira year-to-date and currently is trading near TRY2.092. Buying 2-year Turkish bond and selling the 2-year Portugal bond bond against it picks up 775 bp annualized. The risk of course on such a trade is that the euro rises against the lira. A roughly 5.5% euro rise would bring it to the 61.8% retracement of the decline recorded since late November (~TRY2.2150). More immediately, the TRY2.12 area may cap euro uptick.

Our correlation work suggests that euro-dollar and euro-lira are not tightly related. The correlation (conducted at on the basis of percent changes)was about 33% last year and has eased to about 25% this year. That said, our bearish outlook for the euro may limit the euro's ability to rise against the the lira, making the "buy Turkish 2-year against Portugal 2-year" an interesting trade idea for some medium term investors.

ECB and Greece

Bundesbank President Weber has been the most candid to date about what the ECB could do in case Greece is downgraded again, especially by Moody's. Recall the problem: Prior to the crisis, the ECB would take as collateral only paper rated A- or better. During the crisis they have extended it to BBB-. It is due to revert back at the end of the year. Fitch and S&P rates Greece below A-, leaving only Moody's above the normal threshold.

The ECB seems to loathe to postpone the return to normalcy again. And yet as Austrian central banker Notwotny pointed out earlier this week, it seems unfair and untenable that a single rating agency determines whether a sovereign has access to the ECB's lending facilities.

A solution, Weber suggests, could be that the ECB accepts the lower quality of collateral in exchange for a larger discount--or what the market calls a haircut. There is precedent. For example, some non-sovereign securities used as collateral are given a 20% haircut.

Weber acknowledges this is not the only solution, suggesting that this is a dynamic situation and the ECB has not made any hard and fast decisions. At the same time, it indicates that although many ECB members, like Weber himself, are insisting on a narrow construction of the Maastricht and Lisbon Treaties, it is not above using monetary operations to assist fiscal objectives.

For example, some of the 12-month money the ECB provided at 1% appears to have been used in part to finance the purchases of European sovereign debt. Indirectly, but no less significantly, the ECB helped support the weaker credits in Europe. On July 1st the ECB's 12-month massive 442 bln euro provision expires. The ECB will seek to smooth this out by offering 6 month funds at the end of March and then a special tender at the end of June.

Meanwhile, reports suggest that Greece has made an early preliminary report to the EU (due March 16th) that claims that it is ahead of schedule in implementing its austerity measures. It is said to acknowledge that, as we pointed out, Greece's 2009 GDP was revised lower and that this lowers the 2010 base. Accounts also suggest that report notes that civil servant wage cuts will will crimp consumption. This is one of the ironies. Efforts to address the structural deficit risks adding to the cyclical deficit.

The markets have responded favorably to these developments and Greek bonds and the other weaker credits in the euro zone have rallied. Ten year yields are off 2-4 bp and credit default swap prices have eased. Note that current market conditions appear favorable for new issuance and there is already talk that Greece could come back to the market as early as next week to raise more funds. Last week's bond sale and the next ones, are part of the official effort to pre-fund a good part of the more than 20 bln euros in maturity and coupon payments due in the April and May period.

The euro has also moved higher on the news. Resistance at yesterday's high near $1.3635 needs to be overcome to spur a retest of the week's high near $1.3705. While many would like to see a near-term euro bounce to sell into, the shallowness of the upticks, given the more positive developments in Greece, over the past week disappoints.

China

China reported stronger export and import figures for February than expected, with the net result of a smaller than expected trade surplus. In fact, February's trade surplus of $7.6 bln is the smallest in a year and a bit more than half of the January surplus. This is consistent, however, with an under-appreciated development that we think is important. In terms of global imbalances, the US trade deficit and the Chinese trade surplus have been roughly halved as a percentage of GDP over the last couple of years. In the US case, it seems largely cyclical and the growth differentials that we expected to close the output gap in the US before Europe and Japan will likely see the US trade deficit grow again, though from a lower base. In China's case, the possibility of a structural shift is greater, though too early to tell. China's exports rose 45.7% in February from the depressed year-ago levels. Yet this is more than twice the pace in January and may also have been distorted by the earlier lunar New Year. Imports jumped almost 45%, better than the 39.7% expectations, but well off the mind-boggling 85.5% pace reported in January. There are several implications of today's Chinese trade report. First, with foreign demand improving and domestic demand still appearing robust, it can only add to the near-term inflation pressures. CPI figures are due out as early as tomorrow and the expected 2.5% year-over-year pace would be the fastest pace in 16 months and spur the already growing expectation for a PBOC rate hike. In this regard, note that China reported that commercial and residential real estate in 70 cities rose at an almost 11% clip, which plays on fears of over-heating. Second, although the US Congress is seeking action to try to pressure China into allowing its currency to appreciate, the decline in China's trade surplus makes it all the more difficult for the Obama Administration to cite China as a currency market manipulator in next month's Treasury report. There has been some speculation that China would be cited as the Obama Administration seeks to preempt Congressional action and seeks to get support for some of the outstanding free trade agreements. Some observers note the weapon sales to Taiwan, the Dalai Lama visit to Washington and the trade frictions all as signs that the Administration is edging toward a more direct confrontation with China. Meanwhile, the 12-month non-deliverable forwards are fairly stable today, ahead of more macro economic data; implying almost a 3% appreciation of the yuan over the next year. We suspect that a rate hike is still several months, with additional administrative moves, like the increase in reserve requirements and tweaking money market rates, continuing to be seen first.