European government focus - will it stop the sellers?

It has been a busy few weeks for the Eurozone. The recent announcement of a €750bn facility provided by the International Monetary Fund, European Central Bank and European governments was meant to stop the speculation regarding the indebted European nations. Greece is the poster-child for the European bad debt scenario but is closely followed by Portugal, Spain, Ireland and Italy. 

At the same time as the European bailout news, the UK was dealing with the repercussions of a hung parliament. It is too early to say whether the new coalition will provide the long term stability that is required but the initial signs are that tough decisions will not be shirked.

But then, just as I was putting this article to paper, the European Union backed the Alternative Investment Fund Managers (AIFM) Directive that will provide tighter regulation on hedge funds (despite UK opposition). Then the German regulator, BaFin, announced a ban on naked short selling of 10 financial securities and Eurozone government securities. The initial response seems to suggest that this latter step smacked of panic just after the IMF led bailout had provided some confidence in the Eurozone. Certainly other Data Explorers research suggests that the 10 equities involved were not being widely shorted and, in fact, short interest has declined in those names over the last few months.

But let’s have a look at the situation in the bond markets historically and also during the last few weeks while these changes have been taking place. What has been seen and is the trend changing?

Borrowing levels

We wrote earlier this year in Global Pensions on the level of borrowing of a variety of government securities but let’s focus this time on movements in the major markets by analysing the DX Long-Short Ratio.

The DX Long-Short Ratio takes the institutional longs that are made available to borrow through securities lending programs and divides this by what has been put out on loan. Securities lending is a proxy for short selling so we can reduce the fixed income and equity longs and shorts to a ratio which can be indexed.

The charts (right) clearly show the flight to quality in late 2008 as institutional buyers purchased government bonds sending the Long-Short ratios soaring. But we are more interested in the recent activity.

The UK reached almost 2.5 longs for every loan in early 2009 and since then has dropped back to around 2. In early March 2010 the ratio rose to 2.37 but at the time of writing is continuing to fall. This suggests that the UK was perceived to be relatively safe and for some this is still the case as actually long only positions continue to increase. However, the fact that the index is declining suggests that short positions are growing quicker than new long positions. Therefore, perspective on the UK is mixed – actually a normal position in the capital market and not unhealthy.

Was Chancellor Merkel right that European governments are being shorted (naked or covered)? The chart for European governments (ex UK) shows a similar picture to the UK one but the recent fall has been over a longer period. The decline from 2.9 in February has been gradual but constant with the ratio now below 2.5 for the first time in 18 months. The fall seems to be the result of the general negative sentiment and uncertainty in Europe with little sign that the recently announced bailout is making a difference yet. Long only positions are relatively unchanged so shorting is the driver behind the fall.

One thing is sure though – this is a story, and a market, worth keeping an eye on. 

Andy Dyson is a director at Data Explorers; www.dataexplorers.com