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Hugh Hendry’s zero-carry package

Summary:
The euro-bear manager of CF Eclectica Absolute Macro Fund is sounding as bearish as he’s been, post the crisis that made his name.And we can thank the up-coming French Presidential election for that.Hugh Hendry is not forecasting a Le Pen win. But he does believe that if she did win we’d all be looking at the very real threat of a Euro zone break up. That’s especially so after Brexit, which Hendry compares with Britain’s departure from the gold standard, which set in motion a chain of events at the time that saw three-quarters of gold standard members abandoning the system within two years.You can read here gloomy quarterly letter in full here. But the defensive bet placed here is structured as…A ‘substantial position’ on the spread exploding between Italian and German 10 year paper. The

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The euro-bear manager of CF Eclectica Absolute Macro Fund is sounding as bearish as he’s been, post the crisis that made his name.

And we can thank the up-coming French Presidential election for that.

Hugh Hendry is not forecasting a Le Pen win. But he does believe that if she did win we’d all be looking at the very real threat of a Euro zone break up. That’s especially so after Brexit, which Hendry compares with Britain’s departure from the gold standard, which set in motion a chain of events at the time that saw three-quarters of gold standard members abandoning the system within two years.

You can read here gloomy quarterly letter in full here. But the defensive bet placed here is structured as…

  • A ‘substantial position’ on the spread exploding between Italian and German 10 year paper. The spread has already doubled to around 200 basis points over the past year; a narrowing to 100bps would indicate the Germans have accepted full blown monetary union with Club Med, which isn’t going to happen. Meanwhile, BTPs denominated in lira would trade where Italian sovereign paper used to trade in lira — at above 10 per cent yields.
  • Long European senior financial credit; short European bank stock futures. The (well established) thinking here is that as Europe’s banks have had to use dilutive rights issues rather than retained earnings to boost capital ratios, this has steadily boosted the credit worthiness of senior debt tranches.

The second element here is probably Hendry’s most eye-catching call. After a few years of good payout on the long bank debt/short equity trade, bank stocks have rallied sharply on the back of Trumpian reflation, which could be taken as a sign this particular trade has run its course.

But Hendry thinks it’s the banking sector that has run ahead of itself. French presidential hopefuls are promising public sector spending cuts, and there’s not much budget largess elsewhere across the continent to replicate any US-style growth policies. Moreover, allowing Europe’s banks to get back to more normal levels of returns on equity would require proper rate hikes from the ECB, which the poor European economy is in no fit state to bear.

More likely is a scenario where European banks follow the course of Japanese banks when those were finally recapitalised over a decade ago: since then, in Japan, bank’s ROE figures have rarely got out of single figures.

Hendry himself can summarise:

Combining this position with our sovereign spreads creates a zero-carry package matching two ‘bearish’ trades (the sovereign bond spreads and the bank stock futures short) with one ‘bullish’ bank credit receiving position, which we believe offers an attractive ‘crisis alpha’ like payoff profile.

Serious political shocks on the Continent are likely to lead to sharp widening in the sovereign spreads, with falls in the value of bank equity broadly offsetting losses on the credit position. Alternatively, curtailment of the ECB’s expansionary monetary policy would also tend to push sovereign bond yield spreads higher, with the likely negative impact on the economy in countries like Italy leading to more non-performing loans and hence weaker earnings in the banking sector. And in the scenario that Europe manages to stagger through and the status quo persists, we would expect profits from the bank credit/equity spread to offset modest downside from the sovereign spreads.

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Paul Murphy
Paul Murphy is the founding editor of FT Alphaville and an associate editor of the Financial Times. He joined the FT in London in 2006 as development editor of FT.com, concentrating on the expansion of the online business. Prior to that, he served as the Guardian’s financial editor for seven years. He has also held senior positions in business journalism at the Sunday Business newspaper and the Daily Telegraph. Murphy is a graduate of the London School of Economics.