Squaring the Euro Circle

Rehashing some numbers from the Economist (p. 81 November 26th 2011) illustrates the scale of the imbalance poisoning the heart of the Eurozone.

The net foreign liabilities - what business, households & governments owe to foreigners less the foreign assets they own - of Greece, Ireland, Portugal and Spain are close to 100% of their respective GDP's.

Yeap - that's in all all four cases - not cumulatively.

And to quote the Economist: 'Much of their debt is being financed by local bank borrowing or bonds (issued) in creditor countries - such as Germany.'

Now it's no secret that the so-called 'core' of Europe's banks have lent heavily to finance the 'extravagance' of the so-called 'periphery' - but think about this.

As an Irishman I understand the burden that the EU/ECB's brutal refusal - unfortunately reinforced by the farcical Greek misadventure - to contemplate an orderly restructuring (default) of privately owned debt has placed on my countries finances.

Of course it may be a necessary evil - to save the sovereign you must first save their banks? - but lets not pretend that economic consequences are not very disproportionate.

I doubt this circle can hold.

What is a Government Bond?

Quite simply

“It is the ability to print one’s own currency to pay government bond investors back under any circumstances that makes a government bond a government bond, i.e. a (credit) risk- free asset for hold-to-maturity investors,” Elga Bartsch, the chief European economist at Morgan Stanley in London, said in a report this month to clients.

I believe this is as good as any definition.

And, therefore, following comments highlight why the Euro-17 will continue to see their credit-worthiness eroded: 

European Central Bank President Mario Draghi damped expectations that the bank will step up bond purchases to tame the sovereign debt crisis, saying it can’t overstep its mandate.

“People have to accept that we have to, and always will, act in accordance with our mandate and within our legal foundations,” Draghi told the Financial Times in an interview, confirmed by the Frankfurt-based ECB. “The important thing is to restore the trust of the people -- citizens as well as investors -- in our continent. We won’t achieve that by destroying the credibility of the ECB.”

http://www.bloomberg.com/news/2011-12-18/draghi-tells-financial-times-bond-buying-unlikely-as-ecb-abides-by-mandate.html

As oft repeated, the ECB is NOT the Federal Reserve and - to the chagrin of the French - its NOT the Bank of England either.

That's the (terminal) dilemma that must be solved. 

The Geithner Effect

Aside from worrying about his bosses re-election, Mr. Timothy Geither's idea of a 'solution' to the Eurozone crisis is best described in Simon Carwell's  excellent "Anglo Republic - Inside The Bank That Broke Ireland.'

I paraphrase Chapter 19 - particularly page 312.

In mid-November 2010 Ireland's then Finance minister - the late Brian Lenihan - was (privately) negotiating the terms of the nation's impending bailout with the ECB & IMF. To his eternal credit Mr. Lenihan insisted that senior bondholders in Anglo Irish Bank & Irish Nationwide (Building Society) - both bust; both nationalized - should face substantial haircuts. The deeper the haircuts, the lower the already onerous cost of the bailout.

The IMF - to their credit - believe 'lenders should pay for their stupidity before it has to reach into its own pocket'  - a quaint, seemingly old fashioned idea unless you are a ordinary home owner - and presented a plan that would impose haircuts of up to 2/3rd's upon Euro 30billion of unguaranteed bonds. Lenihan was reportedly 'overjoyed' and told the IMF: 'You are Ireland's salvation.'

Its worth noting that this 'notional saving' of Euro 20billion represents 10-15% of Irish GDP (depending on your timeline) and almost equals the (2008-2015) fiscal adjustment. This is not a small (relative) number.

According to Morgan Kelly (a well known Irish academic/economist - writing in the Irish Times) the IMF's proposal was: ''torpedoed by US Treasury Secretary Geithner, who 'believes bankers take priority over taxpayers.' Unsurprisingly, the US government denied Kelly's account, but Irish government sources confirmed senior European figures were also strongly opposed to burning senior bondholders who had lent money to Irish banks.

As Carswell writes - we will never know. But we do know: 'that every key event from the guarantee (September 2008) to the EU-IMF bailout (November 2010) was structured in a such a way as to make the Irish taxpayers responsible for the massive private losses of the banks and for protecting the vast majority of institutions and investors that lend to them.'

Earlier today Mr Geithner proclaimed; 'Financial crisis are resolved when governments and central banks create conditions that make it compelling for investors to take the risk involved in lending to governments and banks.'

Earlier today Martin Wolf (FT) wrote (amongst much else): 'The decision (the so-called Merkozy compromise) seems to include not compelling private bondholders to take losses on Eurozone bailouts.'

Geithner (& the ECB) have had their way. Greece is 'an exception.' For now.

When these guys talk austerity - they mean it.

Fiscal Liasons

Are we just waiting for the last of the fix of hope-pium to fade?

Whether the ECB commits to some larger scale bond buying/yield limiting program (absence signed and sealed Treaties (with referendums) - not loose intergovernmental commitments - I find this very improbable) OR it simply continues to provided the banks with every which way to finance their (collateral) balance sheets (& they could & should cuts rates again) - does it change the underlying dynamic?

The ECB will liquify the system, buy time (& 'some' bonds) and attempt underwrite the worst of the austerity risks -  but it will not (can not) bail out any member states sovereign debt. One thing is abundantly clear - as far as the Germans are concerned - you borrowed it, you owe it and you will pay it back. However long it takes.

As an Irishman I feel somewhat informed as to how this type of fiscal adjustment will work. The Irish economy has shrunk by 15% since 2008. The government has cut spending and raised taxes by a similar amount. Unemployment stands @ 14.5%. Our deficit will be 10% of GDP in 2011. Best scenario we are looking at 3-4 more years of the same. And we mock our own quiet acquiesce.

Not unsurprising the EU see's us as 'poster boys' for good ('take your well deserved medicine') behavior and takes solace in the robustness our external sector. They think austerity works. They think 'problem' was solely created by the extravagance of the peripheral. They resolutely defend their banks by forcing other counties taxpayers to make their lending whole.

Rightly or wrongly I am skeptical other nations (for example - Italy - with a growth potential of close to ZERO) can travel this road. But then I don't believe the Germans (& French) seriously expect anything like all 17 to survive a  souped up Stability Pact. History (study Latin America) suggests there will be defaults in coming years - but I doubt the ECB, the EFSF/ESM or - more particularly - the German taxpayers will pay for them.

So whenever happens - whatever the market wants to believe for 5 minutes - Thursday/Friday will bring further clarity. I strongly suspect the Euro will survive. But the number of members is to be determined. And the economic cost will be high either way.

Sequence This

Last Thursday (November 24th) I posted 'Inferring the truth' - and suggested a Eurozone 'solution' (of sorts) was in the making and given the market's sentiment a sharp rally was highly probable.

I wish I'd taken all (not just half) of my own advice.

Now we've seemingly spun a full 180 degrees what's next?

Discount the EFSF and other proposals - there'll be a lot more more fudge and fuddle - and you can see the outlines:

 - The Germans (and the French) are driving for full blown - sanctions, veto's et al - fiscal union;

 - They will try to circumvent the democratic (political/referendums) process;

 - We will hear a lot more about the Schengen Agreement, Protocol 14 and other legalistic maneuvers;

 - The minimum objective (December 9th) is that the 'core' (& Italy's unelected government) sign up.

This is all very plausible.

But will it provide the 'political cover' - enough crime and punishment - for the Germans to sanction greater ECB involvement &/or the issuance of some type of 'stability' bond?

Well, that depends.

How many countries will sign away their fiscal independence without any democratic mandate?

How many won't?

Is the ECB ready to commit? And to what?

Will the German Constitutional Court (& others?) re-enter the arena?

I could go on, but the point is obvious:

Fiscal union is the end-game and it probably does unleash the ECB, but getting there - legally? - with all 17? - is going to be extremely difficult.

Either way the problem (shifted onto the ECB's balance sheet) remains and Europe faces a grim (austere)   year or two (if its lucky.)

I see two scenarios:

(1) Markets rally on, European equities complete 'a-b-c' (.618 fib) corrections to the 2011 sell-off into year-end, and a new bear market begins in early 2012.

(2) Markets fail here and it all unravels very quickly.

Inferring the Truth?

Now everyone is agreed.

Now everyone understands the complexities.

It's time to re-assess.

And today - the German press, opposition, Monti appearance, Sarkozy's 'favorable compromise' - gave me much to contemplate.

For non-Europeans, particularly US-centric investors/traders, this has been already been a difficult journey. But, as an Irishman and long(ish) time market participant, I'd advise you not expect a simplistic outcome. In fact I suspect this 'crisis' could be about to get even more convoluted.

German policy makers might be doctrinaire but they are not naive. They know the consequences of a disorderly Euro break-up but they are constrained by (German) public opinion & their assertive Constitutional Court. However, this does not mean they cannot utilize increasing tensions (& yesterday's Bund auction might be pivotal) to coerce popular opinion towards some fiscal concession.

I've consistently dismissed the illusion the ECB would 'do a Fed' &/or there could be some ready made Eurobond solution. The belief in either solution was born of hope &/or a poor appreciation of European (Germanic) history &/or treaties.

In my humble, I was also highly skeptical of the notion the EFSF could be 'leveraged' into an effective firewall. Without increased (hard cash) commitments from the core that was never plausible.

All this is now well understood, but that by no means assures the mutual assured destruction of the Euro.

Far from it.

The Germans (& the the more mercurial French) are not going to walk blindly into the night. I believe there is yet another 'solution' in the making.

I admit the following is pure conjunction - my own opinions - but please consider the probabilities & the implications for your trading/investing.

The 'solution' won't be a TARP-like 'big bazooka.' It won't involve splashy $trillion-type numbers. It will be fiendishly complex - even for nerdy Europeans. And it might even work.

It will seep out, but in short, the Germans are looking for cover. And the cover will be:

(1) A legalistic agreement to implement 'treaty changes' that impose penalties, constraints, and the appearance of 'Fiscal Union';

(2) A <done> deal that irrevocably taking the ECB out of the money printing business - unless your a commercial bank of course.

This will supposedly restore the 'trust' Merkel says has be missing, provide the political spin, and pave the way for some type of 'Stability Bond' - a second tier of government bond issuance (promoted by several economists) &/or additional backing for the EFSF &/or some derivative of a derivate of ......

For the record - I remain deeply skeptical the Euro can survive with or without serious damage to the European economy.

But I don't under-estimate their ability to 'kick this down the road.'

Watch the bearishness. And stay tuned.

Caution Horses

I'm uncomfortably out of the bearish (European-centric) trade.

Technically & sentiment-wise (when everyone gets it?) I feel a bounce is probable.

But more accurately I don't like the risk-reward right here/right now.

Yesterday's SPX weakness made for a tough day, but ironically the 'reason de jour' - the 'failed' Bund auction - may provide the catalyst for a little hopepium.

I'm not sure the auction represented anything other than investors recoiling @ sub-2% yields (six of the last eight 10 year auctions have technically failed) but it was probably poor enough to spook the fiscally conservative horses.

In the coming days I suspect we'll see more Bild-like stories supposedly 'softening' the German resistance to the  EuroBond solution.

This is a long-term aspiration, but hope is all the markets have.

Enough to re-test the recent neckline breaks in European equities?

Full Disclosure

For the first time in weeks 'hopepium' has been replaced by cold truth.

Even the most contrarian thinker/tailor/trader has had to accept the ECB will not be doing a Gandalf - suddenly appearing on the ridge and  riding to the Euro's rescue.

The Germans have drawn some type of inverted Maignot line and believe it will hold.

The pragmatism is almost admirable.

They might be even be right.

But it won't work.

I believe the probability of a full-blown existential 'will the Euro survive' &/or 'who will be left inside' crisis is now very high.

The opportunity to leverage the EFSF is diminishing by the day & France has already effectively lost its precious 'AAA' rating.

The economic & political pressures will continue to build in the peripheries and they will seep dangerously into the core.

Greece might pre-empt everything if Samaras continues to play dare with the 'troika' but I suspect the final installment of the first bail-out will be paid to buy a little more time.

Be patient - respect the fact that now everyone 'gets it' the bounces could be nasty - but time is limited.

As Martin Wolf (FT) observed - the only question is if and when the Merkel & the ECB blinks.

Trust the Technocrats?

Wolfgang Munchau (FT - Monday November 21st 2011):

'The consensus view that the crisis can be solved by technocratic governments imposing structural reform and austerity ......

That proposition is, in my view, INSANE (my emphasis) ......

And any case it will be tested shortly.'

Quite.

Feet to the Fire

The reality?

An increasing sense the German's have enough.

No more short-term fixes. No more equivication (if there ever was?)

Its the hard way. Or ......

Guido Westerwelle's (Germany's Foreign Minister) writes in this morning's FT:

'Only when states regain trust by immediate and through reforms, can the crisis be overcome.'

And:

'Putting the ECB's printing presses to work might at best bring short-term relief. But it will have dire consequences, both raising inflation and dissipating vitally important incentives for reform.'

The Bundesbank quickly re-iterates the ECB will not underwrite any quick fix:

'The economic costs of any form of monetary financing of public debts and deficits outweigh its benefits so clearly that it will not help to stabilize the current situation in any sustainable way,' Bundesbank President Jens Weidmann, who also sits on the ECB’s Governing Council, said in Frankfurt today. 'The lack of success in containing the crisis does not justify overstretching the mandate of the central bank and making it responsible for solving the crisis.' <Bloomberg>

What does this mean?

(1) Limited ECB bond buying (= maximum Euro 20 billion a week) & continued steralization.

(2) Nothing less than severe (fiscal) austerity throughout large chunks of Euro-Zone.

The Euro may survive. It may not.

But either way the economic adjustment is going to be VERY painful.

Cause & Effect

So, in Greece and Italy the technocrats are now in charge - well sort of - but what difference does it make?

At the margins? Some.

But read Wolfgang Munchau's (Monday's FT) 'The only way to save the Eurozone from collapse' ......And face the reality.

Some sort of pseudo-ECB-backed-Eurobond has always been the only solution, but Merkel (perhaps correctly) continues to dismiss the idea and the ECB (as they told you so) is determined to demonstrate they are near their bond buying limit.

Meanwhile, the prospect of meaningfully leveraging the EFSF is diminishing by the day, the whole notion of 'expansionary austerity' is a non-sense, Europe is hurtling towards recession and bond yields are creeping ever higher.

Given Merkel's party congress rhetoric its easy to assume that the so-called 'hard core' are now planning for hard exits. That sounds politically plausible (if legally impossible) but I suspect they no not what they do.

Europe is sliding towards dangerously unintended consequences.

German Economic Policy

With thanks to 'The Macro Man' .....

German economic policy essentially consists of:

1) Tight fiscal policy to crush any signs of a recovery.

2) Tight monetary policy to crush any signs of recovery.

3) Tie yourself to some profligate countries so that you have a cheap exchange rate and can sell shedloads of exports.

4) When the countries you provided vendor finance to start having trouble paying you back insist that they follow 1) and 2).

5) Wonder why everyone hates you.

http://macro-man.blogspot.com/

The Best They've Got?

Beyond returning to the scene of the crime - Euro membership - as Mr. Sarkozy would have it .....


Not sure this inspires great confidence:


Papademos will now have to deal with an issue that he acknowledged a year ago. Last Nov. 10 he said that while fears Greece would restructure its debt were overestimated, they couldn’t entirely be ruled out. In May, he told the Wall Street Journal that “haircuts” for holders of Greek debt should not be part of a rescue package. The accord agreed to on Oct. 26 by European leaders includes a 50 percent writedown of Greek debt.


http://www.bloomberg.com/news/2011-11-10/papademos-who-took-greece-into-euro-must-now-save-country-s-membership.html

Addicted to Hopepium?

Three VERY Uncomfortable Truths

http://www.bloomberg.com/news/2011-11-10/ecb-s-knot-says-central-bank-can-t-do-much-more-to-resolve-debt-crisis.html

Uncomfortable Truth I:

While the central bank has so far bought 183 billion euros ($249 billion) worth of distressed nations’ bonds, it says the purchases are aimed solely at ensuring its interest rates are transmitted on financial markets. To prevent the purchases from fueling inflation, it sterilizes them by draining the same amount of money they create from the banking system.

Knot said the ECB can maintain its bond buying as long as it can continue to remove the same amount of money from the system. “The bigger the portfolio, the more difficult that becomes,” he said. “Interventions can only have a temporary and very limited effect,” Knot added.

Rabobank economist Elwin de Groot estimates there is a “natural limit” of 300 billion euros the ECB can sterilize.

Uncomfortable Truth II:

Bond buying with the aim of bailing out a government is monetary financing and prohibited by the euro’s founding treaty, Bundesbank President Jens Weidmann said this week. He citedGermany’s experience of hyperinflation after World War I as a reason why such action should never be contemplated again.

“That’s absolutely, clearly beyond the mandate of the central bank,” Praet said in comments posted on the Debating Europe website today.

Uncomfortable Truth III:

The ECB is “not the lender of last resort and I wouldn’t advise European governments to ask the ECB to become the lender of last resort,” Stark said in Frankfurt last night. “This will mean that the ECB will immediately lose its independence.”

Italian Austerity

The measures presented to the Senate last night include a pledge to raise 15 billion euros ($20 billion) from real estate sales over the next three years, a two-year increase in the retirement age to 67 by 2026, opening up closed professions within 12 months and the gradual reduction in government ownership of local services.


http://www.bloomberg.com/news/2011-11-09/italy-s-senate-speeds-austerity-vote-as-berlusconi-prepares-resignation.html

His main coalition partner, the Northern League, said the party would not accept a temporary, technocrat government and would push for immediate fresh elections.

"We think elections are the only way, the only solution for the country," spokeswoman Nicoletta Maggi told the BBC. "The people must decide who is going to rule them, nobody else, through the vote."

http://www.bbc.co.uk/news/world-europe-15631265

Greek Probabilites

So, Panpandreou survives (again?) with a 153-145 majority.

But the 'government' needs 180 (of 300) to secure parliamentary approval for the October 26th second aid package.

This will require a 'national government'  - and after this weeks gamesmanship this appears increasingly unlikely.

“The masks have fallen,” Antonis Samaras, head of the New Democracy party, said in an e-mailed statement from his Athens- based office today. “Papandreou has rejected all of our proposals. The responsibility he bears is huge. The only solution is elections.”

Without compromise it either be snap elections &/or Panpandreou trying to find 180 votes.

In which case - outside the news cycle babble - what price (probability) would you (the market) place on the validity of the following analysis?

“I would be very surprised if Greece doesn’t default in the next few weeks,” Lex Van Dam, who manages $500 million in assets at Hampstead Capital LLC in London. “I cannot see how the Europeans will pay the next tranche knowing that the Greeks will try and renegotiate the rest of the original Oct. 26 package once this payment has been made.”

Come Monday - without some mildly convincing form of grand coalition - I suspect it'll be uncomfortably high.

Quotes: http://www.bloomberg.com/news/2011-11-04/papandreou-is-prepared-to-step-aside-if-he-wins-confidence-vote-in-greece.html

Legals

EU treaties make no provision for a country to exit the currency, and the European Central Bank’s legal department said in December 2009 that an expulsion “would be so challenging, conceptually, legally and practically, that its likelihood is close to zero.”

A Little Context

Bloomberg earlier today: 


“The vehicle that’s supposed to borrow on behalf of countries that can’t borrow, can’t borrow,” said Gary Jenkins, head of fixed income at Evolution Securities Ltd. in London. “They should be able to tap the market under any market conditions and it should just be a matter of price.”


You almost couldn't make this up, but it is true - and true because the EFSF 10 year currently yields 3.30% - which is 130bps over Bunds.


That doesn't that sound like 'AAA' rated issuance. Not now. Not with unresolved leverage and structural issues.


This is important because - after Greece - Willem Butler estimates there is Euro 300bn <at most> left of the original EFSF loss absorption commitments/guarantees. 


And Italy - with 10 years stubbornly above 6%,  the last auction barely covered and concerns investors may avoid debt not issued under the new 'insurance' plan - needs to roll over Euro 300bn (of its Euro 1.6 trillion debt) in 2012.


The ECB has already bough Euro 70bn of Italian debt in its bond buying program. 


Per my earlier post ('Endgame Scenarios') Mr. Draghi's patriotism is going to be fully tested.

The Endgame Scenario

I have believed the Euro will survive .....

BUT only after a truly 'existential' crisis threatens its survival.

I believe that level of crisis lies ahead of us ......

BUT I'm less confident in my belief the Euro (certainly not with 16 members) will survive.

I'll defer to the impressive Willem Butler (FT: November 2nd) to outline the increasingly probable binary outcomes:

'The choice, sometime in 212 or, at the latest, 2013,  will be between a collapse in the euro area and the larger scale quasi-fiscal abuse of the ECB.'

Why?

Because 'using the ECB would be opaque, quasi-fiscal, off-budget and off balance sheet for national Treasuries.'

I strongly suspect the ECB (& the Germans) know this.

The question is how and IF we get there.

The Time & The Place - MTM

Briefly ....

Short 'Risk' = SPX; EURO 50 (or DAX) ; EURO & AUD$

Up 2+% from 'entries' on October 27th.

Carrying 1/2 position over close tonight.

Committed to core short but cautious around spiky reversals.

Patience .....

Minimum ( = enough to justify trade) targets:

SPX @ 1100
EURO-50 @ 2060
EURO @ 1.3300
AUD$ @ 0.9600

‘Whole Different Ballgame’

“If the Greek people don’t see the necessity of backing Papandreou we have a whole different ballgame,” Otto Fricke, the budget spokesman in parliament for Merkel’s Free Democratic Party coalition partner, said by phone. “If he doesn’t get a majority, then there’s no second aid package, no voluntary haircut. We’d have a potentially explosive situation, one that leaves us today baffled as to what we could possibly do next.”

THE TIME & THE PLACE?

Full of bearish intent ..... 

I've chopped about the last month with negligible PNL and strong opinions VERY weakly held as the markets waited upon some 'European cartharsis.'.''

Today - post 'THE solutions' - my MICRO and MACRO patterns converged: 

SPX  - 1265 

EURUSD - 1.40+

AUDUSD - 1.05+

DAX - 6200

Markets have/are certainly testing the boundries of my margin of error ....

But you gotta do what you gotta do.

Mixed execution during the day ......

But full trade (=2% Equity Risk) on at/above MY levels.

Approaching the close looking to stay alive through the weekend.

Thinking one of the innumerable moving parts in the still unfolding European melodrama might still wipe the smile from what must be an extremely self-satisfied Frenchman.

Merkel's Mandate - Revisited

Originally written on the 29th September - more relevant then ever?


The Bundestag is about to pass the EFSF legislation with a thumping majority but be very careful how you interpret this vote.

Rather than endorsing the urgency for a more expansive solution to the rolling EuroZone 'debt crisis'  ..... this legislation has passed on solely Germanic concerns.

Two contributions (both sourced from the FT) warn of the (unintended?) second order consequences of this vote.

First - Schaeble (Finanace minister): 'insisted the EFSF would not be secretly boosted by financial leverage ...... it will not be increased ..... that is not under discussion.'

Second - and arguably more profound for the future of the Euro - Norbert Barthle (CDU Budget Spokesman):  'the new law - with its commitment to give the German parliament a vote on all future changes in the EuroZone crisis measures - mean a totally new form of Democratic legitimacy for the EU legislation in Germany.'

If I was the most rabid Germany Euro-sceptic ..... I would have voted for this.

German (democratic) populism will now decide. And that's a good thing - right?

Third order consequences to follow.

The Price is THE News

As we pop higher once again I reminded that very rarely has this familiar trading expression been so true.

This week's 'news/rumor' flow surrounding the EuroZone crisis has been almost farcical.

Every 'wishful' political utterance has been validated, every hard fact ignored, and markets continue to chop at & just below their 'recovery' highs on the belief some Tarp-like 'bazooka' can be found.

In my opinion - whatever is finally cobbled together won't be enough to satisfy the markets 'thank god that's all sorted out' desire. I don't know how it plays out, but in my opinion this is a long way from over.

I believe the art of trading is too manage your risk, respect ongoing price discovery, and take your positions where the potential reward justifies the actual risk.

With humility - all my set-ups look bearish.

Testing